Five reasons 2019 turned out well for investors & key views on markets for 2020

2020 – a list of lists regarding the macro investment outlook

Key points:

  • Despite ongoing bouts of volatility, 2020 is likely to provide solid returns, albeit slower than seen in 2019.
  • Recession remains unlikely (it’s a bigger risk in Australia) & so too is a long deep bear market in shares
  • Watch US trade wars, the US election, the US/Iran conflict, global business conditions indicators, and monetary versus fiscal stimulus in Australia.

Introduction

After the poor returns for investors in 2018, 2019 turned out surprisingly well with average balanced growth superannuation funds looking like they have returned around 15%.

But can it continue this year? Particularly with an intensification of the US/ Iran conflict adding to global uncertainty and the drought and horrendous bushfires further weighing on the Australian economy. Here is a summary of key insights and views in the investment outlook in simple point form.

Five reasons 2019 turned out well for investors

2019 saw slowing growth and weak profits amidst an escalating US/China trade war and tensions with Iran and yet it turned out well for investors. Here are five reasons why:

  • Easy money – central banks eased monetary policy in response to the growth slowdown and various threats to growth reversing the tightening seen in 2018.
  • Cheap starting point for assets – after the falls of 2018 shares started 2019 cheap and they and other assets were made relatively cheaper as interest rates & bond yields fell.
  • The crowd was very gloomy at the start of 2019 with much fear about the outlook – when this is the case it’s always easier for assets to rise in value.
  • While geopolitical threats remained high there was some relief by year end – with the US & China reaching a Phase 1 trade deal; Iran tensions not seeing a major or lasting disruption to oil supplies; and a hard Brexit avoided for now.
  • Global growth was not as bad as feared – despite a mid-year recession obsession as yield curves inverted. In fact, global growth indicators looked to be stabilising by year end.

Seven lessons from 2019

  • Don’t fight the Fed, ECB, PBOC or RBA – as long as recession is avoided monetary easing is positive for investment returns from growth assets.
  • The starting point matters – when assets are cheap, and the crowd is negative as they were at the start of 2019 it’s relatively easier to get good returns.
  • Post GFC caution remains but can be both negative and positive – yes it periodically weighs on growth, but it is keeping economies from overheating and thereby is helping to extend the economic and investment cycle.
  • Geopolitics remains a significant driver of markets and economic conditions – but it can be positive whenever there is any relief and things don’t turn out as bad as feared.
  • Just because Australian housing is expensive & household debt is high does not mean house prices are going to crash.
  • Stick to an investment strategy – 2019 started in gloom and had its share of distractions but investors would have done well if they just stuck to a well-diversified portfolio.
  • Remember that while shares can be volatile and unlisted assets also come with risks, the income stream from a well-diversified mix of such assets can be relatively stable and higher than the income from bank deposits.

 Five big picture themes for 2020

  • A pause in the trade war, but geopolitical risk to remain high. President Trump is likely to want to keep the US/China trade war on the backburner but it could still flare up again and other issues include the escalation seen so far this year in the Iran conflict, a return to worries about a “hard Brexit” at year end if UK/EU free trade talks don’t go well and the US election if a hard left Democrat candidate gets up.
  • Global growth to stabilise & turn up thanks to policy stimulus with business surveys recently showing stabilisation.
  • Continuing low inflation and low interest rates. Growth won’t be strong enough to push underlying inflation up much and some central banks will still be easing (including the RBA).
  • The US dollar is expected to peak and head down as global uncertainty declines a bit and non-US growth picks up.
  • Australian growth is expected to remain weak given the housing construction downturn, weak consumer spending and the drought with bushfires not helping.

Key views on markets for 2020

Improving global growth & still easy monetary conditions should drive reasonable investment returns this year but they are likely to be more modest than the double-digit gains of 2019 as the starting point of valuations for shares & geopolitical risks are likely to constrain gains and create some volatility.

  • Global shares are expected to see total returns around 9.5% in 2020 helped by better growth and easy monetary policy.
  • Cyclical, non-US and emerging market shares are likely to outperform, if the US dollar declines as we expect.
  • Australian shares are likely to do okay this year but with total returns also constrained to around 9% given sub-par economic & profit growth.
  • Low starting point yields and a slight rise in yields through the year are likely to result in low returns from bonds.
  • Unlisted commercial property and infrastructure are likely to continue benefiting from the search for yield but the decline in retail property values will still weigh on property returns.
  • National capital city house prices are expected to see continued strong gains into early 2020. However, poor affordability, the weak economy and still tight lending standards are expected to see the pace of gains slow leaving property prices up 10% for the year as a whole.
  • Cash & bank deposits are likely to provide very poor returns, with the RBA expected to cut the cash rate to 0.25%.
  • The $A is likely to fall to $US0.65 as the RBA eases further, then drift up as global growth improves to end little changed.

Seven things to watch

  • The US trade wars – we are assuming the Phase 1 trade deal de-escalates the trade war, but Trump is Trump and often can’t help but throw grenades.
  • US politics: The Senate is unlikely to remove Trump from office if the House votes to impeach and another shutdown is also unlikely but both could cause volatility as could the US election if a hard-left Democrat gets up (albeit unlikely).
  • The US/Iran conflict – which could escalate further with Iran unlikely to negotiate and Trump wanting to sound tough, potentially disrupting oil supplies.
  • A hard Brexit looks like being avoided but watch UK/EU free trade negotiations through the year.
  • Global growth indicators (PMI’s)
  • Chinese growth – a continued slowing in China would be a major concern for global growth.
  • Monetary v fiscal stimulus in Australia – significant fiscal stimulus could head off further RBA easing.

 Four reasons global growth is likely to improve a bit

  • Global monetary conditions have eased significantly over the last year. China has also seen significant fiscal stimulus.
  • The stabilisation seen in business conditions PMIs in recent months suggests monetary easing is getting some traction.
  • We still have not seen the excesses – massive debt growth, overinvestment, capacity constraints or excessive inflation – that normally precede recessions.
  • The de-escalation of the US/China trade war should help reduce a drag on business confidence (at least for a while).

Five reasons Australia is likely to avoid a recession

The bushfires are estimated to knock around 0.4% mainly from March quarter GDP mainly due to the impact on agriculture, tourism and consumer confidence and spending. Coming at a time when Australian growth is already weak it risks knocking March quarter growth to near zero or below. However, while the risk of recession has increased, it remains unlikely:

 

  • Infrastructure spending is strong.
  • Mining investment is starting to rise again.
  • The bushfires will be followed by a boost to spending from the June quarter as rebuilding kicks in.
  • Already weak growth, made worse by the bushfires in the short term will likely force further fiscal stimulus.
  • The $A is likely to remain weak providing a boost to growth.

 Three reasons why the RBA will cut rates this year

 

  • Growth is likely to disappoint RBA expectations for 2.8% growth this year.
  • This will keep underemployment high, wages growth weak and inflation lower for longer.
  • Fiscal stimulus is unlikely to come early enough.

 

We expect the RBA to cut the cash rate to 0.5% in February & to 0.25% in March, with quantitative easing likely from mid-year.

Three reasons why a deep bear market is unlikely

Shares are vulnerable to a correction after the strong gains seen over the last year, but a deep bear market (where shares fall 20% and a year after are a lot lower again) is unlikely:

  • Global recession remains unlikely. Most deep bear markets are associated with recession.
  • Measures of investor sentiment suggest investors are cautious, which is positive from a contrarian perspective.
  • The liquidity backdrop for shares is still positive. For example, bank term deposit rates in Australia are around 1.3% (and likely to fall) compared to a grossed-up dividend yield of around 5.7% making shares relatively attractive.

Nine things investors should remember

  • Make the most of the power of compound interest. Saving regularly in growth assets can grow wealth substantially over long periods. Using the “rule of 72”, it will take 48 years to double an asset’s value if it returns 1.5% pa (ie 72/1.5) but only 9 years if the asset returns 8% pa.
  • Don’t get thrown off by the cycle. Falls in asset markets can throw investors out of a well thought out strategy at the wrong time – as some were at the end of 2018.
  • Invest for the long term. Given the difficulty in getting short term market moves right, for most it’s best to get a long-term plan that suits your wealth, age & risk tolerance & stick to it.
  • Don’t put all your eggs in one basket.
  • Turn down the noise. Increasing social media and the competition for your eyes and ears is creating a lot of noise around investing that is really just a distraction.
  • Buy low, sell high. The cheaper you buy an asset, the higher its prospective return will likely be and vice versa.
  • Beware the crowd at extremes. Don’t get sucked into the euphoria or doom and gloom around an asset.
  • Focus on investments that you understand and that offer sustainable cash flow. If it looks dodgy, hard to understand or has to be based on odd valuation measures or lots of debt to stack up then it’s best to stay away.
  • Accept that it’s a low nominal return world – when inflation is 1.5%, a 15% superannuation return is very pretty good (and not sustainable at that rate).

Dr. Shane Oliver, Head of Investment Strategy & Chief Economist

Five charts to watch regarding the global economy and markets this year

Key points:

  • Shares are at risk of a short-term correction or consolidation after a strong run over the last year and with sentiment now very bullish. However, this year should still see good returns for investors as global growth edges up and interest rates remain low.
  • Five key global charts to watch are: global business conditions PMIs; global inflation; the US yield curve; the US dollar; and global trade growth.
  • So far, so good with PMI’s improving a bit, inflation remaining low, the yield curve steepening, the $US showing signs of stopping and the US/China trade truce auguring well for some pick up in world trade growth.

Introduction:

Our high-level investment view for this year is that a combination of improving global growth boosting profits and still easy monetary conditions will help drive reasonable investment returns, albeit more modest than the very strong gains of 2019. This note revisits five charts we see as critical to the outlook.

Chart #1 – Global business conditions PMIs

Global Purchasing Managers Indexes (PMIs) – surveys of purchasing managers at businesses in most major countries – are an excellent and timely guide to the state of the global economy. Although services sector PMIs held up better than for manufacturers – which tend to be more cyclical – both softened through 2018 and into mid-2019. Since then they have shown signs of improvement suggesting that the global monetary easing seen through 2019 with interest rate cuts and renewed quantitative easing is working. Going forward they will need to improve further to be consistent with our view that growth will pick up this year.

But so far, the 2018-19 slowdown in business conditions PMIs (and hence global growth) looks like the slowdowns around 2012 and 2015-16 as opposed to the recession associated with the global financial crisis (GFC).

Chart 2 – Global Inflation

Major economic downturns are invariably preceded by a rise in inflation to above central bank targets causing central banks to slam the brakes on. At present, core inflation – ie inflation excluding the volatile items of food and energy – in major global economies remains benign. In the US, the Eurozone and Japan core inflation is well below their central bank targets of 2%. Inflation in China spiked to 4.5% through last year, but core inflation has been falling to 1.4% and is well below the Government’s 3% target/forecast. A clear upswing in core inflation would be a warning sign that spare capacity has been used up, that monetary easing has gone too far, and that the next move will be aggressive monetary tightening. But at present, we are a long way from that.

Chart 3 – The US yield curve

The yield curve is a guide to the stance of monetary policy. When short-term interest rates are low relative to long-term rates businesses can borrow short and lend (or invest) long and this grows the economy. But it’s not so good when short rates are above long rates. An inverted US yield curve has preceded past US recessions. So, when this happened last year there was much concern that a US recession was on the way.

However, in recent months various versions of the yield curve – with the gap between the US 10 year bond yield and the Fed Funds rate and the US 10 year bond yield and the 2 year bond yield shown in the next chart – have uninverted as the Fed cut rates and hence short-term yields fell, good economic data provided confidence that recession will be avoided and the US/China trade war de-escalated reducing the threat posed by the trade war.

While the US yield curve has uninverted in the past and yet a recession has still come along, the uninversion seen in recent months coming after such a shallow and short-lived inversion provides confidence that the inversion seen last year gave a false signal as occurred in the mid to late 1990s (as circled).

In addition, it’s also worth noting that other indicators suggest that US monetary policy was far from tight – the real Fed Fund rate was barely positive, and the nominal Fed Funds rate was well below nominal GDP growth and both are far from levels that in the past have preceded US recessions.

So it’s a good sign that the US yield curve has been steepening in recent months. A return to yield curve inversion – which became deeper than seen last year – would be a concern of course.

Chart 4 – The US dollar

Moves in the value of the US dollar against a range of currencies are of broad global significance. This is for two reasons. First, because of the relatively low exposure of the US economy to cyclical sectors like manufacturing and materials the $US tends to be a “risk-off” currency, ie it goes up when there are worries about global growth. Second, because of its reserve currency status and that a lot of global debt is denominated in US dollars particularly in emerging countries, when the $US goes up it makes it tough for emerging countries.

So when global uncertainty is rising this pushes the $US up which in turn makes it hard for emerging countries with $US denominated debt. If we are right though and global growth picks up a bit, trade war risk remains in abeyance and the Iran conflict does not become big enough to derail things then the $US is likely to decline further which would be positive for emerging countries.

 

Chart 5 – World trade growth

It’s reasonable to expect growth in world trade to slow over time as services become an ever-greater share of economic activity and manufacturing becomes less labour dependent. However, President Trump’s trade wars since 2018 combined with slower global growth saw global trade fall last year. This year should see some reversal if the trade wars remain in abeyance as Trump focuses on keeping the US economy strong to aid his re-election and global growth picks up a bit.

US recession still a way away

In recent years there has been much debate about whether a new major bear market in shares is approaching. Such concerns usually reach fever pitch after share markets have already fallen 20% or so (as they did into 2011, 2016 and 2018). The historical experience tells us that what happens in the US is critical to how deep share market falls get. Deep (“grizzly”) bear markets like the 50% plus fall seen in the GFC are invariably associated with US recession. So, whether a recession is imminent in the US, and more broadly globally, is critically important in terms of whether a major bear market is on the way. The next table summarises the key indicators we are still watching in this regard.

These indicators are still not foreshadowing an imminent recession in the US. The yield curve is most at risk if it inverts again. But other measures of monetary policy in the US are not tight and we have not seen the sort of excesses that normally precede recessions – discretionary or cyclical spending as a share of GDP is low, private debt growth has not been excessive, the US leading indicator is far from recessionary levels and inflation is benign.

Concluding comments

At present, most of these charts or indicators are moving in the right direction, with the PMIs improving a bit, inflation remaining low, the yield curve steepening, the $US showing signs of topping and the US/China trade truce auguring well for some pick up in world trade growth. But to be consistent with our view that this year will see good returns from shares we need to see further improvement and so these charts are worth keeping an eye on.

Dr. Shane Oliver, Head of Investment Strategy & Chief Economist

Review of 2019, outlook for 2020 – the beat goes on

Key points:

  • 2019 saw growth slow, recession fears increase and the US trade wars ramp up, but solid investment returns as monetary policy eased, bond yields fell and demand for unlisted assets remained strong.
  • 2020 is likely to see global growth pick up with monetary policy remaining easy. Expect the RBA to cut the cash rate to 0.25% and to undertake quantitative easing.
  • Against this backdrop, share markets are likely to see reasonable but more constrained & volatile returns, and bond yields are likely to back up resulting in good but more modest returns from a diversified mix of assets.
  • The main things to keep an eye on are: the trade wars; the US election; global growth; Chinese growth; and fiscal versus monetary stimulus in Australia.

2019 – growth down, returns up

Christmas 2018 was not a great one for many investors with an almost 20% slump in US shares from their high in September to their low on Christmas Eve, capping off a year of bad returns from share markets and leading to much trepidation as to what 2019 would hold. But 2019 has turned out to be a good year for investors, defying the gloom of a year ago. In fact, some might see it as perverse – given all the bad news around and the hand wringing about recession, high debt levels, inequality and the rise of the populist leaders.  Then again, that’s often the way markets work – bottoming when everyone is gloomy then climbing a wall of worry. The big global negatives of 2019 were:

  • The trade war and escalating US-China tensions generally. A trade truce and talks collapsed several times leading to a new ratcheting up of tariffs before new talks into year end.
  • Middle East Tensions flared periodically but without a lasting global impact & the Brexit saga dragged on although a near-term hard Brexit looks to have been avoided.
  • Slowing growth in China to 6%. This largely reflected an earlier credit tightening, but the trade war also impacted.
  • Slowing global growth as the trade war depressed investment & combined with an inventory downturn and tougher auto emissions to weigh on manufacturing & profits.
  • Recession obsession with “inverted yield curves” – many saw the growth slowdown as turning into a recession.

But it wasn’t all negative as the growth slowdown & low inflation saw central banks ease, with the Fed cutting three times and the ECB reinstating quantitative easing. This was the big difference with 2018 which saw monetary tightening.

Australia also saw growth slow – to below 2% – as the housing construction downturn, weak consumer spending and investment and the drought all weighed. This in turn saw unemployment and underemployment drift up, wages growth remain weak and inflation remain below target. As a result, the RBA was forced to change course and cut interest rates three times from June and to contemplate quantitative easing. The two big surprises in Australia were the re-election of the Coalition Government which provided policy continuity and the rebound in the housing market from mid-year.

While much of the news was bad, monetary easing and the prospect it provided for stronger growth ahead combined with the low starting point resulted in strong returns for investors.

  • Global shares saw strong gains as markets recovered from their 2018 slump, bond yields fell making shares very cheap and monetary conditions eased. This was despite several trade related setbacks along the way. Global share returns were boosted on an unhedged basis because the $A fell.
  • Emerging market shares did well but lagged given their greater exposure to trade and manufacturing and a still rising $US along with political problems in some countries.
  • Australian share prices finally surpassed their 2007 record high thanks to the strong global lead, monetary easing and support for yield sensitive sectors from low bond yields.
  • Government bonds had strong returns as bond yields fell as inflation and growth slowed, central banks cut rates and quantitative easing returned.
  • Real estate investment trusts were strong on the back of lower bonds yields and monetary easing.
  • Unlisted commercial property and infrastructure continued to do well as investors sought their still relatively high yields. However, Australian retail property suffered a correction.
  • Commodity prices rose with oil & iron up but metals down.
  • Australian house prices fell further into mid-year before rebounding as the Federal election removed the threat to negative gearing & the capital gains tax discount, the RBA cut interest rates and the 7% mortgage test was relaxed.
  • Cash and bank term deposit returns were poor reflecting new record low RBA interest rates.
  • The $A fell with a lower interest rates and a strong $US.
  • Reflecting strong gains in most assets, balanced superannuation funds look to have seen strong returns.

2020 vision – growth up, returns still good

The global slowdown still looks like the mini slowdowns around 2012 and 2015-16. Business conditions indicators have slowed but remain far from GFC levels. See next chart

While the slowdown has persisted for longer than we expected – mostly due to President Trump’s escalating trade wars – a global recession remains unlikely, barring a major external shock. The normal excesses that precede recessions like high inflation, rapid growth in debt or excessive investment have not been present in the US and globally. While global monetary conditions tightened in 2018, they remained far from tight and the associated “inversion” in yield curves has been very shallow and brief. And monetary conditions have now turned very easy again with a significant proportion of central banks easing this year. See chart. The big global themes for 2020 are likely to be:

  • A pause in the trade war but geopolitical risk to remain high.The risks remain high on the trade front – with President Trump still ramping up mini tariffs on various countries to sound tough to his base and uncertainty about a deal with China, but he is likely to tone it down through much of 2020 to reduce the risk to the US economy knowing that if he lets it slide into recession and/or unemployment rise he likely won’t get re-elected. A “hard Brexit” is also unlikely albeit risks remain. That said geopolitical risks will remain high given the rise of populism and continuing tensions between the US & China. In particular, the US election will be an increasing focus if a hard-left candidate wins the Democrat nomination.
  • Global growth to stabilise and turn up. Global business conditions PMIs have actually increased over the last few months suggesting that monetary easing may be getting traction. Global growth is likely to average around 3.3% in 2020, up from around 3% in 2019. Overall, this should support reasonable global profit growth.
  • Continuing low inflation and low interest rates. While global growth is likely to pick up it won’t be overly strong and so spare capacity will remain. Which means that inflationary pressure will remain low. In turn this points to continuing easy monetary conditions globally, with some risk that the Fed may have a fourth rate cut.
  • The US dollar is expected to peak and head down.During times of uncertainty and slowing global growth like over the last two years the $US tends to strengthen partly reflecting the lower exposure of the US economy to cyclical sectors like manufacturing and materials. This is likely to reverse in the year ahead as cyclical sectors improve.

In Australia, strength in infrastructure spending and exports will help keep the economy growing but it’s likely to remain constrained to around 2% by the housing construction downturn, subdued consumer spending and the drought. This is likely to see unemployment drift up, wages growth remain weak and underlying inflation remain below 2%. With the economy remaining well below full employment and the inflation target, the RBA is expected to cut the official cash rate to 0.25% by March, & undertake quantitative easing by mid-year, unless the May budget sees significant fiscal stimulus. Some uptick in growth is likely later in the year as housing construction bottoms, stimulus impacts and stronger global growth helps.

Implications for investors

Improved global growth and still easy monetary conditions should drive reasonable investment returns through 2020 but they are likely to be more modest than the double-digit gains of 2019 as the starting point of higher valuations and geopolitical risks are likely to constrain gains & create some volatility:

  • Global shares are expected to see returns around 9.5% helped by better growth and easy monetary policy.
  • Cyclical, non-US and emerging market shares are likely to outperform, particularly if the US dollar declines and trade threat recedes as we expect.
  • Australian shares are likely to do okay but with returns also constrained to around 9% given sub-par economic & profit growth. Expect the ASX 200 to reach 7000 by end 2019.
  • Low starting point yields and a slight rise in yields through the year are likely to result in low returns from bonds.
  • Unlisted commercial property and infrastructure are likely to continue benefiting from the search for yield but the decline in retail property values will still weigh on property returns.
  • National capital city house prices are expected to see continued strong gains into early 2020 on the back of pent up demand, rate cuts and the fear of missing out. However, poor affordability, the weak economy and still tight lending standards are expected to see the pace of gains slow leaving property prices up 10% for the year as a whole.
  • Cash & bank deposits are likely to provide very poor returns.
  • The $A is likely to fall to around $US0.65 as the RBA eases further but then drift up a bit as global growth improves to end 2019 little changed.

What to watch?

The main things to keep an eye on in 2020 are as follows:

  • The US trade wars – we are assuming some sort of de-escalation in the run up to the presidential election, but Trump is Trump and often can’t help but throw grenades.
  • US politics: The Senate is unlikely to remove Trump from office if the House votes to impeach and another shutdown is also unlikely but both could cause volatility as could the US election if a hard-left Democrat gets up (albeit unlikely).
  • A hard Brexit looks like being avoided but watch UK/EU free trade negotiations through the year.
  • Global growth indicators – like the PMI shown in the chart above need to keep rising.
  • Chinese growth – a continued slowing in China would be a major concern for global growth.
  • Monetary v fiscal stimulus in Australia – significant fiscal stimulus could head off further RBA rate cuts and quantitative easing.

 

Dr. Shane Oliver, Head of Investment Strategy & Chief Economist

Five reasons why the $A may be close to the bottom

Key Points

  • In the absence of significant fiscal stimulus soon, further RBA monetary easing both in the form of rate cuts and quantitative easing point to more downside for the $A. 
  • However, there is good reason to believe we may be close to the low in the $A (or have already seen it): it has already had a large fall; it is just below fair value; the global economic cycle is likely to turn up next year; sentiment towards the $A is very negative; and the current account is in surplus.
  • Our base case remains for the $A to fall to $USO.65 in the months ahead as the RBA eases further, but at the end of 2020 it’s likely to be stuck around $USO.65-70.

Introduction

For a long time, we have been bearish on the Australian dollar, seeing it fall into the high $USO.60s and revising this to around $USO.65 in May. In early October it fell to a low of $USO.6671. While negatives remain significant for the $A there is good reason to believe that we are close to the low or may have already seen it. This note looks at the main issues.

The negatives for the $A are well known

The big negative for the Australian dollar is that growth is weaker in Australia and spare capacity is much higher than in the US. For example, labour market underutilisation is 13.8% in Australia versus just 7% in the US, on the latest available data real growth in Australia is running at 1.4% year on year compared to 2% in the US and that translates to per capita GDP growth of -0.2% in Australia compared to 1.4% in the US. And the drag on growth from the housing downturn, weak consumer spending and the drought is likely to keep growth relatively weak in Australia for the next six months or so.

This will keep inflation lower in Australia than in the US. Ideally more fiscal stimulus is required, and the Government has brought forward infrastructure spending. But combined with extra drought assistance this only amounts to an extra 0.1% of GDP of fiscal stimulus over the next 18 months which is not enough to make a significant difference to the growth outlook. So in the absence of more significant fiscal stimulus soon, the RBA is likely to cut the cash rate further to 0.25% and undertake some quantitative easing (i.e using printed money to boost growth). By contrast the Fed is at or close to the low in US rates and is unlikely to return to quantitative easing. This will continue to make it relatively less attractive to park money in Australia. As can be seen in the next chart, periods of a low and falling interest rate differential between Australia and the US usually see a low and falling $A.

So the higher probability of further monetary easing in Australia points to more downside for the Australian dollar. Of course, a shift in the policy focus away from monetary easing and towards greater fiscal stimulus would be more positive for the Australian dollar but this looks unlikely in the short term with the Government more focused on delivering a budget surplus.

Five positives for the $A

However, it’s no longer an easy (in hindsight) one way bet for the $A. There are basically five positives. First, the $A has already had a big fall. To its recent low it’s fallen nearly 40% from a multi-decade high of $US1.11 in 2011 & it’s had a fall of 18% from a high in January last year of $US0.81.

Second, this decline has taken it to just below fair value. This contrasts to the situation back in 2011 when it was well above long-term fair value. The best guide to this is what is called purchasing power parity according to which exchange rates should equilibrate the price of a basket of goods and services across countries. Consistent with this the $A tends to move in line with relative price differentials over the long term.

And right now, it’s just below fair value. Of course, as can be seen in the last chart, the $A could fall sharply below fair value as it tends to swing from one extreme to another. But this depends on the cyclical outlook for global growth and commodity prices. Which brings us to the next positive.

Third, the global economic and commodity price cycle is likely to turn up next year in response to global monetary easing, a bottoming in the global inventory and manufacturing cycle and a pause in President Trump’s trade wars as he refocuses on winning the presidential election.

Based on historical experience, this should work against the US dollar as the US economy is less exposed to cyclical sectors than the rest of the world (which tends to see capital flow out of the US when global growth picks up and into the US when it slows). A weaker US dollar would in turn be positive for commodity prices & the $A, which is a “risk on” currency given its greater exposure to cyclical industries like raw materials.

Fourth, this comes at a time when global sentiment towards the $A remains very negative as reflected in short or underweight positions in the $A being at extremes – see the next chart. In other words, many of those who want to sell the $A have already done so and this leaves it vulnerable to a rally if there is good news.

Finally, the current account has returned to surplus in Australia. The high iron ore price has helped, but so too have strong resource export volumes, services exports and a rising net equity position in Australia’s favour on the back of rising superannuation assets offshore. So the improved current account may be a permanent feature. This means less dependence on foreign capital inflows which is $A positive.

So where to from here?

The prospects for weaker growth and more monetary easing in Australia relative to the US suggests short-term downside pressure for the $A remains. But with the $A having already had a big fall to just below long-term fair value, the global growth outlook likely to improve, short $A positions running high and the current account in surplus it’s likely that the $A may be close to, or may have already seen, its low. Our base remains for it to fall to around $US0.65 as the RBA continues to ease but at the end of 2020 it’s likely to be stuck around $US0.65-70 (or I’ll be honest & admit I don’t have a strong view either way!).

Of course, if the US/China trade war escalates badly again and the global economy falls apart, causing a surge in unemployment in Australia as export demand and confidence collapses and another big leg down in-house prices the Aussie will fall a lot more…but that’s looking less likely.

What does it mean for investors and the RBA?

With the risks skewed towards the $A bottoming soon the case to maintain a large exposure to offshore assets that are not hedged back to Australian dollars has weakened. Of course, maintaining a position in foreign exchange for Australian-based investors against the $A provides some protection should things go wrong globally (say in relation to trade) or in Australia (say in relation to household debt).

For the RBA a shift in global forces towards being more supportive of the Australian dollar over the year ahead would complicate the RBA’s desire to boost Australian economic growth. Stronger demand for Australian exports would be positive, but upwards pressure on the $A would suggest that further monetary easing may be needed to help keep it down.

Dr. Shane Oliver, Head of Investment Strategy & Chief Economist

Franklin Templeton Market Outlook 2020

It’s that time of year when Franklin Templeton’s investment leaders put pen to paper and share their insights into what lies ahead in 2020, both globally and closer to home. See below Franklin Templeton’s market outlooks across a range of asset classes and sectors. 

Global Fixed Income Outlook

“Abundant liquidity in the market fueled by unconventional monetary policy continues to be a source of financial market distortion, and keeps pushing investors toward riskier, less liquid assets.” Sonal Desai, PHD, Chief Investment Officer, Franklin Templeton Fixed Income Group.

Australian Fixed Income Outlook

“The RBA is likely to cut to 0.50% in early 2020 from where it will consider options for other forms of easing. We feel that the authorities are responding to the record levels of leverage across economies and recognising the dis-inflationary impetus that brings.” Andrew Canobi, Director, Australian Fixed Income.

Global Equity Outlook

“We think investors need not be anxious about global equity markets in 2020 even as markets have staged a strong advance throughout much of 2019 and economic data has softened.” Stephen Dover. CFA, EVP, Head of Equities, Franklin Templeton.

Australian Equity Outlook

“The capacity for fiscal stimulus differentiates Australia’s economic outlook from many global peers. Combined with the recent rate cuts from the Reserve Bank, the risk of recession in the domestic economy has moderated.” Alastair Hunter, Chief Investment Officer, Balances Equity Management, Franklin Templeton.

Global Growth Stocks Outlook

“Global Equity markets face an uncertain 2020, but if the consumer stays resilient and bond yields remain low, global stocks could remain attractive relative to other asset classes.” John Remmert, SVP, Senior Portfolio Manager, Franklin Equity Group.

Why super and growth assets like shares really are long term investments

Key Points

  • While growth assets like shares go through bouts of short-term under-performance versus bonds & cash, they provide superior long-term returns. It makes sense that superannuation has a high exposure to them.
  • The best approach is to simply recognize that super and investing in shares is a long-term investment.

Introduction

After sharp share market falls when headlines scream about the billions wiped off the market the usual questions are: what caused the fall? what’s the outlook? and what does it mean for superannuation? The correct answer to the latter should be something like “nothing really, as super is a long-term investment and share market volatility is normal.” But that often sounds like marketing spin. However, the reality is that – except for those who are into trading or are at, or close to, retirement – shares and super really are long-term investments. Here’s why.

Super funds and shares

Superannuation is aimed (within reason) at providing maximum (risk-adjusted) funds for use in retirement. So typical Australian super funds have a bias towards shares and other growth assets, particularly for younger members, and some exposure to defensive assets like bonds and cash in order to avoid excessive short-term volatility in returns.

The power of compound interest

These approaches seek to take maximum advantage of the power of compound interest. The next chart shows the value of a $100 investment in each of Australian cash, bonds, shares, and residential property from 1926 assuming any interest, dividends and rents are reinvested along the way. As return series for commercial property and infrastructure only go back a few decades I have used residential property as a proxy.

Because shares and property provide higher returns over long periods the value of an investment in them compounds to a much higher amount over long periods. So, it makes sense to have a decent exposure to them when saving for retirement. The higher return from shares and growth assets reflects compensation for the greater risk in investing in them – in terms of capital loss, volatility and illiquidity – relative to cash & bonds.

But investors don’t have 90 years?

Of course, we don’t have ninety odd years to save for retirement. In fact, our natural tendency is to think very short term. And this is where the problem starts. On a day to day basis shares are down almost as much as they are up. See the next chart. So, day to day, it’s pretty much a coin toss as to whether you will get good news or bad. So, it’s understandable that many are skeptical of them. But if you just look monthly and allow for dividends, the historical experience tells us you will only get bad news around a third of the time. If you go out to once a decade, positive returns have been seen 100% of the time for Australian shares and 82% for US shares.

This can also be demonstrated in the following charts. On a rolling 12 month ended basis the returns from shares bounce around all over the place relative to cash and bonds.

However, over rolling ten-year periods, shares have invariably done better, although there have been some periods where returns from bonds and cash have done better, albeit briefly.

Pushing the horizon out to rolling 20-year returns has almost always seen shares do even better, although a surge in cash and bond returns from the 1970s/1980s (after high inflation pushed interest rates up) has seen the gap narrow.

Over rolling 40-year periods – the working years of a typical person – shares have always done better.

This is all consistent with the basic proposition that higher short-term volatility from shares (often reflecting exposure to periods of falling profits and a risk that companies go bust) is rewarded over the long term with higher returns.

But why not try and short-term market moves?

The temptation to do this is immense. With the benefit of hindsight many swings in markets like the tech boom and bust and the GFC look inevitable and hence forecastable and so it’s natural to think “why not give it a go?” by switching between say cash and shares within your super to anticipate market moves. Fair enough if you have a process and put the effort in. But without a tried and tested market timing process, trying to time the market is difficult. A good way to demonstrate this is with a comparison of returns if an investor is fully invested in shares versus missing out on the best (or worst) days. The next chart shows that if you were fully invested in Australian shares from January 1995, you would have returned 9.7% pa (with dividends but not allowing for franking credits, tax and fees).

If by trying to time the market you avoided the 10 worst days (yellow bars), you would have boosted your return to 12.4% pa. And if you avoided the 40 worst days, it would have been boosted to 17.3% pa! But this is very hard, and many investors only get out after the bad returns have occurred, just in time to miss some of the best days. For example, if by trying to time the market you miss the 10 best days (blue bars), the return falls to 7.6% pa. If you miss the 40 best days, it drops to just 3.6% pa.

The following chart shows the difficulties of short-term timing in another way. It shows the cumulative return of two portfolios.

  • A fixed balanced mix of 70 per cent Australian equities, 25 per cent bonds and five per cent cash;
  • A “switching portfolio” which starts off with the above but moves 100 per cent into cash after any negative calendar year in the balanced portfolio and doesn’t move back until after the balanced portfolio has a calendar year of positive returns. We have assumed a two-month lag.

Over the long run the switching portfolio produces an average return of 8.8% pa versus 10.2% pa for the balanced mix. From a $100 investment in 1928 the switching portfolio would have grown to $218,040 compared to $705,497 for the constant mix.

Key Messages

First, while shares and other growth assets go through periods of short-term under-performance relative to bonds and cash, they provide superior returns over the long term. As such it makes sense that superannuation has a high exposure to them.

Second, switching to cash after a bad patch is not the best strategy for maximising wealth over time.

Third, the less you look at your investments the less you will be disappointed. This reduces the chance of selling at the wrong time or adopting an overly cautious stance.

The best approach is to simply recognize that super and investing in shares is a long-term investment. The exceptions to this are if you are really into putting in the effort to getting short-term trading right and/or you are close to, or in, retirement.

Dr. Shane Oliver, Head of Investment Strategy & Chief Economist

Planning for what’s next – Living in retirement

Living in retirement can last decades as life expectancies continue to increase. You will need to plan for different stages of retirement – starting with when you are relatively young and active through your later years when you may find yourself slowing down, both physically and mentally.

 

Lifestyle

  • Continue to reinvent yourself

Whether through physical activity, staying socially connected, or by learning something new, engaging in physical and mental activities encourages your health and well-being as you age.

  • Retirement can mean continuing to work

Find something you enjoy whether it is part-time, an encore career, or volunteering.

 

Financial

  • Keep and eye on your budget and your income

Stay fiscally flexible. Be prepared to make adjustments to your spending and your lifestyle. Financial conditions are seldom the same year after year.

  • Review your asset allocations

Be sure that your investment portfolio reflects your age and risk tolerance. Remember, generating retirement income from investments is not the same thing as growing your investments.

  • Monitor your situation regularly and adjust if conditions warrant

This is especially critical in terms of distributions and regular income payments from your accounts, so you can ensure your savings sustain you through your later years.

  • Be proactive in your tax planning

Plan ahead and understand the tax implications of your investment decisions. Consider getting money to your heirs of your financial situation allows.

  • Mange debt

Pay down your debt, including your mortgage.

  • Consider getting professional financial advice

An objective third-party review can be critical at this stage and may assist you in developing a sustainable withdrawal strategy.

 

Health

  • Make a plan for your future medical expenses

Healthcare expenses can be large or small, expected or unexpected. Think ahead to line up the income you need to meet these expenses.

  • Review your situation regularly

Evaluate your current and potential future healthcare needs, and determine whether private health insurance (or your current cover) is appropriate.

 

Protection

  • Review your estate plan
  • Who do you trust?

Establish powers of attorney in case you are incapacitated.

  • Have a family meeting

Openly discuss your finances in the event that you can no longer manage your own affairs. Educate adult children regarding treatment of your asset upon your death.

 

Pitfalls

  • Elder financial abuse is a growing problem

Take steps early to protect yourself. Consider confiding in relatives or a trusted friend regarding your financial situation.

  • Review and assess

Confirm that all beneficiary designations are in place and that you have a proper will, or other estate planning tool, to ensure your money goes where you want it to go.

Planning for what’s next – Approaching retirement

As retirement nears, you will want to continue planning for this next phase of your life. Remain focused on saving for retirement while beginning to envision and organise how you plan to enjoy these future years.

Lifetsyle

  • Determine what you want to do in retirement.

Maybe you don’t want to stop working altogether, but would rather work part-time or volunteer. Consider ways to keep your mind and body active through physical exercise and hobbies. Determine how to stay connected to friends and family.

  • Want to relocate?

Consider spending time there to help determine whether the move will be right for you.

  • Prepare for the unexpected

Have an emergency fund and plan in place.

Financial

  • Don’t stop saving!

Continue to contribute as much as you can financially handle to your retirement savings, as it is still important. For example, setting up a Transition to Retirement pension can be used in conjunction with increased concessional super contributions to save tax in the lead-up to retirement, and your super balance will get a boost through any increased concessional contributions.

  • Develop a retirement income strategy

Identify sources of income in retirement. Determine how much the sources will generate, and when to use them.

  • What about the Age Pension?

Determine whether you are eligible for a part or full Age Pension. Even if you aren’t eligible, you may still be entitled to other benefits, such as cheaper medicines and reduced water and council rates.

  • What are you planning to do with your superannuation account(s)?

If you have multiple superannuation accounts, consolidating them into one can save you some fees and paperwork. As you approach retirement, your super fund or financial adviser can help you with options for converting your super savings into a stream of income in retirement.

  • Review your asset allocations

How you allocate money to each asset class is one of the most important decisions faced when constructing an investment portfolio. As retirement gets closer, you’ll want to pay closer attention to how your portfolio is allocated.

  • Manage debt

Pay down your debt, including your mortgage.

  • Consider getting professional financial advice

With many decisions, an objective third-party review can be critical at this stage

Health

  • Health care in retirement can be a major expense

Determine how you will cover pharmaceutical and other medical expenses.

  • Understand all insurance options

Medicare doesn’t cover everything. Consider private health insurance for seniors and determine whether you qualify for a government rebate.

Protection

  • Make informed insurance decisions

Decide if long-term care insurance makes sense for you

  • Your plans are not set in stone

Review your estate plan and beneficiary designations and adjust if necessary

Pitfalls

  • Review and assess

Review your retirement savings and investments, as you still have time to make changes and close any gaps to help you enjoy your later years. Make sure your will is up-to-date.

  • Managing ongoing dependent children

Whether you decide to provide continuing support or adopt a “tough love” strategy, consider the impact on your retirement plans – both financially and emotionally.

Preparing for what’s next

When retirement is approaching, it’s important to plan for what’s next. Below are several resources to help you better understand your current situation and get your questions answered.

Oliver’s Insights-Five reasons why I am not so fussed about the global outlook

Key Points:

  • There is no denying concerns about global debt, seemingly never ending QE, more debt trading on negative interest rates, inequality and geopolitical threats.
  • However, some of these concerns are exaggerated and there are five reasons why I am not so fussed about the global outlook. In particular, there is good reason to expect a pick-up in global growth over the next 12 months. This should help underpin further gains in share markets over the next 6-12 months.

There is always someone telling us that there is some sort of economic/financial disaster coming our way. However, there does seem to be a higher level of hand wringing now about the global economic outlook than normal. These concerns basically go something like this:

  • Global debt – both public and private – is at record levels relative to GDP and with public debt ratios so high there is no scope for fiscal stimulus should things go really bad.
  • Years of quantitative easing and other unconventional monetary policies like negative interest rates by central banks in major advanced countries haven’t worked and seem to have no end.
  • More and more debt globally is trading on negative interest rates – it’s now around $US14 trillion including around 25% of all government bonds – which is unnatural and causing distortions in valuing assets with risks of asset bubbles.
  • Inequality (as measured by Gini coefficients) is rising – particularly in the US – which is driving a populist backlash against rationalist market-friendly economic policies of globalisation/free trade (as evident in Trump’s trade wars), deregulation and privatisation.

  • This along with the relative decline of US economic and military power is contributing to geopolitical tensions as we move from a “unipolar world” (dominated by the US after the end of the Cold War) to a “multipolar world” as other countries (China, Russia, Iran/Saudi Arabia, etc) move in to fill the gap left by the US or even “challenge” the US.

This is all seen as being bad for global growth and hence growth assets, all of which is being heightened by the downturn in global growth seen over the last year or so.

Five reasons not to be too fussed.

There is no denying these concerns. Debt is at record levels globally. QE has been running in various iterations for more than a decade now in some countries. Inequality is up – albeit its mainly a US and emerging country issue. Support for market-friendly economic rationalist policies such as globalisation, deregulation and privatisation seems to have waned (except in France). And geopolitical risks are up. All these developments point to the risk of slower global growth and investment returns ahead and may figure in the next major bear market. But there is always something to worry about (otherwise shares would offer no return advantage over cash) and trying to time the next downturn is hard. Moreover, there are five reasons not to get too fussed about the global outlook.

1. Debt is more complicated than being at a record
History tells us that the next major crisis will involve debt problems of some sort. But what’s new – they all do! Just because global debt is at record levels does not mean that a crisis is imminent. There are several points to note here:

  • debt has been trending up ever since it was invented;
  • comparing debt to income (or GDP) is like comparing apples to oranges as debt is a stock and income is a flow – the key is to compare debt against assets and here the numbers are not so scary because debt and assets tend to rise together
  • debt interest burdens are low thanks to low interest rates
  • all of the rise in debt in developed countries since the GFC has come from public debt and the risk of default here is very low because governments can tax and print money.

While Modern Monetary Theory has its issues, it does remind us that as long as a government borrows in its own currency and inflation is not a problem, it has more flexibility to provide stimulus than high public debt to GDP ratios suggest.

2. QE’s end point is not necessarily negative

Quantitative easing and other unconventional monetary policies actually do appear to have helped. Since its high in 2013 unemployment in the Eurozone has fallen from 12% to 7.5% and in the US it fell from 9% in 2011 to 4% in 2017 enabling the Fed to start unwinding unconventional monetary policy. Inflation has not been returned to 2% targets, but wages growth has lifted and at the start of last year it looked like the global economy was getting back to normal. What kicked the global economy off the rails again was a combination of Trump’s trade wars, a debt squeeze in China and tougher auto emission controls. But this it wasn’t due to a failure of quantitative easing.

As to how quantitative easing is eventually unwound there is no easy answer, but there is no reason to believe that it will end with a calamity. First, in the absence of a surge in inflation necessitating a withdrawal of the money that has been pumped into the global economy there is no reason to withdraw it. And when inflation does start to rise it can be reversed gradually by central banks not replacing their bond holdings as they mature.

Second, the assets central banks purchased as part of QE have boosted the size of their balance sheets but the varied size of central bank balance sheets from one country to another as a share of their economy shows that there is no natural optimal level for them. In fact, the Fed is now resuming natural growth in its balance sheet as occurred prior to the GFC so its balance sheet may just stay high (as along as inflation is not a problem).

Finally, if push came to shove just consider what would happen if say the Bank of Japan told the Japanese government that it no longer expects payment at maturity for the 50% of Government bonds it holds? The BoJ would write down its bond holding and the Japanese Government would suffer a loss on its investment in the BoJ but that would be matched by a write down in its liabilities. Basically, nothing would happen except that Japanese government debt would fall dramatically!

3. Inflation and interest rates are low

The key thing that has caused many sceptics to miss out on good returns this decade is that they focussed on low inflation as reflecting low demand growth but missed out on the positive valuation boost to assets like shares and property that low inflation and low interest rates provides.

4. Rapid technological innovation and growth in middle income Asia is continuing

This is well known and has been done to death, so I won’t go over it suffice to say that there are still a lot of positives helping underpin the global outlook and these two remain big ones.

5. Global growth looks like it may pick up

While the slowdown in global growth over the last 18 months has been scary and associated with share market volatility, the conditions are not in place for a deeper slide into global recession like we saw at the time of the GFC – excesses like overspending, surging inflation, excessive monetary tightening are not present. In fact, various signs are pointing to a cyclical global pick up ahead:

  • Bond yields are up from their lows & look to be trending up
  • The US yield curve is now mostly positive – suggesting the inversion seen this year may have been another false recession signal like seen in 1996 and 1998

  • European, Japanese & emerging shares are looking better
  • Cyclical sectors like consumer discretionary, industrials and banks are looking better
  • The US dollar looks like it might have peaked; and
  • Business conditions PMIs for the US, Europe & China were flattish in October & may be stabilising. This saw the global manufacturing PMI go sideways and a rise in the services PMI and both still look like the 2012 and 2016 slowdowns.

These could be pointers to global monetary easing getting traction. Of course, much depends on what happens to geopolitical risks. The US election next year will be a big one to keep an eye on and beyond that US/China tensions look likely to be with us for years. But there is reason to expect some respite in the short term on the geopolitical front:

First, the economic slowdown in both China and the US is pressuring both to defuse the trade dispute in the short term. This pressure is greater now as Trump wants to get re-elected next year and knows that he won’t if he lets the US slide into recession or unemployment rise. China may prefer to wait till after the election but is more likely to opt for the devil it knows.

Second, Trump’s avoidance of retaliation after the attack on Saudi’s oil production facilities in September shows a desire to avoid getting into military conflict in the Middle East.
Third, Brexit risks are on the back burner for now (although they could still come up again next year).

Concluding comment

There is good reason to expect the global economic cycle to turn up in the year ahead just as it did after the growth in 2012 and 2016. This should be positive for growth assets like shares. Finally, for those worried that more and more debt will trade at negative interest rates our view is that this is unlikely: many countries have already sworn off using rates including the US and RBA Governor Lowe says it’s extremely unlikely in Australia. And if growth picks up as we expect the proportion of global debt on negative rates will decline as it did after 2016.

Dr Shane Oliver, Head of Investment Strategy & Chief Economist 

4 surprises about planning for retirement income

Franklin Templeton’s 2019 Retirement Income Strategies and Expectations (RISE) Survey uncovered four findings that may surprise you.

  1. Retirement Expenses May Be Higher than Expected

Australians don’t seem to be under any illusions about the cost of retirement. Nearly 3 in 4 pre-retirees are concerned about rising expenses draining their retirement savings. Furthermore, 40% expect their expenses to increase in retirement – well above the 28% who expect them to decrease.

Unfortunately, the experience of retirees doesn’t provide any relief to these anxieties. Concern about rising expenses is even higher among the retiree population, while nearly half of retiree’s state that their expenses have increased since retirement.

Concern about rising expenses doesn’t fade after retirement

 

Higher expenses in retirement is more common than expected

 

Part of being confident in a retirement strategy is understanding what to expect and then planning for that reality. Consider how each type of expense may change over time – do they rise with inflation? Are they impacted by changes in the economy? By anticipating the types of expenses, you will likely face, you can plan for the appropriate income to meet those needs.

 

  1. Health- Related Concerns are Top of Mind Across All Ages

Planning for retirement isn’t just about saving money. It’s also about appreciating the reality of factors that can have a major impact on an individual’s ability to experience retirement success. Our survey indicated that people are acutely aware of the role health might play.

 

  1. Retiree’s Approach to Spending Their Nest Eggs Is Not Always Strategic

One may assume that once someone is living in retirement, they have a plan for how they will spend their nest egg throughout their retirement years. Our results highlight a different story. Over a third (34%) of retirees are winging it, stating they are ‘spending what they need and hoping it will last.’ And even more (36%) are trying to avoid dipping into their savings at all. When we took a closer look as to why, uncertainty emerged as a common theme – whether it’s not understanding how much they can sustainably spend, what future expenses will look like, or what their time horizon is.

  1. Professional Financial Advice is Critical in Planning Retirement Income

For most pre-retirees, planning for their retirement income is a daunting task. How much will they need? Where will it come from? What strategy is best suited to their situation? These are not always questions with simple answers.

While a range of resources exist to help plan for retirement income, individual advice from a licensed financial professional appears to be one of the most effective ones. One survey indicated that working with a financial adviser is strongly tied to better preparation, reduced stress and increased confidence around the transition to retirement.

Plan for Surprises

No matter what your stage of retirement. There may be surprises that can catch you off guard. Having enough confidence in your income sources when you stop working ultimately comes down to knowledge and planning. Work with a financial adviser to help create a custom, written plan to fit your retirement needs and prepare for the challenges.