Key points

• The Australian housing market is at risk from the Coronavirus recession Australia has now entered.
• A relatively short recession that sees unemployment rise to around 7.5% would likely only set prices back around 5% or so after which prices would bounce back.
• But a deeper recession with say 10% unemployment risks tripping up the underlying vulnerability of the housing market around high prices and high debt levels. This could see a 20% fall in prices.
• This is not our base case, but it highlights the need for the Government & the RBA to minimise the fallout from Coronavirus shutdowns in terms of businesses and jobs.

Introduction

The Australian housing market was boosted from mid-last year by the combination of the Federal election removing the threat of changes to negative gearing and capital gains tax, rate cuts and regulatory easing. So, after a 10% drop in average capital city prices into mid last year – the biggest fall in property prices for at least 40 years – they have since rebounded by 9%. Our assessment was that price increases would slow from the pace seen since mid-year, but that the combination of low rates, solid population growth and the fear of missing out would still see solid price growth this year.

However, the Coronavirus pandemic & associated shutdowns to economic activity now poses a significant threat to the outlook for property prices. The question is how big the threat is?

Social distancing will likely delay property transactions

The absence of many Chinese buyers flowing from travel bans appears to have had little impact on property demand with clearance rates remaining strong in February.

However, auction clearance rates and sales momentum are showing some signs of slowing this month. This may reflect an increasing desire on the part of buyers and sellers to put property transactions on hold to avoid being exposed to the virus unnecessarily. Social distancing policies will only intensify this, on its own this may crash transactions but may just flatten price gains.

Recession is the big threat

However, it’s the likely recession that we have now entered due to Coronavirus related shutdowns that imposes the big risk. We expect at least two negative quarters of GDP growth in the March and June quarters with the risk that the September quarter is also negative. And the contraction could be deep because big chunks of the economy will be largely shut – tourism, travel, and entertainment with a severe flow on to parts of retailing. The toilet paper, sanitiser and canned/frozen food boom may help supermarkets for a while – but as Deutsche Bank recently calculated for every $1 spent on such items there is $15 spent on things that are vulnerable to social distancing.

Past large share market falls have seen a mixed impact on property prices. The 1987 50% share market crash actually boosted home prices as investors switched from shares to property. But the key is what happens to unemployment as this often forces sales and crimps demand. Back in 1987 the economy remained strong and unemployment fell but the recessions of the early 1980s and early 1990s saw falls in average national capital city home prices of 8.7% and 6.2% respectively as unemployment rose. The GFC share market fall of 55% also saw a 7.6% home price fall, even though it wasn’t a recession, because unemployment rose from 4% to nearly 6%.

So, a lot depends on how deep the recession is and how far unemployment rises. Our base case is for a rise in unemployment to around 7.5% which is likely to drive a 5% or so dip in prices ahead of a property market recovery into next year as the economy bounces back and pent up demand is unleashed again helped by ultra-low interest rates. Government and RBA measures to help struggling businesses and households through the coronavirus shutdown should help in preventing a really big rise in unemployment.

However, if the recession turns out to be long – pushing unemployment to say 10% or more – then this risks tripping up the underlying vulnerability of the Australian housing market flowing from high household debt levels and high house prices. The surge in prices relative to incomes (and rents) over the last two decades has gone hand in hand with a surge in household debt relative to income that has taken Australia from the low end of OECD countries to the high end.

This is nothing new and we have long described it as Australia’s Achilles’ heel. Some things have given us a bit of confidence in recent times prices won’t just crash spontaneously.

• First, the property market has been chronically under supplied. Annual population growth since mid-last decade has averaged 373,000 people compared to 217,000 over the decade to 2005, which requires roughly an extra 75,000 homes per year. Unfortunately, the supply of dwellings did not keep pace with the population surge (next chart) so a massive shortfall built up driving high home prices. Thanks to the surge in unit supply since 2015 this has been reduced but capital city vacancy rates are still around their long-term average indicating a lack of over supply, although Sydney may be more at risk.

• Second, talk of mortgage stress has been overstated. Despite some seeing negative equity into mid-last year and a significant proportion of borrowers switching from interest only to principle & interest loans over the last few years (which has seen interest only loans drop from nearly 40% of all loans to 18%) there has been no surge in forced sales and non-performing loans. While Australia saw a deterioration in lending standards with the last boom, it was nothing like other countries saw prior to the GFC. Much of the increase in debt has gone to older, wealthier Australians, who are better able to service their loans.

We have always concluded that the combination of high prices and debt on their own won’t trigger a major crash in prices unless there are much bigger interest rates or a recession. Unfortunately, we are now facing down the barrel of the latter. A sharp rise in unemployment to say 10% or beyond risks resulting in a spike in debt servicing problems, forced sales and sharply falling prices. This could then feedback to weaken the broader economy as falling home prices lead to less spending and a further rise in unemployment and more defaults and so on. This scenario could see prices fall 20% or so.

Bear in mind though that part of this would just be a reversal of the 9% bounce in average capital city prices seen since mid-last year.

It’s also not our base case but it highlights why Governments and the RBA really have to work hard to avoid letting the virus cause a lot of company failures, surging unemployment and household defaults.

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

Key points:

• Successful investing can be really difficult in times like the present with immense uncertainty around the impact of Coronavirus on the outlook.
• This makes it all the more important to stay focused on the basic principles of successful investing.
• These five charts focus on critical aspects of investing that are insightful in times of market stress: the power of compound interest; don’t get blown off by cyclical swings; the roller coaster of investor emotion; the wall of worry; & market timing is hard.

Introduction

The Coronavirus crisis is first and foremost a human crisis and my thoughts are particularly with those on the front line of this battle. But, of course, its impacting many aspects of life at present, including investment markets. Successful investing can be really difficult in times like the present when markets have collapsed into a bear market with falls globally of around 30% from their highs amidst immense uncertainty about the economic hit from Coronavirus and how much policy stimulus and central bank support can head off collateral damage and boost an eventual recovery. Trying to work this out is driving huge volatility in investment markets making it very easy for short term traders to get whipsawed. I will be the first to admit that my crystal ball is even hazier than normal right now. As the US economist, JK Galbraith once said “there are two types of economists – those that don’t know and those that don’t know they don’t know.” And this is certainly an environment where much is unknown.

But while history does not repeat in that each cycle is different it does rhyme in that each has many common characteristics. So, while we haven’t seen a pandemic driven bear market before the basic principles of investing have not changed. This note revisits five charts I find particularly useful in times of stress.

Chart #1 The power of compound interest

This is my favourite chart. It shows the value of $1 invested in various Australian assets in 1900 allowing for the reinvestment of dividends and interest along the way. That $1 would have grown to $242 if invested in cash, to $1017 if invested in bonds and to $481,910 if invested in shares. While the average return since 1900 is only double that in shares relative to bonds, the huge difference between the two at the end owes to the impact of compounding – or earning returns on top of returns. So, any interest or return earned in one period is added to the original investment so that it all earns a return in the next period. And so on. I only have Australian residential property data back to 1926 but out of interest it shows (on average!) similar long term compounded returns to shares.

Key message: to grow our wealth, we must have exposure to growth assets like shares and property. While shares have collapsed lately amidst massive Coronavirus uncertainty and the short-term outlook for Australian housing is vulnerable too, both will likely do well over the long-term.

Chart #2 Don’t get blown off by cyclical swings

The trouble is that shares can have lots of setbacks along the way as is evident during the periods highlighted by the arrows on the previous chart. Just like now. Even annual returns in the share market are highly volatile, but longer-term returns tend to be solid and relatively smooth as can be seen in the next chart. Since 1900, for Australian shares roughly two years out of ten have had negative returns but there are no negative returns over rolling 20-year periods.

The higher returns shares produce over time relative to cash and bonds is compensation for the periodic setbacks they have. But understanding that these periodic setbacks are just an inevitable part of investing is important in being able to stay the course and get the benefit of the higher long-term returns shares and other growth assets provide over time.

Key message: short-term sometimes violent swings in share markets are a fact of life but the longer the time horizon, the greater the chance your investments will meet their goals. So, in investing, time is on your side and it’s best to invest for the long-term when you can.

Chart #3 The roller coaster of investor emotion

It’s well known that the swings in investment markets are more than can be justified by moves in investment fundamentals alone – like profits, dividends, rents and interest rates. This is because investor emotion plays a huge part. This has been more than evident over the past few weeks. The next chart shows the roller coaster that investor emotion traces through the course of an investment cycle. Once a cycle turns down in a bear market, euphoria gives way to anxiety, denial, capitulation and ultimately depression at which point the asset class is under-loved and undervalued and everyone who is going to sell has – and it becomes vulnerable to good (or less bad) news. This is the point of maximum opportunity. Once the cycle turns up again, depression gives way to hope and optimism before eventually seeing euphoria again.

Key message: investor emotion plays a huge role in magnifying the swings in investment markets. The key for investors is not to get sucked into this emotional roller coaster. Of course, doing this is easier said than done which is why many investors end up getting wrong footed by the investment cycle.

Chart #4 The wall of worry

There is always something for investors to worry about. And in a world where social media is competing intensely with old media it all seems more magnified and worrying. This is arguably evident now in relation to Coronavirus uncertainty. The global economy has had plenty of worries over the last century, but it got over them with Australian shares returning 11.5% per annum since 1900, with a broad rising trend in the All Ords price index as can be seen in the next chart, and US shares returning 9.6% pa. (Note that this chart shows the All Ords share price index whereas the first chart shows the value of $1 invested in the All Ords accumulation index, which allows for changes in share prices and dividends.)

Key message: worries are normal around the economy and investments and sometimes they become intense – like now. But they eventually pass. For example, back in mid-January it seemed the bushfires, smoke shrouding our cities and regular news of homes and lives lost would never end. But when I went to regional NSW in the last week it was lovely, green and wet. And so, it is with Coronavirus – this too will pass eventually.

Chart #5 Timing is hard

The temptation to time markets 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 switch between say cash and shares within your super to anticipate market moves. This is particularly the case in times of emotional stress like now when all the news around Coronavirus and its impact on the economy is bad. 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 8% 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 11% pa. And if you avoided the 40 worst days, it would have been boosted to 15.8% 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 6.1% pa. If you miss the 40 best days, it drops to just 2.2% pa.

Key message: trying to time the share market is not easy.

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

Key points:

• The rout in financial markets has continued, on the back of Coronavirus, made worse by a flow on to oil markets
• The risk of a deeper hit to economic activity has risen. Key things to watch are the daily number of new cases, measures of economic stress and policy stimulus.
• Key things to investors to bear in mind remain that: share market falls are normal; selling shares after a fall locks in a loss; share pullbacks provide opportunities; and to avoid getting thrown off a long-term strategy it’s best to turn down the noise during times like this.

Introduction

Coronavirus continues to rattle investment markets as the number of new cases outside China continues to rise posing increasing uncertainty over the impact on economic activity. And its impact has intensified following the collapse of OPEC discipline causing a further plunge in oil prices raising concerns about debt servicing for oil producers. From their highs global shares and Australian shares have had a fall of around 20%.

Given the extreme uncertainty this note looks at various scenarios in relation to global and Australian economic growth and what signposts to look at in relation to how it may unfold.

Much ado about nothing or a major global catastrophe

It seems there are two extreme views on Coronavirus. Some see it as just a bad flu and can’t see what all the fuss is about. Others think that it will trigger a major humanitarian and economic catastrophe killing millions and triggering a major global recession as excessive leverage is finally exposed. The optimist in me wants to lean to the former:

• So far over 114,000 people are reported to have contracted the virus of which nearly 4000 have died. Of course, this number is still growing but in China where the number of new cases has collapsed (see the first chart) the number is 80,754 cases and 3136 deaths. In the 2017-18 US flu season alone 44.8m Americans got sick and 61,099 died.
• The actual death rate from Covid-19 may be 1% or lower, rather than the currently reported rate of 3.5% because many of those who get the virus don’t get sick enough to seek medical help and so won’t be included in the case count. The Diamond Princess episode may provide a rough guide – all 3711 passengers and crew have been tested with 705 contracting the virus of which seven have died and most of those are believed to have been over 70. This would suggest a death rate of 1% which is only just above that for regular flu for those over 65.
• It appears to be less contagious than regular flu.
• China’s experience shows it can be contained. Maybe this is due to extreme containment measures in Hubei that are not possible in other counties. But the case count in the rest of China has also been contained with less extreme measures and Singapore and Hong Kong have had some success in slowing new cases without extreme quarantining.

• Alternatively, at some point authorities outside China may just conclude that containment is impossible and, as the death rate is not apocalyptic, shift from containment to just treating those who get very sick. This could enable life to return to normal, albeit with a change in behavior – less handshaking, frequent hand washing and wearing a mask.

But I also must concede I just don’t know. There is much that is unknown about the virus itself and how long it will continue to spread. And even if there is a switch to just treating the very sick it’s unclear there will be enough hospital beds. And there is also the human or behavioural overlay which is intensifying the economic impact. Just look at the toilet paper frenzy to see that this can have a real economic effect even before the virus has really taken hold in Australia. While there may be a boom in demand for hand sanitisers, toilet paper and long-life food, this will be a temporary boost as the spread of the virus globally and the disruption that containment measures are causing is continuing to increase the risk of a longer and deeper hit to economic activity. And there is a risk of secondary effects as the short-term disruption risks leading to business failures and households defaulting on their debts if they can’t keep up their payments and so causing a deeper impact on economic activity. The secondary effects of the coronavirus outbreak and its flow on is highlighted by the 45% collapse in oil prices since mid-January. Ultimately lower petrol prices will be a good thing as this will boost consumer spending when the virus goes away but for now all the focus is on the downside of lower oil prices – debt problems and less business investment by producers.

Base case versus global recession and beyond

Given all these uncertainties it’s still too early to say that shares, commodity prices and bond yields have bottomed. The following charts present three scenarios for the global economy.

• How we saw global growth panning out prior to the virus. Basically, we were expecting a mild pick-up in growth.
• A sharp downturn centered around the March quarter as the Chinese economy contracts sharply but rebounds in the June quarter offsetting recessions in developed countries including in the US. This is our base case.
• A worse case downturn that sees global growth contract in the March (led by a sharp contraction in China) and the June quarter (as developed countries get badly hit) resulting in a global recession to be then followed by a rebound as life returns to normal led by China.

Note: the scenarios show quarterly annualized growth. The key is to focus on the pattern of growth rather than the precise level.

The next chart shows three scenarios for Australian growth:

• How we saw global growth panning out prior to the virus.
• Mild turndowns in the March and June quarters driven initially by the lockdown in the China and then the Coronavirus flow on to the rest of the world and Australia, followed by a second-half rebound. This is our base case.
• A worse case downturn that sees deeper downturns in the March and June quarters then followed by a rebound as life returns to normal.

Last week we moved to forecasting a recession for the Australian economy in our weekly report. We were already expecting a negative March quarter on the back of the bushfires and the hit to tourism, education exports and commodity exports from the slump in China. But the spread of the coronavirus globally and in Australia has made it likely that we will also see a contraction in the June quarter too. As with the global outlook this should really be “a disruption” that will pass once the virus runs its course – hopefully at least as the Northern Hemisphere heads toward summer. The worse case scenarios would likely see a deeper decline in shares and bond yields.

What to watch?

Shares will bottom when there is confidence that the worst is over in terms of the economic impact from the virus and its largely factored in. So, the debate is largely now about how big the hit to growth will be and this relates to how long the virus will weigh on global growth and any secondary effects it may cause. In this regard, the key things to watch are as follows:

• A peak in the number of new cases – as per the first chart.
• News of successful vaccines or anti – virals.
• Whether governments switch from containment.
• Timely economic indicators, e.g., jobless claims and weekly consumer confidence data in the US and Australia.
• Measures of corporate stress, eg, spreads between corporate bond yields and government bond yields.
• Measures of household stress. E.g, unemployment and non-performing loans.
• Measures of market stress, eg, bank funding costs as measured by the gap between 3-month rates and central bank rates. These have risen but are well below GFC levels.

• The monetary and fiscal policy response – this will be critical in terms of minimising the impact on vulnerable businesses and households from the coronavirus disruption, ensuring financial markets remain liquid and driving a quick recovery once the threat from the virus is over. So far so good with policy makers moving in the right direction (rapidly so in Australia it seems) – but there is a fair way to go.

What does it all mean for investors?

The rapidity of the fall in share market has been scary. In our view the key things for investors to bear in mind are as follows:

• Periodic sharp falls in share markets and healthy and normal. With the long-term trend ultimately remaining up & providing higher returns than other more stable assets.
• Selling shares or switching to a more conservative investment strategy after a major fall just locks in a loss.
• When shares fall, they are cheaper and offer higher long-term return prospects. So, the key is to look for opportunities the pullback provides. It’s impossible to time the bottom but one way to do it is to average in over time.
• While shares have fallen, dividends from the market haven’t. Companies like to smooth their dividends over time – they never go up as much as earnings in the good times and so rarely fall as much in the bad times.
• Shares and other related assets bottom at the point of maximum bearishness, ie, just when you feel most negative towards them.
• The best way to stick to an appropriate long-term investment strategy, let alone see the opportunities that are thrown up in rough times, is to turn down the noise.

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

Key points:

• Share markets have fallen sharply over the last week or so on the back of Coronavirus concerns.
• Shares may still have more downside and the uncertainty around the Coronavirus crisis is very high, but we are of the view that it’s just another correction.
• Key things for investors to bear in mind are that: corrections are normal; in the absence of recession, a deep bear market is unlikely; selling shares after a fall locks in a loss; share pullbacks provide opportunities for investors to buy them more cheaply; while shares may have fallen, dividends are smoother; and finally, to avoid getting thrown off a long-term investment strategy it’s best to turn down the noise during times like this.

Introduction:

The plunge in share markets over the last week has generated much coverage and consternation. This is understandable given the rapidity of the falls – with US shares having their fastest 10% fall from an all-time high on record – and the uncertainty around the Coronavirus (Covid-19) and its impact on economic activity. From their highs to recent lows US shares have fallen 13%, Eurozone shares have fallen 16%, Japanese and Chinese shares have fallen 12% and Australian shares have fallen 12%. This note looks at the issues for investors and puts the falls into context.

What’s driving the latest plunge?

The plunge basically reflects two things.

• After very strong gains from their last greater than 5% correction into August last year, share markets have become vulnerable to a correction.
• The uncertainty around Coronavirus outbreak which is on the verge of becoming a pandemic and its impact on global growth has unnerved investors dramatically. Shares had recovered from their initial fall on the back of the virus into early February on signs that the number of new cases in China was falling (which is continuing), limited cases outside China and expectations that policy easing would limit any damage. This has been blown apart in the last week as cases have popped up en masse in Italy, South Korea and Iran, more cases have appeared elsewhere around the world and this has resulted in expectations of a deeper and longer hit to global growth.

After big falls shares have become technically oversold, measures of negative investor sentiment such as the VIX (or fear) index and demand for option protection have spiked. So, shares could have a short-term bounce. But given the uncertainties around Covid-19 – with more cases in the US and Australia likely to pop up – the situation could get worse before it gets better, so the share pullback could have further to go – notwithstanding short-term bounces.

Considerations for investors

Sharp market falls with headlines screaming that billions of dollars have been wiped off the share market are stressful for investors as no one likes to see the value of their investments decline. The current situation is doubly stressful because of fears for our own and others health – particularly for the elderly. However, several things are worth bearing in mind:

First, while they all have different triggers and unfold a bit differently to each other, periodic corrections in share markets of the order of 5%, 15% and even 20% are healthy and normal. For example, during the tech/dot-com boom from 1995 to early 2000, the US share market had seven pull backs greater than 5% ranging from 6% up to 19% with an average decline of 10%. During the same period, the Australian share market had eight pullbacks ranging from 5% to 16% with an average fall of 8%. All against a backdrop of strong returns every year. During the 2003 to 2007 bull market, the Australian share market had five 5% plus corrections ranging from 7% to 12%, again with strong positive returns every year. More recently, the Australian share market had a 10% pullback in 2012, an 11% fall in 2013 (the taper tantrum), an 8% fall in 2014, a 20% fall between April 2015 and February 2016, a 7% fall early in 2018, a 14% fall between August and December 2018 and a 7% fall into August last year. And this has all been in the context of a gradual rising trend. And it has been similar for global shares – with the last big fall in US shares being a 20% plunge into Christmas eve 2018. See the next chart. While they can be painful, share market corrections are healthy because they help limit a build-up in complacency and excessive risk taking.

Related to this, shares climb a wall of worry over many years with numerous events dragging them down periodically, but with the long-term trend ultimately up & providing higher returns than other more stable assets. Bouts of volatility are the price we pay for the higher longer-term returns from shares.

Second, the main driver of whether we see a correction (a fall of 5% to 15%) or even a mild bear market (with say a 20% decline that turns around relatively quickly like we saw in 2015-2016) as opposed to a major bear market (like that seen in the global financial crisis (GFC)) is whether we see a recession or not – notably in the US as the US share markets tends to lead for most major global markets. The next table shows US share market falls greater than 10% since the 1970s. I know it’s heavy – but I like this table! The first column shows the period of the fall, the second shows the decline in months, the third shows the percentage decline from top to bottom, the fourth shows whether the decline was associated with a recession or not and the fifth shows the gains in the share market one year after the low. Falls associated with recessions are highlighted in red.

Several points stand out:

• First, share market falls associated with recession tend to be longer and deeper.
• Second, after the low the, share markets generally rebound sharply – which invariably make sit very hard for investors to time, as by the time they realise what has happened and get back in the market is above where they sold.
• Finally, as would be expected the share market rebound in the year after the low is much greater following falls associated with recession.

So, whether a recession is imminent or not in the US is critical in terms of whether we will see a major bear market or not. In fact, the same applies to Australian shares. Our assessment is that a US/global recession is not inevitable. We have not seen the excesses – in terms of overall debt growth (although housing debt is a source of risk in Australia), over investment, capacity constraints and inflation – that normally precede recessions in the US, globally or Australia. And we have not seen the sort of monetary tightening that leads into recession. In fact, monetary conditions remain very easy. However, the uncertainty around the coronavirus outbreak and the likelihood of economic shutdowns designed to contain it beyond those in China do suggest a greater than normal risk on this front. That said even if there were a recession growth would likely rebound quickly once the virus came under control as economic activity sprang back to normal helped by policy stimulus.

Third, selling shares or switching to a more conservative investment strategy or superannuation option after a major fall just locks in a loss. With all the talk of billions being wiped off the share market, it may be tempting to sell. But this just turns a paper loss into a real loss with no hope of recovering. The best way to guard against making a decision to sell on the basis of emotion after a sharp fall in markets (as many including me are tempted to do!) is to adopt a well thought out, long-term strategy and stick to it.

Fourth, when shares and growth assets fall, they are cheaper and offer higher long-term return prospects. So, the key is to look for opportunities the pullback provides – shares are cheaper and some more than others. It’s impossible to time the bottom but one way to do it is to average in over time.

Fifth, while shares have fallen, dividends from the market haven’t. They will come under some pressure as the economy and profits take a hit from a deeper and longer coronavirus outbreak. But companies like to smooth their dividends over time – they never go up as much as earnings in the good times and so rarely fall as much in the bad times. So, the income flow you are receiving from a well-diversified portfolio of shares is likely to remain attractive, particularly against bank deposits.

Sixth, shares and other related assets often bottom at the point of maximum bearishness, ie, just when you and everyone else feel most negative towards them. So, the trick is to buck the crowd. “Be fearful when others are greedy. Be greedy when others are fearful,” as Warren Buffett has said.

Finally, turn down the noise. At times like this, negative news reaches fever pitch. Talk of billions wiped off share markets and warnings of disaster help sell copy and generate clicks & views. But we are rarely told of the billions that market rebounds and the rising long-term trend in share prices adds to the share market. Moreover, they provide no perspective and only add to the sense of panic. All of this makes it harder to stick to an appropriate long-term strategy let alone see the opportunities that are thrown up. So best to turn down the noise.

Dr Shane Oliver, Head of Investment Strategy & Chief Economist 

Key points:

• While reported new coronavirus cases in China have slowed, the pickup in cases outside China has led to a renewed sharp fall in share markets and bond yields.
• Our base case is that the outbreak will be contained allowing share markets and bond yields to rebound in the June quarter.
• However, the hit to economic activity is deepening & the risks around Covid-19 becoming a pandemic have risen leaving shares vulnerable to more near term falls.
• The key for most investors though is to recognise that periodic share market falls are inevitable & hard to time & so it’s best to take a long-term approach to investing.

Introduction:

The past week has seen a renewed escalation in concern that the coronavirus outbreak (Covid-19) has become or is becoming a global pandemic. This is first and foremost a human crisis and our thoughts are with all those affected and trying to combat the outbreak. Naturally though investment markets are starting to become increasingly concerned about the disruptive impact on economic activity. As a result, while most share markets recovered their initial decline on the back of the virus with some hitting new highs last week, we are now seeing renewed sharp falls. This note updates our initial analysis from three weeks ago (see The China Coronavirus outbreak) as to the impact of the outbreak.

Scenarios:

Our assessment three weeks ago saw as our base case with 75% probability that the outbreak would be contained within the next month or two. This could still see more downside in share markets & bond yields but there would be a rebound by the June quarter as growth rebounds.  The downside case saw a full-blown pandemic with delayed containment resulting in sharp drawn out slump in economic activity, the risk of recession and a 20% or so fall in share markets with the $A falling to around $US0.60. Of course, there are lots of variations around this. We thought the key things to watch are the daily number of new cases and the spread of new cases in developed countries.

Where are we with the Covid-19 outbreak so far?

• First, while the total number of reported cases is now around 80,000 worldwide there has been some good news in that the daily number of new cases is down from its peak earlier in February. This is due to a sharp fall in the reported number of new cases in China. This has been confused by definitional changes in China – with Hubei initially reporting lab confirmed results, then including clinically tested results, then reverting to lab tested results only. However, both approaches have issues & even if it’s roughly right it’s good news if China is starting to get the outbreak under control.

• Against this, the number of new cases outside China has spiked – particularly in South Korea, Japan, Italy and Iran.

• The mortality rate has increased to 3.3% – although there is uncertainty about it. Some argue it’s higher because it’s wrong to divide deaths into all cases as there is a lag from getting the diseases to dying. Others argue it’s much lower because only those who are seriously ill are showing up for help and being measured. The mortality rate does look to be below the 9% for SARS but above that for swine flu though it’s mainly the old and sick who are most vulnerable.
• There is still much uncertainty about how it’s spread – with leaky plumbing and aerosolising of toilet water or contaminated water possibly playing a role in the spread of the virus in the Diamond Princess cruise ship in Japan.
• Containment measures in China have been aggressive and if the declining number of new cases in China is correct maybe they are working. Australia’s quick toughening on entry and quarantine conditions may also have helped in contrast to other countries that now have many more cases. However, some governments may not be able to implement and enforce such tough measures.

The spread of cases beyond China has raised increasing concerns that Covid-19 is become a global pandemic. While we and others have made comparisons to the SARS outbreak of 2003, the swine flu pandemic of 2009 is also relevant. Despite efforts to contain the disease it is estimated to have ultimately infected 700million to 1.4billion people but because its death rate was low at around 0.02-0.04% it doesn’t get referred to much. Partly due to this swine flu had little impact on the global economic recovery of 2009 although it did occasionally rattle share markets. Though Covid-19’s mortality rate looks to be greater than that of swine-flu its worth noting that swine-flu’s mortality was initially reported to be as high as 9.5%.

A big hit to global growth

Whether Covid-19 is soon contained, turns into a re-run of swine-flu or something a lot more deadly remains to be seen. Our base case remains one of containment by the end of March. But the risk of it taking longer is significant and in any case it’s increasingly clear that the economic impact will be quite severe as containment measures spread globally disrupting supply chains and spending.

• Some estimates suggest that as much as 50% of China’s economy has been locked down for the last three weeks which means nearly 12% knocked off Chinese GDP this quarter. While the Chinese Government is refocusing on efforts to restore economic activity outside Hubei and high-risk areas, so far there is only mixed evidence of that. Coal consumption at power stations, migrant flows to cities, property sales and steel demand are up from their lows but remain well below normal levels for this time of year. And there has been no pickup in traffic congestion.

• Numerous companies globally are reporting disruption to supply chains or reduced demand flowing from Covid-19.
• Containment measures including travel restrictions in countries like Japan, Korea and Italy will spread the economic disruption globally.
• Our rough estimate is that March quarter global GDP could now be zero or slightly negative.
• Australian GDP is likely to go backwards this quarter (with our current estimate being -0.1%) thanks to the bushfires and the hit from coronavirus. The next vulnerability of the Australian economy to China is apparent from the next chart. Exports to China make up nearly 9% of Australia’s GDP including hard commodities at nearly 5%, tourism at 0.2% and education at 0.6%. For other major countries it’s less than 3%. Chinese tourist arrivals stopped with the travel ban, education is under threat although there is a bit more time and bulk commodity shipments are showing signs of being impacted (although this has been distorted by storms). Clearly the longer it drags on and the more the outbreak and disruption spreads globally the bigger the impact on Australia including the risk of two negative quarters, ie recession. The rising threat to the Australian economy from coronavirus is adding to the likelihood that the RBA will cut rates in March or April and the pressure for more fiscal stimulus in the May budget is increasing.

Concluding comments

The increasing global spread of the coronavirus has increased the risk of greater economic disruption for longer resulting in say a 20% fall in share markets. However, our base case of containment is that Chinese, global and hence Australian growth will rebound in the June quarter (avoiding recession in Australia’s case) although the risk of a delay is significant. Against this background share markets, commodity prices and the $A remain at high risk of more downside in the short-term, but assuming some containment and a growth rebound in the June quarter markets should rebound by then. Easier than otherwise monetary and fiscal policies – with ever more stimulus measures announced in China and more monetary and fiscal easing globally – would add to this. The key things to watch for remain a further downtrend in the daily number of new cases globally and a peak in new cases in developed countries.

In a big picture sense, the fall in share markets should be seen as just another correction after markets ran hard and fast into record highs this year from their last decent correction into August last year.

Finally, for most investors given the obvious difficulty in trying to time any of this – whether it’s a further share market fall of 5% or 20% or no further fall at all and then when to get back in – it makes sense to turn down the noise around the virus and stick to a long-term investment strategy.

Dr Shane Oliver, Head of Investment Strategy & Chief Economist

The local residential property market has held strong into the New Year, with solid gains eventuating through January across all capital cities. The best performing were Sydney and Melbourne, which appear to be recovering well following losses experienced from 2017 to the middle of 2019.

With Sydney approximately 4 or 5% below all-time market highs and Melbourne even closer, we should reach record prices in both cities at some stage over the next five months.

These gains are expected to remain solid for the first half of this year with the Reserve Bank keeping interest rates on hold at 0.75% and pent-up demand continuing to have strong influence on the property market. As we’ve seen before, in a rising market there are always a certain number of buyers who are driven by fear of missing out on the market’s upsurge and will jump on the opportunity to purchase.

As the year progresses, it is likely the gains will gradually dwindle for several reasons.

The first is affordability, which will start to become a significant issue again with the record prices expected in Sydney and Melbourne. This will be compounded by the continued slowing of the economy, which will hold some buyers back, particularly as the pent-up demand from previous years begins to taper off. And finally, regulators may step in and attempt to put the brakes on mortgage lending, which will become more of a concern once credit growth starts to pick-up.

Towards the end of 2020, the property market is likely to achieve price gains of around 8-10% on average around the country and leadership will probably shift from Sydney and Melbourne to Brisbane and Adelaide, as value seems to be prominent in these cities. The Perth market is also one to watch, as the mining investment cycle starts to kick in again and spur on the Western Australian economy.

In evaluating property market movements, keep a close eye on interest rate movements and other monetary easing from the Reserve Bank, as well as on the regulators and any potential interventions around lending. More imminently, the impact of the bushfires and coronavirus should also be monitored, as the aftermath may have an adverse effect on people’s purchase decisions.

The bottom line is to expect another year of solid gains out of the Australian property market but potentially some slowing as we move through the second half of the year.

Shane Oliver, Head of Investment Strategy & Economics and Chief Economist

Key points:

• The coronavirus outbreak is just another of a long list of worries. Our natural inclination to zoom in on negative news combined with a massive ramp-up in the availability of information is arguably making us worse investors: more fearful, more jittery, more short-term.
• Five ways to help manage the noise and turn down the worry list are: put the latest worry in context: recognise that shares return more than cash in the long-term because they can lose more money in the short-term; find a process to help filter noise; make a conscious effort not to check your investment so much; look for opportunities that investor worries throw up.

Introduction

2020 has seen a very noisy start to the year with one major event with significant human and investment market implications after another. For Australia it started with an intensification of the bushfires but moved on to a significant ramping of US/ Iran tensions where, according to President Trump, war came “closer than you thought” and now the coronavirus outbreak is creating fears of a global pandemic and a big hit to global economic activity. These are scary in terms of their human consequences, but also in terms of the potential economic fallout and what it means for investors. The coronavirus outbreak in particular continues to pose significant uncertainty around the short-term economic outlook. In terms of the key things to watch there is some good news with signs of a reported slowing in new cases in China and still limited transmission outside China (which has 99% of cases).

And the mortality rate at just over 2% remains lower than with SARS. Against this there remains much debate about the true number of cases, it’s common in outbreaks to see periods of stabilisation only to be followed by a spike in cases and the disruption to economic activity in China and from global travel bans remain significant all of which makes it easy to imagine the worst in terms of economic consequences. Each week China remains say 2/3rds shut it knocks 1.3% off its GDP of 0.25% directly off global GDP.

The gain much of 2018 and 2019 saw endless talk about how much the trade war was going to knock off global growth. More fundamentally, the coronavirus is part of a seemingly never-ending worry list which is receiving and ever-higher prominence as the information enables the rapid dissemination of news, opinion and noise. But as Frank Zappa warned “information is not knowledge, knowledge is not wisdom”. The danger is that information overload is making us worse investors as we focus on one worry after another resulting in ever shorter investment horizons.

Are the worries more worrying than ever?

When I was a teenager in the 1970s I used to bemoan my grandmother for reading too much gloom into the nightly TV news and telling me that the world is much worse today that when she was young…when there was WW1, Spanish influenza that reportedly killed around 50 million people, the Great Depression and WW2 when her brother was killed. However, now it seems the worry list is even bigger. Yes, there is a fundamental element as global growth is slower, technological disruption is leading to worker anxiety and inflated expectations, and the world seems awash in geopolitical risks.

But there is a huge psychological aspect to this that is combining with the increasing availability of information and intensifying competition amongst various forms of media for clicks, that is magnifying perceptions around various worries.

We all suffer from a behavioral trait that in its financial manifestation is known as “loss aversion” in that a loss in financial wealth is felt much more distastefully than the beneficial impact of the same sized gain. This probably reflects the evolution of the human brain in the Pleistocene age when the trick was to avoid being eaten by a sabre-toothed tiger or squashed by a woolly mammoth. This makes us biased to be more risk averse and on the lookout for threats which leaves us more predisposed to bad news stories as opposed to good news stories. So bad news and gloom find a more ready market than good news or balanced commentary as it appeals to our instinct to look for threats. Hence “bad new sells”. Of course, this has always been the case so there is nothing new here.

The big change though is that we are now exposed to more information in relation to everything including our investments. This is great in the sense that we can check things, analyse them and sound informed easier than ever. But often we have no way of weighing such information and no time to do so. If we can’t filter it, it becomes information overload and noise. This can be bad for investors as when faced with more (and often bad) news we can freeze up and make the wrong decisions with our investment as our natural “loss aversion” combines with what is called the “recency bias” that sees people give more weight to recent events which can see investors project recent bad news into the future and so sell after a fall.

Finally, the problem is being compounded by an explosion in media outlets all competing for your attention. We are now bombarded with economic and financial news and opinions with 24/7 coverage by web sites, subscription services, finance updates, dedicated TV and online channels, etc. And in competing for your attention, bad news and gloom trumps good news and balanced commentary as “bad news sells.”

So naturally it seems that the bad news is ‘badder’ and the worries more worrying than ever. Google the words “the coming financial crisis” and you get 236 million search results – up from 115 million when I did it 18 months ago – with titles such as:

• “World economy is sleepwalking into a new financial crisis”;
• “4 early warning signs of the next financial crisis”;
• “The coming economic crash”;
• “Why the next global financial crisis may dwarf…2008”; and
• “Financial crisis- Bible prophecy & current events.”

The trouble is that there is no evidence that all this noise is making us better investors. Average returns are no higher than in the past. A concern is that the combination of a massive ramp up in information combined with our natural inclination to zoom in on negative news is making us worse investors: more fearful, more jittery and more short term focused.

Five ways to manage the perpetual worry list

So here we take another look at five ways to manage the worry list and turn down the noise:

Firstly, put the latest worry list in context. Remember that there has always been an endless stream of worries. Here’s a list of the worries of the last five years that have weighed on markets at various points: deflation; commodity/oil crash; Grexit; China worries; Brazil and Russia in recession; manufacturing slump globally; Fed rate hikes; Brexit; South China Sea tensions; Trump; Eurozone elections; North Korea; Germany; Catalonia; Italy; US inflation and rates; Trade war; China slowdown; Aust Royal Commission; Aust housing downturn; US government shutdown; inverted yield curves; impeachment; Aust recession fears; and Iran tensions. Yet despite this extensive worry list investment returns have actually been okay with average balanced growth super funds returning 7.3% pa over the last five years after taxes and fees. In fact, the global economy has had plenty of worries over the last century, but it got over them with Australian shares returning 11.8% pa since 1900 and US shares 9.9%pa.

And while history doesn’t repeat it does rhyme and it’s often useful to look back at previous similar events to the latest worry to see how they panned out. This is where the experience around SARS is useful in relation to the latest coronavirus outbreak.

Secondly, recognise how markets work. A diverse portfolio of shares returns more than bonds and cash over the long-term because it can lose money in the short-term. While the share market is highly volatile in the short-term it has seen strong returns over rolling 20-year periods. So, volatility driven by worries and bad news is normal. It’s the price investors pay for higher long-term returns.

Thirdly, find a way to filter news so that it doesn’t distort your investment decisions. For example, this could involve building your own investment process or choosing 1-3 good investment subscription services and relying on them. Or simpler still, agreeing to a long-term strategy with a financial planner and sticking to it. Ultimately it all depends on how much you want to be involved in managing your investments.

Fourthly, don’t check your investments so much. If you track the daily movements in the Australian All Ords price index or the US S&P 500, it has been down almost as much as it has been up. So, day to day it’s pretty much a coin toss as to whether you will get good news or bad. By contrast if you only look at how the share market has gone each month and allow for dividends the historical experience tells us you will only get bad news 35% of the time. Looking only on a calendar year basis, data back to 1900 indicates that the probability of bad news in the form of a loss slides further to 20% for Australian shares and 27% for US shares. And if you can stretch it out to once a decade positive returns have been seen 100% of the time for Australian shares and 82% of the time for US shares.

The less frequently you look the less you will be disappointed and so the lower the chance that a bout of “loss aversion” triggered by a bad news event will lead you to sell at the wrong time. So, try to avoid looking at market updates so regularly.

Finally, look for opportunities that bad news throws up. Periods of share market turbulence after bad news throw up opportunities as such periods push shares into cheap territory.

Concluding comment

My long-term experience around investing tells me that its far more productive to into prognostications of financial gloom because most of the time they are wring and end up just distracting investors from their goals.

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

The Coronavirus is slowly jumping international borders after its initial spread in China, and markets have not been immune to its impact.

Coronaviruses are a large family of viruses which have been known to create illnesses. There is currently a new coronavirus affecting people who have recently been in the city of Wuhan, China. From a public health perspective, this is a rapidly evolving situation and there remains “much to learn” about how it is spread, its severity, and best treatment.

The World Health Organisation (WHO) has now agreed that the outbreak meets the criteria for a public health emergency of international concern. This means that WHO can coordinate the global response by advising countries on public health measures and recommending travel bands.

The virus has spread outside China. At this stage there are a few cases globally including in Thailand, Japan, Singapore, Australia the US and France.

Authorities have been proactive in taking steps to contain the spread of the virus, including closing transport in Wuhan and cancelling celebrations for the lunar new year.

“The very strong measures [China] has taken include daily contact with WHO and comprehensive multi-sectoral approaches to prevent further spread. It has also taken public health measures in other cities and provinces; is conducting studies on the severity and transmissibility of the virus and sharing data and biological material. The country has also agreed to work with other countries who need their support. The measures China has taken are good not only for that country but also for the rest of the world,” the WHO said in a statement.

Its spread has impacted confidence, and is now showing signs of having a material impact on tourism, as travel to and from China is restricted.

Here, we take at some of the key market developments in relation to this feared pandemic. It’s important to note that this is a situation which is constantly evolving, and that the below is a point in time assessment.

What we know so far

• This situation is evolving. At this stage, sharemarkets have been hit, especially in Asia on concerns around the impact of the virus. For now, Australian and US shares have been more resilient.
• There have been numerous health scares in recent history (SARS, bird flu, swine flu, MERS, Ebola.) While the loss of life in these instances is tragic and the panic caused in affected regions impacts everyday life, the worst-case scenario of a global pandemic like the 1918 Spanish Flu (that killed up to 50 million people) has not come to pass.
• For markets, investors should be alarmed but not panic just yet. While number of total Coronavirus cases has increased dramatically over the past week, the daily rate of change in new cases looks to be plateauing. While it’s impossible to know exactly how much more the virus can spread, most epidemics have taken 6-18 months to fully run their course and then the actions taken by authorities (hygiene, quarantine, banning gatherings, preventing travel) start having an impact. The 2003 impact of the SARs outbreak was shorter due to rapid action by authorities. The quick reaction by Chinese authorities this time round is reason for optimism.
• Comparing the current episode to SARs is useful. The 2003 SARS outbreak infected 8000 people, mostly in Asia, in 30 countries over 5 months at a mortality rate of 10%. While the number infected was not that great, SARS had a big negative impact on countries economic activity. GDP in Hong Kong and Singapore in the June quarter 2003 fell by over 2% as people stayed home (lower retail sales), missed work and travel was cancelled. Growth then rebounded.

• Asian shares fell in April 2003 even though global shares were rising. Usually the share market low coincides with a peak in the number of new cases (see chart below) so there is a risk that Asian equities fall further.

Disruptions to growth

• This time round, the risk to disrupting economic growth is high because the spread of the virus coincides with the lunar new year, and the associated spending that goes with it (travel, eating out, retail sales).
• It’s also happening around the same time that China and emerging markets economies are showing signs of stronger growth, with the virus having the ability to disrupt activity. The other point to note is that the mortality rate (so far) for the new Coronavirus is lower at 2-3% compared to SARS (10%) and much lower than Ebola (at 50% and higher).
• We expect a fall in Chinese GDP around 2-3% over the March quarter as Coronavirus is more widespread than SARS (although it is less lethal and there have been faster actions by authorities). While this is a big hit to growth initially, GDP growth is likely to rebound in the June quarter, although the total losses from production are unlikely to be fully recouped.
• In Australia, there will be a temporary disruption to tourism, education and exports (particularly commodities and to a lesser extent agriculture). Chinese tourist and education arrivals make up around 20% of total arrivals – a significant chunk. There could also be an impact if Australians start staying home. On our estimates the total detraction to growth is worth around 0.2-0.3% of GDP. But there are offsets – the $A depreciation from a risk-off global environment will boost broad export growth and lower travel to China is seen as a reduction in imports and it could even mean that Australians choose to holiday in Australia. Along with the bushfires, the total negative impact to March quarter GDP growth could be around 0.5% which is a decent amount.

Investors: keep watch, keep calm

Despite the rightly mounting concern about the spread of the Coronavirus, as mentioned above, there is reason to believe that the threat will be contained and managed, but it could take some time with epidemics usually taking 6-18 months to run their course The rapid and widespread response from the Chinese government, and mobilising of countries outside China to detect and contain cases of the virus which have crossed their borders are important steps in containing the virus. Markets have been impacted by similar situations before, like SARS, and have recovered but the concern about the spread of the Coronavirus will keep investors cautious and markets volatile in the near-term given the disruption to economic activity. Once it becomes more evident that the number of people infected has reached a peak, markets tend to take this as a positive signal.

Diana Mousina, Senior Economist

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

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