Introduction

Australian economic growth has slowed to the weakest since the GFC. Talk of recession remains all the rage. And economists don’t have a great track record in predicting recessions globally – with an IMF study finding that of 153 recessions seen in 63 countries around the world between 1992 and 2014, economic forecasters only predicted five in April of the year before they started – so why should they pick one this time? As someone who forecast two of the last one recessions in Australia I am a bit wary. Perhaps the best way to predict recessions would be to forecast one every year and then you would have a perfect track record in predicting them! Some actually do this. But they are totally useless because they miss out on the 90% or so of the time that countries are not in recession and the positive lead this provides for share markets and other growth assets.

Recessions come along when there is a shock to the system (usually high interest rates), invariably at a time when the economy is vulnerable after a period of excess (such as rapid growth in spending, debt or inflation). The shock causes a loss of confidence, lots of little spending decisions are delayed and excesses are unwound. But given the natural tendency of most economies to grow given population growth and new innovations, increasing economic diversity, counter cyclical economic policies and the rise of the more stable services sector recessions are relatively rare at around 10-12% of the time globally. In Australia the last one was 28 years ago.

Why there has been no recession for 28 years

The absence of an Australian recession – whether defined by two quarterly GDP contractions in a row or negative annual growth – for 28 years is instructive. Many forecast recessions at the time of the 1997-98 Asian crisis, 2000-2002 tech wreck, the GFC and from around 2012 as the mining investment boom ended. But it didn’t happen. There are seven reasons why:

• economic reforms made the economy more flexible;
• the floating of the $A has seen it fall whenever there is a major economic problem providing a shock absorber;
• desynchronised cycles across industry sectors;
• strong growth in China that helped through the GFC;
• strong population growth;
• counter cyclical economic policy – like stimulus payments and monetary easing that helped in the GFC; and
• good luck – which can never be ignored lest hubris set in!

But is our luck running out?

June quarter GDP growth was just 0.5%. And annual growth has fallen to 1.4% which is the slowest since the GFC and below population growth of 1.6%. Housing and business investment fell, and consumer spending remains very weak. Were it not for public spending and net exports the economy would have gone backwards in the June quarter.

Going forward, the housing downturn has further to run with building approvals pointing to a further fall in home building.

This is likely to amount to a 0.5-0.6 percentage point pa direct detraction from growth. This along with low property turnover (less people moving) and lagged negative wealth effects from the earlier fall in house prices will all act as drags on consumer spending. In total the housing downturn is likely to detract around 1-1.2 percentage points from growth in the year ahead.

The drought will likely also act as an ongoing drag on growth with a “mild” El Nino hanging around although this may be modest at around a 0.2 percentage point growth detraction. The threats to global growth from trade wars also suggests downside risks to export growth.

The weakness in relation to the economy is clearly evident in soft profit results in the recent June half year profit reporting season. The ratio of upside surprise to downside was the weakest since 2009, only 58% of companies saw profits rise from a year ago and the proportion of companies raising or maintaining their dividends fell to the lowest since 2011 suggesting a lack of confidence. Earnings growth slowed to 1.3% and excluding resources stocks was around -2.4%.

Slow growth but probably not recession

Since last year our view has been less upbeat on growth than the consensus and notably the RBA. This remains the case as the housing construction cycle turns down and weighs on consumer spending. As a result, it’s hard to see much progress in reducing high combined levels of unemployment and underemployment, and hence wages growth and inflation are likely to remain low. But there remains a bunch of positives that should help the economy avoid a recession even though growth will remain weak for a while yet. Here are nine.

• Rate cuts and tax cuts should provide some growth boost – while July retail sales were disappointing, the experience from the GFC stimulus payments is that the tax cuts will provide some lift to growth in the months ahead and various retailers have expressed optimism about this recently.
• The threat of crashing property prices looks to be receding – while it’s so far been on low volumes, buyer interest has returned to the Sydney and Melbourne markets and we never saw the much-feared surge in non-performing loans or forced selling. This has helped remove the threat of a debilitating negative wealth effect on consumer spending.
• Infrastructure spending is booming – recent state budgets saw the projected peak in infrastructure spending pushed out yet another year to 2020. And it’s likely states will seek to take even greater advantage of ultra-low long-term borrowing costs to further push out the peak in infrastructure spending.
• The low $A is helping to support the economy – the $A is down 39% from its 2011 high and is likely to fall further and this provides a boost to Australian businesses that compete internationally by making them more competitive.
• The business investment outlook is slowly improving – the big drag on growth as mining investment fell back to more normal levels as a share of GDP is over and mining investment plans are rising. This is driving some pick-up in the outlook for overall business investment.

• Australia has a current account surplus – the June quarter saw the first current account surplus since 1975. The slide since then in iron ore and coal prices suggests it may not be sustained, but the reasons for the improvement are more than just commodity prices so the deficit is likely to be well below the norm of recent decades going forward. What’s more there has been a significant improvement in our foreign liabilities with a less short-term debt and a growing net equity position. This all means that our reliance on foreign capital inflow has declined. So much for the boiling frog!
• There is scope for extra fiscal stimulus – the Federal budget is nearly back in surplus and while we have had a long run of deficits our public finances are in good shape compared to the US, Europe and Japan. As a result, there is scope to provide more fiscal stimulus and this is probably more important than a narrow focus on the surplus.
• Population growth remains strong – Australia’s population growth at around 1.6% pa remains strong. Of course, strong population growth is not without issues and in terms of living standards it is economic growth per person (or per capita) that matters. But solid population growth also has significant benefits in terms of supporting demand growth, preventing lingering oversupply and keeping the economy dynamic.
• Finally, cyclical spending (consumer durables, housing and business investment) as a share of GDP remains low – suggesting that apart from bits of the housing market there’s not a lot of excess in the economy that needs to be unwound.

Concluding comment

Our assessment remains that growth will remain soft and that the RBA will have to provide more stimulus – by taking the cash rate to around 0.5% and possibly consider unconventional monetary policy like quantitative easing. Ideally the latter should be combined with fiscal stimulus which would be fairer and more effective. While Australian growth is going through a rough patch with likely further to go, recession remains unlikely barring a significant global downturn.

19 Aug, 2019

By, Dermot Ryan

Sydney, Australia

Once elected, one of the first things the new Morrison Government announced was a review of the retirement income system.

The review was proposed due to the increasing complexity of the current system and the challenges brought about by higher life expectancies, the impact of low interest rates and the lack of income available in many asset classes due to current lofty valuations.

In what will be a broad-based review it will look across the key tools to generate an adequate retirement income: the age pension, superannuation (including compulsory contribution levels) and savings outside super.

It will also address some divisive topics such as potential changes to the tax treatment of retirement savings, the role of the family home in retirement, and super contribution limits. It is quite an ambitious agenda that will give retirees and financial advisers much to think about in the months ahead.

Until we hear more about the direction of this review, we thought it would be interesting to take a look at the challenges of generating a reasonable income in retirement. When investing with a goal – such as retirement – in mind, it pays to think long-term. But there is no escaping the realities, and challenges, of today’s investment environment for retirees.

Impact of interest rate changes and high valuations

Interest rates have an impact on the investment landscape when they are low as well as high. Currently, interest rates are as low as they have ever been and this has driven valuations of defensive assets to unprecedented highs.

High valuations mean low yields and we are seeing record-low yields across many fixed income assets and some types of property. Term deposit rates are also at fresh lows following the Reserve Bank of Australia’s decision at its July meeting to drop the cash rate to one per cent, with expectations of more cuts to come later this year.

Low interest rates affect variables such as inflation and investment returns, and as such they have consequences for investment products. This has flow-on effects to all asset classes and, in turn, affects every Australian worker’s ability to save for retirement.

In the past, we had more options as investors – in the high interest rate era of the late 70s and 80s even relatively low-risk assets like term deposits and bonds offered double-digit returns. These days rates of return are all closer to one per cent.

Similarly, property yields in Australia are around two to four per cent depending on the type of property and geography.

Yields on Australian equities are still at 4.3 per cent before franking and about 5.5 per cent including franking. This shows that better yields are available but investors must either accept the valuation risk of defensive assets or take on more earnings risk in growth assets like equities, perhaps alongside a higher cash allocation.

The inflation perspective

Inflation has a big impact on retirees as they are in less of a position to accumulate capital after their working lives have finished. Falling returns mean providing for retirement is challenging, but although returns are low now compared to in the past, the view is not as bad when inflation is considered.

Inflation was running at around 15 per cent in the late 70s and 80s, which ate up much of the bond and term deposit returns mentioned above.

With inflation currently sitting at 1.8 per cent in Australia and returns for an average diversified fund at seven per cent, real returns don’t look so bad compared to two decades ago, taking into account the higher inflation levels of the time. Nevertheless, the combination of low interest rates and low inflation create a challenging returns environment for retirees.

There are risks too, should the current global inflation rate of about three per cent ever break higher than the defensive asset classes. As these assets are priced for the very low inflation of today, they would face major negative revisions. A reason, perhaps, to reduce valuation risk with a bar belled approach, increasing both cash and some growth assets.

The longevity conundrum

With Australians now living longer, another risk to retirement savings is longevity risk – the risk a retiree will outlive his or her savings. Back in 1980, a man starting a pension at age 65 had a life expectancy of 78 – an additional 13 years. Now, a male starting a pension at 65 has a life expectancy of 86 – an additional 21 years. While this is great news in many ways, it poses challenges financially as there are higher income needs as well as the need to grow the assets over time to make up for rising costs of living.

This is a particular concern in an environment which sees retirees drawing down on their pool of retirement assets because they can no longer generate sufficient income returns. This means retirement account balances are being depleted relatively quicker than in the past, especially if retirees lack exposure to growth assets to generate some capital growth over their longer lives.
No easy solutions

Supporting an ageing population to achieve their retirement goals in a market of lower investment returns is one of the major challenges facing our society and financial services businesses. A stable policy framework for superannuation and a long-term approach will be important in giving retirees the best chance of achieving a comfortable retirement.

Introduction

Only last month share markets in the US and Australia were at record highs. But ever since President Trump ramped up the US-China trade war again at the start of August, financial markets have seen a significant increase in volatility. Share markets have had a 6% or so fall from their highs to recent lows and bond yields have plunged to new record lows in many countries. This note takes a look at what is driving the market turmoil, the risk of recession and what it means for investors.

Market Turmoil – what’s driving it

The bout of market turmoil we have been seeing this month basically has three inter-related drivers. First, President Trump ramped up the US-China trade war again with another round of tariffs on China.

Second, Chinese economic data showed more than expected in July and the manufacturing heavy German economy contracted in the June quarter. This is on the back of weak global data.

Third, economic uncertainty drove more money into bonds pushing bond yields down and driving a further “inversion” of bond yield curves – which is when long-term bond yields fall below short-term yields – leading to more talk of recession.

This all drove share markets down. Of course, the turmoil in Hong Kong, Brexit, tensions with Iran, political uncertainty in Italy and increasing risks that a Peronist government will return in Argentina aren’t helping. Talk of policy stimulus has provided some relief though with occasional sharp rallies in shares.

Australia is not in the trade war but anything that weakens global growth threatens our exports and confidence, so we are naturally seeing bouts of weakness in Australian shares and bond yields just like we did last year when the trade war started.

Reason for concern

There are several reasons for concern. First, the trade war still shows no sign of letting up. Optimism on US trade talks with China have been dashed several times now, the threat of tariffs on autos remains and maybe China has decided to wait till after next year’s US elections.

Second, the trade war and the twists and turns it takes is weighing on business confidence and it’s hard to make firm investment plans when they may be rendered uneconomic by a tweet from Trump. This is particularly evident in a slump in manufacturing conditions PMIs worldwide. See the next chart.

Third, it’s been hoped Chinese policy stimulus will offset the trade war for the last year now, but China has continued to slow.

Fourth, inverted yield curves have preceded post-war US recessions so the recent inversion can’t be ignored.

Finally, global and Australian share markets are vulnerable to weakness after roughly 25% gains from their December lows to their July highs left them overbought and vulnerable to a correction. This risk is accentuated as the August to October period often sees share market weakness.

Reasons for optimism

However, while the risks have increased there are several reasons not to get too concerned. First, President Trump is getting twitchy about the negative economic effects of the trade war: he delayed some tariffs last week after some sharp share market falls and had a meeting with major US bank heads on share market falls. The historical record shows that US presidents get re-elected after a first term (think Nixon, Reagan, Clinton, Bush junior and Obama) except when there were recessions in the two years before the election and unemployment is rising (think Ford, Carter and Bush senior). Trump would be aware of this. Share markets have regular corrections but major bear markets are invariably associated with recession and so Trump is wary whenever shares take a sharp lurch lower. As a result, our view remains that at some point Trump will seek more seriously to resolve the trade issue.

Second, policy stimulus is being ramped up: with numerous central banks now cutting interest rates and indicating that more cuts are on the way including from the Fed; the ECB looks like it will soon return to quantitative easing; Chinese economic policy meetings indicate that more policy easing is on the way; Germany is reportedly thinking about some sort of fiscal stimulus; and there is talk of more US tax cuts. This is very different to last year when the Fed was tightening, the ECB and ended QE and other central banks including the RBA looked to be edging towards tightening.

Third, while the risks have increased, a US or global recession remains unlikely: services indicators have held up well (see the first chart) and the services sector is the dominant part of most major economies; we have not seen the sort of excesses that precede global and notably US recessions – there has been no investment boom, private sector debt growth has been modest and inflation is low such that central bankers have not slammed the brakes on; & monetary and fiscal stimulus will provide support.

Finally, the decline in bond yields is making shares relatively cheap. The gap of 4.8% between the grossed-up dividend yield on Australian shares of 5.7% and the Australian 10-year bond yield of 0.94% is at a record high. Similarly, the gap between the grossed-up dividend yield and bank term deposit rates of less than 2% is very wide. In other words, relative to bonds and bank deposits shares are very cheap which should see them attract investor flows providing we are right and recession is avoided.

But what about inverted yield curves?

Long-term bond yields should normally be above short-term bond yields because investors demand a higher return to have their money locked away for longer periods. But sometimes long-term rates may fall below short-rates. This happened briefly in the US in the last week in relation to the gap between 10-year and 2-year bond yields but had already happened a few months ago in relation to the gap between 10-year yield and the Fed Funds rate. See the next chart.

This so called “inversion” is causing increasing consternation as an inverted US yield curve has preceded US recession so it’s natural for investors to be concerned. But the yield curve is not necessarily a reliable recession indicator at present: it can give false signals (circled on the next chart); the lags from an inverted curve to a US recession averaged around 18 months in relation to the last three recessions so any recession may be some time off; various factors unrelated to US recession risk may be inverting the curve such as increasing prospects for more quantitative easing pushing down bond yields, negative German bond yields dragging down US yields and investor demand for bonds as a safe haven from shares; yield curves may be more inclined to be flat or negative when rates are low; and as noted earlier we have not seen other signs of an imminent US recession such as over-investment, rapid debt growth, excessive inflation and tight monetary policy. So, our base case remains that a US recession is not imminent.

The Australian yield curve has also gone negative with 10-year bond yields of 0.94% below the cash rate of 1% but the gap between the 10 and 2-year bond yields only just positive. But it’s worth noting that Australian yield curve inversions around 1985, 2000, 2005-2008 and in 2012 were useless recession indicators.

What does this all mean for investment markets?

In the short-term share markets could still fall further as trade and growth uncertainties remain as we go through the seasonally weak months ahead. This could be associated with further falls in bond yields. In fact, further share market weakness may be needed to get Trump to seriously resolve the trade issue (as opposed to just go through another trade talks/ breakdown cycle again).

However, providing we are right and recession is avoided, a major bear market in shares (i.e. where share fall 20% and a year later are down another 20% or so) is unlikely and given that shares are cheap relative to bonds we continue to see share markets as being higher on a 6-12-month horizon.

What should investors do?

Since I don’t have a perfect crystal ball, from the perspective of sensible long-term investing the following points are repeating.

• First, periodic sharp setbacks in share markets are healthy and normal. This volatility is the price we pay for the higher long-term return from shares. After 25% or so gains from their lows last December shares were at risk of a correction.
• Second, selling shares or switching to a more conservative strategy after falls just locks in a loss. The best way to guard against selling on the basis of emotion is to adopt a well though out, long-term investment strategy.
• Third, when growth assets fall, they are cheaper and offer higher long-term return prospects. So, the key is to look for opportunities that pullbacks provide.
• Fourth, while shares may have fallen in value, the dividends form the market haven’t. The income flow you are receiving from a diversified portfolio of shares remains attractive. So for those close to or in retirement they key is to assess what is most important – absolute stability in the value of your investments or a decent sustainable income flow
• Fifth, shares often bottom at the point of maximum bearishness. So, when everyone is negative and cautious its often time to buy
• Finally, turn down the noise. In times of crisis the negative news reaches fever pitch, which make sit very hard to stick to a long- term strategy, let alone see the opportunities.