We held our quarterly Asset Allocation Investment committee in October. As part of the committee process we assess the macro economic environment, the strength of the business cycle, asset valuations and sentiment.
- The overall economic environment continues to show signs of improvement, economic indicators such as PMIs continued to rise in key economies such as the US, Europe and Japan.
- The US economy is in better shape than commonly appreciated and the global economic environment is more supportive than it has been for quite some time.
- Stronger growth in the United States and globally has been good for equity and credit markets. We believe it can continue over the short-to-medium term.
- In Australia non-mining business investment remains strong and employment is steady, although we remain concerned about the lack of wage growth, which unless shows signs of improving, will be a drag on consumer confidence.
- We continue to watch how central banks approach their monetary policies settings as we see central banks gradually reduce their quantitative easing (QE) programs and subsequently reduce the size of their balance sheets.
- Our medium-term view on interest rates is that rates will increase from their current low levels however we do not expect rates to rise rapidly in the short term which will continue to be constructive for equity markets.
- Our overall view on valuations has not changed materially. Asset prices continue to trade at fair to expensive ranges with the US market being one of the more expensive markets and Australia, only slightly above fair value.
- US tax reform should be a catalyst for improved US earnings and short-term market optimism.
Since our most recent update in March, the overall economic environment continues to show signs of improvement, economic indicators such as PMIs continued to rise in key economies such as the US, Europe and Japan. In a sign of increased optimism, the IMF upgraded its growth forecasts for the first time in six years. The US and Europe currently lead the way, although China and Japan have generally exceeded expectations. While inflation continues to surprise to the downside, the improved growth picture has turned the focus on to the central banks, with the Fed in the early stages of monetary policy normalisation, and the ECB soon to follow.
In Australia non-mining business investment remains strong and employment is steady, although the lack of wage growth has been a drag on consumer confidence. We continue to monitor how central banks approach their monetary policies settings as we see central banks gradually reduce their quantitative easing (QE) programs, and subsequently reduce the size of their balance sheets. The rapid increase in liquidity into markets as a result of QE provided a significant boost to equity markets therefore central backs will need to manage the ‘normalisation’ of their monetary policy carefully as we believe a rapid pull back in liquidity would be negative for markets. Our medium-term view on interest rates is that rates will increase from their current low levels, and we expect 2018 to be the first time since November 2010 when the RBA has raised interest rates.
Our view is that while clearly, we are late cycle in the economic and market expansion led by the US since the GFC, the resilience of financial markets over 2017, particularly from offshore, leads us to believe there is another leg up for financial markets before the end of the current cycle. This does not change the view that asset prices are expensive. Valuations look extremely stretched by historical standards, however that does not mean that they can’t become more stretched before the current cycle ends.
The ASX 200, does not appear as overvalued as US equities. The ASX200 has hardly risen this year and is trading on a price-earnings ratio of just below 16x which is only marginally above the long-term average of around 15x.
Figure 1 Australia S&P/ASX PE ratio
The US, on the other hand, has seen the S&P 500 up 12.5% this year, the NASDAQ up 20.5% and the S&P 500 has moved from a price-earnings ratio of 18x to 23x in the last 2 years. That means that US share prices have risen 27% more than earnings since early 2015. Clearly that is not sustainable over the long term.
Figure 2 S&P 500 PE ratio
Despite all the fundamental factors which have caused us to take a view we are very late in the current expansion cycle (e.g. lending standards deteriorating, and the Fed’s commencement of interest rate rises) the US market looks like it is still accelerating, and it appears this cycle will not end without valuations looking absolutely bubble like as occurred in 1987, 2000 and 2007. We believe US tax cuts which could be implemented in late 2017 or early 2018 will provide the catalyst for the last leg up in the US markets. Historically, the best returns in a cycle are the very early part, as the market recovers from an oversold position (think 2009-2010) and the very late part, as overvaluation sets in and market participants using fundamental valuation analysis begin making bubble calls on the market. They are usually right, but often a year or two too early.
The global synchronized recovery has strengthened. The US economy has rebounded from a weak first quarter; growth in the euro zone remains robust and broad; Japan has now experienced six consecutive quarters of growth, its longest expansion in over a decade; and growth in China continues to exceed the government’s target. Of the 43 major economies tracked by the OECD that have reported second-quarter real GDP, just Iceland had negative GDP growth.
The positive economic data has been good for equity and credit markets, lifting both earnings and earnings forecasts (See table below). We expect that this constructive environment—improved growth, low inflation, and relatively loose financial conditions—will continue over the short-to-medium term. Looking forward, we see geopolitical tensions (particularly in North Korea), the risk of monetary policy mistakes, a failure to raise the debt ceiling, and potential protectionist measures as the biggest risks to our outlook and to market sentiment.
Figure 3 The global synchronized recovery is lifting earnings estimates
As of 31 August 2017
Source: Bloomberg, MSCI
Second-quarter real US GDP rebounded from a weak first quarter, rising by 3.1% at an annual rate. Final sales to private domestic purchasers—the components of GDP that make up private domestic demand—were even stronger, rising by 3.3% at an annual rate. Particularly encouraging has been the rebound in business investment, which has risen by an annualized 6.9% in the first two quarters of the year, helped in part by stable energy prices. However, retail sales and industrial production slowed in August, moderating expectations for third-quarter growth. As a result, the New York Fed’s third-quarter Nowcast and the Atlanta Fed’s third-quarter GDPNow forecast declined considerably, and stand at 1.5% and 2.1% respectively.
Two devastating hurricanes hit the Gulf Coast and the Southeast, as well as a number of Caribbean islands. Outside of their considerable human costs, the damage and recovery will have economic implications. The short-term impact has been to increase headline inflation due to higher gasoline costs and to disrupt income and economic activity, which will affect GDP growth, employment, and many other economic indicators. Over the medium term, we expect the national economic trajectory to return to the trend before the hurricanes, although local metrics will continue to reflect rebuilding.
We continue to be encouraged by data suggesting that middle class income is increasing more solidly after stagnating since the turn of the century. Newly released data shows that real median household income rose 3.2% in 2016, the second-largest gain since 1998 after 2015’s record-setting 5.2% gain, capping the largest two-year increase in the data series’ 50-year history (See table below). While not quite as strong and as broad as in 2015, the details of the release also were positive, showing that real income rose for most household groups-regardless of age, income, race/ethnicity, education, and region. More recent trends in wages and employment imply that middle class household income has continued to rise in 2017, which should be positive for consumption and the economy. It is no accident that these developments have come in a tightening labour market.
Figure 4 2015–2016 Was the Largest Two-Year Increase in Real Median Household Income since 1967
As of 30 September 2017
Source: Census Bureau, Haver Analytics
The Federal Open Market Committee (FOMC) announced that the Fed will begin to reduce the size of its balance sheet, beginning in October by allowing $6 billion of Treasuries and $4 billion of mortgage-backed securities to mature without reinvesting the principal. Despite understandable concerns that unwinding quantitative easing (QE) will have unforeseen consequences, we believe its impact on rates and markets will be small.
In the latest Summary of Economic Projections (SEP), the FOMC also indicated that the meeting participants still anticipate an additional rate hike in 2017 and three rate hikes in 2018.
Inflation has decelerated since the beginning of the year. New “transitory factors” have contributed, especially sharply lower prices for wireless plans. However, the inflation weakness has been broad enough, and inflation has fallen short of the Fed’s target (and projections) for long enough, that there are fresh concerns about inflation’s fundamental drivers. These were discussed by Fed Governor Lael Brainard in a recent speech: “in today’s economy, there are reasons to worry that the Phillips curve will not prove very reliable in boosting inflation as resource utilization tightens.”3 Our view remains that with continued growth, inflation should rise to a 2%–3% range (as measured by the Consumer Price Index (CPI)). Regardless, the implication of recent trends for markets is that inflation should be controllable and that the Fed’s hiking cycle will be gradual and short—a view currently priced in fed funds futures but not in the Fed’s projections of future rate hikes.
The upcoming 2018 mid-term elections leave a short timeline for the congressional GOP legislative agenda, making economists relatively pessimistic about the near-term prospects for tax reform and an infrastructure package. Some hopes for bipartisan cooperation on these issues, and on health care, emerged with the deal between President Donald Trump and Congressional Democrats on hurricane relief. We remain concerned that a Congressional vote to increase the debt ceiling—now pushed back to December or possibly to the first quarter—will become contentious, which we think is more likely to disrupt markets than will the Fed’s balance sheet policies. We also believe meaningful risks remain that protectionist policies could surface on the White House agenda, particularly if cooperation with Congress becomes difficult.
Through much of the recovery since 2009, wage gains have been surprisingly low. A variety of factors contributed to this disappointing wage rebound:
- the severity of the global financial crisis, which saw the headline unemployment rate hit 10.0%;
- “pent-up wage deflation” as wage growth slowed less than expected during the crisis; and
- “hidden slack” in the form of people working part time who wanted full-time work, people who took jobs for which they were overqualified, and people who withdrew from the labour force.
In 2013, wage growth began to grind higher, but more recently it appears to have plateaued across several measures. This stabilisation has caused understandable concerns, given that it has coincided with a slowdown in inflation more generally. However, we believe this plateau is temporary and expect wage growth to accelerate again.
Figure 5 Wage Growth Recently Plateaued
As of June 2017. Avg. hourly earnings and Atlanta Federal Wage Growth Tracker as of August 2017.
Average Hourly Earnings are for all employees. Employment Cost Index (ECI) is for wages & salaries of civilian workers excluding incentive-paid occupations. The ECI is a disaggregated quarterly series. The Atlanta Federal Wage Growth Tracker is adjusted downwards by 0.6 percentage points to reflect its historical spread with other wage measures.
Source: Bureau of Labour Statistics, Federal Reserve Bank of Atlanta, Haver Analytics
We believe the recent plateau in wage growth reflects two different mix shifts in the labour market, the impacts of which have been enlarged by the severity of the crisis and the length of the recovery. One mix shift is related to the jobs being filled and another is related to who is filling them:
The first mix shift relates to the positions being filled. Early in the recovery, employers had substantial bargaining power and could hire overqualified people to part-time jobs, e.g., the college-educated barista at Starbucks. As the recovery has progressed, an increasing number of employees have been able to improve their circumstances, graduating to better jobs, and moving from part-time work to full-time work, from unemployment to employment, and from discouraged and out of the workforce to back into labour force participation. As this shift has taken place, it has put downward pressure on wage growth as “new” employees command lower full-time wages than those with recent experience in similar jobs. In fact, in a 2014 speech, Janet Yellen described how this mix shift might translate to the recent pattern of wage growth: “profound dislocations in the labour market in recent years—such as depressed participation associated with worker discouragement and a still-substantial level of long-term unemployment—may cause inflation pressures to arise earlier than usual as the degree of slack in the labour market declines.
However, some of the resulting wage and price pressures could subsequently ease as higher real wages draw workers back into the labour force and lower long-term unemployment.” The Graph below isolates the impact of this mix shift on wages by showing that earnings growth for individuals already in full-time employment has been much stronger than the median, which has been dragged down by the impact of flows into and out of full-time employment by part-timers, the unemployed, and people outside of the labour force. The critical point is that the impact of this mix shift should fade over time.
Figure 6 Aggregate Wage Growth Has Been Held Down by Flows into Full-Time Work
As of 30 June 2017,
Source: Daly, Mary C., Bart Hobijn, and Benjamin Pyle. 14 August 2017. “The Good News on Wage Growth.” Federal Reserve Bank of San Francisco Blog
The second mix shift could reflect the demographic profile of the applicants for jobs. Since 2015, the employment-population ratio, which captures net flows into employment of the unemployed and of people outside of the workforce, has risen by three times as much for prime-age (25–54) women as for prime-age men and nine times as much for African Americans as for whites. Similarly, it has risen by 1.7 percentage points for people without a high school degree and fallen by 0.4 percentage points for college graduates.9 To the extent the faster-growing portions of the labour market have historically been paid lower wages, we believe this could also lead to lower wage growth in aggregate. Shifting demographics may exert a similar generational impact on wage growth over the medium term, as retiring baby boomers are replaced in the workforce by millennials.
As these mix shift effects dissipate, we would expect wage growth to more closely resemble the historical relationship seen before the global financial crisis. In short, we think the recent pullback in wage growth acceleration is still consistent with a healthy labour market and income growth more generally. To the extent this is the case, and more people are able to enter better, and higher-paying, employment, it should be positive for the economy.
Looking forward, we expect this plateau in wage growth to be relatively short-lived. Demand for labour remains strong, with job openings at record highs and most surveys of employers reporting difficulty filling jobs. Our view is that employers will eventually come to grips with the need to pay higher wages if they wish to fill open positions and attract qualified candidates. At the same time, we believe the synchronized global economic recovery should also add confidence in completing hiring plans, where in the past, employers might have been reluctant to commit to adding to full-time staff.
While he attempts to overhaul American tax, trade, and immigration policies, President Donald Trump is mulling over a set of decisions that could prove even more consequential for the U.S. economy. With Federal Reserve Vice Chair Stanley Fischer having retired this month, three of the seven seats on the Fed Board of Governors are now vacant. And in February 2018, Fed Chair Janet Yellen’s first term will end, giving Trump a unique opportunity to stamp his brand on the institution.
Trump’s nominees to fill these positions, and how he goes about choosing them, could have an enduring impact not just on the Fed, but also on the U.S. economy and its central position in the global financial system.
The Favorites to lead the Fed are Jay Powell and John Taylor. Powell is assumed to be a candidate that is seen to favour the status quo of the current board, while Taylor is expected to be in favour of more aggressive tightening of monetary policy. Whom is appointed, and their policy stance will likely play a major role in determining the length of the current expansion.
The Chinese Communist Party (CCP) held its 19th Party Congress in Beijing from October 18–25, 2017, a twice-per-decade event to set the party’s national policy goals and elect its top leadership. Although observers eagerly awaited the conclusion of the First Plenum of the 19th Central Committee on October 25, when the new members of the CCP’s all-powerful Politburo Standing Committee were unveiled, the weeks leading up to that moment were also rich with important developments. Likewise, the influence of China’s new leadership team on the direction of the country’s foreign and domestic policy will gradually play out over the coming months and years.
October’s Party Congress is part of a series of decision-making events over the next six months. The government’s working plan for 2018, including economic policies, will be presented at the National People’s Congress in March, where the new cabinet also will be appointed. While the challenges facing the Chinese economy are acknowledged by its leadership, addressing them is immensely complicated. The incentive to maintain relatively high growth is still strong, especially since real growth of 6.5% per year is still necessary to achieve the target of doubling 2010 GDP and per capita income by 2020, ahead of the CCP’s 100th anniversary in 2021.
Like many, we think a smooth deceleration in growth in China is overdue and would be a positive outcome. Our concern over the medium term is that it is not clear that any leader can “engineer” the necessary rebalancing of the economy and deceleration of growth, even setting aside political and institutional constraints and incentives. However, contained its financial system, we worry that China’s massive build-up of leverage in recent years, much of it hidden and hard to understand, as well as the rapid shifts in directions of its capital flows, could trigger a future global economic slowdown or even crisis.
European stock performance has been relatively muted in recent months, due mostly to the resurgence of the euro. While some commentators have cited the strength of the euro as a cause for concern, we regard it as a testament to Europe’s ongoing economic recovery.
The performance of the Stoxx Europe 600 Index has been impressive, in our view, considering the euro’s strength. While the index rose 1.8% in local currency terms over the last two quarters, the euro has appreciated a staggering 10.9% against the US dollar over the same period. A significant proportion of companies listed in Europe derive their earnings from overseas markets (44%), particularly from the United States (18%), so this currency story—and the positive return generated by European markets in spite of it—is consequential. When adjusting for the euro’s appreciation, the trajectory of European equities has been markedly different, outperforming both the US and global stock markets.
Figure 7 European Stocks Outshine US and Global Indices in US Dollar Terms
Source: FTSE, Standard & Poor’s, STOXX
In our view, the stronger euro has been a reflection of the improving economic backdrop and political sentiment in Europe, rather than the repricing of monetary policy expectations. Investor expectations of an interest rate hike in Europe by the end of next year have fallen to the lowest on record, according to futures markets. Investors are pricing in a less than 50% chance that the European Central Bank (ECB) will lift interest rates in 2018, despite the central bank laying the groundwork for a decision on winding down its asset-purchasing programme.
The ECB is treading carefully as it attempts to normalise monetary policy in a balanced way that brings inflation to just under 2% over the medium term, in line with its target, without compromising the momentum in economic growth. The ECB has scope to remain accommodative as the Harmonised Index of Consumer Prices—the ECB’s preferred measure—currently stands at 1.5%. Despite inflation’s short-lived foray between 1.5% and 2.0% from January through April, consumer prices have yet to show convincing signs of a sustained upward trend, a key requirement for the ECB to withdraw its ultra-loose monetary policy. At the same time, the stronger euro also effectively implies a tightening of financial conditions and further disinflationary pressure, if sustained, as it pushes down import costs. The ECB has trimmed its medium-term inflation forecasts, despite acknowledging the strength of the euro zone’s economic recovery. Since the start of the year, the ECB has revised lower its inflation forecasts for 2018 from 1.5% to 1.3% and then to 1.2% in its September staff macroeconomic projections. For 2019, its inflation forecasts were lowered from 1.8% to 1.6% and then, most recently, to 1.5%.
At the same time, economic growth in the euro zone has continued to surprise to the upside, as unemployment has trended lower into single digits. In September, the ECB raised its 2017 economic growth forecast for the euro zone to 2.2%, putting it on track for the strongest growth in 10 years. In a sign of growing confidence in the euro zone’s recovery since the doldrums of the European sovereign debt crisis, Standard & Poor’s restored Portugal’s government debt rating to “investment grade” status after holding it at “junk” for five years. At the height of the crisis, the yield on Portugal’s benchmark 10-year bond rose above 16%, but as of September 2017 it stands at around 2.5%. Equally, other formerly “frail” economies have been on an upward trajectory. Spain has been growing above trend and in excess of euro area averages since 2014.
While some economists have voiced concerns about the strength of the euro and its potential impact on export-led growth, the euro zone recovery has, in recent years, increasingly been driven by domestic demand relative to net exports. If we are entering a new era of euro strength that is structural in nature, there are reasons to remain constructive on the outlook for European stocks, as a stronger euro has in the past often coincided with stronger European stock markets.
Figure 8 Euro Strength Has Coincided with European Equity Outperformance
As of 30 September 2017
Much of the election uncertainty that dominated sentiment earlier this year has passed, offering a supportive backdrop for investors. Elections in the Netherlands and France earlier this year yielded market-friendly outcomes, while in Germany, Chancellor Angela Merkel secured a fourth term in office. While the gains for the far-right party Alternative für Deutschland in the German election came as a surprise—making the party the first openly nationalist partly to reside in parliament in almost 60 years—and will likely change the tone of the Bundestag, we do not anticipate coalition talks to be materially impacted by their presence in parliament.
We would argue that Italy and Spain—given Catalonia’s ongoing campaign for independence—remain flash points of political risk in Europe, albeit relatively contained.
Overall, we think the outlook for European stocks remains constructive owing to the continued positive momentum in economic growth and subdued inflation profile, which suggests the ECB has scope to remain accommodative for longer. Political sentiment has improved materially since the start of the year and while Italy and Spain remain flash points of political risk in Europe, longer term, it is our belief that company fundamentals will play out and assert themselves, irrespective of political noise. Furthermore, the European stock market remains attractive versus other markets, such as the United States, on a valuation basis.
The United Kingdom
The medium-term growth outlook for the UK remains highly uncertain and will depend in part on the new economic relationship with the EU and the extent of the increase in barriers to trade, migration, and cross-border financial activity. GDP rose 0.4% in the last three months, beating the 0.3% estimates. Services rose 0.4%; industrial production jumped 1% while construction shrank the most in five years. The UK’s comparatively tepid growth in the last 12 months has left it the odd one out in the global upswing.
While the IMF raised its forecasts for almost every advanced economy the month, the UK outlook was left unchanged at 1.7% this year and 1.5% in 2018. The IMF predicts it will grow at just half the global average. With inflation at the fastest in more than five years, Governor Mark Carney has said tightening may be needed within months, and economists and traders expect the bank to increase borrowing costs on November 2. Even though the latest quarter was better than expected, growth is still running at a weaker pace than it was in 2016. The pace is also slower than when the BOE has raised interest rates in the past.
Some have warned that a hike could be a policy mistake given the UK’s relatively sluggish growth and Brexit-related uncertainty that’s clouding the outlook. They also argue that inflation is being driven by the weaker pound, rather than being domestically generated.
But in Carney’s assessment, Brexit has crimped UK potential growth, lowering the level of expansion the economy can take without overheating.
We remain cautious on the UK until further clarity on the terms and conditions of Brexit become known and prefer the opportunities provided by continental Europe at present.
Japan’s economy expanded by an annualized rate of 4% during the June quarter, beating market expectations and outpacing most other developed economies. Wage gains and consumption were two of the biggest contributors to this GDP growth. While a late revision to capital expenditures (capex) led to a downward revision of GDP, the general trend of positive demand driving higher production remained in place. Moreover, improvements in global purchasing managers’ indices (PMI) helped boost Japan’s manufacturing sector as investors anticipated better demand and pricing to positively influence profits for the coming fiscal year. During the quarter, corporate profits rose by 21% over the previous year, providing a much-needed lift to both the earnings outlook and equity valuations.
Positive economic data continues to compound in Japan. Domestic and global PMIs suggest improvements in production and the potential for upward surprises to economic growth. Historically, Japan’s market has had a high correlation with global PMIs, so this shift to the upside should be a welcome surprise. Many investors think that the end to the growth cycle is near, but we believe both macro and micro data continue to suggest that demand and pricing of everything from steel to chemicals to semiconductor equipment is improving. Since these areas are traditional strengths for Japanese manufacturers, this trend should help sentiment regarding profits and valuations in what many consider richly priced segments of the market.
Figure 9 Global Purchasing Manager Indices Are Strong and Improving
As of 31 August 2017
Source: Markit, Nikkei
From a geopolitical perspective, the ongoing issues with North Korea have presented Prime Minister Shinzo Abe with an array of problems. As long as the North Korean government continues to ignore convention and test launch more intercontinental ballistic missiles, Japan faces a real test of its military mettle. There is a significant risk that Japan, or a similarly minded ally, chooses to shoot down one of these missiles. This could spark a military clash with North Korea. As long as this conflict lasts, it is important to monitor how Abe is perceived and how the market reacts. If anything, the recent rise in Abe’s popularity points to a potential improvement in sentiment as he is seen as one of the few Japanese leaders with the ability to stand up to a military rival.
Regardless of general market sentiment, it appears that better growth and an improvement in pricing are closely associated. As long as the United States continues down this quantitative tightening path, we believe the Japanese market will follow. Financial stocks, which have rarely provided upside surprises in the past, now look attractive from a relative value perspective. Therefore, we believe there is significant upside potential for cyclical sectors, like financials which have long been ignored, and for the Japanese market as a whole.
After a soft patch in the March quarter, Australian economic growth bounced back in the June quarter with quarterly growth of 0.8%, up from 0.3%. However, annual growth is still subdued at 1.8% year on year, which is well below potential of around 2.75%. In the quarter, growth was helped by a pick-up in consumer spending and business investment, strong public investment and a contribution from net exports after a detraction in the March quarter.
Figure 10 Australian Real GDP Growth
Source: ABS, AMP Capital
Australia continues to defy the doomsters’ endless recession calls. Against this, economic and underlying profit growth is lagging that seen in major economies. However, there are some positives pointing to a pick-up in growth.
Putting global threats aside, Australia’s worry list is well known:
- Housing construction is starting to slow with falling approvals pointing to a further slowing.
- Consumer spending is constrained by record low wages growth and high levels of underemployment. While consumer spending has been running faster than income growth, as rising wealth has allowed consumers to run down household savings (to now just 4.6%) this is unlikely to continue as the wealth effects flowing from property price gains in Sydney and Melbourne slow. Rapid power cost increases and high debt are also not helping. All of which is driving low consumer confidence.
- Mining investment is still falling with business investment intentions pointing to another 22% fall this financial year.
- The Australian dollar is up 14% from last year’s low and at around $US0.78 it is at risk of slowing growth and investment in trade-exposed sectors like tourism, agriculture and manufacturing.
- Underlying inflation is too low and risks staying below target for longer due to record low wages growth, a rising $A, competitive pressures & weak rents as new supply hits.
- Our political leaders seem collectively unable to undertake productivity-enhancing economic reforms and take decisive action (eg, on energy policy). With the citizenship crisis threatening an early election, it’s unlikely we will see an improvement any time soon.
Figure 11 Falling building approvals
Source: ABS, AMP Capital
These worries are well known and despite them we remain of the view that recession will be avoided and growth will pick up over the year ahead. First, the growth drag from falling mining investment is nearly over. Mining investment peaked at nearly 7% of GDP four years ago and has since been falling at around 25% per annum (pa), knocking around 1.5% pa from GDP growth. At around 2% of GDP now, its weight in the economy has collapsed reducing its growth drag to around 0.4% this year and it appears near a bottom.
Figure 12 Mining investment as % of GDP
Source: ABS, AMP Capital
Non-mining investment is likely to rise this year. Comparing corporate investment plans for this financial year with those made a year ago points to a decline in business investment this year of around 3.5% (see next chart). But this is the best it’s been since 2013 and once mining investment is excluded this turns into an 8% gain for non-mining investment.
Figure 13 Actual and expected capital expenditure
Source: ABS, AMP Capital
Public investment is rising strongly, up 14.7% over the last year, reflecting state infrastructure spending. Net exports are also likely to continue adding to growth as the completion of resources projects boosts mining and energy export volumes and services sectors like tourism and higher education remain strong.
Finally, profits for listed companies are rising again after two years of falls. This is a positive for investment and the flow of dividends helps household incomes.
Figure 14 Australian Share market EPS growth
Source: ABS, AMP Capital
These considerations should ensure that the Australian economy continues to avoid recession and that growth should pick up to around a 2.5% to 3% pace over the year ahead. This should be enough to head off further cuts in the cash rate. But with growth still a bit below RBA forecasts, wages growth likely to pick up only slowly, inflation likely to remain subdued abstracting from higher electricity prices, and the RBA likely wanting to avoid pushing the $A higher, our view remains that the RBA will keep the cash rate unchanged at 1.5% out to at least the middle of 2018 before starting to raise rates.
In conclusion, there is reason to be generally optimistic in terms of the global growth outlook and financial markets for the remainder of 2017 and early into 2018. Global growth is accelerating, and any positive outcomes on tax reform, could provide the catalyst to another leg up in financial markets. Our fears that faster growth would spark inflation and force central banks hands to tighten financial conditions and complete the cycle have not yet materialised and we are currently in a goldilocks environment – that is growth in the world economy, but not with too much inflation.
Figure 15 Goldilocks – above trend growth and below trend inflation
Source: BofA Merrill Lynch Global Fund Manager Survey
The environment for equities is positive, barring unforeseen geopolitical and policy shocks, on the back of potentially positive tax policy changes and low global interest rates. While there are some very real risks in the global economy, we believe the positive momentum can endure, at least until the middle of 2018.
Consequences for Asset Allocation and Portfolio Construction
Conditions appear to be favourable for equity markets in the short term as the current cycle plays out. As it appears markets want to continue to head higher, we want to ensure our equity and fund manager exposure in the growth asset portion of investors portfolio’s will capture as much of the upside as possible as a potential bubble forms in equity markets in the next 6-12 months. While we are cautious holding financial assets that are beginning to look overvalued, we don’t fear the onset of an equity bubble. We think it is very unlikely for the trend to change until after US tax reform has been implemented, as tax cuts are likely to improve corporate earnings again next year. So, if we do get a fully blown equity bubble of the back of that enthusiasm, we intend to take advantage of it.
This short term bullish tilt, does not mean we believe investors should be ‘all in’ on risk assets. We also want to have hedges and diversity in the portfolio this late in the cycle, as correctly calling the peak, or end of the cycle is almost impossible. There is also always the risk of a left field event or the breakdown in the US political process grinding reform to a halt, so ensuring you maintain diversification in line with your individual risk profile remains critical.
We outline our approach below for the present environment:
To develop a clear diversified investment strategy with an outcomes based asset allocation to ensure relevant cash flow is produced in a tax efficient manner
Moderate but accelerating economic growth with a solid employment picture should underpin outperformance by the US and other developed markets. We see the U.S. dollar as likely to strengthen against the $AUD and most other major currencies. We view this as a cyclical upswing rather than a secular or structural shift. Longer term we expect lower economic growth and lower natural interest rates due to demographics and debt levels.
Risks continue to lie in China and the UK where caution is warranted
We remain in a very low but rising interest rate world. Sustainable equity income strategies should still provide decent long term returns for patient investors.
Investors hoping beta (the market) will provide longer term gains beyond the current cyclical Trump reflation are likely to be disappointed, so active strategies sourcing non correlated returns appear attractive. We believe American and European Consumers will benefit from oil price declines and boost spending.
Assets which have a high probability of retaining their capital value to provide defence when growth assets fall.
|Increase exposure to:
At call cash
Very short Duration bonds
Reduce exposure to:
Fixed rate bonds for medium to long durations
Bond yields have begun to rise as expectations for deflation wane and inflation begins to rise. With elevated yields there is a risk of capital loss on long duration low coupon instruments.
Increasing cash holdings and Term Deposits.
|Stable cash flows
Assets where income streams are regular, steady and rising rather than focussing on capital growth
|Increase exposure to:
Growing dividend streams form Australian and International equities
Reduce exposure to:
High yield Debt (junk bonds)
|Equity and credit income strategies with a focus on dividend growth should remain in favour and preserve capital over the long run. Leveraged property and Infrastructure assets are likely to hit headwinds as interest rates rise.
||Payden Income Opportunities Fund
Henderson Tactical Income Fund
Pimco Diversified Fixed Income Fund
Investors Mutual Equity Income Fund
|Equity Market Direction
Exposure to equity markets domestically or globally for both income and growth
|Increase exposure to:
Active strategies where stock picking drives longer term return outcomes.
Indices such as S&P500
|Traditional market cap weighted passive strategies cannot protect on the downside. However, in the short term, the Trump reflation trade is likely to lift indices over a 12- 18 month timeframe.
||Magellan Global Fund
Platinum Japan Fund
Allan Gray Australian Equity Fund
Spheria Microcap Fund
Access to opportunities or skills which have potential to produce better returns than holding investments passively. Higher returns may be delivered by skilful risk management and protection of capital in falling markets
|Increase exposure to:
Australian manager’s that tilt away from top 20 stocks
Stock pickers who can hold more cash
Long short strategies
S&P 500, technology and Financials in the US
|We favour strategies with flexible mandates with the ability to raise cash and use shorting to protect capital.
||The Montgomery Fund
L1 Capital Long Short
Antipodes Global Fund
VGI Partners Global Long Short
Investment strategies designed to produce returns which are lowly correlated to the direction of equity or fixed income markets
|Increase exposure to:
Market Neutral Strategies
Reduce exposure to:
|Greater divergence in stock market returns should benefit market neutral managers.
With our exposure to China and the Asian region a hedge by holding some $USD continues to make sense.
|Watermark Market Neutral Fund
Winton Global Alpha Fund
Invesco Targeted Returns Fund
October 2017 Global Outlook, Ronald Temple, Lazard Asset Management (October 2017)
Income & Fixed Interest Newsletter, Vimal Gor, BT Investment Management (October 2017)
Where are we in the global investment cycle and what’s the risk of a 1987 style crash? , Shane Oliver, AMP Capital (October 2017)
Bloomberg (October 2017)
ANZ Bank (October 2017)
Bank of America/ Merill Lynch (October 2017)
PIMCO (October 2017)