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Why I still love dividends and you should love them too

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By Dr Shane Oliver – Head of Investment Strategy and Economics and Chief Economist, AMP Capital | 4 Mar 2019

Key points

  • Dividends are great for investors. They augur well for earnings growth, provide a degree of security in uncertain times, are likely to comprise a relatively high proportion of returns going forward and provide a relatively stable source of income.
  • Including reinvested dividends, the Australian share market has surpassed its 2007 record high.
  • It’s important that dividend imputation is not weakened in Australia to ensure dividends are not taxed twice.

Introduction

Prior to the 1960s most share investors were long-term investors who bought stocks for their dividend income. Investors then started to focus more on capital growth as bond yields rose relative to dividend yields on the back of rising inflation. However, thanks to an increased focus on investment income as baby boomers retire, interest in dividends has returned. This is a good thing because dividends are good for investors in more ways than just the income they provide.

Australian companies pay out a high proportion of earnings as dividends. This is currently around 65% compared to around 45% for global shares. However, some argue that dividends don’t matter – as investors should be indifferent as to whether a company pays a dividend or retains earnings that are reinvested to drive growth. Or worse still, some argue that high dividend pay outs are a sign of poor long-term growth prospects, that they are distraction from business investment or that they are often not sustainable. And of course, some just see dividends as boring relative to speculating on moves in share values. My assessment is far more favourable.

Seven reasons why dividends are cool

First, dividends do matter in terms of returns from shares. For the US share market, it has been found that higher dividend payouts lead to higher earnings growth1. This is illustrated in the next chart, which shows that for the period since 1946 when US companies paid out a high proportion of earnings as dividends (the horizontal axis) this has tended to be associated with higher growth in profits (after inflation) over the subsequent 10 years (vertical axis). And higher profit growth drives higher returns from shares. So dividends do matter and the higher the better (within reason). There are several reasons why this is the case: when companies retain a high proportion of earnings there is a tendency for poor hubris driven investments; high dividend payouts are indicative of corporate confidence about future earnings; and high payouts indicate earnings are real.

Source: Global Financial Data, Thomson Reuters, AMP Capital

Second, dividends provide a stable contribution to the total return from shares, compared to the year-to-year volatility in capital gains. Of the 11.7% pa total return from Australian shares since 1900, just over half has been from dividends.

Source: Global Financial Data, AMP Capital Investors

Third, the flow of dividend income from a well-diversified pool of companies is relatively smooth. As can be seen below, dividends move in line with earnings but are smoother.

Source: Thomson Reuters, RBA, AMP Capital

Companies like to manage dividend expectations smoothly. They rarely raise the level of dividends if they think it will be unsustainable. Sure, some companies do cut their dividends at times, but the key is to have a well-diversified portfolio of sustainable and decent dividend paying shares.

Fourth, investor demand for stocks paying decent dividends will be supported as the ranks of retirees swell.

Fifth, with the scope for capital growth from shares diminished thanks to relatively high price to earnings ratios compared to say 40 years ago, dividends will comprise a much higher proportion of total equity returns. More than half of the total medium-term return from Australian shares is likely to come from dividends, once allowance is made for franking credits.

Sixth, dividends provide good income. Grossed up for franking credits the annual income flow from dividends on Australian shares is around 5.7%. That’s $5700 a year on a $100,000 investment in shares compared to $2150 a year in term deposits (assuming a term deposit rate of 2.15%).

Source: Bloomberg, RBA, AMP Capital

Finally, while Australian shares are still 10% below their 2007 high, once reinvested dividends are allowed for (ie looking at the ASX 200 accumulation index) the market is well above it.

Source: Bloomberg, AMP Capital

Another way to look at dividend income

How powerful investing for dividend income can be relative to investing for income from interest is illustrated in the next chart. It compares initial $100,000 investments in Australian shares and one-year term deposits in December 1979.

Source: RBA, Bloomberg, AMP Capital

The term deposit would still be worth $100,000 (red line) and last year would have paid $2,200 in interest (red bars). By contrast the $100,000 invested in shares would have grown to $1,111,435 as at December last year (blue line) and would have paid $47,792 in dividends last year (blue bars). Or around $62,240 if franking credits are allowed for. Over time an investment in shares can rise but a term deposit is fixed.

But don’t dividends crimp capex?

This issue has been wheeled out repeatedly since the GFC. But it’s ridiculous. First the rise in dividends this decade has mainly come from cashed up miners and it’s hard to argue they should invest more after the mining investment boom. Second the dividend payout ratio is not high historically. Third the reasons for poor business investment lie in: business sector caution after the GFC & the rise in the $A above parity, which squeezed competitiveness; the fall back to more normal levels in mining investment; and the shift to a capital lite economy based around IT and services. Don’t blame dividends for poor capex.

Source: Thomson Reuters, RBA, AMP Capital

Why dividend imputation is so important

Dividend imputation was introduced in the 1980s and allows Australians to claim a credit against their tax liability for tax already paid on their dividends in the hands of companies as profits and boosts the effective dividend yield on Australian shares by around 1.3 percentage points. However, over the years it has been subject to claims that it creates a bias to invest in domestic equities, that it biases companies to pay dividends and not invest and that it benefits the rich. This is all nonsensical as dividend imputation simply corrects a bias by removing the double taxation of company earnings – once in the hands of companies and again in the hands of investors. The removal of dividend imputation would not only reintroduce a bias against equities but would also substantially cut into the retirement savings and income of Australians, discourage savings and lead to lower returns from Australian shares.

Labor’s proposal to make franking credits in excess of a taxpayer’s tax liability non-refundable could be argued to remove an anomaly in the tax system as dividend imputation was designed to prevent the double taxation of dividends, not to stop them being taxed at all. But a problem is that many Australians have planned their retirement around receiving such refunds. This is a subject for another note. But it is worth noting that Labor’s proposal does not affect at least 92% of taxpayers who will continue receiving franking credits as they have a sufficient income tax liability (as will pensioners who will be exempted). If it sets off a broader wind back of franking credits, then it would be a bigger concern.

Concluding comments

Dividends provide a great contribution to returns, a degree of protection during bear markets and a great income flow. For investors needing income the trick is to have a well-diversified portfolio of companies paying high sustainable dividends.

The Aussie economy in 2019; it’s not boom but it’s not doom either

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By Dr Shane Oliver

Head of Investment Strategy and Economics and Chief Economist, AMP Capital

Investors might be confused about the mixed news coming out late last year for the Australian economy and what it means for returns and rates.

Economic growth has been okay, and unemployment has fallen to five per cent which is quite low by Australian standards. But we’re also seeing ongoing weakness in house prices. Some say house price falls could be worse that those seen during the global financial crisis, and, ultimately, I think they will be.

So what’s going on here?

How we avoided recession

Basically, we’re seeing ‘desynchronisation’ across key sectors in the Australian economy – that is, when one part of the economy weakens, another picks up.

Desynchronisation partly explains why the Australian economy has dodged recession for almost 28 years.

We enjoyed a mining boom. When that came to an end, the mining-exposed parts of the economy, notably Western Australia, suffered. But that enabled lower interest rates and a lower Australian dollar which helped stimulate the economy. The housing market also strengthened and we had a housing boom in Sydney and Melbourne.

A new rotation

The economy is now rotating again, creating another two-speed economy.

On the positive side, we’re getting close to the end of the mining investment slump, which is taking pressure off Western Australia, the Northern Territory and parts of Queensland. We’re also seeing good signs in terms of non-mining investment and export values are doing ok.

But on the negative side, the housing boom is coming to an end and the key drivers for weaker housing returns remain in place:

  • Credit tightening
  • Rising supply in the unit market
  • Reduced foreign buyer demand
  • A lot of investors having to switch from interest-only loans to principle and interest loans.
  • Uncertainty about changes to taxation concessions around negative gearing and capital gains tax should Labor win the upcoming federal election

Also evident is a psychological change in attitudes to the housing market from ‘I’ve got to get in now otherwise I’ll miss out’ – (fear or missing out or FOMO); to ‘if I don’t get out now, I’ll be in trouble’ – (Fear of not getting out or FONGO).

So we’re likely to see more weakness in house prices as we go through 2019, particularly in Sydney and Melbourne where prices could come off another 10 per cent or so, probably more in Melbourne which has lagged a little bit going into this downturn.

That would take top to bottom falls in Sydney and Melbourne to around 20 per cent (10 per cent in 2019). Other parts of Australia will hold up a bit better, with the national average prices having top to bottom fall of around 10 per cent.

That’s going to cause a degree of weakness in terms of consumer spending in Australia because we will get a negative wealth effect flowing through. (When house prices fall, Australians are likely to feel less wealthy and trim consumption). That will also be a bit of a constraint for the banks.

Rate cut risk

When we put all this together, it’s going to mean an ongoing environment where wages growth remains low and inflation remains low, and so we’re unlikely to see the Reserve Bank raise interest rates in 2019.

In fact, the likelihood is that the Reserve Bank ends up cutting interest rates in 2019. If they do that as we expect, it could well be a second half 2019 story because it will take them a while to come around to the view rates need to be cut.

It’s a close call, but we think rates will be cut in 2019 and that there will be no rise.

Avoiding recession

Despite the negatives, when I look at the Australian economy, I don’t see a recession.
There are areas of the economy which are quite strong, and which will keep growth going to counter the other areas which will constrain it.

This year we’re probably looking at overall economic growth of around 2.5 to 3 per cent; we’re looking at unemployment going sideways – it may come down a little bit, but nothing to get excited about; and we’re looking at ongoing weak wages growth and low inflation.

What this means for investors

This outlook above has a number of implications for investors, including:

  • Returns from bank deposits will remain poor,
  • With a rate cut likely in Australia and further rate rises likely in the US, albeit at a slower rate, the Australian dollar is likely to fall into the high $US0.60s,
  • Australian bonds are likely to outperform global bonds,
  • Australian shares will remain great for income, but global shares will deliver better capital growth, and
  • The housing downturn will hit retailers, retail property, banks and building material stocks.

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13 common sense tips to help manage your finances

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Introduction

A few months ago Reserve Bank Governor Phillip Lowe provided four common sense points we should all keep in mind regarding borrowing to finance a home. (The Governor’s speech can be found here). I thought they made sense and so summarised them in a tweet to which someone replied that every checkout operator knows them. Which got me thinking that maybe many do know them, but a lot don’t, otherwise Australians would never have trouble with their finances. So I thought it would be useful to expand Governor Lowe’s list to cover broader financing and investment decisions we make. I have deliberately kept it simple and in many cases this draws on personal experience. I won’t tell you to have a budget though because that’s like telling you to suck eggs.

1. Shop around

We often shop around to get the best deal when it comes to consumer items but the same should apply to financial services. As Governor Lowe points out “don’t be shy to ask for a better deal whether for your mortgage, your electricity contract or your phone plan”. The same applies to your insurance, banking, superannuation, etc. It’s a highly-competitive world out there and financial companies want to get and keep your business. So when getting a new financial service it makes sense to look around. And when it comes time to renew a service – say your home and contents insurance – and you find that the annual charge has gone up way in excess of inflation (which is currently around 2%) it makes sense to call your provider to ask what gives. I have often done this to then be offered a better deal on the grounds that I am a long-term loyal customer.

2. Don’t take on too much debt

Debt is great, up too a point. It helps you have today what you would otherwise have to wait till tomorrow for. It enables you to spread the costs associated with long term “assets” like a home over the years you get the benefit of it and it enables you to enhance your underlying investment returns. But as with everything you can have too much of it. Someone wise once said “it’s not what you own that will send you bust but what you owe.” So always make sure that you don’t take on so much debt that it may force you to sell all your investments just at the time you should be adding to them or worse still potentially send you bust. Or to sell your house when it has fallen in value. A rough guide may be that when debt servicing costs exceed 30% of your income then maybe you have too much debt – but it depends on your income and expenses. A higher income person could manage a higher debt servicing to income ratio simply because living expenses take up less of their income.

3. Allow that interest rates can go up as well as down

Yeah, I know that it’s a long time since offical interest rates were last raised in Australia – in fact it was way back in 2010. So as Governor Lowe observes “many borrowers have never experienced a rise in official interest rates”. But don’t be fooled by the recent history of falling or low rates. My view is that an increase in rates is still a long way off (and they may even fall further first) – but that’s just a view and views can be wrong. History tells us that eventually the interest rate cycle will turn up. Just look at the US where after six years of near zero interest rates, official US interest rates have risen 2% over the last three years. So, the key is to make sure you can afford higher interest payments at some point. And when official rates move up the moves tend to be a lot larger than the small out of cycle moves from banks that have caused much angst lately.

4. Allow for rainy days

This is another one raised by Governor Lowe who said: “things don’t always turn out as we expect. So for most of us having a buffer against the unexpected makes a lot of sense.” The rainy day could come as a result of higher interest rates, job loss or an unexpected expense. This basically means not taking all the debt offered to you, trying to stay ahead of your payments and making sure that when you draw down your loan you can withstand at least a 2% rise in interest rates.

5. Credit cards are great, but they deserve respect

I love my credit cards. They provide me with free credit for up to around 6-7 weeks and they attract points that can really mount up (just convert the points into gift cards and they make optimal Christmas presents!). So, it makes sense to put as much of my expenses as I can on them. But they charge usurious interest rates of around 20-21% if I get a cash advance or don’t pay the full balance by the due date. So never get a cash advance unless it’s an absolute emergency and always pay by the due date. Sure the 20-21% rate sounds a rip-off but don’t forget that credit card debt is not secured by your house and at least the high rate provides that extra incentive to pay by the due date.

6. Use your mortgage for longer term debt

Credit cards are not for long term debt, but your mortgage is. And partly because it’s secured by your house, mortgage rates are low compared to other borrowing rates – at around 4-5% for most. So if you have any debt that may take longer than the due date on your credit card to pay off then it should be on your mortgage if you have one.

7. Start saving and investing early

If you want to build your wealth to get a deposit for a house or save for retirement the best way to do that is to take advantage of compound interest – where returns build on returns. Obviously, this works best with assets that provide high returns on average over long periods. But to make the most of it you have to start as early as possible. Which is why those piggy banks that banks periodically hand out to children have such merit in getting us into the habit of saving early.

Of course, this gives me an opportunity to again show my favourite chart on investing which tracks the value of $1 invested in Australian shares, bonds and cash since 1900 with dividends and interest reinvested along the way. Cash is safe but has low returns and that $1 will have only grown to $237 today. Shares are volatile (& so have rough periods highlighted by arrows) but if you can look through that they will grow your wealth and that $1 will have grown to $526,399 by today.

Source: Global Financial Data, AMP Capital
Source: Global Financial Data, AMP Capital

8. Allow that asset prices go up and down

It’s well known that the share market goes through rough patches. The volatility seen in the share market is the price we pay for higher returns than most other asset classes over the long term. But when it comes to property there seems to be an urban myth that it never goes down in value. Of course property prices will always be smoother than share prices because it’s not traded daily and so is not subject to daily swings in sentiment. But history tells home prices do go down as well as up. Japanese property prices fell for almost two decades after the 1980s bubble years, US and some European countries’ property values fell sharply in the GFC and the Australian residential property market has seen several episodes of falls over the years and of course we are going through one right now. So the key is to allow that asset prices don’t always go up – even when the population and the economy are growing.

9. Try and see big financial events in their long-term context

Hearing that $50bn was wiped off the share market in one day sounda scary – but it tells you little about how much the market actually fell and you have only lost something if you actually sell out after the fall. Scarier was the roughly 20% fall in share markets through 2015-16 and worse still the GFC that saw roughly 50% falls. But such events happen every so often in share markets – the 1987 crash saw a 50% in a few months & Australian shares fell 59% over 1973-74. And after each the market has gone back up. So, we have seen it all before even though the details may differ. The trick is to allow for periodic sharp falls in your investment strategy and when they do happen remind yourself that we have seen it all before and the market will find a base and resume its long-term rising trend.

10. Know your risk tolerance

When embarking on investing it’s worth thinking about how you might respond if you found out that market movements had just wiped 20% off the value of your investments. If your response is likely to be: “I don’t like it, but this sometimes happens in markets and history tells me that if I stick to my strategy I will see a recovery in time” then no problem. But if your response might be: “I can’t sleep at night because of this, get me out of here” then maybe you should rethink your strategy as you will just end up selling at market bottoms and buying tops. So try and match your investment strategy to your risk tolerance.

11. Make the most of the Mum and Dad bank

The housing boom in Australia that got underway in the mid-1990s and reached fever pitch in Sydney & Melbourne last year has left housing very unaffordable for many. This contributed to a huge wealth transfer from Millennials to Baby Boomers and some Gen Xers. Hopefully the current home price correction underway will help in starting to correct that. But for Millennials in the meantime, if you can it makes sense to make the most of the “Mum and Dad bank”. There are two ways to do this. First stay at home with Mum and Dad as long as you can and use the cheap rent to get a foot hold in the property market via a property investment and then using the benefits of being able to deduct interest costs from your income to reduce your tax bill to pay down your debt as quickly as you can so that you may be able to ultimately buy something you really want. (Of course, changes to negative gearing if there is a change to a Labor Government could affect this.) Second consider leaning on your parents for help with a deposit. Just don’t tell my kids this!

12. Be wary of what you hear at parties

A year ago Bitcoin was all the rage. Even my dog was asking about it – but piling in at around $US19,000 a coin just when everyone was talking about it back then would not have been wise (its now below $US6500) even though many saw it as the best thing since sliced bread. Often when the crowd is dead set on some investment it’s best to do the opposite.

13. There is no free lunch

When it comes to borrowing & investing there is no free lunch – if something looks too good to be true (whether it’s ultra-low fees or interest rates or investment products claiming ultra-high returns & low risk) then it probably is and it’s best to stay away.

Concluding comment

I have focussed here mainly on personal finance and investing at a very high level, as opposed to drilling into things like diversification and taking a long-term view to your investments. An earlier note entitled “Nine keys to successful investing” focussed in more detail on investing and can be found here.

Is the Australian dollar headed for more downside?

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AMP Capital chief economist Shane Oliver says he expects the Australian dollar ($A) to weaken further – making unhedged offshore investments more attractive — as interest rates continue to rise in the US. However solid commodity prices should put a floor under falls.

So far this year the $A has fallen from around US$0.80 to around US$0.72. “I think the likelihood is it’s got more downside,” Oliver says.

He notes that there are two conflicting processes at work.

The “dominant” force at the moment is the US Central Bank, the Federal Reserve, which has been steadily raising interest rates – 25 basis points every three months. The next interest rate decision is in September. But at the same time Australia’s central bank, the Reserve Bank (RBA), has kept rates on hold for several years and is likely to remain doing so for some time to come.

“The result is that the interest rate differential between the US and Australia has gone strongly in favour of the US dollar and is attracting money into the US economy,” Oliver says. “Cash is being parked there as opposed to be parked in Australia. So that’s a big negative for the $A.”

The interest rate differential is the difference between official interest rates in countries. The RBA’s official cash rate sits at 1.5%. The current federal funds rate target is 1.75% to 2%.

“We think that [interest rate differential] has got a lot further to go because we expect the Fed will continue those rate hikes going into 2019 at least. But the RBA is leaving interest rates on hold through 2019, at least. So that interest rate differential will get wider, pushing the $A down probably to around US$0.70.”

Oliver says the other force impacting the $A is commodity prices. He notes that bulk commodity prices are solid with iron ore around US$65-70 a tonne recently and coal prices are strong. “That’s providing a degree of support for the $A.”

Oliver says that these strong commodity prices are probably going to provide a “bit of a floor” of around US$0.68 to US$0.69 “rather than pushing it [the $A] higher.”

But he says there are other risks. “If this trade war [between the US and China] gets worse, then that could turn into a negative as commodity prices come under pressure.” Similarly, the turmoil in some emerging markets led by Turkey is also creating uncertainty for global growth and adding to downwards pressure on the $A.

“The bottom line is, investors should expect more downside for the $A. That enhances the value of offshore investments which are unhedged. But I don’t see a crash in the $A unless commodity prices take a big hit.”

As the recent fall in the $A on the back of the Turkish crisis highlights, being short the Australian dollar and long (unhedged) foreign exchange (particularly the $US and Yen) could work in certain cases as a hedge against threats to the global outlook.

By Dr Shane Oliver
Head of Investment Strategy and Economics and Chief Economist, AMP CapitalSydney, Australia

 

Important notes

 

While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

The US economy – Is a recession imminent?

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19 Jul, 2018

By Dr Shane Oliver
Head of Investment Strategy and Economics and Chief Economist, AMP CapitalSydney, Australia

Key points

If you are worried about a recession and a major bear market, the US economy is the key to watch.

While traditional measures of the US yield curve have flattened sending warning signs about future growth, it has given false signals in the past, is still positive and other versions of the yield curve point to rising growth.

Moreover, apart from very low unemployment, other US indicators still show little sign of the sort of excesses that precede major economic downturns, profit slumps and major bear markets.

Introduction

Ever since the Global Financial Crisis (GFC) there has been an obsession with looking for the next recession. In this regard, over the last year or so there has been increasing concern that a flattening yield curve in the US – ie the gap between long-term bond yields and short-term borrowing rates has been declining – is signalling a downturn and, if it goes negative, a recession in the US. This concern naturally takes on added currency given that the current US bull market and economic expansion are approaching record territory in terms of duration and given the trade war threat.

The increased volatility in shares seen this year, including a 10% or so pull back in global shares earlier this year, adds to these fears. Whether the US is about to enter recession is critical to whether the US (and hence global) bull market in shares is about to end. Looking at all 10% or greater falls in US shares since the 1970s (see the table in Correction time for shares?), US share market falls associated with a US recession are longer lasting and deeper with an average duration of 16 months and an average fall of 36% compared to a duration of 5 months and an average fall of 14% when there is no recession. Similarly, Australian share market falls are more severe when there is a US recession. So, whether a recession is imminent or not in the US is critically important in terms of whether a major bear market is imminent. This note assesses the risks.

The long US economic expansion and bull market

The cyclical bull market in US shares is now over nine years old. This makes it the second longest since WW2 and the second strongest in terms of percentage gain. And according to the US National Bureau of Economic Research the current US economic expansion is now 109 months old and compares to an average expansion of 58 months since 1945. See the next two tables. So, with the bull market and the economic expansion getting long in the tooth it’s natural to ask whether it will all soon come to an end with a major bear market.

OI-20180719-table1

The yield curve flattens – but it’s complicated

The yield curve is watched for two reasons. First, it’s a good guide to the stance of monetary policy. When short-term interest rates are low relative to long-term rates it indicates businesses can borrow short and lend (or invest) long & this grows the economy. But it’s not so good when short rates are above long rates – or the curve is inverted. And secondly an inverted US yield curve has preceded US recessions. So, when it’s heading in this direction some start to worry. However, there are several complications.

First, which yield curve? Much focus has been on the gap between 10-year bond yields and 2-year bond yields which has flattened to just 0.3%, but the Fed has concluded that the traditional yield curve based on the gap between 10-year bond yields and the Fed Funds rate is a better predictor of the economy and it has flattened but only to 1%. Moreover, a shorter yield curve based on the gap between 2-year bond yields and the Fed Funds rate predicted past recessions like the longer yield curves but has actually been steepening in recent years which is positive.

OI-20180719-chart1

Second, the yield curve can give false signals – the traditional version flattened or went negative in 1986, 1995 and 1998 before rebounding – and the lags from an inverted curve to a recession can be long at around 15 months. So even if it went negative now recession may not occur until late 2020.

Third, various factors may be flattening the yield curve unrelated to cyclical economic growth expectations including still falling long-term inflation and real rate expectations, low German and Japanese bond yields holding down US yields and higher levels of investor demand for bonds post the GFC as they have proven to be a good diversifier to shares in times of crisis.

Fourth, a flattening yield curve caused by rising short term ratesand falling long term rates is arguably more negative than aflattening when both short and long term rates go up like recently.

Finally, a range of other indicators which we will now look at are not pointing to an imminent US recession.

Watch for exhaustion, not old age

A key lesson of past economic expansions is that “they do not die of old age, but of exhaustion”. The length of economic expansions depends on how quickly recovery proceeds, excess builds up, inflation rises and the central bank tightens. The US economic recovery may be long, but it has been very slow such that average economic and employment growth has been around half that seen in post WW2 expansions. So as a result it has taken longer than normal for excesses to build up. Apart from flattening yield curves one area where the US is flashing warning signs is in relation to the labour market where unemployment and underemployment have fallen about as low as they ever go warning of a wages breakout and inflation pressure.

OI-20180719-chart2

However, there is still arguably spare capacity in the US labour market (the participation rate has yet to see a normal cyclical rise) and wages growth at 2.7% remains very low. The last three recessions were preceded by wages growth above 4%. Secondly, while US GDP is now back in line with estimates of “potential”, what is “potential” can get revised so it’s a bit dodgy and more fundamentally, industrial capacity utilisation at 78% is still below normal of 80% and well below levels that in the past have shown excess and preceded recessions.

Thirdly, cyclical spending in the US as a share of GDP remain slow. For example, business and housing investment are around long term average levels as a share of GDP in contrast to the high levels in one or both seen prior to the tech wreck and GFC.

OI-20180719-chart3

Finally, while the rising Fed Funds rate and flattening traditional yield curve is consistent with tightening US monetary policy, it’s a long way from tight. Past US recessions have been preceded by the Fed Funds rates being well above inflation and nominal economic growth whereas it’s still a long way from either now. See the next chart.

OI-20180719-chart4

US likely to see overheating before recession

Apart from the amber lights flashing from the flattening yield curve and very low unemployment our assessment is that a US recession is still some time away as it will take time for excesses to become extreme and US monetary policy to become tight. Looked at another way, the US is still more likely to overheat before it goes into recession. We have been thinking recession is a 2020 risk. The end of the current fiscal stimulus around then would also be consistent with this. However, given the current slow pace in terms of building excess, that 2020 is a presidential election year – do you really think Trump will allow the US to go off a fiscal cliff then? – and with 2020 being the consensus pick for a downturn, the risk is that it comes later. Of course, an escalating trade war could mess things up earlier, although we still see a negotiated solution. The rising US budget deficit is a concern but it’s more of an issue for when the economy turns down as this is when investors will start to worry about its sustainability. And of course a 1987 style share market crash cannot be ruled out but probably requires a share market blow off before hand. In the meantime, the Fed has more tightening to do and while sharemarket volatility is likely to remain high as US inflation and short rates rise, excesses gradually build and given risks around Trump and trade, with recession still a way off the US and global share bull market likely still has some way to go.

Important notes

While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

Putting the global “debt bomb” in perspective – seven reasons to be alert but not alarmed

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Key Points

  • Global debt levels have reached new records.
  • Countries with very high gross debt to GDP include Japan, Belgium, Canada, Portugal and Greece. The main areas of rising debt since the Global Financial Crisis (GFC) have been public debt in developed countries (with more to come in the US) and private debt in emerging countries (and of course household debt in Australia).
  • Global debt is not as a big a concern as headline numbers suggest & debt to income ratios will tend to rise through time simply because of saving & investing.
  • Key signs to watch though are a broad-based surge in debt along with signs of excess such as overinvestment, rapid broad-based gains in asset prices and surging inflation and interest rates.

Introduction

Here’s my forecast: “The global economy is going to have a significant downturn and record levels of debt are going to make it worse.” Sound scary enough? Put it in the headline and I can be assured of lots of clicks! I might even be called a deep thinker! The problem is that there is nothing new or profound in this. A significant economic downturn is inevitable at some point (it’s just the economic cycle), debt problems are involved in most economic downturns and such calls are a dime a dozen.

A standard scare now is that memories of the role of excessive debt in contributing to the GFC have worn thin and total global debt has pushed up to a new record high of over $US200 trillion – thanks largely to public debt in developed countries (with more to come in the US as Trump’s fiscal stimulus rolls out), Chinese debt and corporate debt (and household debt in Australia of course). Also, that its implosion is imminent and inevitable as interest rates normalise and that any attempt to prevent or soften the coming day of reckoning will just delay it or simply won’t work. However, in reality it’s a lot more complicated than this. This note looks at the main issues.

Global debt – how big is it and who has it?

Total gross world public and private debt is around $US171 trillion. Adding in financial sector debt pushes this over $US200 trillion but that results in double counting. Either way it’s a big and scary number. But it needs to be compared to something to have any meaning or context. A first point of comparison is income or GDP at an economy wide level. And even here new records have been reached with gross world public and private non-financial debt rising to a record of 233% of global GDP in 2016, although its fallen fractionally to 231% since. See the next chart.

Source: IMF, Haver Analytics, BIS, Ned Davis Research, AMP Capital

The next table compares total debt for various countries.

Source: IMF, Haver Analytics, BIS, Ned Davis Research, AMP Capital

The next chart shows a comparison of developed world (DM) and emerging world (EM) debt – both public and private.


Source: Haver Analytics, BIS, Ned Davis Research, AMP Capital

It can be seen that the rise in debt relative to GDP since the GFC owes to rising public debt in the developed world and rising private debt in the emerging world. Within developed countries a rise in corporate debt relative to GDP has been offset by a fall in household debt, so private debt to GDP has actually gone down slightly. And a rapid rise Chinese debt (particularly corporate) has played a role in the emerging world.

Of course, it needs to be mentioned that measures of gross debt exaggerate the total level of debt. For example, because of government holdings of debt instruments via sovereign wealth funds, central bank reserves, etc, net public debt is usually well below gross debt. In Norway net public debt is -91% of GDP and in Japan it’s 153% of GDP. But as an overview:

  • Japan, Belgium, Canada, Portugal and Greece have relatively high total debt levels;
  • Germany, Brazil, India and Russia have relatively low debt;
  • Australia does not rank highly in total debt – it has world-beating household debt but low public & corporate debt;
  • Emerging countries tend to have relatively lower debt, but rising private debt needs to be allowed for particularly in China, where corporate debt is high relative to GDP.

The bottom line is that global debt is at record levels even relative to GDP so it’s understandable there is angst about it.

Seven reasons not to be too alarmed about record debt

However, there are seven reasons not to be too alarmed by the rise in debt to record levels.

First, the level of debt has been trending up ever since debt was invented. This partly reflects greater ease of access to debt over time. So that it has reached record levels does not necessarily mean it’s a debt bomb about to explode.

Second, comparing debt and income is a bit like comparing apples and orangesbecause debt is a stock while income is a flow. Suppose an economy starts with $100 of debt and $100 in assets and in year 1 produces $100 of income and each year it grows 5%, consumes 80% of its income and saves 20% which is recycled as debt and invested in assets. How debt, debt to income & debt to assets evolves can be seen in the next table.


Source: AMP Capital

At the end of year 1 its debt to income ratio will be 120%, but by the end of year 5 it will be 173%. But assuming its assets rise in line with debt its debt to asset ratio will remain flat at 100%. So the very act of saving and investing creates debt and {% rising debt to income ratios. 1 China is a classic example of this where it borrows from itself. It saves 46% of GDP and this saving is largely recycled through banks and results in strong debt growth. But this is largely matched by an expansion in productive assets. The solution is to spend more, save less and recycle more of its savings via investments like equity.
Third, the rapid rise in private debt in the emerging world is not as concerning as they have a higher growth potential than developed countries. Of course, the main problem emerging countries face is that they borrow a lot in US dollars and either a sharp rise in the $US or a loss of confidence by foreign investors causes a problem. This has started to be a concern lately as the $US is up 7% from its low earlier this year.

Fourth, debt interest burdens are low and in many cases falling as more expensive, long maturity, older debt rolls off. And given the long maturity of much debt in advanced countries it will take time for higher bond yields to feed through to interest payments. In Australia, interest payments as a share of household disposable income are at their lowest since 2003, and are down by a third from their 2008 high. There is no sign of significant debt servicing problems globally or in Australia.

Fifth, most of the post GFC debt increase in developed countries has come from public debt & governments can tax and print money. Japan is most at risk here given its high level of public debt, but borrows from itself. And even if Japanese interest rates rise sharply (which is unlikely with the BoJ keeping zero 10-year bond yields with little sign of a rise) 40% of Japanese Government bonds are held by the BoJ so higher interest payments will simply go back to the Government.

Sixth, while global interest rates may have bottomed, the move higher is very gradual as seen with the Fed and the ECB, Bank of Japan and RBA are all a long way from raising rates. What’s more, central banks know that with higher debt to income ratios they don’t need to raise rates as much to have an impact on inflation or growth as in the past.

Finally, debt alone is rarely the source of a shock to economies. Broader signs of excess such as overinvestment, rapid broad-based gains in asset prices and surging inflation and interest rates are usually required and these aren’t evident on a generalised basis. But these are the things to watch for.

Concluding comment

History tells us that the next major crisis will involve debt problems of some sort. But just because global debt is at record levels and that global interest rates and bond yields have bottomed does not mean a crisis is imminent. For investors, debt levels are something to remain alert too – but in the absence of excess in the form of booming investment levels, surging inflation and much higher interest rates, for example, there is no need to be alarmed just yet.

1.↩  [My favourite example of the complex relationships between income, saving and debt came from Bank Credit Analyst Research. Suppose there is an island with 100 people, each making 100 coconuts a year. Here’s three possibilities.

Case 1: Output is 10,000 coconuts with each person consuming 100. Saving and investment are zero and no debt is created.
Case 2: Each person consumes only 75 coconuts a year, selling the remainder to a plantation who buys them with a bank loan and plants them resulting in 2500 new coconut trees. Consumption is 7500 coconuts. Savings and investment are 2500 and debt has gone up by 2500 coconuts.
Case 3: Each person consumes 125 coconuts, by importing 25 each from foreign islands. Consumption is now 12,500 coconuts, savings is -2500 coconuts, investment is zero and the current account deficit is 2500. External debt goes up by 2500. This gets risky if the other islands want their coconuts back!

So debt can rise even if an economy lives within its means & invests for the future. ]↩ 

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

An additional 21 great investment quotes

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Introduction

Investing can be frustrating and depressing at times, particularly if you don’t understand how markets work and don’t have the right mindset. The good news is that the basics of investing are timeless, and some have a knack of encapsulating these in a sentence or two that is both insightful and easy to understand. In recent years I’ve written insights highlighting investment quotes that I find particularly useful. Here are some more.

Having a goal and a plan

“Financial peace isn’t the acquisition of stuff. It’s learning to live on less than you make, so you can give money back and have money to invest. You can’t win until you do this.” Dave Ramsey

The only way to be able to build wealth is to save and invest and you can only do this if you spend less than you earn. That is, you have to start with a savings plan.

“Put time on your side. Start saving early and save regularly. Live modestly and don’t touch the money that’s been set aside” Burton G Malkiel

In investing time is your friend and the earlier you start the better. This is the best way to take advantage of the magic of compound interest. The next chart – my favourite – shows the value of $1 invested in various Australian asset classes since 1900 allowing for the reinvestment of any income along the way. That $1 would have grown to just $234 if invested in cash, $866 in bonds but a whopping $529,293 if invested in shares.


Source: Global Financial Data, AMP Capital

While the average share return since 1900 is only double that in bonds, the huge gap in the end result between the two owes to the magic of compounding returns on top of returns. A growth asset like property is similar to shares over long periods in this regard. Short-term share returns bounce all over the place and they can go through lengthy bear markets (shown with arrows on the chart). But the longer the time period you allow to build your savings the easier it is to look through short-term market fluctuations and the greater the time the compounding of higher returns from growth assets has to build on itself.

“If you fail to plan, you plan to fail.” Often attributed to Benjamin Franklin

Having a clear understanding of your investment goals – like saving for a home or retirement or generating income to live on – and a plan to get there is critical. If you don’t have a clear plan you will be subject to all sort of distractions which can blow you a long way from where you want to get with your investments.

The investment cycle

“Bull markets don’t die of old age but of exhaustion.” Anon 

Bear markets are invariably preceded by excess in the economy – over investment, high levels of debt growth, high levels of inflation and tight monetary conditions – and excess in the share market in the form of overvaluation and investor euphoria. It’s this excess which drives exhaustion and hence the end of a bull market, not its age.

“The stock market has predicted 9 of the past 5 recessions.” Paul Samuelson

In the short term the share market moves all over the place with each significant plunge eliciting calls for an impending recession and a deep bear market. But most of the time it’s just noise providing an opportunity for investors before a rebound. For example, over the past 50 years in the US there has been 21 episodes of 10% or greater share market falls, but only seven saw recessions and bear markets.

Risk

“The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. Not only is the mere drop in stock prices not risk, but it is an opportunity.” Li Lu

Risk is often portrayed as market volatility when in reality it’s a whole lot more: the risk of capital loss; the risk of not having enough investment income; the risk of not having enough to last through retirement. It’s also perverse – the risk of capital loss is lowest after a period of high volatility and vice versa.

Contrarian investing

“The day after the market crashed on 19th October 1987, people began to worry that the market was going to crash” Peter Lynch

This is perhaps a bit flippant, but it goes to the heart of crowd psychology and why it’s best to go against the crowd at extremes. When times are good the crowd is relaxed, happy and fully invested. So everyone who wants to buy has. This leaves the market vulnerable to bad news because there is no one left to buy should prices drop. Similarly, after a sharp fall the crowd gets negative, sells their investments to the point that everyone who wants to sell has and so the market sets up for a rally when some good or less bad news comes along. So the point of maximum risk is when most are euphoric, and the point of maximum opportunity is when most are pessimistic.

Pessimism

“It is easier being sceptical, than being right.” Benjamin Disraeli

The human brain evolved in a way that it leaves us hardwired to be on the lookout for risks. So a financial loss is felt more negatively than the beneficial impact of the same sized gain. Consequently, it seems easier to be sceptical and pessimistic. As a result, bad news sells and there seems to be a never-ending stream of warnings regarding the next disaster. But when it comes to investing, succumbing too much to scepticism and pessimism doesn’t pay. Historically, since 1900 shares have had positive returns seven years out of 10 in the US and eight years out of 10 in Australia.

“A pessimist sees the difficulty in every opportunity, an optimist sees the opportunity in every difficulty.” Winston Churchill

This is what stops many investing after big falls – all they see are the reasons the market fell. Not the opportunity it provides.
“Without a saving faith in the future, no one would ever invest at all. To be an investor, you must be a believer in a better tomorrow.” Jason Zweig

If you don’t believe your term deposit is safe, that borrowers will pay back their debts, that companies will see good profits and that properties will earn rents then there is no point in investing.

Psychology

“An investment said to have an 80% chance of success sounds far more attractive than one with a 20% chance of failure. The mind can’t easily recognise that they are the same.” Daniel Kahneman

Beware of tricks that your mind plays on you when investing. Numerous studies show that people suffer from lapses of logic – eg, assuming the current state of the world will continue, being overly confident and assessing the risk of certain events by how they are presented. The key for investors is to be aware of these biases and try to correct them.

Noise

“Stock market news has gone from hard to find (in the 1970s and early 1980s), then easy to find (in the late 1980s), then hard to get away from.” Peter Lynch

The information revolution has given us access to an abundance of information and opinion regarding investment markets. The danger is that it adds to the uncertainty around investing resulting in excessive caution, a short-term focus, a tendency to overreact to news and to focus on things that are of little relevance. The key is to recognise that much of the noise and opinion around investing is ill informed and of little value.

“The ability to focus is a competitive advantage in the world today.” Harvard Business Review

The key in the face of this information and opinion onslaught is to turn down the noise and focus.

“If you can keep your head when all about you are losing theirs…If you can wait and not be tired by waiting… If you can trust yourself when all men doubt you…Yours is the Earth and everything that’s in it.” Rudyard Kipling, If, as quoted by Warren Buffett 

Keeping your head and remaining calm is critical in times of extreme – when the crowd is convinced the path to instant riches has been revealed or when the crowd is convinced that economic disaster is upon us. These periods throw up great temptation to buy when you should be selling and vice versa. But you will only get it right if you keep your head & stay calm.

Forecasting

“I believe that economists put decimal points in their forecasts to show that they have a sense of humour.” William Gillmore Simms

The dismal track record of precise forecasts regarding things like economic growth, share prices and currencies indicates that relying on them when investing can be dangerous. There is often a big difference between getting some forecasts right and making money. Good experts will help illuminate the way and put things in context, so you don’t jump at shadows but don’t over rely on expert forecasts – particularly the grandiose ones.

Having a process

“I am going to reveal the grand secret to getting rich by investing. It’s a simple formula that has worked for Warren Buffett, Carl Icahn and the greatest investment gurus over the years. Ready? Buy low, sell high.” Larry Kudlow

Yep it’s that simple. Or it should be, but many do the exact opposite and buy high after a lengthy period of strong returns convinces people it’s a great investment (but the risks point down), and then sell low after fall in the price of an asset leads people to believe that it’s a bad investment (but that’s when the risks point up). The key to is do the opposite – buy low, sell high and it’s very helpful to have an investment process to do that.

“Three simple rules – pay less, diversify more and be contrarian – will serve almost everyone well.” John Kay

This helps bring the essentials of investing together. They stand to reason: the less you pay for an investment the greater the return potential; just having one or two shares leaves you very exposed should the news turn bad regarding those shares but if you diversify across a range of shares you can reduce the risk of a fall in your overall portfolio; and doing the opposite to the crowd means you can avoid the points of maximum risk in markets when most are fully invested and take advantage of periods of maximum opportunity when most have sold.

“Success consists of going from failure to failure without loss of enthusiasm.” Winston Churchill

As with all things we need to recognise that to learn we need to make mistakes and to be persistent.

Balance

“A calm and modest life brings more happiness than the pursuit of success combined with constant restlessness” Albert Einstein

This applies to life in general, but it also applies to investing – don’t jump around all over the place and keep it simple.

“A man should make all he can, and give all he can.” Nelson Rockefeller

It’s not financially possible for everyone but consider giving a bit away for good causes if you can – and not just for the tax deduction as you will feel good and it will bring good karma.

“The trouble with doing nothing is that you don’t know when you have finished.” Cafe blackboard in Byron Bay

…so it’s always good to do something and investing is something worth doing (and worth doing well)!

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

2017 – a list of lists regarding the macro investment outlook

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Despite a terrible start to the year and a few political surprises along the way, 2016 saw good returns for diversified investors who held their nerve. Balanced super funds had returns around 7.5%, which is pretty good given inflation was just 1.5%. 2017 is commencing with less fear than seen a year ago but there is consternation regarding Donald Trump’s policies, political developments in Europe and the growth outlook. This note provides a summary of key insights on the global investment outlook and key issues around it in simple dot point form.

 

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NINE RULES FOR INVESTORS TO KEEP IN MIND

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Due to an obsession with Taylor Swift and then The Carpenters I decided I needed to have a Carpenters’ CD with the full Burt Bacharach medley they performed in the early 1970s. So I went to Amazon and found that it was only on a Japanese Carpenters’ Anthology CD which would set me back $US150 from the US or $65 for a “very good” second hand edition from Japan. The last time I got a “very good” second hand Elvis book from Amazon it had some pages missing but I decided to give the Japanese CD a go.

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PUTTING RECENT SHARE MARKET FALLS IN CONTEXT

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Uncertainties regarding the emerging world and specifically China and the US Federal Reserve’s much talked about first interest rate hike have continued to result in volatile share markets over the last few weeks even though most have not made new lows for this downturn.

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