This time last year we published “The five biggest risks facing Australian investors”, and soon we’ll be retiring that series and launching a new one
FIIG’s Smart Income publications run on a one year cycle: in January we launch the Smart Income Report, and June a new series of webinars and seminars. This time last year we published “The five biggest risks facing Australian investors”, and soon we’ll be retiring that series and launching a new one (stay tuned). Before we say farewell, it’s worth having a look at how the five themes have played out and highlight that no research is infallible!
#5: EU economic malaise and risk of breakup
This was the longest dated of our risks, which offered projections for 2018 and beyond. In particular, the identified risk was the challenge of the EU turning around its economic slump – given the very high levels of debt and demographic challenges, with many countries facing falling population sizes and record low birth rates.
The way that risk plays out is complicated by the structure of the EU itself. Any populous facing economic austerity, particularly fiscal austerity (such as tax increases, government spending cuts), will fight back via their democratic rights. In Europe, those rights include voting to leave the EU. Britain’s Brexit is not just a fight for retaining the UK in the EU; it is a fight to stop the potential breakup of the EU itself.
Over the past year, this risk has increased overall. Brexit has become a far closer battle since it was announced in January. Italy and France have increased their debt further, and both face bad loan issues with their major banks. The ECB (European Central Bank) has highlighted the economic malaise the continent faces, and has dialled up its QE (quantitative easing) program in a desperate move to turn the ship around. There are early signs that QE might finally be working, but as always, QE is a short term fix. Europe’s problems (fiscal and demographic) are long term, and difficult to turn around in a meaningful way.
As mentioned in the seminars, the EU’s economic volatility is of lower concern for Australian investors than other risks, however it is rising. Stay clear of the Euro or high risk European assets such as equities unless you have strategic or personal reasons to get exposed.
#4: US recovery stalls
In contrast to the EU risk, we identified this as a short term risk. Specifically, we said that the US recovery was going well and that if this risk didn’t play out in 2015/16, it probably wouldn’t for some time. The phrase we coined for the US economy was “good, but not great”.
Over the past year this has remained the case. Their economy has continued to strengthen, but is still not great. The US Fed has been able to increase rates once, but that caused significant volatility and so they were very cautious about moving again, stepping back from their initial forecast of four more increases in 2016, to now suggest just two increases. During the seminars, we forecast that there would be one increase in 2015 and probably only one more in 2016, and therefore we forecast the 10 year bond rate in the US to fall from its then level of 2.3% to around 1.7 to 1.9% pa, which it did by January this year.
That remains our view. Most of the data out of the US suggests their economy is holding up, despite the drag caused by weakness in Japan, Europe and China. The first quarter GDP in the US was a very low 0.8% pa, but this quarter will be more like 2.5% pa, and the annual GDP rate for 2016 will average around 2.0% pa or slightly lower. Naturally the US election presents a small risk to that growth, but if it slows decisions, even under a Trump presidency, momentum in the US economy will likely continue.
The impact of a US slowdown on Australian investors would be significant, but on this one the risk is subsiding. The US was highlighted in the seminars as the brightest face on the economic globe, and that is in fact truer today than last year.
#3: Australian economy dragged down by a slowing housing cycle
Again this was identified as a short term risk, and the triggers identified at the time was a construction slow down as unit prices in Brisbane and Melbourne first, then Sydney, started to fall due to oversupply. Prices were still rising sharply this time last year, so the risk was a turnaround and the knock on impact on construction activity and therefore the Australian economy, as well as consumer confidence.
Unlike the two above, on this theme we score around 50%. Apartment prices, particularly in Brisbane and Melbourne, have definitely started to fall. New apartments bought off the plan are now selling for as much as a 30% discount in suburbs of highest over supply. House prices are holding up, so the impact of the apartment oversupply is so far contained to a drop in construction activity. Consumer confidence remains high, despite the questionable economic outlook and the election cycle.
The Ai Group/Housing Industry Association’s Performance of Construction Index fell sharply from 50.8 points to 46.7 points (“50” is the line between expansion and contraction), and has been below 50 over the past six months excluding April. Their apartment sub index slumped 8 points to 41.5, its lowest level in three years, and orders for new apartments fell even faster, from 49.1 to 37. But standalone housing construction jumped, particularly in established areas. Commercial and engineering activity remains very subdued.
One consequence of slowing construction activity has been a dramatic drop in construction sector wage growth. Wage growth for Australia as a whole is at its lowest level since the last recession, but construction has suffered more than most: falling from around 5% pa pre GFC, to 4% during the mining boom and 3% post mining boom, to just 1.2% pa now – its lowest level on record. Low wage growth is an early indicator of low inflation, and low inflation is a major driver of the RBA to lower interest rates, as was seen when they cut rates on 3 May this year.
The risk to the Australian economy as a whole from this measure is probably unchanged. On one hand, each month that ends with an orderly fall in apartment prices and construction levels, without a steep decline in consumer confidence and overall economic activity, signals a lower risk to the economy as a whole. On the other hand, wage and income growth for Australia is at a record low, a concern for the RBA.
This risk remains on close watch, but stable. If the RBA reacts by continuing to lower interest rates, which we believe they will, the result will likely be a lower AUD. With recent strength in the AUD well above our target level of 65 to 70c against the USD, the suggested hedge against the risk of a slower Australian economy, namely shifting some assets into USD denominated assets, remains relevant and viable.
The other strategy highlighted to deal with the economic risks facing Australia, whether due to the housing market, a China hard landing (#2 risk below), or just global mediocrity (#1 risk below), is the “Safe harbour strategy”. This strategy involves shifting more of one’s portfolio into assets that are far less impacted by the economic cycle: infrastructure assets. For those that attended our seminars, you will recall that we showed that even in the US’ worst recession since the great depression, activity levels for infrastructure assets barely moved while normal commercial sectors like finance or property saw 20 to 40% declines in activity. Infrastructure is a great hedge for those worried about the impact of an economic downturn on their portfolio value and income.
#2: China hard landing (or fears thereof)
Again this was flagged as a short term risk and of major concern to Australian investors, and equity investors everywhere. Two concerns were raised during the year: the first was the widening gap between GDP growth, implied by industrial and other data and the official GDP growth rate published by the Chinese Government; the second was the rising levels of debt in China. Like most financial market risks, this is both a risk of an actual hard landing and the fear of a hard landing.
The jury remains out on the actual hard landing, but we saw the impact of rising fears about China in August last year and then again in January this year, amid fears of China’s credit bubble accelerating over the past 3 to 4 months. Equity markets have faced far higher volatility over the past year, and returns are well down. High yielding favourites in the Australian market are still 10 to 20% off their levels from a year ago, erasing any income earned in that time.
One year on from our original description of this risk and little has changed. The industrial sector has held up, but we would argue this is mostly due to a large credit fuelled stimulus program in Q1 of 2016, which is already showing signs of waning. The consumer sector is holding up well, and could represent a great opportunity for Australian investors, and the economy as a whole, once China comes through this transition phase. But the biggest change in the past year is now the biggest concern: the credit expansion, and the implications for the economy as a whole as the government attempts to wean the economy off its credit addiction, or worse if it chooses not to wean.
This remains the biggest risk for Australian investors, outside of the “mediocre” global economy base case below. The hedge against this risk again is to “short the AUD”, or in other words look to put some of a portfolio into non AUD (eg USD or GBP) denominated assets. At current levels of 74c against the USD and 51p against the GBP, this remains attractive.
(For more on this topic, refer to data on China’s credit expansion in the February smart income report, and a feature on the shadow banking sector and “wealth management products” published last month).
#1: The New Mediocre
This was considered our highest risk at the time, and still is. The risk is considered the highest because the probability is so high; in our view 80% or more. While a China “hard landing” would be far more impactful for Australian investors, we still have the probability of such an event at less than 50%.
During the webinar series, one client offered a far better name for the new mediocre: “muddling along”. We adopted this as it better describes the nature of this risk – that the world’s central banks, governments and banking sectors are muddling along. They are all trying to find a way to jumpstart the global economy, but losing the battle on multiple fronts. The combined impacts of four major headwinds for the global economy are proving too strong, and in our view this will remain the case for at least the next decade. The four headwinds are:
- Fiscal constraints in most of the western world
- Much slower emerging economies’ growth
- A 20 to 30 year demographic headwind caused by the retiring baby boomer generation
- The shorter term impact of the world weaning itself off QE, or trying to in some cases
Constraints will be imposed on western economies for at least the next 10 to 20 years as governments attempt to get fiscal debt under control, but cannot cut deeply into this debt without getting voted out of government. There is nothing to prevent the inevitable drop in spending that will occur as baby boomers, a major population bubble, enter into retirement. Emerging economies grew quickly over the past 20 years, providing a tailwind for the global economy, so this is less about a headwind and more about the absence of that tailwind, but the issue is that we needed that tailwind in the past 20 years to achieve a global growth rate of 3.5% pa. Without it and the other headwinds, we faced a tougher road ahead.
To summarise the implications of this risk is simply to state that interest rates and equities returns will be “lower for longer”, leaving deposit rates at record low levels and equity returns well below long term averages. Cash rates will likely be at or around their current levels in Australia, Japan and Europe for the next 5 to 10 years, and only slightly higher than current in the US. Equity returns will be around 5 to 6% pa, compared to the 8 to 10% pa we’ve become used to, meaning high dividend stocks will likely exhibit zero or even negative capital growth as the world adjusts future expectations of earnings downwards.
Overall, we did okay: there is more evidence now of the EU’s instability fuelled by economic malaise, particularly highlighted by the Brexit referendum; the US continues to be good but not great; long term rates in the US have fallen to our forecast levels; Australia’s construction sector is slowing, housing is holding up, but the RBA has started cutting rates regardless; fears about China have grown, but the economy is holding up for now.
Most importantly, the lower for longer outlook is now the globally accepted norm, in strong contrast to this time last year. Investment markets are adjusted to a future of lower returns that even sovereign giants such as the Future Fund can’t avoid . The key for smart income investors now is to rebalance that part of their portfolio designed to provide them with the income they need. For these investors, sitting in cash and expecting interest rates to rise is potentially the greatest risk they can take – the rebalance is crucial and advised to be done sooner than later. The resetting of global expectations will continue to drive up the prices of income producing investments, making decent value yields increasingly difficult to find.
And so, no surprises really, that the topic for our next series of seminars is: “Top five income producing strategies beyond 2016”. Look out for your invitation and we’ll see you there!