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Thursday, 08 August 2013 06:04

The Australian election and investors

The Federal Election

With the much anticipated Australian Federal election now set for 7 September it is natural to wonder what impact, if any, there might be on investment markets – both in terms of the uncertainty created by the election itself and in terms of the outcome. At present while opinion polls have Labor and the Coalition running at around 50% each on a two party preferred basis, according to bets placed on online betting agency Centrebet the Coalition remains the clear favourite.

Source: Centrebet

The performance of markets around elections

Elections can potentially have a short-term impact on investment markets. This is because investors don’t like the uncertainty associated with the prospect of a change in government during the campaign and then there may be relief once the poll is out of the way and possibly optimism associated with the election of a new Government.

The next chart shows Australian share prices from one year before till six months after Federal elections since 1983. This is shown as an average for all elections (but excludes the 1987 and 2007 elections given the global share crash 3 months after the 1987 election and the start of the global financial crisis in 2007), and the periods around the 1983 and 2007 elections, which saw a change of government to Labor, and the 1996 election, which saw a change of government to the Coalition. The chart suggests some evidence of a period of flat lining in the run up to elections, possibly reflecting investor uncertainty before the poll, followed by a relief rally soon after it is over.

Source: Thomson Financial and AMP Capital

However, the elections when there has been a change of government have seen a mixed picture. Shares rose sharply after the 1983 Labor victory but fell sharply after the 2007 Labor win, with global developments playing a big roll in both. After the 1996 Coalition victory shares were flat to down. The point is that based on the historical experience it’s not obvious that a victory by any one party is best for shares in the short term and, in any case, historically the impact of swings in global share markets arguably played a much bigger role than the outcomes of Federal elections.

What is clear though is that after elections shares tend to rise more than they fall.The next table shows that 8 out of 11 elections since 1983 saw the share market up 3 months later with an average gain of 5.4%, which is above the 1.8% average 3 monthly gain over the whole period.

Source: Bloomberg, AMP Capital

The next chart shows the same analysis for the Australian dollar. In the six months or so prior to Federal elections there is some evidence the $A experiences a period of softness and choppiness which is consistent with uncertainty about the policy outlook, but the magnitude of change is small – just a few percent. On average, the $A has drifted sideways after elections. While the $A fell soon after the 1983 Labor victory this was due to a policy devaluation in the dying days of the fixed exchange rate system.

Source: Thomson Financial, AMP Capital

The next chart shows the same analysis for Australian bond yields. Interestingly, on average bond yields have drifted down over the six months prior to Federal elections since 1983. The average decline has been around 0.75% which is contrary to what one might expect if there was investor uncertainty regarding the policy outlook. However, the tendency for bond yields to decline ahead of Federal elections appears to be more related to the aftermath of recessions, growth slowdowns and/or falling inflation prior to the 1983, 1984, 1987 and 1993 elections and the secular decline in bond yields through the 1980s and 1990s in general. More broadly, it’s hard to discern any reliable affect on bond yields from Federal elections.

Source: Thomson Financial, AMP Capital

Policy change and shares

Over the post war period shares have had an average return of 12.9% pa under Liberal/National Coalition Governments compared to 9.8% pa under Labor Governments.

Source: Thomson Financial and AMP Capital

Some might argue though that the Labor Governments led by Whitlam in the 1970s and Rudd and Gillard more recently had the misfortune to be affected by severe global bear markets beyond their control and if these periods are excluded the Labor average rises to 14.6% pa. Then again that may be pushing things a bit too far. But certainly the Hawke/Keating government defied conventional perceptions that conservative governments are always better for shares. Over the Hawke/Keating period from 1983 to 1996 Australian shares returned 17.3% pa, the strongest pace for any post war Australian government.

Once in government political parties of either persuasion are usually forced to adopt sensible macro economic policies if they wish to ensure rising living standards. Both the Coalition and Labor agree on the key macro fundamentals – i.e. the need to keep inflation down, to return the budget to surplus and in the benefit of free markets.

Policy differences

The main areas of difference between the two parties of probable economic significance relate to taxation, climate change, government spending & the budget and regulation.

  • in terms of tax the Coalition has promised to cut the company tax rate (although for large companies this is partly offset by a paid parental leave scheme) and abolish the mining tax;
  • the Coalition is proposing to abolish the carbon tax/Emissions Trading Scheme and will rather pay companies to reduce emissions;
  • the Coalition is likely to take a lighter/more business friendly approach to regulation than a Labor government. This may involve some partial wind back of industry regulation; and
  • the Coalition will likely try and speed up the return to a budget surplus by cutting government spending, much as it did under John Howard following the 1996 election.

As a result, perceptions that the Coalition will be lower taxing and less focussed on regulation and hence more business friendly than a Labor government may increase the chance a Coalition victory will result in a typical post election share market bounce. However, it’s worth noting that this may be partially offset if it announces aggressive fiscal tightening after the election (given the negative impact this could have on economic growth and profits at a time when the economy is already soft). What's more if a returned Labor Government follows up on its commitment to a National Competitiveness Agenda working to seriously boost productivity growth then it could have a positive long term impact on growth, profits and ultimately share market returns.

However, it does seem that there is the potential for significant sectoral impacts with the Coalition’s policies likely to be positive for miners, heavy carbon emitters and small companies (due to the company tax rate cut).

Concluding comments

The historical record points to the strong chance of a post election share market bounce. This may also fit in as we move out of the September quarter, which is often the weakest of the year, into the normally strong December quarter, as the profits reporting season ends in Australia and as uncertainty is removed post a possible September decision by the US Federal Reserve to start tapering its monetary stimulus.

Another potential positive from the election is that it is likely to see the end of minority government in Australia as whoever wins is likely to have a clear majority in the House of Reps. This could help usher in a period of more certain and rational policy making. However, it’s not guaranteed as whoever wins may still not have control of the Senate.

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital

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.
Tuesday, 06 August 2013 07:09

RBA cuts rates to 2.50%

bank-building-icon1Surprisingly moves to neutral bias.

As widely expected the Reserve Bank Board decided to lower the cash rate by 25bps to 2.50% at its August Board meeting.

For us by far the most significant aspect of the Governor's statement was the decision to move back to a neutral bias from the consistent easing bias that we have seen in recent statements.

It does not hold that a central bank should necessarily move to a neutral bias following a rate move. An easing bias was used in the May statement despite delivering a rate cut. The words used were: "The Board has previously noted that the inflation outlook would afford scope to ease further ... at today's meeting the Board decided to use some of that scope". That is a more dovish explanation for a rate cut than that used today "The Board judged that a further decline in the cash rate was appropriate".

We were expecting that the Bank would choose to maintain downward pressure on the AUD by repeating the rhetoric from the June and July statements which said: "The Board judged that the inflation outlook ... may provide some scope for further easing should that be required to support demand". In today's statement the key final sentence was: "The Board will continue to assess the outlook and adjust policy as needed to foster sustainable growth in demand and inflation outcomes consistent with the inflation target over time" – a clear neutral bias.

Other aspects of the statement were more encouraging from the perspective of our forecast which has been and remains for another cut in November. Firstly, the statement followed the structure in July by pointing out that although the Australian dollar has depreciated 10% since early April it remains at a high level. The only change in this statement was to revise that change up to 15%.

The other really important point was that despite the 15% fall in the currency the Governor repeated his confidence that inflation pressures are expected to remain under control. Comments on the real economy did not change from the July statement with growth being described as "a bit below trend" and the unemployment rate being recognised as edging higher.

The international outlook remains unchanged with global growth being described as "running a bit below average this year". A new observation is the linking of volatility in the global financial markets with a downturn in a number of emerging market economies. That link to emerging markets was not made in July.

Conclusion

In choosing not to maintain a clear easing bias it seems very unlikely that the September meeting will be 'in play'. Of course, with that meeting being timed for four days before the Federal election it would have been quite surprising to see any change in monetary policy so close to an election. We are not unnerved by today's approach because it in no way implies that rates have reached some form of institutional low and that should the economy evolve in the way we expect the Bank will cut rates again.

The calling of the election, by providing some political certainty by early September, might boost confidence measures but hard decisions showing up in the data to raise employment and investment seem a lot further off. We also agree with the Reserve Bank that the fall in the currency is most likely to impact importers' margins rather than consumer prices. A much stronger demand environment would be required for importers to confidently pass on price increases. We have not doubt that the Bank expects there is more work to be done. Note that the Government raised its unemployment forecast for 2013-14 from 5.75% to 6.25% and expects it to remain there over the course of the next year. We expect that the Reserve Bank feels the same way, although Friday's Statement on Monetary Policy will only include growth and inflation forecasts.We expect the Bank would therefore have no hesitation in cutting rates again once more information is available on inflation which will print in late October and the response of business/consumers to the election result has been clearly signalled.

We also believe that these dampening forces will be sustained through into early 2014 providing scope for another cut in February.

 

Written by Bill Evans

Chief Economist - Westpac Banking Corporation

Monday, 05 August 2013 09:03

Election cartoon collection

Sick of the election already.

Here we have put together some of the cartoons that have been created on the 2013 election campaign.

Enjoy.

2013-07-27-McMillan-Shakespeare-fringe-benefits-450

 

 

 

 

 

 

 

 

 

 

greens-warren

 

 

 

 

 

 

 

 

home-improvement-smaller

 

599046_521555084549309_2106560519_n

 

 

 

 

 

 

 

 

969224-mark-knight

AbbottTheHabbit

The company reporting season is just about to get underway.

Perpetual Funds Management talk about their expectation for the 2013 company reporting season in this 2 minute video segment.

 

http://www.youtube.com/watch?v=w1mzrL74-5g

716719-kevin-ruddKevin Rudd last week announced the pre-election budget update.  Here is an extract from UBS economic team that provides a summary of this announcement.

Budget downgrade

 

 

 

Key new measures (over 4 years) are:

Savings:

Tobacco tax $5.8bn

PBS price changes $2.0bn

FBT on cars $1.8bn

Other ETS saves $2.1bn

Public sector efficiency $1.8bn

Delayed Foreign aid $1.0bn

Higher tax compliance $0.8bn

Bank deposit levy $0.7bn

Superannuation changes $0.6bn

 

Spending:

New PBSA listings $1.4bn

PNG aid and resettlement $0.5bn

Non-claw back of carbon comp $3-4bn

Deffered self-education changes $0.3bn

 

 

Friday, 02 August 2013 03:59

New levy on bank deposits - not on banks

413401-130803-bill-leak-galleryExpect depositors to take the hit!

Media outlets reported on Thursday that the Federal Government was planning to introduce a deposit insurance levy on Australian Banks.  Details of the proposed change have just been released.

The levy is to be implemented by the way of fixed fee of 0.05% on deposits up to $250,000.  There are a number of possible reactions by the banks to such a levy. Banks will either (i) absorb the fee and deliver a lower profit to shareholders, (ii) source additional revenue through fees and higher mortgage rates, or (iii) reduce the deposit rates paid to investors.

Given the oligopolistic nature of the Australian banking industry, we think outcome (iii) is most likely.  Indeed, Australian Bankers Association head Steven Munchenberg said that he expects that the banks will pass the levy on to customers in terms of lower interest rates on their deposits.  Combined with an anticipated cut in official interest rates from 2.75% to 2.50% at the RBA’s meeting next Tuesday, Australian savers face the prospect of a one-two hit to their income stream in quick succession, after already suffering significant reductions in income streams following a series of successive interest rates cuts since October 2011.  The question investors need to answer becomes what should they do in the face of these changes.

Sacrifices in income levels and lifestyle are embedded in the lower returns from bank deposits, making alternative sources for yield more compelling. Take for example, the current Australian equity market yield of around 4.3% net. After including the full benefit of franking credits, the gross yield of the Australian share market becomes 5.7% which is more than double the RBA cash rate.

Finally - it must be remembered that this is not yet law, and it's outcome depends on the timing of the election, and who wins.

This material has been provided for general information purposes and must not be construed as investment advice. This material has been prepared without taking into account the investment objectives, financial situation or particular needs of any particular person. Investors should consider obtaining professional investment advice tailored to their specific circumstances prior to making any investment decisions and should read the relevant Product Disclosure Statement.

Friday, 02 August 2013 02:17

$AUD - it's still very strong

MD_7The $AUD has come down dramatically against the $US in recent months, particularly when the US Federal Reserve started discussing the cessation of their money printing program.

While the reduction in the $AUD has been significant (from $1-05 to below $0-90 at the time of writing), when taken in the context of the last 30 years, the $AUD is still very strong as can be seen in the chart below.

HHL chart 1

Or looking at this another way, the $AUD has traded below $0-80 for 74% of the time since it was floated in 1983.

HHL Chart 2

 One of the drivers of the upward pressure on the $AUD was the fact that some global investors mandates specified that they can only invest in AAA-stable bonds.  Australia is one of the few countries that offer AAA-stable Government bonds which attracted significant flows of money into Australia.  Below is a list of the only countries in the world that can offer AAA-stable rated bonds:

Australia

Canada

Denmark

Finland

Norway

Singapore

Sweden

Switzerland

This, plus an offshore diversification away from owning US bonds (due partly to their low interest rate, made artificially low by the US Federal Reserve) has led to a significant rise in demand of Australian Government Bonds (referred to as CGS in graph below).  But the demand has slowed significantly in recent times, which coincides with the drop in the $AUD.

HHL Chart 3

Another driver of the $AUD has been the carry trade (that allows foreign investors to borrow in a foreign currency and earn a higher rate of return investing in $AUD).  This also seems to be giving way.

As we have previously flagged, the path for the $AUD has changed and in speaking with many investment specialists we respect, the consensus view is that the decline of the $AUD has further to run.

This will benefit investors with exposure to International Shares and those Australian companies who derive income from foreign sources.

This material has been provided for general information purposes and must not be construed as investment advice. This material has been prepared without taking into account the investment objectives, financial situation or particular needs of any particular person. Investors should consider obtaining professional investment advice tailored to their specific circumstances prior to making any investment decisions and should read the relevant Product Disclosure Statement.

We have spoken previously about current cash levels in Australia in term deposits, as a supporting factor share prices going forward.  Should investor confidence improve, and investors look to invest some of this, it would be positive for share prices.

The chart below highlights the weight of money still sitting in the safety of cash at a time where cash returns are likely to be further depressed by RBA interest rate cuts.

Funds in Australian bank term deposits are at record highs of $546bn.

20130730_cash

 

 

 

 

Draper_05This is the first year that the tax free threshold has risen to $18,200, and therefore many more Australians now no longer need to complete a full tax return.

Those with investments in Australian shares (owned either directly or through managed funds) should ensure that they claim their entitlement to imputation credits.  But you may not have to complete a full tax return to do that.

We have sourced this article from the ATO to assist you in determining whether you need to complete a full tax return or whether you can simply use the "Application for Refund of Franking Credits" form.

Important Point - Retirees should pay particular attention to "Reason 2"

 

If any of the following applies to you then you must lodge a tax return.

Reason 1

During 2012-13, you were an Australian resident and you:

  • paid tax under the pay as you go (PAYG) withholding or instalment system, or
  • had tax withheld from payments made to you.

Reason 2

You were eligible for the seniors and pensioners tax offset, and your rebate income (not including your spouse's) was more than:

  • $32,279 if you were single, widowed or separated at any time during the year
  • $31,279 if you had a spouse but one of you lived in a nursing home or you had to live apart due to illness (see the definition of Had to live apart due to illness in T2 Seniors and pensioners (includes self-funded retirees)), or
  • $28,974 if you lived with your spouse for the full year.

To work out your rebate income, see Rebate income or use the Rebate income calculator for seniors and pensioners tax offset.

Reason 3

You were not eligible for the seniors and pensioners tax offset but you received a payment listed at question 5 and other taxable payments which when added together made your taxable income more than $20,542.

Reason 4

You were not eligible for the seniors and pensioners tax offset and you did not receive a payment listed at question 5 or question 6, but your taxable income was more than:

  • $18,200 if you were an Australian resident for tax purposes for the full year
  • $416, if you were under 18 years old at 30 June 2013 and your income was not salary or wages
  • $1 if you were a foreign resident and you had income taxable in Australia which did not have non-resident withholding tax withheld from it, or
  • your part-year tax-free threshold amount if you became or stopped being an Australian resident for tax purposes; read question A2 or phone 13 28 61.

Other reasons

You must lodge a tax return if any of the following applied to you:

    • You had a reportable fringe benefits amount on your:
      • PAYG payment summary - individual non-business, or
      • PAYG payment summary - foreign employment.
    • You had reportable employer superannuation contributions on your:
      • PAYG payment summary - individual non-business
      • PAYG payment summary - foreign employment, or
      • PAYG payment summary - business and personal services income.
    • You did not claim your full private health insurance rebate entitlement as a premium reduction, or a direct payment from Medicare, and your income for surcharge purposes is below $84,000 for singles and $168,000 for families*

* The family income threshold is increased by $1,500 for each Medicare levy surcharge dependent child after the first child.

  • You carried on a business.
  • You made a loss or you can claim a loss you made in a previous year.
  • You were 60 years old or older and you received an Australian superannuation lump sum that included an untaxed element.
  • You were under 60 years old and you received an Australian superannuation lump sum that included a taxed element or an untaxed element.
  • You were entitled to a distribution from a trust or you had an interest in a partnership and the trust or partnership carried on a business of primary production.
  • You were an Australian resident for tax purposes and you had exempt foreign employment income and $1 or more of other income. (Read question 20 Foreign source income and foreign assets or property for more information about exempt foreign employment income. For the 2009-10 income year and subsequent years, there are changes limiting the exemption for foreign employment income.)
  • You are a special professional covered by the income averaging provisions. These provisions apply to authors of literary, dramatic, musical or artistic works, inventors, performing artists, production associates and active sportspeople.
  • You received income from dividends or distributions exceeding $18,200 (or $416 if you were under 18 years old on 30 June 2013) and you had:
    • franking credits attached, or
    • amounts withheld because you did not quote your tax file number or Australian business number to the investment body.
  • You made personal contributions to a complying superannuation fund or retirement savings account and will be eligible to receive a super co-contribution for these contributions.
  • You have exceeded your concessional contributions cap and may be eligible for the Refund of excess concessional contributions offer: see Super contributions - too much super can mean extra tax.
  • Concessional contributions were made to a complying superannuation fund or retirement savings account and will be eligible to receive a low income superannuation contribution, providing you have met the other eligibility criteria.
  • You were a liable parent or a recipient parent under a child support assessment unless you received Australian Government allowances, pensions or payments (whether taxable or exempt) for the whole of the period 1 July 2012 to 30 June 2013, and the total of all the following payments was less than $22,379:
  • You were either a liable parent or a recipient parent under a child support assessment. If this applies to you, you cannot use the short tax return.

Deceased estate

If you are looking after the estate of someone who died during 2012-13, consider all the above reasons on their behalf. If a tax return is not required, complete the and send it to us. If a tax return is required, see Completing individual information on your tax return for more information.

Franking credits

If you don't need to lodge a tax return for 2012-13, you can claim a refund of franking credits by using the publication Refund of franking credit instructions and application for individuals 2013 (NAT 4105) and lodging your claim by mail, or phone 13 28 65.

Thursday, 18 July 2013 03:07

The US Federal Reserve, Rates and Bonds

Introduction

As the US economy continues to recover, it was inevitable that investor focus would shift from the need for more stimulus, which has been the dominant issue over the last few years, to when the US Federal Reserve will actually start to reverse the stimulus. This is important because easy monetary conditions on the back of poor growth and low inflation – first low rates and then QE – have helped underpin a fall in bond yields to record lows. This in turn has underpinned strong returns from sovereign bonds and gains in bond-like high yield investments, notably corporate debt, real estate investment trusts (REITs) and high yield shares, such as banks and telecommunications companies in Australia.

Nervousness about a change in direction from the Fed has been building this year, particularly over the last month following Fed Chairman Bernanke’s comments that he is prepared to slow or “taper” the pace of quantitative easing “in the next few meetings”. This would likely mean cutting the US$85 billion a month it is buying in government bonds and mortgage-backed securities to around US$60 billion a month.

Fearing this signals a shift towards the start of US monetary tightening, expectations for interest rate hikes in the US have been brought forward a year or so, bond yields have increased sharply and beneficiaries of easy money in the US, such as non-government debt, REITs, emerging market debt and equities, high yield shares and the A$ have all been under pressure. This has happened at a time when not all US economic data has been strong, leading some to fear a premature tightening by the Fed.

So the Fed’s latest monetary policy setting meeting was much anticipated for greater clarification around these issues.

The message from the Fed

The basic message from the Fed may be summarised as follows.

First, Chairman Ben Bernanke confirmed that the Board may start to slow the pace of QE later this year. He added that the reduction is likely to be gradual and that QE could end by mid next year. However, he also noted that this is conditional on the economy continuing to improve as the Fed expects, with growth projected to accelerate to 3-3.5% next year. While the immediate reaction in share markets has been negative, taking the lead from confirmation that QE is on track to be phased down, the fact it will only be phased down if the economy continues to improve is likely to be supportive for shares going forward, as this means stronger profits. When it does start to taper, the Fed is likely to prefer a meeting after which it has a press conference where it can explain its actions. This would suggest action will be taken at the September meeting at the earliest.

Second, the pace of QE can still be increased or decreased in the future, depending on how the US economy is performing. In other words, just because the Fed might start to taper in say, September, doesn’t mean that all the next moves will automatically be towards a further reduction. In fact, Bernanke appears to have made a steady decline in QE towards ending the program in mid-2014 contingent on expectations being met that the unemployment rate will fall to around 7% by then. For growth-oriented investments, this is effectively what some have called the “Bernanke put”, i.e. either the economy and profits improve (supporting share markets) or QE continues. It’s very different to the first two rounds of QE that automatically ended in March 2010 and June 2011, only to be followed by significant share market weakness.

Third and most importantly, the Fed reiterated that any decision to slow QE does not mean that interest rate hikes are any closer. In fact, 15 of the 19 Fed meeting participants don’t expect the first Fed Funds rate hike until 2015 or later. This is one more than in March. Moreover, the Fed continues to indicate that near zero interest rates will be justified at least as long as unemployment remains above 6.5% and inflation expectations remain low, with Bernanke pointing out that the 6.5% unemployment rate is a threshold, not a trigger. This suggests that the move forward over the last six weeks in money market expectations for the first Fed rate hike from mid-2015 to mid-2014 is premature. Expect rate hike expectations to settle down again and push back into 2015.

Our assessment

Our assessment is that while the Fed will likely start to slow quantitative easing later this year, this will actually be a good thing because it will only occur because the Fed’s mission has been accomplished. In other words, the US economy can start to be taken off life support. Moreover, by the time this occurs it will be a surprise to no one.

However, as the Fed keeps telling us, it is unlikely to want to rush into raising interest rates, given that:

  • Growth is still a long way from booming and is still relatively fragile as the private sector continues to reduce debt ratios. This is evident in bank loans growing at just 3%p.a and fiscal stimulus now being reversed. This is also evident by the mixed tone of recent economic indicators, with a solid housing recovery but soft readings for the ISM and most other manufacturing conditions indices.
  • Spare capacity remains immense as evident by a 7.6% official unemployment rate and double-digit labour market underutilisation and a still very wide output gap (i.e. the difference between actual and potential growth), as shown in the next chart.

Source: Bloomberg, AMP Capital

  • As the labour market continues to strengthen, labour force participation will likely start to bounce back, slowing the fall in the unemployment rate and achievement of the Fed’s 6.5% threshold.
  • Inflation is low and falling, currently just 1.4%.

So short of a sharp acceleration in the US economy, it’s very hard to see the Fed raising interest rates for the next year at least. This is important because the 1994 ‘bond crash’, which saw US 10-year bond yields rise nearly 300 basis points, was triggered and underpinned by an aggressive rise in the US Fed Funds rate (its official short term interest rate). See the next chart.

Source: Bloomberg, AMP Capital

Implications for investors

Despite an initially negative reaction, the message from the Fed remains reasonably market friendly. The pace of quantitative easing will only slow when the economy is stronger and rate hikes are unlikely any time soon.

The bottom line is that at this stage, a 1994-style bond crash still seems unlikely.1 US interest rates are unlikely to rise any time soon and in Japan, Australia and probably Europe, monetary conditions are still in the process of being eased.

However, we remain cautious of sovereign bonds, given that yields remain well below long term sustainable levels, for which potential nominal GDP growth provides a good guide. See the next table.

Bond yields are well below sustainable levels

Source: Bloomberg, AMP Capital

After four years of record inflows, US bond funds are at risk of seeing big outflows as investors start to see lower or poor returns. In fact, they have started to see outflows in the last few weeks and this could have a long way to go if sentiment towards bonds really turns negative. And of course, this in turn will create upward pressure for bond yields.

Finally, periodic bouts of nervousness regarding the Fed will likely continue as the US economy continues to improve. As a result, we remain of the view that sovereign bond yields will continue to gradually trend higher, resulting in poor returns for bond investors.

Against this backdrop, the chase for yield will likely continue as interest rates will remain low, albeit with perhaps less enthusiasm than seen over the last year. However, returns from assets that have already benefitted immensely from low bond yields like credit and real estate investment trusts will likely slow.

Shares have also benefitted from lower bond yields, although it is worth noting that in relation to US shares, gains have been underpinned by record profits. Moreover, they still trade on relatively high forward earnings yields compared to bond yields. See the next chart.

Source: Bloomberg, AMP Capital

This suggests that earnings yields on shares still offer a reasonable buffer as bond yields normalise, albeit a too rapid or great an increase in bond yields will result in more short term volatility as we have seen over the last month.

One final point to note is that a move towards the end of quantitative easing in the US will further reverse the upward pressure seen on the A$ since 2009. This will be good news for the Australian economy as the stubbornly strong A$ has been a key factor holding the economy back recently. Expect the A$ to fall to around US$0.80.


1. See “What’s the chance of a bond crash?” Oliver’s Insights, Feb 2013.

 

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital

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.