05 Mar Economic Update – March 2018
This month Andrew Starke of Kaplan Professional speaks with Shane Oliver, Chief Economist at AMP Capital about the recent plunge in global markets, his key themes for 2018 and the RBA’s February policy update.
The pullback in shares over the last week or two has generated a great deal of concern and headlines. Can you take us through some of the drivers behind the fall in global share prices?
I think there are a few factors involved. Obviously, the trigger has been a reassessment, particularly in the US, regarding how much inflation will rise, how quickly the Fed will tighten and how much bond yields will rise. That partly came on the back of a stronger than expected wage outcome in the US. US wages growth spiked dramatically from 2.5% to 2.9%. That generated a bit of excitement, and then on top of that we’ve gone a long way in the US without a decent correction.
The US sharemarket had gone a record 310 days without having a 3% or greater pullback, and of course that’s rather unusual. In fact, the last decent correction was just prior to Donald Trump being elected, so there was a degree of vulnerability there that had built up. And finally, it seems that lots of people were betting that volatility would continue to go down, as it had over the course of the last year or so, and they assumed that would continue.
Beats me why, but that’s what they were betting on. When volatility spiked, they had to close those positions down, so they were called short-volatility trades. And, of course, the closing down of those positions meant a ricochet effect back to the sharemarket, which is probably why we had a few days where the US sharemarket came down very aggressively.
So, all of those factors have been involved, but the main fundamental one was an improvement in news coming out of the US on the wages front, and the flow on of that to what the Fed might do, bond yields and so on. And, you might say, “Well, that’s good news”. It is actually good news, but many investors have been betting that interest rates would stay low forever and of course that was never going to be the case. So, there’s a bit of an adjustment going on in markets.
Sharp market falls with talk of billions of dollars being wiped off shares are stressful for investors. What would your advice be to financial advisers dealing with concerned clients?
There’s no doubt that the sharp falls we’ve seen can be quite stressful. Talk of billions being wiped off — of course, we never hear when the billions are put back and of the billions that are created through the rising trend in the sharemarket over time. A lot of the media focus is on the Dow Jones Index, and the problem with an Index is the higher it goes, a given percentage change will result in more being wiped off the Index, which is almost meaningless.
The best thing to focus on is the percentage change, but I think at the end of the day there are several things worth focusing on for investors. The first one is to realise that corrections are normal. Go back through history; lots of pullbacks greater than 5%. Lots of pullbacks greater than 10%. They’re quite normal. It’s just the way the market operates. Look at 2012. Look at 2013, 2014, even 2015/16. They all had pullbacks, but against a rising trend. Some of those pullbacks were quite deep, so that’s the first thing to note.
The second point to note is that the losses being talked about are only paper losses. You only trigger a loss if you actually sell. The trouble with selling on the back of a fall is that you’re letting the emotion get ahead of you and you’re better off getting a long-term approach and sticking to it rather than responding emotionally to something and selling when the market is down and locking in a loss.
Another point on top of all of this is that it’s a very noisy environment out there. It’s very important for investors, for financial advisers, for people like me, to try and turn down some of that noise. It’s often difficult, but I think that’s critically important in this environment to recognise that sharemarkets provide a higher return for investors only because they’re more volatile, so that volatility is the price we pay to get that higher return.
If you don’t get the volatility, you won’t get that high return through time. So, I think they’re just some points to put this in context, and putting these events in context is critically important. Corrections happen. They’re just the way markets operate.
In your key themes for 2018, you predicted a further rise in global growth to around 3.9% with continuing low inflation and easy global monetary conditions keeping investment returns favourable. Do you still see global shares trending higher over the year?
Our view hasn’t really changed on this. We thought that it would be a more volatile year because we are coming into a situation where in the US inflation would start to rise and that would result in a more aggressive US Federal Reserve, and with that volatility we would see more constrained returns from equities. Don’t forget last year was pretty good, particularly the global shares.
The US sharemarket rose around 20%, other markets by more, so we thought it would become a more constrained environment and that remains our view. We’ve started to see the volatility. I think it’s healthy to get a decent pullback in markets, but there’s no real change in our view. We still see a somewhat more aggressive Fed, but by the same token other central banks are lagging behind. So in that sense we’re still at the sweet spot of the cycle — it’s just a little bit less sweet than it was last year.
Donald Trump, the business-friendly pragmatist, dominated in 2017, but you have forecast that we may see a bit more of Trump the populist in 2018. Why is this?
Well, if you think about the period since Donald Trump was elected, [there was] a lot of fear prior to him being elected that would see a populist rabble-rouser picking trade wars with China, getting into battles with everybody. It turned out that there was a lot of noise through the first year of Donald Trump, but it turned out to be the business-friendly pragmatist that dominated. That was very positive — the focus on deregulation, tax cuts and so on.
I have a leaning towards that business-friendly pragmatist remaining, but this year it might switch a little bit back the other way because we have the mid-term elections in the US, so it’s another election year. Polling, late last year particularly, was showing that the Republicans would lose control of the Lower House of Congress.
Now, that polling has become a bit more balanced. Nevertheless, Donald Trump will probably do what he can to ensure Republicans do reasonably well and hopefully, from his point of view, retain control of Congress, and that could involve appealing more to his base. More pressure on China regarding trade is one area, or pushing harder in terms of Iran or North Korea, which could raise the risk of military conflict. So, these sorts of things could get investment markets a bit more on edge and be another source of volatility as we go through 2018.
Now ultimately, I don’t think he wants to push so far that it works against him — slapping tariffs on all imports from China is just going to put up consumer prices and everyone that goes to Walmart is not going to be very happy with that. So, I don’t think he’s going to go too far but you should expect a bit more volatility around Donald Trump. The other thing worth bearing in mind is that the Mueller inquiry into his campaign links with Russia, and so on, that’s still progressing, and you can argue [is] getting a little bit closer to Donald Trump. There may be a bit more political noise around that issue.
You mentioned a downturn in the housing cycle and uncertainty around the consumer as the main risk facing Australia in 2018, but you’ve also cited plenty of reasons for optimism.
When you think about Australia, the main risk is what happens to housing. We’ve had a boom in Sydney and Melbourne. That’s been associated with a big rise in household debt, and that’s led to all the normal concerns that, mind you, have been around for the last 13-14 years that maybe it’s going to crash, and of course that’s going to cause some sort of debt problem which will cause problems with the banks and consumer spending and so on.
Those risks are certainly there and it’s certainly worth keeping an eye on how quickly the Sydney and Melbourne property markets slow down. So far, it’s been relatively restrained. The prices have come off, but not dramatically. I think we’ve got a bit more to go. Prices ultimately could come down 5 or 10%, but in the absence of much higher interest rates or much higher unemployment that’s probably going to be it.
I don’t see a crash in the property market, [but] it’s certainly something worth keeping an eye on. Obviously, the nexus with household debt is worth keeping an eye on, but in the absence of much higher interest rates and much higher unemployment, neither of which we expect, it’s not going to cause a crash.
Therefore, you flip back to the apple for the broader economy and, yes, as always, there are people out there predicting doom and gloom, predicting the recession that they’ve been predicting ever since the mining boom ended a long time ago. But I think they miss the point about the Australian economy and that is it’s a lot more diversified than it used to be. We used to have, when I started my career, when one sector was booming — whether it’s mining or whatever — all sectors would be booming at the same time. That’s no longer the case.
Over the last few years, mining investment has been in steep decline knocking 1–2% off economic growth, but housing and consumer spending have been strong. Now we’re starting to see housing construction and consumer spending slowing down.
Uncertainty is around both of those, but by the same token mining investment looks to be close to the bottom, and business investment more broadly is picking up, as is infrastructure spending. So it looks to me like growth will continue in the Aussie economy. We might even see a little bit of an acceleration towards 3% growth as we go through this year. Not fantastic — you could argue better growth prospects globally — but reasonably good.
National capital city residential property price gains are expected to slow to around zero as the air comes out of the Sydney and Melbourne property boom. Is this slowdown a threat to broader growth, and [result in] fragile consumer confidence?
Well I guess consumers in recent times in Australia have been eating into their savings, and that’s been made possible by their wealth going up. It’s been dominated by the two biggest cities, Sydney and Melbourne, where home price growth has been very strong, so people are seeing their wealth rise. When their wealth goes up, they’re quite happy to run down their savings a little bit and fund consumer spending, even though wages growth has been quite weak.
If the housing market continues to slow or collapse in Sydney and Melbourne, then obviously people are going to be less willing to run down their savings rate. The wealth effect will go negative potentially, and that has a drag on overall economic growth. If house prices crash, then there’s also worries that people might default on their loans, causing problems for the banks. So, there is certainly risks around that, but I guess you’ve also got to put it in context.
People have been predicting crashes for Sydney and Melbourne or Australia’s property market for years. Unless you get much higher interest rates or much higher unemployment, it would be hard to see that happening. We still have a degree of undersupply. We still got a very high population growth underlying demand relative to the supply coming on, except in apartments. Of course, the rest of Australia hasn’t really had the boom that Sydney and Melbourne have had, so it’s very hard to generalise.
You could argue that Perth and Darwin are actually at the bottom and they’re about to pick up. It’s almost back to where we were middle of last decade when Perth and Darwin — Perth in particular — had been struggling, Sydney and Melbourne were the ones booming and they took a back seat. Prices came off a bit in Sydney and Melbourne, and the other cities dominated as we went through last decade.
Finally, the RBA reiterated in mid-February that it expects growth to pick up to around 3.25% over 2018 and 2019, with talk up for wage growth and inflation also unchanged. However, business conditions are looking more positive and employment growth would seem to offer some grounds for optimism. How do you see wages growth and inflation playing out over the next 12 months?
Basically, I would agree with the Reserve Bank. It’s going to be one of gradual improvement. We have seen in the US wages growth pick up, but it’s taken a long time over there just to get towards 3%. That’s required unemployment to push down towards 4% and a huge reduction in underemployment in the US, whereas in Australia we’re still lagging. We’ve still got relatively high unemployment compared to the US, and we’ve still got relatively high underemployment, so there’s a lot more spare capacity in our labour markets. It’s going to take a little bit longer for our wages growth numbers to pick up.
I think by the end of the year there might be a bit more light at the end of the tunnel there, so that should look a little bit healthier, but it’s going to be very gradual process. Likewise, the flow-on to inflation will be quite gradual.
If you look at the most recent inflation numbers in Australia, they’re actually quite low if you subtract government-related charges in the areas of utilities, health, education, tobacco. You don’t have a lot of inflation in the Australian economy, and that reflects the very competitive environment. It’s going to take a while before that works its way through.
So, I think by the end of the year things might have improved a little bit to allow the RBA to start tightening, but the risk is that that tightening will be pushed into 2019. Again, when the Reserve Bank does start moving, it’s going to be a gradual process.
They won’t be on autopilot. Interest rates won’t go shooting up to 3.5%. It’ll be one move to see what the impact has been, and then they might do another move. If it turns out to be okay, they’ll keep going, but they’re not going to automatically jack interest rates up 100 basis points. This is not 1994 all over again, and they know that households have a lot more debt. It’s a bit like a car trying to slow down when it’s going up a hill. They don’t need to put the brakes on as hard as they did in the past.