Share markets are at or around record levels despite lots of worries, particularly around the coronavirus (Covid-19) outbreak. A common concern is that this is because central banks (like the Fed and the RBA) are distorting market forces and just want higher asset prices. And flowing from this its argued that prices for assets like shares and property are overvalued, record highs are artificial, and a crash is inevitable. Markets are at risk of a short-term correction given the large gains since the last greater than 5% correction into August and given the risks around Covid-19. But beyond this it’s a lot more complicated than the bears would have it.

Central banks really just responding to market forces…

There is some truth to the claim that central banks want higher asset prices. Higher asset prices are part of the transmission mechanism for monetary easing to the economy because they boost wealth and this helps boost spending. As former Fed Chair Alan Greenspan said in 2010 “a stock market rally may be the best economic stimulus”. But it’s not quite that simple:

• First, central banks also fret about that financial instability that flows from higher asset prices as they may lead to overvalued markets that could crash or encourage people to take on too much risk say via excessive debt. Recall Alan Greenspan’s concerns about “irrational exuberance” and don’t forget the credit tightening that occurred from 2017 in Australia that was designed to slow “risky” housing lending. 

• Second, more fundamentally central banks are really just responding to market forces. In the post GFC world we have seen lower inflation in response to ongoing spare capacity and competition from online disruptors, offshoring and automation. More fundamentally, reflecting greater caution we have seen desired saving exceed desired investment globally. All of which has driven lower interest rates which central banks have just responded too. To have not cut official interest rates would have defied market forces and caused even weaker growth, higher unemployment and even lower inflation. 

• Finally, its rational for asset prices to move up in response to lower inflation and lower interest rates.

…lower inflation equals higher PEs (and lower yields)

The next chart shows the ratio of share prices to consensus expectations for earnings over the next 12 months, which is often referred to as forward PEs. As can be seen, these are now above their long-term averages in the US and Australia, although US and global PEs are still well below tech boom extremes.

Source: Thomson Reuters, AMP Capital

However, the next chart shows the long-term relationship between inflation on the horizontal axis and the price to earnings ratio on the vertical axis. The PE tends to move higher as inflation falls, although its less clear once inflation falls into deflation. And right now we have very low inflation of just below 2% globally.

Source: Bloomberg, AMP Capital

A rise in PEs in response to low inflation, providing it’s not deflation, makes sense for three reasons:

• First, low inflation means lower interest rates which boosts the value of future profits and dividends making shares more attractive. Or put simply lower inflation and interest rates boosts the attractiveness of higher yielding assets so investors switch into those higher yielding assets which pushes up their price relative to their earnings, dividends or rents. 

• Second, low inflation means reduced economic volatility and uncertainty and hence investors are prepared to price shares on higher price to earnings multiples. The next chart shows rolling 10-year volatility in annual GDP growth for the US and Australia. It’s been in a downtrend since the first half of last century with the drivers being the growing importance of the more stable services sector, declining inventory levels which reduced the manufacturing inventory cycle and macro policies aimed at stabilising economic growth. But the shift to lower inflation from the 1980s and 1990s has likely also contributed.

Source: Bloomberg, AMP Capital

• Finally, low inflation means improved quality of earnings as firms tend to understate depreciation when inflation is high and so overstate actual earnings. So again, investors are prepared to pay more for shares when inflation is low.

The equity risk premium remains okay

So, while share markets may be around record levels and price to earnings multiples are relatively high there is some rational for this given that it’s a low inflation and low interest rate world. And the longer inflation remains down its conceivable that the higher PEs may go. How high is impossible to know for sure. But as a result, it makes sense to look at share market valuations that allow this. The next chart subtracts the 10-year bond yield for the US and Australia from their earnings yields (using forward earnings). This basically gives a sort of proxy for the equity risk premium – the higher the better. While this gap is well down from its post GFC highs, it’s still reasonable, suggesting shares are still more attractive than bonds. Of course, this will change if bond yields rise, but as we have seen in recent years this is taking a long while to eventuate with various events including trade wars and the coronavirus outbreak conspiring to keep yields low.

Source: Thomson Reuters, AMP Capital

What about property?

Basically, the same applies in relation to property and other assets in that lower inflation drives higher valuations for them too. This is evident in lower rental yields (or capitalisation rates) as lower inflation and interest rates pushes up the price relative to rents that investors are prepared to buy property at. This has certainly happened in Australian property markets with rental yields falling sharply since the 1980s and 1990s. This is particularly the case for residential property to the point that it is overvalued on some measures, with a shortage of dwellings relative to underlying demand enabling this to be perpetuated (but that’s a whole other issue beyond the scope of this note!). If the rental yield is inverted and expressed as a PE it would have risen to around 20 times for high quality commercial property but to a whopping 50 times for residential property, compared to around 12 times for both in the early 1980s and compared to around 18 times for shares. This would suggest residential property remains relatively expensive!

Source: REIA, JLL, Bloomberg, AMP Capital

So, what’s the catch?

There are two catches. First valuations are no guide to timing markets and none of this precludes a correction in shares, particularly given the risks around coronavirus as noted earlier.

Second, just as low interest rates and low bond yields mean low prospective returns from cash and bonds, high PEs – or their inverse of lower earnings yields – and lower rental yields for property point to more constrained returns from shares and property on a medium-term basis. The following chart shows a scatter plot of the PE ratio for US shares since 1900 (horizontal axis) against subsequent 10-year total returns (ie dividends and capital growth) from shares. It indicates a negative relationship, ie when share prices are relatively high compared to earnings subsequent returns tend to be relatively low.  

Source: Bloomberg, AMP Capital

The same inverse relationship exists for Australian shares.

Concluding comment

The bottom line is that while shares may be vulnerable to a correction, the rally in markets does not seem excessive given the low inflation and low interest rate environment. Key to watch for would be a recession, which would depress earnings and risk tolerance, or a sharp acceleration in inflation, which would drive sharply higher interest rates and a revaluation downwards in prices for shares and other assets. But beyond the risks to economic activity posed by the coronavirus outbreak both seem unlikely at present.

Source: AMP Capital 19 Feb 2020

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) (AMP Capital) 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 and must not be provided to any other person or entity without the express written consent of AMP Capital.

2020 has seen a very noisy start to the year with one major event with significant human and investment market implications after another. For Australia it started with an intensification of the bushfires but moved on to a significant ramping up of US/Iran tensions where, according to President Trump, war came “closer than you thought” and now the coronavirus outbreak is creating fears of a global pandemic and a big hit to global economic activity. These are scary in terms of their human consequences, but also in terms of the potential economic fallout and what it means for investors. The coronavirus outbreak in particular continues to pose significant uncertainty around the short-term economic outlook. In terms of the key things to watch there is some good news with signs of a reported slowing in new cases in China and still limited transmission outside China (which has 99% of cases).  

Source: PRC National Health Commission, Bloomberg, AMP Capital

And the mortality rate at just over 2% remains lower than with SARS. Against this there remains much debate about the true number of cases, it’s common in outbreaks to see periods of stabilisation only to be followed by a spike in cases and the disruption to economic activity in China and from global travel bans remain significant all of which makes it easy to imagine the worst in terms of economic consequences. Each week China remains say 2/3rds shut it knocks 1.3% off its GDP or 0.25% directly off global GDP.

Then again much of 2018 and 2019 saw endless talk about how much the trade war was going to knock off global growth. More fundamentally, the coronavirus outbreak is part of a seemingly never-ending worry list which is receiving an ever-higher prominence as the information age enables the rapid dissemination of news, opinion and noise. But as Frank Zappa warned “information is not knowledge, knowledge is not wisdom”. The danger is that information overload is making us worse investors as we focus on one worry after another resulting in ever shorter investment horizons.

Are the worries more worrying than ever?

When I was a teenager in the 1970s I used to bemoan my grandmother for reading too much gloom into the nightly TV news and telling me that the world is much worse today than when she was young….when there was WW1, Spanish influenza that reportedly killed around 50 million people, the Great Depression and WW2 when her brother was killed. However, now it seems the worry list is even bigger. Yes, there is a fundamental element as global growth is slower, technological disruption is leading to worker anxiety and inflated expectations, and the world seems awash in geopolitical risks.

But there is a huge psychological aspect to this that is combining with the increasing availability of information and intensifying competition amongst various forms of media for clicks, that is magnifying perceptions around various worries.

We all suffer from a behavioural trait that in its financial manifestation is known as “loss aversion” in that a loss in financial wealth is felt much more distastefully than the beneficial impact of the same sized gain. This probably reflects the evolution of the human brain in the Pleistocene age when the trick was to avoid being eaten by a sabre-toothed tiger or squashed by a woolly mammoth. This makes us biased to be more risk averse and on the lookout for threats which leaves us more predisposed to bad news stories as opposed to good news stories. So bad news and gloom find a more ready market than good news or balanced commentary as it appeals to our instinct to look for threats. Hence “bad new sells”. Of course, this has always been the case so there is nothing new here.

The big change though is that we are now exposed to more information in relation to everything including our investments. This is great in the sense that we can check things, analyse them and sound informed easier than ever. But often we have no way of weighing such information and no time to do so. If we can’t filter it, it becomes information overload and noise. This can be bad for investors as when faced with more (and often bad) news we can freeze up and make the wrong decisions with our investment as our natural “loss aversion” combines with what is called the “recency bias” that sees people give more weight to recent events which can see investors project recent bad news into the future and so sell after a fall.

Finally, the problem is being compounded by an explosion in media outlets all competing for your attention. We are now bombarded with economic and financial news and opinions with 24/7 coverage by web sites, subscription services, finance updates, dedicated TV and online channels, etc. And in competing for your attention, bad news and gloom trumps good news and balanced commentary as “bad news sells.”

So naturally it seems that the bad news is ‘badder’ and the worries more worrying than ever. Google the words “the coming financial crisis” and you get 236 million search results – up from 115 million when I did it 18 months ago – with titles such as:

• “World economy is sleepwalking into a new financial crisis”;

• “4 early warnings signs of the next financial crisis”;

• “The coming economic crash”;

• “Why the next global financial crisis may dwarf…2008”; and

• “Financial crisis – Bible prophecy & current events.”

The trouble is that there is no evidence that all this noise is making us better investors. Average returns are no higher than in the past. A concern is that the combination of a massive ramp up in information combined with our natural inclination to zoom in on negative news is making us worse investors: more fearful, more jittery and more short term focussed.

Five ways to manage the perpetual worry list

So here we take another look at five ways to manage the worry list and turn down the noise:

Firstly, put the latest worry list in context. Remember that there has always been an endless stream of worries. Here’s a list of the worries of the last five years that have weighed on markets at various points: deflation; commodity/oil crash; Grexit; China worries; Brazil and Russia in recession; manufacturing slump globally; Fed rate hikes; Brexit; South China Sea tensions; Trump; Eurozone elections; North Korea; Germany; Catalonia; Italy; US inflation and rates; Trade war; China slowdown; Aust Royal Commission; Aust housing downturn; US government shutdown; inverted yield curves; impeachment; Aust recession fears; and Iran tensions. Yet despite this extensive worry list investment returns have actually been okay with average balanced growth super funds returning 7.3% pa over the last five years after taxes and fees. In fact, the global economy has had plenty of worries over the last century, but it got over them with Australian shares returning 11.8% pa since 1900 and US shares 9.9%pa.

Source: ASX, AMP Capital

And while history doesn’t repeat it does rhyme and it’s often useful to look back at previous similar events to the latest worry to see how they panned out. This is where the experience around SARS is useful in relation to the latest coronavirus outbreak.

Secondly, recognise how markets work. A diverse portfolio of shares returns more than bonds and cash over the long-term because it can lose money in the short-term. While the share market is highly volatile in the short-term it has seen strong returns over rolling 20-year periods. So, volatility driven by worries and bad news is normal. It’s the price investors pay for higher long-term returns.

Source: Global Financial Data, AMP Capital

Thirdly, find a way to filter news so that it doesn’t distort your investment decisions. For example, this could involve building your own investment process or choosing 1-3 good investment subscription services and relying on them. Or simpler still, agreeing to a long-term strategy with a financial planner and sticking to it. Ultimately it all depends on how much you want to be involved in managing your investments.

Fourthly, don’t check your investments so much. If you track the daily movements in the Australian All Ords price index or the US S&P 500, it has been down almost as much as it has been up. So, day to day it’s pretty much a coin toss as to whether you will get good news or bad. By contrast if you only look at how the share market has gone each month and allow for dividends the historical experience tells us you will only get bad news 35% of the time. Looking only on a calendar year basis, data back to 1900 indicates that the probability of bad news in the form of a loss slides further to 20% for Australian shares and 27% for US shares. And if you can stretch it out to once a decade positive returns have been seen 100% of the time for Australian shares and 82% of the time for US shares.  

Data from 1995 and 1900. Source: Global Financial Data, AMP Capital

The less frequently you look the less you will be disappointed and so the lower the chance that a bout of “loss aversion” triggered by a bad news event will lead you to sell at the wrong time. So, try to avoid looking at market updates so regularly.

Finally, look for opportunities that bad news throws up. Periods of share market turbulence after bad news throw up opportunities as such periods push shares into cheap territory.

Concluding comment

My long-term experience around investing tells me that it’s far more productive to lean into prognostications of financial gloom because most of the time they are wrong and end up just distracting investors from their goals.

Source: AMP Capital 12 Feb 2020

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) (AMP Capital) 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 and must not be provided to any other person or entity without the express written consent of AMP Capital.

The last few weeks have seen escalating concern that a new coronavirus (called 2019 novel coronavirus or nCoV) originating in the Chinese city of Wuhan in Hubei province will become a global pandemic. Concern has been heightened after the World Health Organisation (WHO) declared the outbreak an “international public health emergency” on 30 January and the number of cases has continued to escalate.

While this is first and foremost a human crisis, there has been increasing concern that the associated disruption to economic activity will trigger a global economic slump. Consequently, share markets have seen falls (ranging from 3% for global and Australian shares to around 7% for Asian shares and 12% for Chinese shares), commodity prices have fallen, and bond yields have collapsed again. While the current situation is highly uncertain, the experience with SARS, bird flu, swine flu & Ebola highlight worst-case pandemic fears don’t usually eventuate.

What do we know about this Coronavirus

Here is a summary of information regarding nCoV:

• Coronaviruses circulate in animals but can be transmitted to humans and affect the respiratory system. SARS in 2003 & MERS in 2012 were examples. Symptoms can be treated but there are no vaccines or antiviral drugs for them (at present). Like SARS, nCoV looks to have originated in wildlife markets in China.

• So far there are over 24,500 confirmed cases worldwide, with 99% of cases in China. But the number of cases is still rising rapidly and more/faster testing could mean many more with spikes in the number of new daily cases.

• So far the mortality rate is running at 2% which puts it above swine flu but well below SARS (which settled around 9%). And of those dying, its mainly been older people or those with pre-existing conditions (as with common flu). 

• Against this, nCoV has been more contagious with total cases well above those for SARS (8000) and patients can be contagious but without symptoms for 1-2 weeks.

Source: PRC National Health Commission, Johns Hopkins CSSE, AMP Capital

Source: PRC National Health Comm, Johns Hopkins CSSE, WHO, AMP Capital

• Containment measures – notably in China – have been more aggressive and started earlier than in the case of SARS. These include restricting travel into and out of Hubei province and various countries have restricted (and in some cases banned) foreign travellers entering from China.

Past experiences

To provide some context it is worth reviewing past pandemics – both real and feared. There were three influenza pandemics in the last century: 1918-19, 1957 and 1968. The 1957 and 1968 pandemics are estimated to have killed up to 4 million people. However, the 1918 Spanish flu pandemic was the most severe. While the mortality rate was low, up to 50 million people died worldwide. With a big proportion of the population staying at home, economic activity was severely disrupted, although this was compounded by the ending of World War I. US industrial production slumped 18% between March 1918 and March 1919. Australian real GDP slumped 5.5% in 1919-20 (but then rebounded 13.6% in 1920-21). The share market impact is hard to discern given the ending of WWI, however US and Australian share markets rose through much of the pandemic period.

The SARS outbreak of 2003 is a more useful guide. After emerging in China around February 2003, SARS infected about 8000 people (mostly in Asia) in 30 countries over a five-month period and had a mortality rate of about 9%. SARS had a big negative impact on the countries most affected as people stayed home for fear of catching it. GDP in China, Hong Kong and Singapore slumped by over 2% in the June quarter of 2003. Growth then subsequently rebounded.

Source: Thomson Reuters, AMP Capital

Reflecting SARS, Asian shares fell in April 2003, even though global shares started to move out of a three year bear market from March. The April 2003 low in Asian shares coincided with a peaking in the number of new cases.

Source: Thomson Reuters, AMP Capital

Most pandemics have taken 6-18 months to run their course and peter out as measures are taken to slow their spread (eg, hygiene, quarantining, banning gatherings, preventing travel). SARS ended quicker due to the nature of the virus and rapid action by authorities. In 2005/2006, there was significant concern that a severe strain of bird flu (called H5N1), which was resulting in human casualties, mainly in parts of Asia where people had contact with chickens, would mutate into a form that was readily transmissible between humans. However, this didn’t really eventuate and as such the economic impact was modest although it did cause bouts of volatility in share markets. Similarly, concern that the spread of swine flu would become a global pandemic rattled share markets for a while around April 2009, and Ebola did the same in 2014, but both quickly faded.

The economic and financial impact of nCoV

After strong double-digit gains over the last year and with investor sentiment pushing up to high levels indicating a degree of complacency, share markets were at high risk of a correction in mid Jan and the fears around coronavirus have provided the trigger. Given their greater sensitivity to Chinese growth, commodity prices like Chinese shares are down by more and the Australian dollar has fallen to October lows below $US0.67. What happens from here depends on how long it takes for the outbreak to be contained. The higher number of cases than with SARS or swine flu suggests a greater economic impact. But given the range of possibilities, the best way to get a handle on the economic and investment market impact is to consider several scenarios. Here we consider two.

1. Containment within the next month or two – the number of cases continues to rise but it remainsmainly contained to China (and Hubei) and the number of new cases starts to peak in the next month or so. This would allow travel restrictions to be removed by the June quarter. Under this scenario:

• GDP in China and parts of Asia would likely take a 2 to 3% hit (taking Chinese GDP growth from 6% year on year in the December quarter to 3-4%yoy in the current quarter) as workers stay home and travel dries up. With the Chinese economy now being four times the share of global GDP it was at the time of SARS, this along with some drag on growth in developed countries would knock world growth to around 2.5% year on year (from around 3%). However, growth would rebound in the June quarter as travel restrictions are removed and things return to normal.

• Australian growth could see a 0.2% hit in the current quarter mainly due to the loss of Chinese tourists (which account for 20% of tourism earnings and 0.2% of GDP) but also lower raw material demand and an impact on confidence. With the bushfire impact this could see GDP contract, but growth would rebound in the June quarter.

• Against this background share markets, commodity prices and the $A could still fall a bit further in the near term but would quickly rebound by the June quarter. Easier than otherwise monetary and fiscal policies – with more stimulus measures already announced in China – would aid this.

2. Global pandemic – the number of cases continues to escalate beyond China and aren’t contained until say mid-year.

• This scenario would see a bigger and longer negative impact on economic activity. Global travel would collapse. Many would simply not come into work – a reasonable estimate is around 20% of workers, although this might be spread over time. This would see a sharp slump in global GDP and the risk of global recession. Australia would not be immune and would likely see two negative quarters of growth with flow on to education exports to China (which accounts for another 0.6% of Australian GDP).

• Share markets would likely fall sharply – maybe by 20% or so – reflecting the huge economic uncertainty. Cash would be the place to be. The $A could fall to around $US0.60.

• However, economic activity would rebound quickly once it’s clear the pandemic is under control. Share markets are likely to anticipate this. But this wouldn’t occur till the second half of the year.

Concluding comment and what to watch

While there is reason for concern and it is easy to dream up nightmare scenarios, the experience with SARS, bird flu (with “predictions” it could kill as many as 150 million people) and the mini panic regarding swine flu and Ebola tell us that the worst case fears of pandemics usually don’t come to pass. Rapid containment measures provide some confidence this will be the case. As such, our base case scenario (with 75% probability) is one of containment over the next month or two. This could still see more downside in share markets and bond yields in the near term, but they are likely to rebound by the June quarter as economic growth rebounds. The key things to watch are:

• The daily number of new cases – the SARS experience saw markets rebound once this showed signs of peaking.

• The spread of new cases and deaths in developed countries – if this remains limited then markets will also get more confident that the economic fallout will be short lived.

Source: AMP Capital 5 Feb 2020

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)  (AMP Capital) 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 and must not be provided to any other person or entity without the express written consent of AMP Capital.