At the start of last year, with global and Australian shares down around 20% from their April/May 2015 highs, the big worry was that the global economy was going back into recession and that there will be another Global Financial Crisis (GFC). Now, with share markets having had a strong run higher, it seems to have been replaced by worries that a crash is around the corner and this will give us the global recession and new GFC that we missed last year!

Australians seem particularly vulnerable to worries these days. On the weekend I read that Australians are suffering from an “epidemic of anxiety” and that out of a survey of 24 nations Australians ranked in the upper half in terms of worries about a health epidemic (9^th highest), a terrorist attack (8^th highest) and a nuclear attack (5^th highest) – way above South Korea in terms of the latter despite Kim Jong-un’s new found nuclear capability just across the border! And a Roy Morgan survey has found that only 31% of surveyed Australians expect next year to be a better year than 2017, which is the lowest on record and only just above the 30% who expect next year to be worse. See the next chart.

No survey results for 1996, 2010-2016, Source: Roy Morgan, AMP Capital

In fact, it’s the lowest net balance of “better” less “worse” expectations for the year ahead since Australia was in the midst of the last recession in 1990. Whatever happened to the “she’ll be right” approach? Surely it’s not that bad!

At a broader global level, there seems to be a never ending worry list which since the GFC has rolled on through worries about a new collapse in the US (on the back of too much debt, hyperinflation on the back of money printing, deflation after the hyperinflation failed to materialise, a slump when monetary stimulus ends, or whatever), to worries the Eurozone will blow (or vote) itself apart, to worries that China will collapse as a result of too much debt and/or a property crash, interspersed by worries about the emerging world, Ebola, Ukraine, deflation, North Korea and various elections including the advent of President Trump along the way. And of course, the worries about Australia collapsing keep rolling on with the focus switching from a commodity crash to a housing crash.

Despite this ongoing worry list, investment returns have generally been good. Most assets have had good returns over the last year and the last five years, and balanced growth superannuation funds after fees and taxes returned an average 8.2% over the year to September and 9.3% per annum over the last five years.

So why the persistent gloom?

Some might argue that post the GFC, the world is now a more negative place and so gloominess is understandable today. But given the events of the last century – ranging from flu pandemics, the Great Depression, several major wars and revolutions, numerous recessions and financial panics – it’s doubtful that this is the case.

More fundamentally, it’s well known that humans are naturally attracted to bad news stories. The evolution of the human brain through the Pleistocene age where the trick was to dodge woolly mammoths and sabre toothed tigers means that much more space in our brains is devoted to threat than reward. This means that we are constantly on the lookout for risks and so more disposed to check out bad news stories as opposed to good news. In the investment world, an outcome of this is known as “loss aversion” in that a financial loss is felt far more keenly than a same-sized gain. As a result, doomsters are far more likely to be seen as deep thinkers than optimists and “bad news sells”.

But there is nothing new here. What has changed is the flow of information from a trickle to an avalanche. This is the case everywhere and the investment world is not immune. As the well-known US stock picker Peter Lynch observed “stock market news has gone from hard to find (in the 1970s and early 1980s), then easy to find (in the late 1980s), then hard to get away from”. This can be great in a way, but it can also just add to confusion.

But more significantly, the information age has led to not just greater access to information but also an explosion of media begging for attention. And in the scramble to get me and you to tune in, bad news and gloom beats good news and balance. I just have to swipe right (no, not Tinder!) on my smart phone to see an updated list of links to bad news stories and celebrity gossip (but rarely anything positive!).

Arguably, the political environment has added to this in some countries with politicians becoming more polarised to the left and the right and more willing to scare the electorate into supporting them.

Despite the improvement in the global economy over the last year, Google the words “the coming financial crisis” and you’ll still get 49.3 million search results including such gems as:

• “The next financial crisis is coming ‘with a vengeance’.”

• “The next financial crisis is coming, I just don’t know when.”

• “Financial crisis coming by end 2018: Prepare urgently.”

• “Trump can’t stop the next financial crisis.”

• “It’s a scary time with a global crisis on the way.”

• “Major crisis coming, bigger than 2008 financial crisis.”

And on and on.

Of course, people have always been making such predictions of imminent disaster – my favourite was Ravi Batra’s The Great Depression of 1990, which didn’t happen so it morphed into The Crash of the Millennium, which saw an inflationary depression that didn’t happen either.  It’s just that it’s now a lot easier and cheaper to access it and be scared by it.

So with all the talk of another global financial crisis and some sort of collapse in Australia, it’s not that surprising that people are apprehensive and Australians are less positive about the future. 

But the world is actually looking good

While all countries have their challenges, the global economy is in its best shape in years:

• After years of downgrading its global growth forecasts, the IMF has been revising them up this year.

Source: IMF, AMP Capital

• Global profits are up around 15% over the last year.

• Unemployment has been falling virtually everywhere (except Japan where it’s just 2.8%!).

And while Australia could be doing a lot better and is not without its issues (notably around record low wages growth, high underemployment, expensive housing and high household debt), the economy has managed to keep growing despite the mining investment boom going bust and should benefit from stronger global growth and the end of the drag from falling mining investment. All of which should be able to keep it growing, albeit we don’t see strong enough growth or inflation for the RBA to start raising rates for a while yet.

The case for optimism as an investor

Dr Don Stammer – a doyen of Australian economists and investing – has said there are six things we owe our children or grandchildren: a sense of humour; a reasonable education; an early understanding of the magic of compounding; an awareness the cycle lives on; some help when they buy their first house or apartment; and a feeling of optimism. I completely agree.  I have written lots on the importance of compounding and the cycle but I think a degree of optimism is essential if you wish to succeed as an investor.

Benjamin Graham once said: “To be an investor you must be a believer in a better tomorrow.” If you don’t believe the bank will look after your term deposits, that most borrowers will pay back their debts, that most companies will see rising profits over time, that properties will earn rents etc then there is no point investing. This is flippant but true – to be a successful investor you need a favourable view of the future.

Of course this does not mean blind optimism where you get sucked in with the crowd when it becomes euphoric or into every new whiz bang investment obsession that comes along (with bitcoin the latest in a long list of manias that goes back to Dutch tulip bulbs and includes the dot com stocks of the late 1990s). If an investment looks and feels too good to be true and the crowd is piling in, then it probably is… particularly if the main reason you are buying in is because of huge recent gains and their extrapolation off into to the future. So the key is cautious optimism, not blind optimism.

But when it comes to conventional investments like shares, since 1900 shares in the US have had positive returns around seven years out of ten and in Australia it’s around eight years out of ten. So getting too hung up in permanent pessimism on the next financial crisis and when it will come and what will on the basis of history inevitably drive the market down in the two or three years out of ten may mean missing out on the years it rises.

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.

I don’t normally comment directly on articles by others but an article by Matt Barrie with Craig Tindale called “Australia’s economy is built on shaky foundations, and it’s about to collapse,” has been sent to me several times for comment so I thought I would make an exception this time. 

The gist of the article seems to be that growth in the Australian economy has been built on “a property bubble inflating on top of a mining bubble, built on top of a commodities bubble, driven by a Chinese bubble” and that “Australia has relied on China for too long – our whole economy is built on China buying our stuff. And it’s about to collapse.”

This note takes a look at this risk.

Crash calls for the Australian economy are like a broken record

The first thing to note is that there is nothing really new in the latest call for a collapse in the Australian economy. In fact, for as long as I have been an economist there have been calls for the Australian economy to collapse. Back in 1985, I recall going to presentations on fears the economy might soon “default” and require a rescue by the IMF. The crash calls have accentuated post the Global Financial Crisis (GFC). The Australian economy was supposed to have crashed when the mining investment boom ended in 2012-13 and every year since then there has been an ad on the internet titled “Australian recession 2014: why it’s coming, what to do and how you can profit” but the year just keeps getting updated to the current year. I guess it will be right one day. 

Is China about to collapse?

China is Australia’s number one trading partner so Australia is more vulnerable to the Chinese economy than in the past. But warnings of a Chinese collapse have been around for years now and I continue to regard it as unlikely. The most common concerns about high and rising debt in China miss the reality that China’s high debt growth reflects its high saving rate (of around 46% of GDP compared to around 22% in Australia), which in turn gets largely channelled through the banking system as its capital markets remain underdeveloped. China does not rely on foreign capital (in fact it supplies savings to the rest of the world) and to slow its debt growth, it actually needs to save less and spend more (so very different to countries that normally have debt problems!) and broaden its capital market beyond the banks. But this will take time and the Chinese authorities will not act precipitously. And in the meantime, yes, there is a risk that some corporate loans will go bad but don’t forget much of the growth in debt has gone from state-owned banks to state-owned businesses and will be supported by the Government if there is too much trouble (just like the Chinese Government solved its local government debt problem of a few years ago).

But isn’t China at peak commodity demand?

Similarly, concerns about China’s property market and commodity demand are misplaced. The Chinese property cycle has regular ups and down as the property market is generally undersupplied but the Government periodically tries to keep a lid on prices. But every time there is a downturn in the property cycle (usually after Government moves to cool it down), out comes new crash stories. The “ghost cities” stories of a few years ago were evident of this but were literally just scary stories – they are part of an effort to decentralise away from crowded cities and the biggest “ghost city” (Ordos Kangbashi) is now almost full. The reality is that much of China continues to have a housing shortage as the population urbanises and many of the apartments built 20 years ago are now substandard and need to be replaced. So demand for steel and concrete from the property market is likely to remain strong for many years to come. Similarly, much of China remains under developed in terms of infrastructure. So yes, China is trying to wind back excess capacity in some sectors that have got ahead of themselves but peak raw material demand from China is a long way off. Yes, Chinese growth could slow towards 6% over the next few years but I doubt a hard landing any time soon. Certainly there was no sign of any hard landing in China when I visited it again in the last week – things were just as frantic as ever!

Australia has always had some export dependence

It’s worth noting that over the years Australia has always seemed to have some dependence on some foreign country in terms of export demand – the UK, Japan, it’s now China but as China’s industrialisation phase slows I suspect other countries will just jump into the commodity demand space (Vietnam, India, Pakistan) and in any case our relationship with China is also shifting across to services.

But the mining boom has long ended so why hasn’t the Australian economy collapsed already?

If Australia is so dependent on the commodity price boom and mining investment boom, why didn’t it crash when they crashed after 2011 and 2012-13 respectively? The simple answer is that the Australian economy is actually less dependent on mining and hence China than many commentators claim. In reality, mining activity is only 7% of Australian economic activity (or GDP) and agriculture is 3%, which taken together hardly suggests an excessive reliance on exports and China.

The mining boom basically meant that south east Australia – and sectors like manufacturing, tourism and higher education along with housing – was suppressed by high interest rates and the high Australian dollar. Once the commodity and mining investment booms went away and interest rates and the $A fell, south east Australia was able to bounce back offsetting the slump in Western Australia and the Northern Territory and parts of Queensland. So Victoria, NSW and even Tasmania were able to go from near recessionary conditions and at the bottom of state rankings a decade ago to now being at the top.   

More than housing

This has not just been driven by housing-related activity, smashed avocados and flat whites (how come Chai tea brewed with soy never gets a look in?) but also in services like tourism and higher education (our third biggest export earner), which are booming. Even manufacturing is looking better. In fact, for many Australians the China driven mining boom was more a curse than a blessing – the saying in Sydney was that the people of western Sydney were paying the price for the mining boom in Western Australia.

Housing construction is starting to slow causing many to wheel out the disaster scenarios again. But the contribution to economic growth from growth in housing construction is regularly exaggerated. Last year it contributed around 0.3% directly to growth and indirect effects are likely to have taken that contribution to around 0.6%. In other words its relatively modest and a housing construction slowdown should be easily offset as the drag on growth (of around 1-1.5% per annum) from slumping mining investment is nearly over, infrastructure spending is booming (partly on the back of the asset swap program), non-mining investment looks to be bottoming at last and export volume growth is strong.

What about a house price crash?

Yes, there is a risk of a house price collapse but it’s a lot more complicated than most people think as pointed out in my last house price note http://bit.ly/2y97kCE . Basically: we have not built enough housing to keep up with strong population growth since mid-last decade (see the next chart); the boom lately has been confined to Sydney and Melbourne (which were more harmed than helped by the mining/China-related boom); and the deterioration in lending standards has been modest with, for example, little in the way of the NINJA (no income, no jobs, no assets) loans that caused so much trouble in the US. 

Source: ABS; AMP Capital

Sydney and Melbourne home prices are likely to fall by 5-10% (like in 2008 and 2011-12) but a crash is unlikely unless unemployment goes up a lot (unlikely), the RBA raises rates aggressively (again unlikely) or the current unit supply surge continues for several more years (again unlikely with approvals off their peak). 

More than “dumb luck” in Australia’s 26-year expansion

While luck has played a role in Australia’s 26 years of economic expansion, it’s worth noting that the China-related boom only really ran for eight or nine years of it (from 2004-2012), and a significant contribution came from the economic reforms of the 1980s and 1990s that made the Australian economy more flexible in responding to shocks. Also, sensible economic policy meant that we managed the China boom well (by avoiding an overheating economy and running budget surpluses), which meant we were better placed to ride out the global shock from the GFC and the subsequent end to the commodity and mining investment booms.

26 years of economic expansion has left the Australian economy with lots to show for it: the economy is 129% bigger in real terms than it was when the 1990-91 recession ended, per capita GDP is up 61%, unemployment is less than half its early 1990s high and our dependence on foreign capital as measured by the current account deficit relative to GDP is about one third smaller than it was 26 years ago. Sure we can do better – underemployment, weak wages growth and poor housing affordability are serious problems and we seem to have given up on serious economic reform – but the economy is in better shape than some give it credit for.

Australia versus the world

Finally, I should note that while we are not in the crash camp for Australia, we remain of the view that it will be a while before interest rates can rise and that Australian economic and profit growth will be subpar compared to other countries for a while yet. As a result, we remain of the view that while Australian shares have more upside they are likely to remain relative underperformers versus global shares for some time yet and that the Australian dollar still has more downside. This is really just a continuation of the “mean reversion” of the huge outperformance in Australian shares versus global shares and in the Australian dollar seen last decade. 

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.

Introduction

The surge in bitcoin has attracted much interest. Over the last five years, it has soared from $US12 to over $US8000; this year it’s up 760%. Its enthusiasts see it as the currency of the future and increasingly as a way to instant riches with rapid price gains only reinforcing this view. An alternative view is that it is just another in a long string of bubbles in investment markets.

Nobel Economics Laureates Daniel Kahneman, Robert Shiller and Richard Thaler and many others shown that investors and hence investment markets can be far from rational and this along with crowd psychology can drive asset prices far from fundamentally justified levels. This note provides a refresher on the psychology of investing before returning to look at bitcoin.

Irrational man and the madness of crowds

Numerous studies show people suffer from lapses of logic. In particular, they:

• Tend to down-play uncertainty and project the current state of the world into the future – eg, resulting in a tendency to assume recent investment returns will continue;

• Give more weight to recent spectacular or personal experiences in assessing probabilities. This results in an emotional involvement with an investment – if it’s been winning, an investor is likely to expect it to keep doing so;

• Tend to focus on occurrences that draw attention to themselves such as stocks or asset classes that have risen sharply or fallen sharply in value;

• Tend to see things as obvious in hindsight – driving the illusion the world is predictable resulting in overconfidence;

• Tend to be overly conservative in adjusting expectations to new information – explaining why bubbles and crashes normally unfold over long periods; and

• Tend to ignore information conflicting with past decisions.

This is magnified and reinforced if many make the same lapses of logic at the same time giving rise to “crowd psychology”. Collective behaviour can arise if several things are present:

• A means where behaviour can be contagious – mass communication with the proliferation of electronic media are perfect examples of this as more than ever investors get their information from the same sources;

• Pressure for conformity – interaction with friends, social media, performance comparisons, fear of missing out, etc;

• A precipitating event or displacement which motivates a general investment belief – the IT revolution of the late 1990s or the rapid industrialisation of China which led to talk of new eras are examples upon which were built general believes that particular investments will only go up.

Bubbles and busts

The combination of lapses of logic by individuals and their magnification by crowds goes a long way to explaining why speculative surges in asset prices develop (usually after some good news) and how they feed on themselves (as individuals project recent price gains into the future, exercise “wishful thinking” and receive positive feedback via the media). Of course this also explains how the whole process can go into reverse once buying is exhausted, often triggered by bad news.

The chart below shows how investor psychology develops through a market cycle. When times are good, investors move from optimism to excitement, and eventually euphoria as an asset’s price moves higher and higher. So by the time the market tops out, investors are maximum bullish and fully invested, often with no one left to buy. This ultimately sets the scene for a bit of bad news to push prices lower. As selling intensifies and prices fall further, investor emotion goes from anxiety to fear and eventually depression. By the time the market bottoms out, investors are maximum bearish and out of the market. This sets the scene for the market to start rising as it only requires a bit of good news to bring back buying.

The roller coaster of investor emotion

Source: Russell Investments, AMP Capital

This pattern has been repeated over the years. Recent examples on a globally-significant basis have been the Japanese bubble and bust of 1980s/early 1990s, the “Asian miracle” boom and bust of the 1990s, the tech boom and bust of the late 1990s/early 2000s, the US housing and credit-related boom and bust of last decade and the commodity boom and bust of late last decade into this decade. History may not repeat but rhymes and tells us asset price bubbles & busts are normal.

Where are we now?

Our assessment in terms of global share markets is that we are still around “optimism”. Investor sentiment is well up from its lows last year and some short-term measures are a bit high, warning of a correction (particularly for the direction-setting US share market) but we are not seeing the “euphoria” seen at market tops. The proportion of Australians nominating shares as the “wisest place for savings” remains very low at 8.9%.

But what about bitcoin? Is it a bubble?

Crypto currencies led by bitcoin and their blockchain technology seem to hold much promise. The blockchain basically means that transactions are verified and recorded in a public ledger (which is the blockchain) by a network of nodes (or databases) on the internet. Because each node stores its own copy, there is no need for a trusted central authority. Bitcoin is also anonymous with funds just tied to bitcoin addresses. Designed to work as a currency, bitcoin therefore has much to offer as a low-cost medium of exchange with international currency transfers costing a fraction of what, say, a bank may charge.

However, bitcoin’s price in US dollars has risen exponentially in value in recent times as the enthusiasm about its replacement for paper currency and many other things has seen investors pile in with rapid price gains and increasing media attention reinforcing perceptions that it’s a way to instant riches.

However, there are serious grounds for caution. First, because bitcoin produces no income and so has no yield, it’s impossible to value and unlike gold you can’t even touch it. This could mean that it could go to $100,000 but may only be worth $100.

Second, while the supply of bitcoins is limited to 21 million by around 2140, lots of competition is popping up in the form of other crypto currencies. In fact, there is now over 1000 of them. A rising supply of such currencies will push their price down.

Third, governments are unlikely to give up their monopoly on legal tender (because of the “seigniorage” or profit it yields) and ordinary members of the public may not fully embrace crypto currencies unless they have government backing. In fact, many governments and central banks are already looking at establishing their own crypto currencies.

Regulators are likely to crack down on it over time given its use for money laundering and unregulated money raising. China has moved quickly on this front. Monetary authorities are also likely to be wary of the potential for monetary and financial instability that lots of alternative currencies pose.

Fourth, while bitcoin may perform well as a medium of exchange it does not perform well as a store of value, which is another criteria for money. It has had numerous large 20% plus setbacks in value (five this year!) meaning huge loses if someone transfers funds into bitcoin for a transaction – say to buy a house or a foreign investment – but it collapses in value before the transaction completes.

Finally, and related to this, it has all the hallmarks of a classic bubble as described earlier in this note. In short, a positive fundamental development (or “displacement”) in terms of a high tech replacement for paper currency, self-reinforcing price gains that are being accentuated by social media excitement, all convincing enthusiasts that the only way is up. Its price now looks very bubbly, particularly compared to past asset bubbles (see the next chart – note bitcoin has to have its own axis!).

Because bitcoin is impossible to value, it could keep going up for a long way yet as more gullible investors are sucked in on the belief that they are on the way to unlimited riches and those who don’t believe them just “don’t get it” (just like a previous generation said to “dot com” sceptics). Maybe it’s just something each new generation of young investors has to go through – based on a thought that there is some way to instant riches and that their parents are just too square to believe it.

Source: Thomson Reuters, Bloomberg, AMP Capital

But the more it goes up, the greater the risk of a crash. I also still struggle to fully understand how it works and one big lesson from the Global Financial Crisis is that if you don’t fully understand something, you shouldn’t invest.

At this stage, a crash in bitcoin is a long way from being able to crash the economy because unlike previous manias (Japan, Asian bubble, Nasdaq, US housing in the chart above) it does not have major linkages to the economy (eg it’s not associated with overinvestment in the economy like in tech or US housing, it is not used enough to threaten the global financial system and not enough people are exposed to it such that a bust will have major negative wealth effects or losses for banks).

However, the risks would grow if more and more “investors” are sucked in – with banks ending up with a heavy exposure if, say, heavy gearing was involved. At this stage, I think it’s unlikely that will occur for the simple reason that being just an alternative currency and means of payment won’t inspire the same level of enthusiasm that, say, tech stocks did in the late 1990s (where there was a real revolution going on).

That said, it’s dangerous to say it can’t happen. There was very little underpinning the Dutch tulip mania and it went for longer than many thought. So it’s worth keeping an eye on. But as an investor I’m staying away from bitcoin.

What does this mean for investors?

There are several implications for investors.
 

1. The first thing investors need to do is recognise that investment markets are not only driven by fundamentals, but also by the often-irrational and erratic behaviour of an unstable crowd of other investors.

2. Investors need to recognise their own emotional capabilities. In other words, investors must be aware of how they are influenced by lapses in their own logic and crowd influences.

3. To help guard against this, investors ought to choose an investment strategy which can withstand inevitable crises & remain consistent with their objectives and risk tolerance.

4. If an investor is tempted to trade they should do so on a contrarian basis. Buy when the crowd is bearish, sell when it is bullish. But also recognise contrarian investing is not fool-proof – just because the crowd looks irrationally bullish (or bearish) doesn’t mean it can’t get more so.

5. Finally, while crypto currencies and blockchain technology may have a lot to offer bitcoin’s price is very bubbly.

Source: AMP Capital 21 November 2017

Author: Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP Capital is responsible for AMP Capital’s diversified investment funds. He also provides economic forecasts and analysis of key variables and issues affecting, or likely to affect, all asset markets.

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.

The low interest rates of recent times along with periodic turmoil in investment markets has provided us with a reminder of the importance of the income (cash) flow or yield an investment provides. It’s particularly important for those relying on investment income to fund their living expenses. As with all investment topics, investing for income can seem complicated and daunting once you move beyond bank deposits but in fact it’s really quite simple. So this note looks at five charts I find useful in understanding investing for income or yield.

Chart #1 There are lots of alternatives to bank deposits

The yield an investment provides is basically its annual cash flow divided by the value of the investment.
 

• For bank deposits, the yield is simply the interest rate, eg bank 1-year term deposit rates in Australia are about 2.25% and so this is the cash flow they will yield in the year ahead.

• For ten-year Australian Government bonds, annual cash payments on the bonds (coupons) relative to the current price of the bonds provides a yield of 2.8% right now.

• For corporate debt, it’s a margin above government bond yields and depends on the riskiness of the company but is currently averaging around 3.6% in Australia.

• For residential property, the yield is the annual value of rents as a percentage of the value of the property. On average in Australian capital cities it is about 3.9% for apartments and around 2.5% for houses. After allowing for costs, net rental yields are about 2 percentage points lower.

• For unlisted commercial property, yields are around 5.5%. For infrastructure investment it averages around 4.5%.

• For a basket of Australian shares represented by the ASX 200 index, annual dividend payments are running around 4.3% of the value of the shares. Once franking credits are allowed for, this pushes up to around 5.7%.

The next chart shows the yield available on a range of investments both now and in December 2009.

Source: Bloomberg, REIA, RBA, JLL, AMP Capital

Key messages: first, there are plenty of alternatives to cash when it comes to yield or income. Second, the yields on these investments will move over time and since the aftermath of the Global Financial Crisis (GFC) the trend has been down.

Of course investors need to allow for risk. Bank deposits have close to zero risk but any move to higher-yielding investments does entail taking on risk. More on this later.

Chart #2 The gap between yields on different assets relative to historic norms provides a guide to value

The next chart shows average yields on Australian shares and unlisted commercial property relative to the one-year term deposit rate since 2000. While yields have fallen, the gap between share and property yields and the bank deposit rate is extreme historically, with neither share or property yields plunging to the degree bank deposit rates have. In fact, the share yield is in its historic range. All things equal, this suggests commercial property and Australian shares continue to provide better value. The same would apply to unlisted infrastructure. 

Source: JLL, Bloomberg, AMP Capital

Key message: comparing yields provides a guide to relative value and right now shares and unlisted commercial property remain very attractive relative to bank deposits.

Chart #3 Shares can provide stronger growth in income with less volatility than bank deposits

Investing in shares of course entails the risk of capital loss. But it can offer a higher and less volatile income flow over time. The next chart is a bit heavy but it compares initial $100,000 investments in Australian shares and one-year term deposits in December 1979 and the income they have provided over time (before franking credits are allowed for in the case of shares).

Source: RBA, Bloomberg, AMP Capital

The term deposit would still be worth $100,000 (red line) and last year would have paid roughly $2450 in interest (red bars). By contrast the $100,000 invested in shares would have grown to $1.12 million (blue line) by end 2016 and last year would have paid $51,323 in dividends before franking credits (blue bars). The point is that dividends tend to grow over time (because profits and hence an investment in shares tends to rise in value) and are relatively stable compared to income from bank deposits, which vary with interest rate settings. Over the period the worst decline in dividend income from shares was a 32% decline between 2009 and 2011, whereas the income from bank deposits plunged 68% between 1990 and 1994 and by 60% between 2011 and last year. Once franking credits are allowed for, the comparison would become even more favourable towards shares.

Key message: while shares come with the risk of capital loss, a well-diversified portfolio of Australian shares can provide stronger growth in income with less volatility in that income than bank term deposits. Investors focussed on income need to decide what is most important: stability in the value of their investment or a higher, more sustainable income flow. The key when investing in shares for income is to have a well-diversified portfolio. Or better still a well-diversified portfolio of shares paying high and sustainable dividend yields. Finding high dividend yields is easy but the key is to look for stocks that have a reliable track record of growing those dividends and that have dividends that are not threatened by things like excessive gearing.

Chart #4 A bird in the hand is worth two in the bush

A high and sustainable starting point yield provides some security during volatile times. Since 1900, dividends (prior to allowing for franking credits) have provided just over half of the 11.8% average annual return from Australian shares and as can be seen in the next chart their contribution has been stable in contrast to the capital value of shares.

Source: Global Financial Data, Bloomberg, AMP Capital

Dividends are relatively smooth over time because most companies hate having to cut them as they know it annoys shareholders so they prefer to keep them sustainable.

Key message: a high and sustainable income yield for an investment provides some security during volatile times. It’s a bit like a down payment on future returns.

Chart #5 Yield provides a guide to future returns

The yield an investment provides forms the building block for its total return, which is essentially determined by the following.  
 

Total return = yield + capital growth

As a general principle, the higher the yield an investor invests at, the higher the return their investment will likely provide. This is self-evident in the case of bank deposits because the yield is the return (assuming the bank does not default on its deposits – which is very unlikely in Australia given Government protections). It can be seen in relation to bonds in the next chart, which shows a scatter plot of Australian ten-year bond yields since 1950 (along the horizontal axis) against subsequent ten-year bond returns based on the Composite All Maturities Bond Index (vertical axis). Over short term periods, bond prices can move up and down and so influence short-term returns, but over the medium term the main driver of the return a bond investor will get is what bond yields were when they invested. If the yield on a ten-year bond is 5%, then if you hold the bond to maturity your return will be 5%. Of course a portfolio of bonds will reflect a range of maturities and so the relationship is not perfect, but it can be seen in the next chart that the higher the starting point bond yield, the higher the subsequent return.

Source: Global Financial Data, Bloomberg, AMP Capital

Put simply when bond yields are high they drive high bond returns over the medium term and vice versa. For example, when Australian ten-year bond yields in January 1982 were 15.2% it’s not surprising that returns from bonds over the subsequent ten years were 15.4% per annum. Similarly, when bond yields were just 3.1% in January 1950, it’s no surprise that returns from bonds over the next ten years were 3.1%. At 2.8% now, we are off the bottom of the chart meaning record low bond returns for the next decade.

Similar albeit less perfect relationships exist for other asset classes – the higher the yield, the higher the subsequent return.

Of course there are some risks investors must watch out for. At the individual share level, a very high dividend yield may be a sign of a “value trap” – where current profits and dividends may be fine but there is an impending threat to the company and so the share price is low. Second, high distributions may also be unsustainable if they are being paid for out of debt and reflect excessive gearing or high risk investments (eg, sub-prime mortgages prior to the GFC). Just remember that there is no free lunch.

Key message: while returns have been solid lately, low investment yields do warn of lower returns ahead – most notably from government bonds.

Source: AMP Capital 24 October 2017

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.