Growth bounces back (again)

Threats, risks and worries

• Housing construction is starting to slow with falling approvals pointing to a further slowing (see next chart).

• Related to this, there is the risk of a house price crash “as seen” on Four Corners. However, there have been endless property crash calls since around 2004. In the absence of a stronger supply surge, the Reserve Bank of Australia (RBA) making a mistake and raising rates too high and/or unemployment surging, our view is that a slowdown in Sydney and Melbourne is likely, but not a crash.

• Consumer spending is constrained by record low wages growth and high levels of underemployment. While consumer spending has been running faster than income growth, as rising wealth has allowed consumers to run down household savings (to now just 4.6%) this is unlikely to continue as the wealth effects flowing from property price gains in Sydney and Melbourne slow. Rapid power cost increases and high debt are also not helping. All of which is driving low consumer confidence.

• Mining investment is still falling with business investment intentions pointing to another 22% fall this financial year.

• The Australian dollar is up 16% from last year’s low and at around $US0.80 (and threatening to go higher) it is at risk of slowing growth (and investment) in trade-exposed sectors like tourism, agriculture and manufacturing.  

• Underlying inflation is too low and risks staying below target for longer due to record low wages growth, a rising $A, competitive pressures & weak rents as new supply hits.

• Our political leaders seem collectively unable to undertake productivity-enhancing economic reforms and take decisive action (eg, on energy policy). With the citizenship crisis threatening an early election, it’s unlikely we will see an improvement any time soon.

Five reasons to expect growth to improve

These worries are well known and despite them we remain of the view that recession will be avoided and growth will pick up over the year ahead: First, the growth drag from falling mining investment is nearly over. Mining investment peaked at nearly 7% of GDP four years ago and has since been falling at around 25% per annum (pa), knocking around 1.5% pa from GDP growth. At around 2% of GDP now, its weight in the economy has collapsed reducing its growth drag to around 0.4% this year and it’s near the bottom (see next chart). 

Source: ABS, AMP Capital

• Second, non-mining investment is likely to rise this year. Comparing corporate investment plans for this financial year with those made a year ago points to a decline in business investment this year of around 3.5% (see next chart). But this is the best it’s been since 2013 and once mining investment is excluded this turns into an 8% gain for non-mining investment.

Source: ABS, AMP Capital

• Third, public investment is rising strongly, up 14.7% over the last year, reflecting state infrastructure spending.

• Fourthly, net exports are likely to continue adding to growth as the completion of resources projects boosts mining and energy export volumes and services sectors like tourism and higher education remain strong.

• Finally, profits for listed companies are rising again after two years of falls. This is a positive for investment and the flow of dividends helps household incomes.

Implications for investors

Source: Thomson Reuters, AMP Capital

Source: AMP Capital 06 September 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.

 I am regularly called on to provide forecasts for economic and investment variables like growth, interest rates, currencies and the share market. These usually come in the form of point forecasts as to where the variable that is being forecast will be in, say, a year’s time or its rate of return. Such point forecasts are part and parcel of the investment industry. In fact, forecasts about all sort of things – from the environment to economics to politics to sport – have become part of everyday life.

Economic and investment-related forecasts are useful as a means of communicating a view, as an input to the construction of budgets and as a base case against which to assess risks and formulate economic policy. But one of the big lessons I have learnt over the years is that relying too much on precise forecasts when making investment decisions regarding the asset allocation of multi asset funds (ie, funds that have exposure to a range of assets like cash, bonds, property, infrastructure and equities) can be dangerous. This was amply demonstrated during the global financial crisis (GFC), but has always been apparent.¹ In particular, there is often a big difference between being right – ie, getting some forecast right – and making money. And of course, as Ned Davis has pointed out, for investors the key is to make money, not to be right.

If forecasting was easy I wouldn’t be writing this…

…and you wouldn’t be reading it! We would be very rich and sipping champagne in the south of France (or something like that!). As my first manager used to tell me “forecasting is difficult because it concerns the future”. The difficulty of getting economic forecast right is reflected in the long list of jokes about economists and their forecasts. Here’s some:

• Three economists went target shooting. The first missed by a metre to the right, the second missed by a metre to the left and the third exclaimed “we got it”.

• Economists were invented to make weather forecasters and astrologers look good.

• An economist is a trained professional paid to guess wrong about the economy.

• An economist will know tomorrow why the things she or he predicted yesterday didn’t happen.

• Economic forecasting is like driving a car blindfolded and getting instruction from a person looking out the rear window.

• Economics is the only field in which two people can share a Nobel Prize for saying the complete opposite.

• For every economist there exists an equal and opposite economist.

• Economists have predicted six of the last two recessions.

• There are two classes of forecasters: those who don’t know and those who don’t know they don’t know (J.K. Galbraith).

Hit and miss

Surveys of economic forecasts are regularly compiled and published in the media. It is well known that when the consensus (or average) forecast is compared to the actual outcome, it is often wide of the mark. This is particularly so when there has been a major change in direction for the variable being forecast – such as around events like the tech wreck in the early 2000s and the GFC. This applies not only to economists’ forecasts for economic variables, but also to share analysts’ forecasts for company profits and to most forecasts across most disciplines except those where precise linear relationships apply (where A = B, eg in predicting the date and time of the next eclipse as opposed to the non-linearity in economics and investing and most things people like to forecast where a slight shift in the balance can result in A = B or C or…).

And of course the bigger the call, invariably the bigger the miss. There are numerous examples of gurus using grand economic, demographic or financial theories – usually resulting in forecasts of “new eras” or “great depressions” – who may get their time in the sun but who also usually spend years either before, or after, losing money. For example, the gurus who foresaw a “new era” in the late 1990s – with books like Dow 36,000 – looked crazy in the tech wreck bear market of the early 2000s. And many of those who did get the tech wreck or GFC “right” were bearish years before and would have lost their fortune if they had shorted shares when they first got bearish.

Grand prognostications of doom can be particularly alluring, and wrong. Calls that the world is about to bump into some physical limit, causing some sort of “great disruption” (famine, economic catastrophe – all those sort of things!), have been made with amusing regularity over the last two hundred years: Thomas Malthus, Paul Ehrlich’s The Population Bomb of 1968, the Club of Rome report on The Limits to Growth in 1972, the “peak oil” fanatics who have been telling us for decades that global oil production will soon peak and when it does the world will be plunged into a Mad Max-style chaos. Such Malthusian analyses underestimate resources, the role of price increases in driving change and human ingenuity in facilitating it. And when you’re reading books like those from Harry S Dent about The Great Depression Ahead (2009), The Great Crash Ahead (2011) and The Demographic Cliff (2014), all of which had disaster happening well before now, just recall that there has been a long list of prognostications for a great depression, often linked to a debt-related implosion, the bulk of which turned out to be wrong. Amongst my favourites are Ravi Batra’s The Great Depression of 1990 – well, that didn’t happen so it was just delayed to The Crash of the Millennium that foresaw an inflationary depression, which didn’t happen either. Google “the coming depression” and you’ll find 72.3 million search results!

Psychology and forecasting

Forecasts for economic and investment indicators can be useful but quite clearly need to be treated with care:

• Like everyone, forecasters suffer from psychological biases including the tendency to assume the current state of the world will continue, the tendency to look for confirming (not contrary) evidence in new information, the tendency to only slowly adjust forecasts to new information and excessive confidence in their ability to foresee the future.

• Quantitative point forecasts – eg, that the S&P 500 will be 2450 by December 31 – convey no information regarding the risks surrounding the forecasts. They are conditional upon the information available when the forecast was made. As new information appears, the forecast should change. Setting an investment strategy for the year based on forecasts at the start of the year and making no adjustment for new information is often a great way to lose money.

• In investment management, what counts is the relative direction of one investment alternative versus others – precisely where they end up is of little consequence.

• The difficulty in forecasting financial variables is made harder by the need to work out what is already factored in to markets. And rules of logic often don’t apply. Benjamin Graham coined the term “Mr Market” (in 1949) as a metaphor to explain the share market. Sometimes Mr Market sets sensible share prices based on economic and business developments. At other times he is emotionally unstable, swinging from years of euphoria to years of pessimism. Trying to get a handle on that and presenting it as a precise forecast or a grand market call is not easy.

In the quest to be right, the danger is that clinging to a forecast will end up losing money.

Why are forecasts treated with such reverence?

So why are forecasts seen by many as central to investing? First, many see the world through the rear view mirror where everything seems clear and assume that the future must be easy to forecast too for anyone who has the expertise. Second, and more fundamentally, precise quantified forecasts seem to provide a degree of certainty in an otherwise uncertain world. People hate uncertainty and will try to reduce or remove it however they can. And if we don’t have the expertise, the experts must know. And finally, prognostications of doom can be alluring because investors suffer from a behavioural trait 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 leaves us more risk averse and it also leaves us more predisposed to bad news stories as opposed to good news stories. Flowing from this, prognosticators of gloom are more likely to be revered as deep thinkers than are optimists.

What to do? Three things to consider

While I like to think that I and my colleagues are better than the market, I know that if we simply relied on point forecasts for key investment market variables (like the share market, bond yields and the exchange rate) to set our investment strategy, it may not be the best way to make money for our clients. So in embarking upon investing, what should one do? In my opinion, there are three things to consider in the light of this note.

First, don’t over rely on expert forecasts. While point forecasts can help communicate a view, the real value in investment experts – the good ones at least – is to provide an understanding of the issues around investment markets and to put things in context. While financial history does not repeat, it does rhyme and so in many cases we have seen a variant of what may be currently concerning the market before. This is particularly important in being able to turn down the noise and focus on a long-term investment strategy designed to meet your investment goals.

Second, invest for the long term. In the 1970s, Charles Ellis, a US investment professional, observed that for most of us investing is a loser’s game. A loser’s game is a game where bad play by the loser determines the victor. Amateur tennis is an example where the trick is to avoid stupid mistakes and thereby win by not losing. The best way for most investors to avoid losing at investments is to invest for the long term. Get a long-term plan that suits your level of wealth, age, tolerance of volatility, etc, and stick to it. Alternatively, if you can’t afford to take a long-term approach or can’t tolerate short-term volatility, then it is worth considering investing in funds that use strategies like dynamic asset allocation to target a particular goal – be that in relation to a return level or cash flow.

Finally, if you are going to actively manage your investments, make sure you have a disciplined process. Ideally, this should rely on a wide range of indicators – such as valuation measures (ie, whether markets are expensive or cheap), indicators that relate to where we are in the economic and profit cycle, measures of liquidity (or some guide to the flow of funds available to invest), measures of market sentiment (the crowd is often wrong) and technical readings based on historic price patterns. The key to having a disciplined process is to stick to it and let the “weight of indicators” filter the information that swirls around financial markets so you are not distracted by the day-to-day soap opera engulfing them. Forecasting should not be central to your process. My preference is to focus on key themes as opposed to precise point forecasts.

Conclusion

It is always tempting to believe that you or someone else can perfectly forecast the market. However, as Ringo Starr said “it don’t come easy”! There are plenty of investors who have been “right” on some particular market call but lost a bundle by executing too early or hanging on to it for too long. The key is to know where expert views can be of use, but stick to a strategy designed to attain your goals and if you are going to actively manage your investments have a disciplined process.

¹This note is an update of “Making money versus being right in the loser’s game”, Oliver’s Insights, September 2006.

Source: AMP Capital 31 May 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.

Around May each year I normally get a bit wary about the risks of a pullback in shares. It seems the old saying “sell in May and go away…” is permanently stuck in my mind. And of course shares have had a great run since their global growth scare “bear market” lows in February last year to their recent highs with global shares up 31% and Australian shares up 25%, and both saw good gains year to date to their recent highs of 7% and 5% respectively. Meanwhile, although there have been several calls this year that the so-called “Trump trade” – anticipation of his pro-business policies that supposedly drove the surge in shares since the US election – is over, the risks have intensified lately given the issues around Trump, the FBI and Russia with some fearing the Trump trade is now set to reverse. This note looks at the main issues.

Trump trade or Trump bump

It’s now six months since Donald Trump was elected President of the US and four months since he was inaugurated. In many ways, it has gone better than feared: he has not withdrawn the US into isolationism, there has been no trade war with China, he has appeared more focussed on pro-business policies such as deregulation and tax reform than populist policies, and he appears far more supportive of the Federal Reserve under Janet Yellen than feared. But by the same token, many would see the events of the last two weeks – his firing of FBI director James Comey when it’s in the midst of looking into the links between Trump’s campaign and Russia, claims he may have attempted to influence the FBI to stop its investigation and reports he shared classified material with Russian officials all surrounded by a barrage of tweets and leaks – as confirming that his narcissism, short fuse, erratic nature and divisive approach render him unfit to be president. Comparisons to Nixon and talk of impeachment seem to be growing by the day.

In terms of investment markets, a common view seems to be that the “Trump trade” drove the surge in global share markets since the US election and that this will now reverse because of the political crises now surrounding Trump. However, this is too simplistic. First, the main reason for the rally in shares since last November has been the improvement in economic conditions and surging profits that has occurred globally and which had little to do with Trump. Second, unless things become terminal for Trump quickly the political crisis around him is more likely to speed up his pro-business reform agenda than slow or stop it. In this regard, the following are worth bearing in mind:

• The process to remove a president by impeachment is initiated by the US House of Representatives and can be for whatever reason the majority of the House decides and conviction, removal from office, is determined by the Senate and requires a two-thirds majority.¹

• At present, Republicans control the House with a 21-seat majority and won’t vote for impeachment unless it’s clear that Trump committed a crime (and so far it isn’t obvious that he has) and/or support for him amongst Republican voters (currently over 80%) collapses.

• However, Trump’s overall poll support is so low that if it does not improve the Democrats will gain control of the House at the November 2018 mid-term elections and they will likely vote to impeach him (they will almost certainly find something to base it on much like the Republican Congress found reason to impeach President Clinton) and then it’s a question of whether Trump can get enough support amongst Republican Senators to head off a two-thirds Senate vote to remove him from office (as Clinton did).

In short, Republicans only have a window out to November next year to get through their pro-business reforms. And the more the politics around Trump worsens, the more they need a win. So if anything, the current mess speeds up the urgency to get tax and other pro-business reforms done because after the mid-terms they probably won’t be able to. On this front, work on tax reform is continuing and Trump’s infrastructure plan looks likely to be announced soon.

The impact of past impeachments on the US share market is mixed and proves little. The unfolding of the Watergate scandal through 1973-74 occurred at the time of a near 50% fall in US shares but this was largely due to deep recession and double-digit inflation at the time. (President Nixon resigned before impeachment.) President Clinton’s impeachment had little share market impact but was in the midst of the tech bull market.

Correction risks and seasonality

Share markets have had a great run and are arguably due a decent (5% or so) correction as a degree of investor complacency has set in. The latest scandals around Trump along with various other risks – North Korea and the ongoing march of Fed rate hikes – could be the trigger. (Corruption scandals in Brazil are a sideshow and are unlikely to have much impact beyond Brazil.) And it’s well known that the best time for shares is from November to May and the worst time is from May to November. This can be seen in the next chart, which shows the seasonal pattern in share markets since 1985.

Source: Bloomberg, AMP Capital

Most major share market falls have occurred in the May to October period (1929, 1987, worst of GFC, etc). Hence the old saying “sell in May and go away, come back on St Leger’s Day” still resonates. The seasonal pattern reflects tax loss selling by US mutual funds around the end of their tax year that sees them sell losing stocks around September in order to reduce capital gains tax bills, followed by having to buy shares back in November, the investment of year-end bonuses, New Year optimism and the absence of capital raising over Christmas and New Year all serving to drive shares higher from around October/November, which then peters out around May giving way to weakness that’s accentuated by tax loss selling in the September quarter. The only difference in Australia is that July tends to see a strong boost (as investors buy back after tax loss selling), but it otherwise follows the same pattern as the US.

Five reasons for optimism

However, beyond current short-term risks and threats, there are several reasons for optimism. First, valuations for most share markets are not onerous. While price to earnings multiples for some markets are a bit above long-term averages, that is not unusual in an environment of low inflation. Valuation measures that allow for low bond yields show shares to no longer be as cheap as a year ago but they are still not expensive.

Source: Thomson Reuters, AMP Capital

Second, while the US share market may be vulnerable on some measures, other share markets are not. If US shares are compared to a ten-year moving average of earnings (referred to as a Shiller or cyclically adjusted PE) then they are expensive and of course monetary conditions in the US are gradually tightening. However, the so-called Shiller PE remains cheap for most markets globally including Eurozone and Australian shares (next chart). Note also the last ten years include the GFC earnings slump and this will drop out next year, which will see the Shiller PE fall in most countries including the US.

Source: Global Financial Data, AMP Capital

Third, global monetary conditions remain easy and in the absence of broad-based excess (in growth, debt or inflation) look likely to remain so. The Fed is likely to hike rates two more times this year and start allowing its balance sheet to run down later this year but it’s still from a very easy base & other central banks are either on hold or easing. So a shift to tight money bringing an end to the economic cycle looks a fair way off.

Fourth, global economic growth is looking healthier. Global business conditions indicators (or PMIs) are strong (next chart), the OECD’s leading economic indicators have turned up, jobs markets are tightening and for the first time in years the IMF has been revising up (not down) its estimates of global growth. US growth looks to be bouncing up again after a seasonal soft spot early this year, Chinese economic growth appears to be stabilising around 6.5% after an earlier upswing, Japanese growth looks to be good, the Eurozone looks strong and Australia is continuing to muddle along (not great but not bad – but nevertheless highlighting the ongoing case for Australian investors to have a decent global equity exposure).

Source: Bloomberg, AMP Capital

Fifth, profits are strong: US profits are up 14% year on year, Japanese profits are up 15%, Eurozone profits are up 24% and Australian profits look set to rise 20% this financial year.

Concluding comment

After strong gains over the last year and a strong start to the year until their recent highs, shares are vulnerable to a short-term correction as we go through seasonally weaker months. The political scandal around Trump, North Korea and Fed worries could all be a trigger. However, with most share markets offering reasonable value, global monetary conditions remaining easy and global growth and profits looking good, the trend in shares is likely to remain up.

Source: AMP Capital 23 May 2017

¹The alternative to impeachment would be where Vice President Pence and Trump’s Cabinet remove him from office under the 25th Amendment of the Constitution which is aimed at dealing with a President who has become mentally incapable. While some may claim this should have happened from the start, it’s doubtful that Pence and Trump’s Cabinet see it that way!

About the Author

In January 2016 the Australian dollar fell to just above $US0.68, its lowest level since 2009 and down 38% from its 2011 high. But since then, after a brief rebound, it has been stuck in a range between $US0.72 and $US0.78, defying our expectations for a decline. This note looks at why the $A has been so resilient over the last year, why we still think its longer term downtrend will resume and what it all means for investors.

What drives the $A?

Over the long term, the Australian dollar tends to move in line with relative price differentials. This is the theory of purchasing power parity (PPP) according to which exchange rates should equilibrate the price of a basket of goods and services across countries – see the next chart. So if over time Australian inflation and costs rise relative to US inflation and costs, then the value of the $A should fall relative to the $US to maintain its real purchasing power and competitiveness. But in the short to medium term, swings in the $A are largely driven by swings in the prices of Australia’s key commodity exports and hence the terms of trade (when they go up the $A tends to rise and vice versa) and relative interest rates such that a rise in US rates relative to Australian rates makes it more attractive to park money in the US and hence pushes the $A down and vice versa. The positioning of investors also has an impact in the short term. Suppose investors are underweight the $A and then commodity prices rise encouraging them to close their underweights – this can add to upwards pressure on the $A.

Why the bounce a year ago & relative “stability” since?

These shorter-term forces were evident in the Australian dollar’s bounce back from below $US0.70 in January last year and relative stability in the $A since.

First, late in 2015 and early last year there was a lot of negative sentiment towards Australia with talk about a “big short” in property, banks and the $A as another round of calls for a crash in property prices did the rounds. This contributed to a big build up in speculative short or underweight positions, which left the $A vulnerable to positive news and set the scene for a rebound.

Second, the prices for Australia’s key industrial commodity exports – iron ore, coal, metals and energy – all rose sharply pushing Australia’s terms of trade up significantly.

Third, the US Federal Reserve delayed raising interest rates last year and this reduced upwards pressure on the $US.

Fourth, while RBA rate cuts last year helped prevent the $A from rising through $US0.78, so far this year there has been a feeling that Australian interest rates have bottomed and the next move is up with some saying later this year.

Finally, the rebound and then relative resilience in the $A has been consistent with a “risk on” environment as the $A is seen as a “risk on” currency, ie it’s strong when global conditions and growth assets improve and it’s weak when they deteriorate.

Three reasons why the $A is likely to fall

At current levels, the Australian dollar is roughly where it should be against the $US on a purchasing power parity basis. This is apparent in the next chart which shows where the $A should have been over time if it had moved to equilibrate relative consumer price levels between the US and Australia.

Source: RBA, ABS, AMP Capital

Right now, fair value on this measure is around $US0.75, which is not far from the current level for the $A. But as can be seen, the $A rarely spends much time at the purchasing power parity level and tends to be pushed to extremes above and below it.

Our assessment is that a resumption of the downtrend in the $A seen since 2011 is likely for three reasons.

First, commodity prices likely remain in a long-term downtrend thanks to a surge in supply after record investment in resource projects. Raw material prices go through roughly 10 year upswings followed by 10 to 20 year downswings. These long-term moves reflect long lags in supply. For example, if commodity prices surge after years of undersupply, producers initially don’t believe it’s sustainable but, after several years, start to invest in new supply by which time the cycle is peaking. Then, when the new supply comes on stream it accentuates the downswing and it all repeats in reverse.

Source: Global Financial Data, Bloomberg, AMP Capital

Of course there are cyclical swings in commodity prices within these long-term moves and the recent bounce in commodity prices was one of those, but the iron ore price has since come back down again and oil prices have struggled to maintain upwards momentum with rising supply constraining both.

Second, the interest rate differential in favour of the $A is likely to narrow further as the Fed continues to hike rates and the RBA remains on hold or maybe even cuts rates. This will make it relatively less attractive to park money in Australia putting downwards pressure on the $A. The Fed is on track to hike rates again in June and September as the US economy continues to improve as highlighted by a tightening jobs market. This will take the Fed Funds rate to a range of 1.25-1.5%. If the RBA leaves rates on hold at 1.5%, which is our base case, then the gap between Australian and US official interest rates will have virtually closed by September, from 4.5% in 2011. As the next chart shows, periods of a low and falling official interest rate differential between Australia and the US usually see a low and falling Australian dollar.

Source: Bloomberg, AMP Capital

While our base case is that the RBA is on hold, there is a high risk that it may have to cut rates again later this year as we may go through a bit of a soft patch in growth, which is contrary to the RBA’s own forecasts. The contribution to growth from housing is set to slow as falling building approvals flows through to slowing housing construction and slowing home price gains in Sydney and Melbourne dampen wealth effects, at a time when consumer spending is subdued, mining investment is still falling and cyclone Debbie has disrupted coal export volumes.

Public infrastructure spending will provide an offset but there is a risk of another negative quarter for GDP in either the March quarter just passed or the current June quarter or at least subdued growth in both. Which in turn points to continuing high underemployment and record low wages growth. All of which suggests downside risks to inflation. Against this backdrop, we ideally need the $A to fall further to help support growth in export-oriented sectors like tourism and higher education to help boost overall economic growth. The bottom line though is that there is more risk that the RBA will cut rates than hike them by year end and if the RBA does cut, the interest rate differential in favour of the $A will go negative this year.

Of course the financial stability risks associated with continued strength in the Sydney and Melbourne residential property markets have been cited as a significant constraint on the RBA cutting rates again, but this constrain looks like it will fade over the next six months. The peak in home price growth in these cities has likely been seen with the combination of bank rate hikes, tightening lending standards, surging unit supply and a reduction in expenses that can be claimed under negative gearing all likely to help drive a slowing going forward.

Third, speculative positioning in the $A has gone from short at the lows early last year to long now, which leaves the $A vulnerable to any further commodity price softness, Fed rate hikes and or RBA cuts.

Source: Bloomberg, AMP Capital

In short, our assessment is that the $A will resume its downswing and will likely fall below $US0.70 by year end.

What does it mean for investors?

With the risks skewed towards more downside in the value of the $A, there are several implications for investors.

First, there remains a strong case to maintain a decent exposure to offshore assets that are not hedged back to Australian dollars. A decline in the value of the $A boosts the value of an investment in offshore assets denominated in foreign currency by one for one. This can be seen over the last five years where the fall in the value of the $A turned a 12.2% per annum (pa) return from global shares measured in local currencies (US dollars, Yen, Euros, etc) into a 17.7% pa return for Australian-based investors when measured in Australian dollars. Over the same period, Australian shares returned 11% pa which is good, but it paid to have money in global shares, particularly on an unhedged basis.

Second, if the global outlook turns sour, having an exposure to foreign currency provides a useful hedge for Australian-based investors as the $A usually falls (and foreign currencies rise) in response to weaker global growth.

Finally, a further leg down in the value of the $A would be positive for Australian sectors that have to compete internationally like tourism, higher education, manufacturing, agriculture and mining.

If you would like to discuss anything in this article, please call us on Phone: 07 5641 4134.

Source: AMP Capital 17 May 2017