• The past financial year saw solid to strong returns from most asset classes drive good returns from balanced and growth oriented investment strategies, including from super funds.
• Investors should expect returns to slow over the year ahead, but they are likely to remain solid as share valuations are still reasonable, the global economy continues to grow, the Australian growth outlook improves and monetary conditions remain easy.

Introduction

The past financial year saw another 12 months of strong returns. Returns of around 20% from shares, solid returns from property assets and good returns from bonds saw balanced growth superannuation funds return around 13% on average. This was the second year in a row of double digit gains. By contrast the return from cash was poor and average 12 month bank term deposits returned less than 4%.

As always there has been plenty to fret about, including:

• The mid 2013 “taper tantrum” in the US, with investors fearing the Fed’s decision to start winding down its quantitative easing program would threaten the US economy and shares;
• The US Government shutdown and debt default worries in October and the March quarter economic contraction;
• The slow recovery and deflation worries in Europe;
• Fears of a sales tax hike driven recession in Japan;
• Another bout of hard landing worries regarding China centred on the property and shadow banking sectors;
• Worries about the impact on emerging countries of Fed tapering;
• Geopolitical worries regarding Syria, Ukraine and Iraq;
• Ongoing worries as to how Australia will fare as the mining boom fades and whether the May Budget will worsen the economic outlook; and
• The last six months has seen intensifying concerns that share markets are set for a fall.

But these concerns were offset by a range of factors:

• A continuing improvement in the global economy;
• The Fed’s tapering has clearly been contingent on improving growth with a rate hike still a fair way off;
• Further easing measures by the European Central Bank;
• Little global economic damage from geopolitical risks;
• Continuing record monetary stimulus in Japan;
• A stabilisation in Chinese economic growth helped by various mini-stimulus measures;
• No sign of capital flight from emerging countries and election optimism regarding India and Indonesia; and
• Okay growth in Australia helped by low interest rates.

This has all seen growth assets boosted by a reasonable growth and profit outlook and bonds helped by continued easy monetary conditions. The latter has also seen an ongoing search for yield by investors. With shares no longer dirt cheap its likely returns will slow – indeed they have over the last six months. However, the cyclical bull market in shares likely has further to go. This along with reasonable returns from property assets should underpin further gains in diversified investment portfolios over the year ahead.

Equity valuations – ok

After strong gains through 2012 and 2013 shares are no longer dirt cheap. However, as can be seen in the next chart valuation measures (which are based on a range of measures including a comparison of the yield on shares with that on bonds) show shares are not expensive.

Cyclical bull markets in shares invariably see three phases. First an unwinding of cheap valuations helped by low interest rates. The second is driven by stronger profits. And the third phase is a blow off as investor confidence becomes excessive pushing shares into expensive territory. Our assessment is that we are still in the second phase and as such the cyclical/profit backdrop remains critically important.

The economic cycle – slow improvement

We are still in the sweet spot of the global economic cycle. Growth is on the mend but only gradually such that spare capacity and excess savings remains immense so inflation remains tame, monetary conditions easy and bond yields low. In fact the March quarter growth soft patch seen in the US, Europe and China was more positive than negative because it wasn’t threatening but further pushed out the timing of any monetary tightening. By region:

• After a contraction in the March quarter driven by mostly temporary factors, the US economy is continuing to improve and looks on track for circa 3% growth. The jobs market and business investment are improving and shale oil boom is providing a long term boost both directly and indirectly via cheap electricity costs for business.
• Growth has returned to Europe. Ireland and Portugal have emerged from their bailout programs and structural reform seems to be on track. But growth is far from robust, inflation too low and uncertainty around the banks is likely to linger till later this year after the completion of the ECB’s bank asset quality review. All of which means continuing recovery but ongoing need for ECB support.
• Japan appears to be weathering its sales tax hike well, with ultra easy money and economic reforms providing confidence growth will continue.
• Chinese growth looks to be on track for around 7.5% helped by various mini-stimulus measures.
• Emerging world growth generally isn’t as strong as it used to be but it looks to be stabilising around 5%.

Reflecting this, the global manufacturing conditions PMI is at levels consistent with good, but not booming global growth.

This suggests global growth is likely to pick up a notch which should underpin a modest improvement in profit growth.

In Australia, while the mining investment slowdown, the impact on confidence from the May Budget and the too high $A pose a short term threat, underlying growth is likely to have picked up to a 3% pace by year end and continue through next year helped by a housing construction boom, a Senate induced softening in some of the harsher aspects of the Budget and strength in resource export volumes.

Monetary conditions to remain easy

When the Fed will start to raise interest rates and reverse its QE program has been a constant source of speculation. While such speculation may intensify over the next six months – resulting in bouts of volatility for investment markets – global monetary conditions are set to remain easy:

• The tightening US jobs market indicates the first rate hike in the US is coming on to the horizon. But continuing high levels of excess capacity indicate it may still be 9-12 months away and will be a gradual process when it starts. In other words it will take a long time before US monetary policy is tight – with above “normal” interest rates and short term rates being above long term rates.
• The ECB has only just eased monetary policy and has signalled it stands ready to do more, including via a quantitative easing program, if deflation risks don’t recede. Rate hikes are well over the horizon.
• Unprecedented quantitative easing in Japan will continue until underlying inflation is firmly ensconced around 2% and there is still a way to go. Rate hikes are not in sight.
• In Australia, the RBA is not expected to start raising rates till sometime next year. And as the Fed is likely to go first, the Australian dollar is likely to resume its downtrend.

While there will be a few bumps regarding the Fed (just like last year’s taper tantrum) the monetary backdrop is set to remain supportive for investment markets.

Investor sentiment a long way from excessive

We remain a long way from the sort of investor exuberance seen at major share market tops. It seems everyone is talking about share market corrections and crashes and tail risk hedging seems all the rage. In the US the mountain of money built up in bond funds during the post GFC “irrational exuberance for safety” has yet to really reverse.

And in Australia, the amount of cash sitting in the superannuation system is still double average levels seen prior to the GFC and Australians continue to prefer bank deposits and paying down debt to shares and superannuation. There is still a lot of money that can come into equity markets as confidence improves.

Concluding comments

After a bout of relatively smooth sailing there will inevitably be a correction at some point. There are plenty of possible triggers: geopolitical risks, the risk of an inflation/Fed rate hike scare, deflation in Europe, the property slowdown in China and in Australia the transition to more broad based growth. However, while investment returns are likely to slow, still reasonable share valuations, gradually improving economic conditions, easy monetary conditions and a lack of excessive optimism suggest further decent investment returns ahead.

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

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Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) make 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 document 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 document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.

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Key points

• 2010 has been somewhat disappointing for investors, with continuing economic recovery but various macro scares resulting in a constrained and volatile ride for share markets and other related investments.
• 2011 is likely to see global growth continue, and this combined with attractive valuations and easy money is likely to underpin renewed acceleration in the recovery in shares and other growth oriented investments.
• Key risks relate to the US housing market, sovereign debt in advanced countries and emerging market inflation. However, with shares cheap and so much liquidity around its also possible that returns surprise on the upside after the consolidation of 2010.

2010 consolidating the recovery

The key global themes of 2010 have been continued global economic recovery, benign inflation and easy global money, yet all against a backdrop of periodic macro threats resulting in a mixed and perhaps disappointing ride for investors. Global growth in 2010 has actually turned out a little better than expected, coming in at around 4.7%, with emerging countries leading the charge. Even advanced countries with growth of around 2.8% have come in a bit better than we expected. Despite fears of a global dip back into recession the recovery has continued.

While inflation has been a bit of a concern in emerging countries, this has mainly been due to higher food prices. In advanced countries underlying inflation has fallen, with the US coming close to joining Japan in deflation.

Global monetary conditions as a whole have remained very easy as advanced countries have kept interest rates near zero and the US and Japan have embarked on more quantitative easing. While there has been some monetary tightening in emerging countries this has arguably just offset capital inflows which have resulted from resistance to upwards pressure on their currencies.

Contrary to the global experience, Australian economic growth has come in a little less than expected as housing construction has rolled over, rate hikes and greater caution with respect to debt have weighed on consumer spending, public sector stimulus has come to an end and mining exports and investment are yet to fully ramp up. Nevertheless, the labour market has been very strong with unemployment falling to 5.2%

However, despite a solid economic growth backdrop investment returns have generally been sup-par. All was fine up until mid April, but the June quarter saw macro worries return in a big way – led by the European sovereign debt crisis, worries about a double dip in the US on renewed housing sector weakness and concerns that Chinese policy tightening would crash its economy. This all weighed on returns for listed growth assets. Returns for major asset classes are shown in the following table.

Investment returns for major asset classes

• While returns are well down on 2009, the key winners over the last year have been global listed property, Asian and emerging shares, and commodity prices.
• Global bonds have also had solid returns as government bond yields fell on growth worries and deflation concerns and credit rallied.
• Returns from global shares were pretty subdued, but turned into losses once the rise in the $A is allowed for.
• Australian shares were also a disappointment, with global macro worries made worse by Australia’s exposure to China (with Chinese A shares being one of the world’s worst performers in 2010), monetary tightening in Australia and the rise in the $A.
• Australian unlisted commercial property provided good returns as investors took advantage of attractive yields
• By contrast, Australian housing was subdued as poor affordability in response to last year’s price surge and higher mortgage rates flattened sales and house prices.

The subdued and mixed experience across asset classes saw subdued returns from super funds.

Outlook for 2011

While aftershocks from the Global Financial Crisis will continue to cause volatility, 2011 is likely to be a year of continuing global recovery. The key themes of relevance for investors for 2011 are likely to be:

1. Continuing solid global growth. Business conditions indicators remain at levels consistent with solid growth ahead. There remains plenty of pent up demand globally and while fiscal conditions are tightening monetary conditions remain very easy. In the US, strength in the corporate sector is driving a pick up in employment and capital spending, housing indicators appear to have found a floor and retail sales growth is surprising on the upside. In Europe, strength in Germany has offset weakness in debt impaired countries. 2011 is likely to see global growth of around 4.3%.
2. Emerging world to remain stronger, but gap to narrow. Thanks to stronger domestic demand, growth in the emerging world is likely to remain stronger than in the advanced world, but reflecting relatively tighter monetary conditions the gap between the two is likely to narrow with emerging country growth of 6.5% versus 2.5% in advanced countries. China is likely to grow by 9.5%, India by 8% and Brazil by 4.5%.
3. Essentially benign inflation. Excess capacity is likely to ensure inflation remains low in advanced countries. Less spare capacity is likely to see inflation stay somewhat higher in emerging countries, but declining food prices – including in China – are likely to remove upwards pressure.
4. Fiscal tightening, but easy money. Fiscal tightening is already in train and likely to be the equivalent of one percentage point of GDP in 2011 in advanced countries and somewhat less in emerging countries. However, the negative effect will be offset by continued, very easy monetary conditions with still high unemployment ensuring monetary tightening will be unlikely before 2012. While emerging countries will likely be tightening to keep inflation under control this is unlikely to be aggressive (especially with food prices likely to fall) and will continue to be offset by a reluctance to allow faster currency appreciation resulting in capital inflows.
5. Solid earnings growth. As economic growth continues, earnings growth will likely remain solid. Profit growth is likely to be of the order of 10-15% in the US and Australia, and 20% in emerging countries.
6. Solid, but two speed, Australian economic growth. Growth in Australia is likely to be around 3.5% though 2011, but this will mask huge strength in the mining sector as a 50% boost in mining investment adds 2% to GDP growth, and tougher conditions elsewhere. The overall growth back drop will probably be enough to push unemployment down to 4.75% by end 2011, but for home builders and manufacturers it may feel pretty tough. Inflation is likely to be benign initially but to start rising towards 3% later in the year as growth constraints start to impact. While the RBA will leave rates on hold until the June quarter, we expect more hikes designed to contain inflation ultimately taking the cash rate to 5.5% by end 2011. Soft non-mining growth will likely head off the need for a more aggressive rise.

Looking at the major asset classes for the year ahead:

• After undergoing a decent correction in 2010 shares are well placed to put in strong gains in 2011. Shares are cheap (with forward price to earnings multiples around 12.5 times compared to longer term averages around 14.5 times) suggesting risks are well allowed for, the continuing economic recovery should underpin further gains in profits, the global liquidity backdrop is positive underpinned by very low interest rates and quantitative easing in some countries and the corporate sector is cashed up which is likely to result in a further pickup in merger and acquisition activity, share buybacks and dividends. 2011 is also the third year in the US presidential cycle, which usually sees above average share market gains. The Australian ASX 200 index is expected to rise to around 5500 by end 2011. Strength in the $A is likely to see unhedged international shares underperform Australian shares.
• Key sector outperformers in Australia are likely to be resources, cyclicals such as media and undervalued retailers, and telcos.
• Asian and emerging markets are likely to remain out performers reflecting similar valuations to Australian and global shares but better growth prospects, lower debt related risks and likely strong capital inflows from traditional advanced countries.
• Commodity prices are likely to remain strong with the oil price likely to breach $US100 a barrel in 2011.
• Commodity strength is likely to push the $A to $US1.10 by end 2011, but expect occasional sharp corrections as US growth strengthens.
• Cash remains unattractive reflecting low interest rates. Cash returns are likely to be around 5%.
• Low starting point bond yields and a rising trend in yields as the global economic recovery continues is likely to result in poor returns from international government bonds. Corporate debt remains far more attractive with higher yields.
• Unlisted non-residential property is likely to see good returns on the back of yields around 7% and modest capital growth thanks to favourable space demand/supply fundamentals and investor demand.
• Australian house prices are likely to flat line due to poor affordability and the threat of more rate hikes.

Our return expectations imply that most super funds should see a return to solid gains after the soft returns of 2010.

What are the risks?

The main risks are recurring sovereign debt crises in Europe and possibly also in other advanced countries, another bout of US house price weakness, and a more persistent rise in inflation in emerging countries, leading to a sharper than expected tightening in China. In Australia, it’s worth keeping on eye on the RBA as excessive tightening could threaten the Australian housing market.

Conclusion

The second year after a bear market ends often sees volatile trading and poor returns as share markets are constrained by worries about a double dip back into recession or concerns about the removal of stimulus measures. This has certainly been the case in 2010. However, the experience of past cycles points to the resumption of better returns in the third year and we expect this to play out in 2011.

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