Could last year’s strong equity returns keep on rolling?
On the home front, the economic cycle in Australia is less advanced than in other developed economies. Activity remains subdued as housing investment moderates and consumers remain cautious on account of anaemic wages growth. Nonetheless, the preconditions for an improvement in growth are in place. Business confidence has improved and there is evidence of broad-based acceleration in business investment. At the same time, large public-sector transport infrastructure projects are beginning to ramp up.
The domestic economy should also benefit from a lower exchange rate, which is likely to emerge as interest rates in the US are pushed up to levels above those in Australia. This downward pressure on the Australian dollar is likely to be reinforced by a modest decline in key commodity prices later in the year as activity in China moderates.
While an abrupt slowdown in China would be quite negative for Australia, we remain confident that authorities have the capacity to deal with any issues associated with the build-up of debt in less productive parts of the economy.
The Australian share market isn’t as well-positioned as many of its global counterparts to benefit from the cyclical pick-up in global growth due to its over-sized exposure to domestic financial companies. Nonetheless corporate cash flow should remain solid and dividends are likely to remain strong, providing a reasonably secure source of return.
Our optimistic view on the prospects for the economy and our constructive outlook for equity markets are currently shared by many other investors. So it is appropriate to consider what could go wrong.
There are ever-present geopolitical risks whose potential impact is hard to predict. At present, the major concerns are focussed on the threat of war on the Korean peninsula, political instability in Europe associated with the upcoming election in Italy and the prospect of a trade war if overt nationalist policies gained traction in important economies.
The major macro-economic risk for both bond markets and share markets is a surge in inflation which would provoke an aggressive interest rate reaction from central banks.
Markets are priced on an expectation that inflationary pressures remain muted and interest rates persist at low levels for a considerable period, so a surge in inflation would force a material downward re-pricing of assets. We do know that employment growth has been strong for a quite some time. At some point in the future we should expect upward pressure on wages and inflation. If the amount of under-employment in the labour market is being materially over-estimated then prevailing asset prices would turn out to be unsustainable. While the probability of such an outcome appears low, it does require careful monitoring.
Meanwhile, central banks have been signalling for some time that as conditions improve they will progressively withdraw the asset buying programs established in the wake of the Global Financial Crisis. These programs may have contributed to elevated asset prices and certainly have served to supress market volatility. So another potential risk is that investors or consumers turn out to not be adequately prepared for this policy normalisation. It is possible that the withdrawal of the asset buying program undermines some investment strategies whose effectiveness was over-reliant on easy monetary conditions.
Closer to home, we are watching developments in the Australian housing market.
Overall, we believe market returns in 2018 will be lower than in 2017 and market volatility will rise from the exceptionally low levels experienced last year.
But to be sure, we continue to expect that investors in our diversified funds will be rewarded with attractive positive returns which are well in excess of the cash rate and that will serve to grow their purchasing power. Given the more volatile equities environment and potential risks emerging a larger portion of portfolio returns in the period ahead is likely to be sourced from the skill of active funds managers.
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. © Copyright 2018 AMP Capital Investors Limited. All rights reserved.