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Evidence for the long-term: economic growth could increase until 2026 then slow thereafter

By | Economy, Headline Article | No Comments

If Brexit and Donald Trump have taught us anything, the world is getting tired of the slow growth status-quo. According to exit-polls from the USA election, the biggest reason for voter dissatisfaction is the state of the economy.

While it is not exactly clear what voters expect to see from the economy (unemployment is near cyclical lows and both economies have been recession free for several years), what is clear is that people are desperate for greater wage growth and GDP growth at a household level.

Therefore, we are digging under the hood of this economic concern by looking deeper into the population statistics. What we find is not particularly favourable in absolute terms, although we find that Australia and India are better placed than most. As a part of this analysis, we conclude Donald Trump is pushing uphill to “double the growth rate” as he suggests.

Is there a link between the population and economy?

The real economy relies heavily on population growth; both logically and practically. There are many ways we can verify this importance, however one of the best ways is to illustrate it over the very long-term by showing the 20-year trend of the economy, household spending and population growth. This is an effective method because it massages out economic cycles and shows that all three are intricately linked and generally mean-reverting in the long-term. Below is the case for Australia, showing a strongly aligned relationship.

The unemployment rate will be a critical factor to household spending in the short-term, however is generally seen to be cyclical. Therefore, while an unemployment spike is very likely to coincide with an economic downturn, over the very long-term it gets largely massaged out as excess capacity shifts in waves. Similarly, household savings could have a material impact in the medium term, as people spend more or save more depending on the state of the economy. However, in the very long-term this can also be expected to remain somewhat cyclical.

Employment considerations should be contemplated more broadly though. With an ageing population and extended life expectancies, we can anticipate that the percentage of the elderly workers will increase (as in the case of Japan). We may also see a higher percentage of individuals enter the workforce (especially in countries with a low female participation rate), which could provide further upside. These factors all materially impact the growth outlook.

What does it mean going forward? Why slow-growth may be the new-normal after 2026.

Using population and peak spender logic, we can illustrate the “population effect” and the added “ageing population effect” as per the chart below. This uses the Australian Bureau of Statistics expected population projection (accounting for expected changes in birth rates, death rates and an estimate of net migration) and is adjusted for the “peak spender theory” in the dark blue dotted line. We find the ageing population is expected to support the Australian economy in the short-term but will slow thereafter.

 

Take it as a grain of salt

While our analysis is a brave attempt to provide clarity and logic to an uncertain dynamic, it should not be considered a guarantee by any means. It must be understood there is significant scope for error. To provide full transparency on the scope for error as we see it, below are some of the points worth considering.

First and foremost, the entire premise of this analysis is that the economy and household spending are intricately linked. If this breaks down, the accuracy of the analysis breaks down. While we are confident in the link remaining to some extent (there appears no logical reason it wouldn’t), the reality is that household spending accounts for 55% of GDP which leaves 45% unaccounted for. Therefore, if we see a period of structural change in the remaining 45%, GDP could move markedly from the population trend.

There are also significant risks to any changes in what we’ve labelled as “household effectiveness”. The pace of innovation and technological development continues to drive progress at a household level, but our assumption this will continue at approximately 2% has inherent scope for error. Whether it is 1%, 2% or 5% is anyone’s guess in a world of robots and driverless cars.

The projection data is also subject to potential error, as birth rates or migration rates could change between now and 2100. There are also event risks, such as a world war that could materially impact both population numbers and household spending. A major asset market crash could have a similar impact and interrupt the trend significantly to the downside.

Lastly, from a technical perspective we have considered GDP in real terms throughout our analysis, meaning inflation has been discounted. The reason is that the relationship between population change and inflation is complex, due to the interaction between money supply and the velocity of money. Withstanding this, any period of hyper-inflationary or deflationary conditions could create further inaccuracies.

 

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Long-term banking concerns: high existing debt levels must logically limit loan growth

By | Headline Article, Share-Market | No Comments

With the banking sector changing under our feet and global trade in slowdown, it should come as little surprise geopolitical tensions are high and shareholders are questioning the longevity of company earnings. Specific to the major banks, we have witnessed one of the strongest and longest periods of loan growth in history which has pushed household debt levels to record highs.

As a general rule, none of this would typically portend to be beneficial for banks in a forward looking context. However, balancing the questionable long-term outlook is a potential tailwind from rising inflation expectations, which have the ability to increase net interest margins and thereby profitability.

The Long-Term Backdrop for Traditional Banking is Ominous

One needs to ask themselves how much scope for future growth is available in the major banks given high existing debt levels. One way to illustrate this is to provide a global perspective, which shows Australian banks growing household lending at a very healthy rate of 6.2% against the headwind of the highest existing debt levels in the world. This lending has increased in importance as it accounts for approximately 60% of total lending – as opposed to commercial lending (data is at 31 October 2016).

This creates a sense of nervousness for people that explicitly focus on the dividend yield and forget about the cash-flow that finances the dividends. It is worth considering how much more leveraged Australian households can get, especially as the average household is getting older.

The secondary consideration is value. Below is an extract from our November 2016 edition showing the valuations of the broad financials index excluding property. We can see the sector appeared modestly overvalued on the metric below, however would need to be balanced with alternative valuation methodologies.

 

 

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Australian stocks are up 63,338% since 1900. This chart shows why long-term investing is not gambling

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The life of an investor inevitably involves periods of frustration and can prove to be an emotional experience for many – whether it involves shares, property or bonds – as we navigate the ups and downs of the economic cycle and the impact this has on our portfolio value. For this reason, some broad perspective can help appease these concerns and focus on the underlying objective of investing.

Are you an active investor? Are you a buy-and-hold investor? Or a reasonably balanced individual that wants to participate in the upside but avoid the major setbacks that occur from time to time?

long-term-chartAustin Donnelly was a great advocate of these perspective pieces, as they should instil a longer-term mindset. In the past 100+ years, we have faced two world wars, a great depression and multiple recessions. Yet, despite all of this, the market continued on a reasonably stable trajectory.

In fact, the market went up 63,338% excluding dividends in the past 116 years (equal to approximately 71% every 10 years). This is despite the fact it experienced 10 “crashes”, defined as falls of over 20%, meaning approximately once every decade anyone that was fully invested had to stomach up to a 20% loss to their life savings. Of course, there are techniques available to reduce the drawdown risk (such as diversification to negatively correlated assets) or one can attempt to identify the risks in advance and avoid the losses altogether.

Today’s concerns are arguably similar, as we face the short-term issues of a US election, US debt ceiling negotiation, an Italian vote, the Brexit process and Chinese debt concerns. We also face the long-term issues of an ageing population, high household debt levels, a seemingly elevated property market and technological change that can have a material impact on investment values. crashes

The truth is that there are no guarantees in financial markets. The best we can do is make reasonable assumptions on the best path forward and retain conviction throughout the noise and inevitable periods of market panic.   

Therefore, as an investor, it helps to consider in advance whether you have the knowledge and temperament to identify these risks in advance (plus a willingness to act on your conviction when most people remain optimistic) or whether a buy-and-hold strategy is more akin to your style.

Knowing that most people wish to avoid crashes, we provide a framework that hopefully helps you to identify the key risks and position accordingly. However, just like the 1987 crash or the 2008 financial crisis; the timing and depth of a crisis is often a great unknown. In the end, intelligent investing requires temperament and deep analysis – in that order.

 

 

 

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Shares vs property: Which will win over the next 5 years?

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DSC00808 (640x480)What is going to the best investment over the next five years? Shares, property, cash, gold, hedge funds, bonds, commodities or an alternative asset? This is a question with significant scope for error, however the drivers of supply and demand are a good place to start.

The Investing Times has helped readers assess the risk and return landscape of the share-market and many other opportunities for more than 45 years on the basis of supply and demand, however has never before released research on whether shares or property are likely to be the better investment – until now.

This research is intended to push forward our contribution to value-based investment research, and as such we have compiled a summary of the findings as well as inviting readers to download the full report at the end of this article.

History shows property has been the winner

Looking back through recent history, it should be little surprise that Australian bricks and mortar have outperformed shares. In fact, Australian residential property has outperformed shares in 73.8% of rolling 5 year periods over the past 15 years and in 55.0% of periods since our records commenced 30 years ago (capital returns). This is despite having 34.3% less risk over the past 15 years and 23.8% less risk over 30 years (standard deviation).

Shares v property 1The fact Australian property hasn’t even experienced a negative 5-year return since 1986 has led numerous Australians to form a view that property is a safe bet. This view may or may not prove to be misleading over the next 30 years, however international perspective shows it isn’t always a one-way street.

In addition, even in Australia shares have outperformed property significantly at different times in the cycle. For example, we can see that the period from 1990 to 2000 and 2003 to 2007 was a prosperous time for shares, whereas the period from 2000 to today has been a generally golden period for property.

The big question is not whether one asset-class in permanently better than the other – we know for a fact they both have the ability to produce significant wealth gains and will produce different results depending on the stage of the cycle. The big question is whether it is possible to determine the times when one is better than the other using value metrics including supply and demand fundamental analysis.

What drives shares and/or property?

If we are any chance of identifying the winner in shares versus property going forward, it is not good enough to assume property will crash relative to shares merely because it has grown so much further in the past decade and a half (although this may be a partial indicator of a “buy low sell high” logic).

It requires logical analysis and the deconstruction of the key drivers of each asset – including but not limited to debt level analysis, rental and dividend yield comparisons, interest rate moves, employment growth (or lack thereof), population changes, building supply changes; and more.

For example, we know property tends to excel in times of economic prosperity (no recessions), when unemployment is stable, interest rates are falling and the population is booming. We also know that shares tend to produce the highest performance in times when the share-market is cheap (“buy low, sell high”), when dividend yields are high, when earnings are rising and when households are generally increasing their participation in the share-market.

Our research agenda allows us to explore these drivers in impeccable detail, and we monitor what we consider to be nine of the key drivers for each market. These drivers can be considered a part of the “science of investing” and are detailed with the intention of helping readers make assessments on the risk and return outlook for asset types.

MetricsDo the drivers work?

If done correctly, the analysis should hopefully speak for itself. As a hint of what to expect, it can be seen in the charts below that the 9 drivers are generally quite predictive of the future 5-year return – especially for shares but also for property. For example, in times when the less than 4 of the 9 share-market drivers are positive, the average forward 5-year annual return is 1.1%. In times when more than 6 of the 9 drivers are positive the average forward 5-year annual return is +17.5%. The same applies to property, with 4.1% versus 10.5% forward 5-year annual returns respectively.

If the future valuations of property and shares stay true to their underlying drivers, which is probable but not guaranteed, one should have a reasonable view of the relative value between the two assets (we say “if” because we must acknowledge the limitations of using any system as a basis for future returns).

It is a combination of logic/common-sense as well as historical perspective.

What do the drivers say today? 

Shares v property 6At present, the share-market has 6 of the 9 drivers positive, while the property-market has 3 of the 9 drivers positive. All things being equal over the next 5 years, this leads us to expect reasonable positive returns for shares versus an expectation for relatively subdued returns for property.

In fact, using 25 years of historical analysis, we can see the likelihood of shares beating property over the next 5 years is approximately 3:4 or 74% from the current backdrop. Obviously this means there is room for error. The backdrop is also likely to change over the course of the next 5 years and clearly the results will vary by sector and individual asset.

Regardless, keeping up with the trends in fundamental valuations of shares and property may prove to be useful asset allocation information at the highest level. This is especially true in the current world of excessive noise and fear-mongering.

We wish you safe and prosperous investing and note that if you wish to see the full report, including the full analysis of all 18 drivers, it can be downloaded via the link below at no cost. All you give is your email and name, which we use to share similarly insightful and valuable reports (no spamming) to advance our authority as an independent research house.

Trial today

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IMG_1116 (640x477)What does it take to identify an impending recession? Obviously, this is an extremely complex question. However, there are at least 10 factors that have had a strong historical track-record of identifying recessions, and below we outline ten metrics to add to your watch-list:

  • Household spending – The amount of money households spend on everyday goods and services is the number one determinant of economic growth. It represents more than half of GDP at 55.7% and is thus a directly attributable indicator and of significant importance to any GDP insight. Household spending changes tend to change instantaneously with the rate of economic growth, however given that consumer confidence tends to go in cycles it is still a useful tool to foresee future recessionary risks.
  • Business investment – Technically called ‘private fixed capital formation’, business investment is a direct line in the GDP calculation and thus has a direct effect on recessionary conditions. Business investment accounts for 20% of GDP so it’s thus seen to be a very important component and indicator for future recessions. Apart from its direct impact, it is also a clear signal of business confidence which has flow on effects for future GDP results.
  • Dwelling formation – Dwelling formation refers to the activities involved in new and used private houses, including alterations and renovations. It now accounts for 5.3% of the entire economy and is thus seen to be strongly correlated with the overall economic growth rate. Similar to household spending, it is seen to be an indicator of consumer confidence and thus has the ability to act as a leading indicator for economic growth. An encouraging signal involves a positive and/or growing rate.
  • Corporate earnings – Corporate earnings refer to the aggregate profitability of businesses and is a data series produced to gauge the health of the corporate sub-set of the economy. If the average company is highly profitable, it makes sense that the overall economy will be expanding. With this logic, we can see a strong correlation between the current status of corporations and the future growth rate of the country. The risk of recession is seen to increase when corporate profitability is deteriorating on average.
  • Yield curve – The yield curve simply refers to the difference in ‘borrowing rates’ on 10 year bonds versus 5 year bonds. If the 10-year bond pays a higher rate than the 5-year bond, this is seen to be normal, however when the opposite occurs it is seen to be the markets way of pricing for a recession. Across the globe, there has been a very strong long-term connection between the shape of the yield curve and the risk of recession. The link in Australia has been relatively weak but remains an insightful measure of risk.
  • Historical GDP growth – It makes intuitive sense that the risk of recession is higher if the economic growth rate is off a lower base. For example, it would seem highly unlikely for a recession to occur from a base of 5% or more, but would be far more plausible to slide into recession from a growth rate of 2% or less. This momentum effect is a powerful force behind economic growth, and for this reason the historical GDP growth rate can be an insightful measure for future recessionary risks.
  • Worker productivity – The driving force behind an economy is the workforce. The more people work, or the more efficient they become, the stronger the economy tends to be. There are many useful measures to track workplace productivity, however the most useful measure tends to be the total number of hours worked as this factors in population growth and demographic changes. A low and/or falling work ethic increases the risk of recession, whilst a growing rate is a positive sign for the future economy.
  • Retail sales – Retail sales is a vital component of household spending and is a very useful measure of the future direction of the economy. If consumers aren’t shopping and money isn’t passing through people’s hands, the economy is unlikely to be growing with conviction.
    If retail sales are falling, there is a reasonably high likelihood that a recession could be impending as consumer confidence becomes dented. History has shown that this connection with GDP is strong.
  • Housing starts – The process to build a house begins with a housing approval or ‘housing start’. This commitment is a clear sign of confidence that the economy will hold up, and marks the commencement of a long list of transactions that eventually push the economy forward. The new housing starts data is subject to volatility, however, if more people are committing to build a new home, more people are signalling their confidence in the economy. This reduces the risk of a future recession.
  • Employment growth – Similar to the workforce productivity indicator, the employment rate is of vital importance for the future prospects of the economy. The total employment growth figure is a more useful measure than the unemployment rate because it accounts for new additions to the workforce. While the employment growth figure tends to have a strong instantaneous correlation with GDP, the indicator has also proven to be an effective measure for future recessionary risks.

Of course, this list is not conclusive and there are an array of other important economic fundamentals that will impact the likelihood of a recession. In reality, there is no such thing as a perfect model, simply because the economy is so dynamic.

Creating a view from the data

Despite the limitations, an individual that wants any form of success should be trying to formulate a view based on the “known-known’s” while acknowledging the inability to predict the future with any precision. On this basis, the Investing Times opens up this research to help its readers, and produces a global recession risk report that is freely available to the public via the link below. This is a value-add service at no cost that covers at least five of the major global economies.

To give readers an idea of what to expect, the chart below is a historical view of the “recession trackers” ability in Australia, with a strong connection between the leading indicators and the future GDP growth rate.

Recession tracker performance

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