Review of 2007 and outlook for 2008

Key points

• 2007 provided a fairly volatile ride for investors with more modest and mixed returns than in recent years.
• 2008 is likely to see weaker global economic growth, however, lower global interest rates should help ensure reasonable, yet constrained, investment returns overall.
• Returns are likely to remain volatile, particularly in the first half. The key risk is a US recession.

The key themes of 2007

The past year has been somewhat messy compared to the previous three years.

• The year was dominated by the US housing slump and related problems in sub-prime mortgages. Cracks first appeared in February, but by August losses in sub-prime related securities had transformed into turmoil in credit markets affecting investors around the world and driving fears of a US recession.
• Growth in the US, Europe and Japan was solid but characterised by increasing signs of a slowdown, whereas emerging countries (led by China) boomed.
• Credit market turmoil saw global interest rates start to fall. This was led by the US.
• Commodity prices remained strong. Oil made it to just below US$100 a barrel, gold rose to near record levels, bulk commodity prices rose, but base metal prices tracked sideways after the previous years’ strength.
• Global underlying inflation was benign, while headline inflation rose due to higher energy and food prices.
• The US dollar (US$) continued to slide on worries about the US economy. This saw the euro reach record levels and the Australian dollar (A$) rise to a 23-year high.

The Australian economy accelerated with growth rising above 4% on the back of strong commodity prices, strong business investment and more tax cuts. This saw underlying inflation pushed back up to 3% which prompted more interest rate increases. Export volumes remained soft and this has seen the trade deficit remain high.

Mixed returns, but okay overall

The cross-currents listed above, resulted in massive second half volatility and contributed to fairly mixed returns.

• Global shares had modest returns overall, helped by reasonable valuations, solid profit growth and takeover activity. Asian shares were again the star performers and Japanese shares were the laggards. A$ strength detracted about 7% from global share returns.
• Australian shares again came in well ahead of most expectations, on the back of solid (albeit slowing) profit growth, reasonable valuations, initial merger and acquisition (M&A) activity and strong fund inflows. Resource shares led the market, but listed property trusts, consumer discretionary and utility shares lagged. Australian shares were caught up in sub-prime related volatility yet were protected to some degree by a stronger economy, minimal bank sub-prime exposure and by greater Asian exposure.
• Bond returns remained modest on the back of generally low yields. Global bonds were helped by a rally in US bonds, while in Australia bond yields rose resulting in capital losses and weak returns.
• Listed property returns were poor, particularly globally, as several years of strong gains left them vulnerable to the impact of higher borrowing costs flowing from the turmoil in credit markets.
• Australian unlisted non-residential property returns remained strong as falling vacancy rates led to rising rents and as investors chased attractive yields.
• Infrastructure had another solid year with 10% or so returns. Private capital returns remained strong.
• Housing provided stronger returns than in the past three years, yet this masked a mixed bag with Perth stalling and Sydney having only modest price gains.

The mixed return profile across asset classes meant overall returns for diversified investors were less than in previous years, but more in-line with long-term sustainable levels.

Investment returns for major asset classes

*Yr to date to Nov. Source:Datastream, Intech, REIA, AMP Capital Investors

Outlook for major asset classes in 2008

The high risk of a US recession, along with the fact that the share bull market is now into its fifth year, means the investment outlook is shrouded in a higher degree of uncertainty than has been the case for some time. However, our assessment is that investment returns will be reasonable. Likely key macro themes are as follows:

1. Global growth will slow but should avoid a hard landing. The risk of a US recession is high at around 40%, but it should be avoided thanks to the corporate sector being in good shape, the US Federal Reserve (Fed) cutting interest rates and the trade sector being likely to contribute 1% to US growth. As such, we expect US growth to slow to around 1% to 2% over the next year. This will likely drag down Europe and Japan which are already slowing. However, growth in the emerging world is likely to remain relatively strong due to strong consumption and capital spending, easy monetary conditions and minimal exposure to sub-prime related problems. Growth in China is likely to slow as monetary policy tightens – but still remain robust at around 10%. During the second half of the year the global growth outlook should start to improve due to lower interest rates.
2. Inflation will fall as global growth slows leading to excess capacity and increased discounting pushing inflation down. Flat to lower oil prices will also help.
3. Slowing growth and receding inflation will see global interest rates fall. US interest rates are likely to fall to 3.5%. Slowing growth is also likely to force Europe to cut rates by mid year and Japan may even lower rates. China is likely to be the key exception.
4. The combination of lower interest rates and cash from surplus countries (e.g., Asia) should ensure reasonable liquidity conditions for investment markets. However, credit market problems will likely remain a drag in the first half of 2008.
5. Commodity prices are likely to be low for the next six months or so due to soft global growth. Renewed strength is unlikely until later in the year when the global growth outlook is expected to improve.
6. Profit growth globally should remain positive, but is likely to slow to around 5% to 8% as growth slows. Conditions for a profit slump are not in place.
7. The Australian economy is likely to remain solid. Growth is likely to slow to around 3.5% as higher interest rates and the strong A$ constrain growth, but it should still be strong on the back of further tax cuts, strength in business investment, a gradual recovery in housing investment and a mild pick-up in mining and rural export volumes. Sub-par growth globally and the strong A$ should lead to some moderation in inflation allowing the Reserve Bank of Australia (RBA) to leave interest rates on hold. Australian profit growth is expected to be around 10% over the next year.

Looking at the major asset classes over the next year:

• Global shares should provide reasonable returns. The first half of 2008 is likely to see volatility remain high as investors continue swinging between worries about a US recession and euphoria at the prospect of lower interest rates. However, conditions should improve in the second half as shares are cheap in absolute terms and relative to bonds, profit growth will slow but is unlikely to slump. Lower interest rates should also help price to earnings multiples rise and the profit outlook should improve later in the year. Asian shares are likely to be outperformers on relatively better growth prospects. US shares are likely to outperform European shares on easier monetary policy and the weak US$.
• The A$ is likely to remain strong on the back of high commodity prices and a rising interest rate differential in Australia’s favour. A spike to parity versus the US$ is likely some time in the year.
• While the Australian share market is likely to be volatile in the first half of the year in response to US worries and Chinese tightening, the trend is likely to remain up. The ASX 200 share index is likely to rise to around 7300 by the end of 2008 due to a combination of reasonable valuations, okay profit growth and solid fund inflows. The normal signs of a major market top are still not present – valuations are not extreme, sentiment towards shares is not euphoric, capital raisings are modest relative to market capitalisation, M&A activity has faded before reaching extremes and the breadth of participation in share market gains remains reasonable. With profit growth likely to be around 10%, capital growth should slow, yet Australian shares should still outperform global shares thanks to a higher dividend yield, the Australian economy being in good shape, local banks having little sub-prime exposure and greater exposure to Asia. Sectors likely to do well include Resources, Banks, Telecommunications and Media.
• Bonds continue to offer subdued returns due to low running yields. However, bonds will offer good protection should the US economy fall apart.
• Listed property may remain constrained in the first half of 2008 by high borrowing costs and US recession worries, but thanks to improved valuations it should have a better year overall in 2008.
• Unlisted non-residential property should provide reasonable returns as the underlying supply/demand fundamentals remain favourable, but scope for further yield contraction is limited.
• The outlook for residential investment is mixed. Affordability is poor, Australian housing is very expensive, rental yields are low and interest rates may rise further. Against this, there is an undersupply of housing, rental vacancy rates are very low and rents are rising. Thus, average housing returns are likely to be reasonable.

Overall, our return expectations suggest a gain of 9.5% for diversified growth investment strategies in 2008.
A US recession is the big risk?

If we are wrong, it is likely to be due to a US recession as the US housing slump spreads. A US recession would mean a slump in US consumer and investment spending which are more import intensive than housing and would thus drag down the rest of the world (including Asia risking a bear market in growth assets).

Conclusion
While 2008 will be volatile, returns should be reasonable due to okay valuations and as global interest rates fall.

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