Introduction

Most of the time share markets are relatively calm, but periodically they tumble and generate headlines like “billions wiped off share market.” Sometimes it ends quickly and the market heads back up again. But every so often share markets keep falling for a while. Sometimes the falls are foreseeable (usually after a run of strong gains), but rarely are they forecastable (which requires a call as to timing and magnitude). And now with the US and Israel waging War on Iran its happening again with falls gathering pace as the War drags on. From their record highs earlier this year 7%, Japanese shares have fallen 12%, Eurozone shares are down 11% and Australian shares are down 9%. While the details regarding the current plunge differ from past falls, from the point of view of basic investment principles, it’s hard to say anything new. Which is why this note may sound familiar with “5 key charts for investors to keep in mind”.

The current state of the War and flow on to markets

We are now into the fourth week of the War with no clear sign of an end – despite President Trump’s frequent reassurances that the end is near.

• A problem is Trump indicated regime change was a goal – along with a group of military objectives – and killing of Iran’s leaders and musing about replicating the Venezuelan model appear to confirm this.
• So, Iran took the long-predicted response of attacking regional oil and gas infrastructure and effectively closing the Strait of Hormuz.
• Which in turn has potentially created the biggest oil & energy shock in history given 20% of world oil and gas flows through the Strait.
• This in turn has led to a surge in oil and gas prices which in turn has seen bond yields rise on inflation fears, the expected profile for official central bank interest rates rise sharply and shares fall on fears of higher inflation and rates and weaker growth and profits.
• By declaring that the War would be over “very soon” on 9 March and that he was considering “winding down” the War on 20 March, both after sharp oil price rises, Trump has signalled he can’t bear the full economic and political costs of the War. So just like his tariff TACO back down, many assume he will do the same this time which is why the rise in oil prices and fall in shares has so far been relatively mild.
• But the Iranian leadership shows no sign of waving a white flag and in fighting for survival wants to inflict maximum economic and political pain on Trump – which they know they can do by restricting oil supplies. So this makes it harder to him to do a TACO.
• There are various workarounds to the Strait blockage – Saudia Arabia’s pipeline to the Red Sea, stockpile releases, US naval escorts, Iran letting non-enemy ships through, etc – but its unclear they are enough or will work. Eg the US doesn’t have the capacity to defend every tanker. If Iran lets too many ships pass it weakens its leverage. And the US may not like the idea of Iran deciding who goes through.
• Right now, despite lots of confusing comments from Trump the risk is more escalation – with a consideration of using troops and now threatening to obliterate Iran’s power plants. Iran is threatening more retaliation against energy infrastructure in response.
• Past oil price shocks unfolded over months as the impact became clearer – 4 months in 1973 when oil prices rose four-fold & more than a year in 1979-80 when oil prices rose three-fold. It’s still early days.
• So, the threat of stagflation remains and it’s at a time of various other threats to shares around AI, private credit & stretched valuations.
• Current average capital city petrol prices in Australia of around $2.45 will if sustained add 1.5% to inflation taking it above 5% and add $114 a month to the household petrol bill which along with increasing risks of fuel shortages will lead to a big hit to economic activity.

Our base case is that the War and oil shock will be relatively short as Iran will not be able to keep the Strait closed indefinitely and Trump will look for an off ramp as political pressure builds ahead of the midterms. But it could still go on for weeks yet and so could still see oil prices rise more in the interim say to $US150. We continue to see the risk of a 15% or so correction in shares this year but the size of the threat means there is a high risk it may be deeper. Trying to work out how all this plays out is not easy. But looking at shares around major geopolitical events, the typical playout is for a sharp fall of around 8% but then a recovery over the next 12 months of around 14%. Of course, there are wide ranges around this. Given the uncertainty now is a critical time to stick to basic principles of investing. So, this note revisits 5 key charts investors should keep in mind.

Chart #1 The power of compound interest

This chart shows the value of $1 invested in various Australian assets in 1900 allowing for the reinvestment of dividends & interest along the way.

That $1 would have grown to $278 if invested in cash, to $998 if invested in bonds and to $1,000,977 if invested in shares up till now. While the average return since 1900 is only double that on shares versus bond, the huge difference between shares and bonds owes to the impact of compounding – or earning returns on top of returns over time. So, any return earned in one period is added to the original investment so that it all earns a return in the next period. And so on. Which means higher average returns over time compound into much higher end point values.

Key message: to grow wealth, we must have exposure to growth assets like shares and property that provide higher long term average returns.

Chart #2 Don’t get blown off by cyclical swings

The trouble is that shares can have lots of setbacks, eg, see the arrows on the previous chart. Even annual returns are highly volatile, but longer-term returns tend to be solid and relatively smooth. Since 1900, for Australian shares roughly two years out of ten have had negative returns but there are no negative returns over rolling 20-year periods.

Understanding that these periodic setbacks are just an inevitable part of investing is important in being able to stay the course.

Key message: big short-term swings in shares are normal but the longer the horizon, the greater the chance your investments meet their goals.

Chart #3 The rollercoaster of investor emotion

Investment markets move more than can be justified by moves in their fundamentals, because investor emotion plays a huge part. The next chart shows the roller coaster that investor emotion traces through the course of an investment cycle. Once a cyclical bull market turns into a bear market, euphoria gives way to ultimately depression at which point the asset class is under loved and undervalued and everyone who is going to sell has – and it becomes vulnerable to good (or less bad) news. This is the point of maximum opportunity for investors to buy into an asset at depressed prices. Once the cycle turns up again, depression gives way to hope and eventually euphoria. This is the point of maximum risk.

Key message: investor emotion plays a huge role in driving swings in markets. The key for investors is not to get sucked into this emotional roller coaster. Of course, this is easier said than done, so many investors end up getting wrong footed – by buying at the top when everyone is bullish and selling at the bottom when everyone is bearish (like in April last year on US tariffs, or maybe soon on worries about the oil supplies).

Chart #4 The wall of worry

There is always something for investors to worry about. And this has certainly been the case since Trump returned with his contradictory and confusing utterances. But the global economy has had plenty of worries, but it got over them with Australian shares returning 11.6% per annum since 1900, in a broad rising trend, and US shares returning 10% pa.

Key message: worries are normal around the economy and investments and sometimes they become intense – like now. But they eventually pass.

Chart #5 Timing markets is hard

With the benefit of hindsight many swings in markets around things like the GFC and the 2022 inflation surge look inevitable and so it’s natural to think about switching between say cash and shares within your super fund to anticipate market moves. But trying to time the market is difficult. A good way to demonstrate this is with a comparison of returns if an investor is fully invested in shares versus missing out on the best (or worst) days. The next chart shows that if you were fully invested in Australian shares from January 1995, you would have returned 9.4% pa.

If by trying to time the market you avoided the 10 worst days (yellow bars), you would have boosted your return to 12% pa. And if you avoided the 40 worst days, it would have been 16.5% pa! But many investors only get out after bad days & miss some of the best days. If by trying to time things you miss the 40 best days (blue bars), the return falls to 3.7% pa.

Key message: trying to time the share market is not easy. For most – whether as a super fund member or as an investor outside super – its best to stick to an appropriate well thought out long term investment strategy.

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

Introduction

The RBA’s decision to hike rates to 4.1% means that it has now reversed all but one of the three rate cuts we saw last year, which of course followed 13 rate hikes seen in 2022 and 2023. Once passed on to mortgage holders it will leave mortgage rates around levels prevailing 14 years ago. Of course, it should also mean a slight rise in deposit rates.

In hiking rates again, the RBA noted higher than expected capacity pressures in the economy, some further tightening in the labour market, sharply higher fuel prices due to the War which will add to inflation if sustained, a material risk that as a result of the War inflation will stay above target for longer and that inflation expectations will rise.

While the 5/4 vote in favour of a hike versus a hold suggests a close decision, Governor Bullock indicated that the debate was about timing not the direction of rates.

With the RBA hiking and the money market expecting nearly two more hikes by year end, interest rates in Australia are moving very differently to other major countries. This partly reflects inflation being further above target in Australia than in most other countries, but there is also a risk that the RBA has over-reacted.

The supply shock from the Iran War risks stagflation

As was the case with the 1970s oil shocks the current oil shock is a double-edged sword in terms of its impact on the economy. Of course, the economic impacts may not be as bad as they were in the 1970s because of a sharp 60% fall in the oil intensity of GDP since then. But working the other way, the International Energy Agency has noted that the current event could be the biggest oil supply shock on record if it persists. This is because the hit to oil supplies flowing through the effective closure of the Strait of Hormuz could be at least 15 million barrels a day or 15% of global oil consumption (after allowing for some diversion to pipelines) whereas the second oil shock in 1979, for example, was only a hit to around 5% of oil supply and yet saw a threefold rise in world oil prices. The IEA release of oil reserves (maybe 3.3% of daily global oil consumption), an easing of Russian sanctions (maybe another 1.5%) and Iran allowing ships from non-enemy countries (eg China, India and Pakistan which normally take 7.5% of global oil consumption) to pass through may ease some pressure but not all of it. So, it remains potentially at least as big an oil supply shock as the 1979 oil shock.

In terms of the impact on inflation:

• Petrol prices have already increased by around 35% from their average in February which if sustained implies a direct boost to inflation of around 1.2 percentage points which will take it to around 5% if prices stay around current levels.

• Obviously if oil and hence petrol prices rise further the boost to headline inflation from higher petrol prices will rise. The longer oil supply is constrained the more oil prices risk going even higher and could reach say $US150 a barrel even if the War ends next month. This could add roughly another 50 cents a litre to petrol prices, adding another 0.7% or so to inflation.
• The longer this persist the more there will be some flow through to higher underlying inflation via higher costs for transport (eg airlines and groceries) and products like plastic. Underlying inflation may also be boosted if fuel shortages lead to supply side problems.
• And with Australian inflation already above target and now likely to be more so the greater the risk that this will flow through to higher inflation expectations leading to higher wage demands and business being more inclined to put through bigger price rises. The longer inflation stays above target, and it now looks like doing so for five of the last six years including the present year, the more people will expect it to stay above target and the harder it will be for the RBA to get inflation back down.

So it’s understandable that the RBA is concerned and wants to show that it remains determined to get inflation back to target and not let it spiral higher as occurred in the 1970s partly because central banks at the time, including the RBA, were too lax in trying to head off higher inflation expectations flowing from the then oil supply shocks.

Working the other way though, and complicating the RBA’s job, is the hit to growth from the War which could be big. And weaker growth or demand in the economy will lower underlying inflation.

• Global growth is likely to be depressed by the rise in oil prices if its sustained. Rough IMF estimates suggest that each 10% rise in world oil prices will knock 0.1-0.2% off global growth and so far they are up 50% since the War started implying a 0.75% or so hit to global growth. This would mean less demand for Australian exports.
• The rise in petrol prices in Australia if sustained at current levels will mean a roughly $20 a week rise in the average household’s fuel bill or around $86 a month. It’s now at a record high. This is effectively like a tax hike and along with the $110 a month in extra mortgage interest payments flowing from the latest RBA rate hike (for a mortgage holder with a $660,000 mortgage) on top of that flowing from the February rate hike implies a roughly $300 a month hit to household spending power for those households with a mortgage and a petrol car. And this demographic is far more sensitive to changes in their disposable income than older Australians who may benefit from higher rates on their bank deposits. It’s also worth noting that the value of household debt in Australia is almost double the value of household bank deposits so higher rates cost the household sector far more than it benefits it. While households have been boosting their saving rate it’s hard to see this coming down much given the fall in consumer confidence levels since the War started. So, household spending growth is likely to soften significantly.

• Finally, because Australia now imports 80-90% of its oil products and only has about 30-35 days in reserve we could suffer shortages if the crisis continues for another month as refining countries restrict their exports, as China announced it would do two weeks ago. This worst-case scenario would impose a restriction on economic activity similar to pandemic lockdowns – back to “work from home” for those who can!

All up and depending on how long the oil disruption lasts, the hit to economic activity could knock 1 percentage point of GDP growth and knock the economy back into a per capita recession.

Of course, the War may quickly end in which case the RBA may have reacted prematurely. But the duration of the War and more importantly the restriction of oil through the Strait is a bit of a guessing game with Trump saying it may end soon but in reality, being dependent on Iran which seems to be digging in and Trump now asking other countries for help in reopening the Strait of Hormuz. Our Base Case remains a limited war but that could still take us into April and oil prices could still spike as to $US150 a barrel or so in the interim. Of course, a longer effective closure of the Strait could result in a much bigger impact.

On balance we think that the potential significant hit to economic growth cannot be ignored by the RBA and is a reason why having hiked for two months in a row its now likely to remain on hold for several meetings at least to see how long the oil disruption lasts and to get a fuller picture of the inflationary and deflationary impacts from the crisis.

How can the Government take pressure off inflation?

Another fuel excise cut would just be a band aid solution which as the 2022 experience and the energy rebates show provides no lasting solution once the relieve is removed.

Rather the best approach for the Government would be to deliver on its commitment to announce spending savings, productivity and tax reform packages in the May budget.

Ever since the GFC it seems the global economy is subject to more periodic crises – partly due to the rise of populist leaders and geopolitical tensions. The best way to insulate Australia from this is to make our economy as productive as possible which in turn requires freeing up individuals and business to produce more.

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