Conventional wisdom used to dictate Australians were better paying off their home loans, and then, once debt-free turning their attention to building up their super. But with interest rates ramping up over the past two years, and uncertainty as to when they are likely to reduce, what’s the right strategy in the current market?

It’s one of the most common questions financial advisers get. Are clients better off putting extra money into superannuation or the mortgage? Which strategy will leave them better off over time? In the super versus mortgage debate, no two people will get the same answer – but there are some rules of thumb you can follow to work out what’s right for you.

One thing to consider is the interest rate on your home loan, in comparison to the rate of return on your super fund. As banks ramped up interest rates following the RBA hikes over the past two years, you may find that the gap between home loan interest rates and the returns you get in your super fund has potentially shrunk in comparison.

Super is also built on compounding interest. A dollar invested in super today may significantly grow over time. Keep in mind that the return you receive from your super fund in the current market may be different to returns you receive in the future. Markets go up and down and without a crystal ball, it’s impossible to accurately predict how much money you’ll make on your investment.

Each dollar going into the mortgage is from ‘after-tax’ dollars, whereas contributions into super can be made in ‘pre-tax’ dollars. For the majority of Australians, saving into super will reduce their overall tax bill – remembering that pre-tax contributions are capped at $30,000 from 1 July 2024 and taxed at 15% by the government (30% if you earn over $250,000) when they enter the fund.

So, with all that in mind, how does it stack up against paying off your home loan? There are a couple of things you need to weigh up.

Consider the size of your loan and how long you have left to pay it off

A dollar saved into your mortgage right at the beginning of a 30-year loan will have a much greater impact than a dollar saved right at the end.

The interest on a home loan is calculated daily

The more you pay off early, the less interest you pay over time. In a higher interest rate environment many homeowners, particularly those who bought a home some time ago on a variable rate, will now be paying much more each month for their home loan.

Offset or redraw facility

If you have an offset or redraw facility attached to your mortgage you can also access extra savings at call if you need them. This is different to super where you can’t touch your earnings until preservation age or certain conditions of release are met.

Don’t discount the ‘emotional’ aspect here as well. Many individuals may prefer paying off their home sooner rather than later and welcome the peace of mind that comes with clearing this debt. Only then will they feel comfortable in adding to their super.

Before making a decision, it’s also important to weigh up your stage in life, particularly your age and your appetite for risk.

Whatever strategy you choose you’ll need to regularly review your options if you’re making regular voluntary super contributions or extra mortgage repayments. As bank interest rates move and markets fluctuate, the strategy you choose today may be different from the one that is right for you in the future.

Case study where investing in super may be the best strategy

Barry is 55, single and earns $90,000 pa. He currently has a mortgage of $200,000, which he wants to pay off before he retires in 10 years’ time at age 65.

His current mortgage is as follows:

Barry has spare net income and is considering whether to:

• make additional / extra repayments to his home mortgage (in post-tax dollars) to repay his mortgage in 10 years, or
• invest the pre-tax equivalent into superannuation as salary sacrifice and use the super proceeds at retirement to pay off the mortgage.

Assuming the loan interest rate remains the same for the 10-year period, Barry will need to pay an extra $775 per month post tax to clear the mortgage at age 65.

Alternatively, Barry can invest the pre-tax equivalent of $775 per month as a salary sacrifice contribution into super. As he earns $90,000 pa, his marginal tax rate is 32% (including the 2% Medicare levy), so the pre-tax equivalent is $1,148 per month. This equals to $13,776 pa, and after allowing for the 15% contributions tax, he’ll have 85% of the contribution or $11,710 working for his super in a tax concessional environment.

To work out how much he’ll have in super in 10 years, we’re using the following super assumptions:

• The salary sacrifice contributions, when added to his employer SG contributions, remain within the $30,000 pa concessional cap.
• His super is invested in 70% growth/30% defensive assets, returning a gross return of 3.30% pa income (50% franked) and 2.81% pa growth.
• A representative fee of 0.50% pa of assets has been used.

If these assumptions remain the same over the 10-year period, Barry will have an extra $161,216 in super. His outstanding mortgage at that time is $132,662, and after he repays this balance from his super (tax free as he is over 60), he will be $28,554 in front. Of course, the outcome may be different if there are changes in interest rates and super returns in that period.

Case study where paying off the mortgage may be the best strategy

40 year old Duy and 37 year old Emma are a young professional couple who have recently purchased their first apartment.

They’re both on a marginal tax rate of 39% (including the 2% Medicare levy), and they have the capacity to direct an extra $1,000 per month into their mortgage, or alternatively, use the pre-tax equivalent to make salary sacrifice contributions to super.

Given their marginal tax rates, it would make sense mathematically to build up their super.

However, they’re planning to have their first child within the next five years, and Emma will only return to work part-time. They will need savings to cover this period, as well as assist with private school fees.

Given their need to access some savings for this event, it would be preferable to direct the extra savings towards their mortgage, and redraw it as required, rather than place it into super where access is restricted to at least age 60.

Get in touch

We can help you decide between mortgage repayments and super contributions based on your individual circumstances, life stages, and risk tolerance. Contact us to find the best option for you.

Current as at July 2024

Introduction

It’s often said that shares climb a wall of worry. And with good reason. The next chart shows the Australian All Ords price index since 1900 and despite wars, pandemics, and economic calamities, it’s managed to pick itself up and move on to new highs providing solid long term returns for investors.

Australian shares climb a wall of worry

Source: ASX, Bloomberg, AMP

Shares have certainly climbed a wall of worry lately. Despite numerous concerns about the economic and interest rate outlook, valuations, concerns that enthusiasm for AI may be excessive and geopolitics, global and Australian shares have made new record highs. See the next chart. This has seen the Australian ASX 200 burst through its March record high of 7897 and then the 8000 level, after being below 7000 just last November.

Of course there is no particular significance in the 8000 level, being largely a function of the base date when the share market index was started and at what level making it a rather arbitrary line in the sand. But there is a psychological significance to going through big round numbers which can be referred to as “roundaphobia”, which can have the effect of attracting investor interest to it, possibly serving to push it even higher. The big question though is whether it’s sustainable? The historical experience suggests that it is, if seen as just part of the market’s rising trend over the long term and so it’s nothing remarkable. But what about over the next year?

Australian and global shares

Source: Bloomberg, AMP

Why the strength?

Three related factors have driven the Australian share market above the 8000 level. First, there is renewed optimism about interest rate cuts from the Fed. After hot March quarter inflation data which saw US rate cut expectations cut drastically and talk of possible rate hikes, US inflation has turned down again seeing renewed confidence the Fed will soon cut rates. A US rate cut is now fully priced in for September with nearly three cuts priced in by year end. This follows cuts in Switzerland, Sweden, Canada and Europe. And the Reserve Bank of NZ has pivoted from talking of rate hikes back in May to now talking of rate cuts, which has been reinforced by lower June quarter inflation. Lower interest rates offer the prospect of better global growth in 2025 and they also help improve share market valuations. This has further boosted global shares, pulling Australian shares up.

Secondly, the optimism about the Fed and the RBNZ’s pivot towards rate cuts has in turn led to optimism that the same will apply in Australia and the RBA will avoid another rate hike and head towards cuts. Consequently, we have seen money market expectations swing from around 70% probability of another hike by year end a few weeks ago to now just 16%. This has further helped boost interest sensitive Australian shares.

Number of rate RBA hikes/cuts priced in for the…

Source: Bloomberg, AMP

Just as Australia was part of the global upswing in inflation and rates in 2021-22 there is no reason to expect it to be different on the way down.

Global Inflation

Source: Bloomberg, AMP

Finally, there are signs of a rotation from tech shares which offer the security of high long term growth potential to value & cyclical shares which will benefit from rate cuts and any associated pickup in economic growth next year. This has been most evident in the US with a resurgence in small caps, with the Russell 2000 small cap index up more than 11% in the last week, but it may also benefit the relatively cyclical Australian share market.

Reflecting all this along with a lack of the sort of investor euphoria normally seen at major market tops, our assessment is that the Australian share market likely still has more upside on a six-to-12-month view.

Does this mean relative underperformance is over?

So far this year Australian shares are up 6%, which is good, but global shares are up by 16% & US shares are up by 18%. In fact, Australian shares have been underperforming since 2009. This can be seen in the next chart which compares the relative performance of Australian to global shares since 1970 in terms of: relative share prices in local currency terms (green line); relative total returns with dividends added in (blue line); and relative total returns with global shares in Australian dollars (red line).

Australian shares relative to global shares allowing for dividends and currency movements

Source: Thomson Reuters, Bloomberg, AMP

A rising ratio means Australian outperformance and vice versa. Several things stand out. First over long periods of time and when dividends are allowed for, Australian shares have had better returns than global shares when measured in local currency terms (the blue line). Since 1970 Australian shares have returned (capital growth plus dividends) 10.1% per annum compared to 8.7% pa for global shares in local currency terms. However, the falling $A over this period has enhanced the return from global shares to 10.2% pa which is roughly the same as Australian shares. Second, the swings in the relative performance of Australian shares are apparent if dividends and currency movements are allowed for or not. Since October 2009, when Australian shares peaked relative to global shares after the mining boom of the 2000s, Australian shares have underperformed returning 8.1% pa compared to 11.2% pa from global shares in local currencies or 12.7% pa in $A terms (as the $A fell).

The near 15 year period of underperformance since 2009 reflects a combination of: payback for the huge outperformance of the 2000s on the back of the mining boom; the slump in commodity prices from 2011; the lagged impact of the surge in the $A into 2011; relatively tighter monetary policy in Australia for much of the post GFC period; fear more recently that rate hikes will hit Australia harder due to more indebted households and Australia’s relatively expensive property market; worries about tensions with China and the slowing Chinese economy; and a low exposure to tech stocks – with tech stocks propelling US shares in the pandemic and more recently with AI excitement.

Some of these factors have waned – the 2000s’ outperformance has been significantly unwound, the $A is low and commodity prices appear to be in a new long-term upswing. But some still remain with regards to the relative impact of rate hikes on Australian households and the property market and the outlook for the Chinese economy and AI/tech enthusiasm could still push US and hence global shares up more than Australian shares. So having been too early in anticipating this in the last few years, it is probably too early to be confident that the underperformance is over even though Australian shares offer better medium-term prospects.

What are the main risks facing Australian shares?

There are five key risks facing the Australian share market.

• The RBA may yet still hike again, with June quarter inflation key.
• Valuations are stretched with Australian shares offering their lowest risk premium over bonds since 2010. It’s even less in the US.

Equity risk premium over bonds

Source: Bloomberg, AMP

• The risk of recession remains high, as the full impact of rate hikes is yet to show up due to normal lags and as the economy has been protected to some degree by pandemic savings buffers.
• Risks around the Chinese economy (which takes around 35% of our exports) remain high, with recent indicators showing growth slowing. Policy stimulus could quickly reverse this risk though.
• Geopolitical risk is high – in particular betting markets now put Trump’s chance of winning at 67% at a time when his policies threaten a new trade war far bigger than that seen in 2018 which would threaten global growth and potentially boost inflation. As a small trading nation Australia would be vulnerable.

Concluding comment

The bottom line is that we have revised up our year-end target for the ASX 200 to 8100 (from 7900) reflecting prospects for lower interest rates globally and eventually in Australia boosting the 2025 growth outlook, but in view of the risks around valuations, near term growth and geopolitics, we are not yet prepared to go further. We anticipate a more volatile and constrained outlook with a high risk of a correction in the seasonally weak August/September period, particularly if investors start to factor in the potentially more negative economic implications for a Trump victory.

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

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.

Introduction

Changes in the value of the Australian dollar are important as they impact Australia’s international export competitiveness and the cost of imports, including that of going on an overseas holiday. They are also important for investors as they directly impact the value of international investments and indirectly impact the performance of domestic assets like shares via the impact on Australia’s competitiveness. But currency movements are also notoriously hard to forecast. Late last year it seemed the $A was at last on a recovery path but it topped out in December and slid back to $US0.64. Lately it’s been looking stronger again getting above $US0.67. So maybe the five reasons we thought would drive the $A higher in a note last November (see here) are at last starting to work?

The $A has been weak since the mining boom ended

But first some history. Way back in 1901 one $A bought $US2.40 (after converting from pounds to $A pre 1966), but it was a long downhill ride to a low around $US0.48 a century later. See the blue line in next chart.

The $A is below fair value baed on relative prices

Source: RBA, ABS, AMP

Thanks to the mining boom of the 2000s, the $A clawed back to $US1.1 by 2011, its highest since the 1981. But since 2011, the $A has been mostly in a downtrend again briefly hitting a low around $US0.57 in the pandemic after which there was a nice rebound into 2021 up to near $US0.80 but with weakness quickly resuming. The key drivers of the weakness since 2011 have been: the end of the commodity boom; increasing worries about the outlook for China which takes around 35% of Australia’s goods exports; a narrowing gap between Australian and US interest rates (which makes it less attractive for investors to park their cash in Australian dollars); and a long term upswing in the value of the $US generally. See the next chart.

The $US v major currencies & the $A

Source: Bloomberg, AMP

But there remain five reasons to expect the $A to rise

Back in November we saw five reasons to expect a higher $A. These largely remain valid and the $A seems to be perking up again.

• Firstly, from a long-term perspective the $A remains somewhat cheap. The best guide to this is what is called purchasing power parity (PPP) according to which exchange rates should equalise the price of a basket of goods and services across countries – see the red line in the first chart. If over time Australian prices and costs rise relative to the US, then the value of the $A should fall to maintain its real purchasing power. And vice versa if Australian inflation falls relative to the US. Consistent with this the $A tends to move in line with relative price differentials – or its purchasing power parity implied level – over the long-term. This concept has been popularised over many years by the Big Mac Index in The Economist magazine. Over the last 25 years the $A has swung from being very cheap (with Australia being seen as an old economy in the tech boom) to being very expensive into the early 2010s with the commodity boom. Right now, it’s modestly cheap again at just above $US0.67 compared to fair value around $US0.72 on a purchasing power parity basis.
• Second, after much angst not helped by another US inflation scare, relative interest rates might be starting to swing in Australia’s favour with increasing signs that the Fed is set to start cutting rates from September whereas there is still a high risk that the RBA will hike rates further. Central banks in Switzerland, Sweden, Canada and the ECB have already started to cut rates. Money market expectations show a narrowing of the negative gap between the RBA’s cash rate and the Fed Funds rate as the Fed is expected to cut by more than the RBA. As can be seen in the next chart, periods when the gap between the RBA cash rate and the Fed Funds rate falls have seen a fall in the value of the $A (see arrows – and this been the case more recently) whereas periods where the gap is widening have tended to be associated with a rising $A. More broadly the $US is expected to fall further against major currencies as US interest rates top out.

The interest rate gap between Aust & the US versus the $A

The dashed part of the rate gap line reflects money mkt expectations. Source: Bloomberg, AMP

• Third, global sentiment towards the $A remains somewhat negative, and this is reflected in short or underweight positions. In other words, many of those who want to sell the $A may have already done so, and this leaves it susceptible to a further rally if there is any good news.

$A positioning remains short

Source: Bloomberg, AMP

• Fourth, commodity prices look to be embarking on a new super cycle. The key drivers are the trend to onshoring reflecting a desire to avoid a rerun of pandemic supply disruptions and increased nationalism, the demand for clean energy and vehicles and increasing global defence spending all of which require new metal intensive investment compounded by global underinvestment in new commodity supply. This is positive for Australia’s industrial commodity exports.

Long term bull and bear markets in commodity prices

Source: Bloomberg, AMP

• Finally, Australia’ current account surplus has slipped back into a small deficit as commodity prices have cooled and services imports have risen (particularly, Australian’s travelling overseas) but it remains much better than it used to be over the decades prior to the pandemic. A current account around balance means roughly balanced natural transactional demand for and supply of the $A. This is a far stronger position than pre-COVID when there was an excess of supply over demand for the $A which periodically pushed the $A down.

Aust current account surplus remains in better shape

Source: ABS, AMP

Where to from here?

We expect the combination of the Fed cutting earlier and more aggressively than the RBA, a falling $US at a time when the $A is undervalued and positioning towards it is still short, to push the $A up to around or slightly above $US0.70 into next year.

Recession & a new Trump trade war are the main risks

There are two main downside risks for the $A. The first is if the global and/or Australian economies slide into recession – this is not our base case but it’s a very high risk. The second big risk would be if Trump is elected and sets off a new global trade war with his campaign plans for 10% tariffs on all imports and a 60% tariff on imports from China. If either or both of these occur it could result in a new leg down in the $A, as it is a growth sensitive currency, and a rebound in the relatively defensive $US.

What would a rise in the $A mean for investors?

For Australian-based investors, a rise in the $A will reduce the value of international assets (and hence their return), and vice versa for a fall in the $A. The decline in the $A over the last three years has enhanced the returns from global shares in Australian dollar terms. When investing in international assets, an Australian investor has the choice of being hedged (which removes this currency impact) or unhedged (which leaves the investor exposed to $A changes). Given our expectation for the $A to rise further into next year there is a case for investors to stay tilted towards a more hedged exposure of their international investments.

However, this should not be taken to an extreme. First, currency forecasting is hard to get right. And with recession and geopolitical risk remaining high the rebound in the $A could turn out to be short lived. Second, having foreign currency in an investor’s portfolio via unhedged foreign investments is a good diversifier if the economic and commodity outlook turns sour as over the last few decades major falls in global shares have tended to see sharp falls in the $A which offsets the fall in global share values for Australian investors. So having an exposure to foreign exchange provides good protection against threats to the global outlook.

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

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.