The Experts

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David Bassanese
Expert
+ About David Bassanese

David Bassanese is one of Australia’s leading economic and financial market analysts, who has authored several investment books and works in a number of advisory roles.

David is Chief Economist at BetaShares, which involves providing economic and investment portfolio advice to both retail and institutional investors. David is also an economic advisor to the National Institute for Economic and Industry Research.

Prior to these roles, David was Economics Commentator with The Australian Financial Review, where is regular “Bassanese” column appeared three times per week, as well as monthly in Smart Investor Magazine.

David’s analysis and commentaries cover local and international economic trends, interest rates, the exchange rate, and share market analysis.

Prior to becoming a Fairfax business columnist in 2003, David spent several years in financial markets as a senior economist and interest rate strategist at Bankers Trust and Macquarie Bank. David started his career at the Federal Treasury in Canberra, after which he spent several years as a research economist at the Organisation for Economic Cooperation and Development in Paris, France.

David has authored two e-books: The Australian ETF Guide: cheap and easy investment strategies using exchange traded funds (ETFs), and The Australian Investor’s Guide to Asset Allocation.

David has a first class honours degree in Economics from the University of Adelaide, and a Master in Public Policy from the J.F Kennedy School of Government at Harvard University.

Why have Australian stocks outperformed our global peers?

Wednesday, July 11, 2018

As is often the case, a look back at financial market performance can throw up a few surprises. And given Australia’s generally sluggish economy and the intense global focus on the power house United States economy in recent times, it may surprise some investors to know the overall stock market did not do too badly last financial year.

In fact, our often-maligned large cap stocks - as covered by the S&P/ASX 200 Index - returned a respectable 13% over the past financial year. Our market even outperformed many of our global peers, with the S&P Global 1200 Index returning 11.5%.

As you’ll see, this result is a testament to the increasingly diversified range of success stories across our economy, partly due to our maturing relationship with China. 

For starters, note our market held its own even though the global technology sector went on another tear, with the S&P Global technology sector returning 27% over the year.  Technology accounts for around 15% of global stock market capitalisation overall, but only a paltry 1.4% in Australia. So while our technology sector did even better than global peers (returning an impressive 32%), our lack of exposure to this booming sector handicapped our performance. 

But even in this albeit tiny sector of the stock market, there are some shining successes with WiseTech Global, Xero, NextDC, REA Group and CarSales.com all producing strong returns last financial year. 

Along with our underweight technology, also hurting relative performance last financial year was the financial sector.  Our market just so happens to be overweight one of the sectors that underperformed globally last year, with the global financials returning 5.4%.  Our market has a 35% weight to financials, compared to only 17% globally.  Adding insult to injury, our financial sector even underperformed global peers, returning only 1.6% as slowing credit growth and shocking revelations stemming from the Banking Royal Commission weighted on investment sentiment.

Using an analysis called “shift-share” to compare our performance to that of the world, we can say that our underweight to the strongly performing technology sector and over weight to the weaker performing financial sector created a negative “industry mix effect”.  

So far, so bad.  So how did we manage to punch out a world beating return?

We can put this down to the fact that several other sectors managed to produce much stronger returns than their global peers.  Again in the shift-share jargon, we enjoyed a positive “industry competitiveness” effect.

For example, our energy sector surged forward, returning 42%, compared to only a 7% return globally. Ditto our materials sector (including our major miners), which returned 30%, or almost twice the 16% return from the global materials sector. This outperformance across the resources sector appears to reflect our exposure to commodity and energy producers in particular, which have benefitted from strong coal and oil prices especially.

But two other standout sectors are far removed from mines, oil and gas wells.  The consumer staples sector also returned a whopping 30% last year, far outstripping the global return index which declined by 1%.  And for this we can probably thank China’s broadening interest in our non-mining products, such as processed food, health and beauty products.  A2 Milk, Bellamy’s, Costa Group and Blackmores all chalked up very strong returns of between 50% to almost 200%.

The other standout sector was health care, which returned 28%, and again outstripped the global health care benchmark which only returned 6%.  And here we can cite the usual suspects as star healthcare performers, including CSL, Resmed and Cochlear. Our leading health care companies retain strong market positions in booming markets around the world and the local value of the offshore earnings have also been helped weakening trend in the Aussie dollar.

On a less positive note, our telecommunications sector did drag the chain, dropping 30% (thanks Telstra!) compared to only a 3% drop among global telecommunications companies.

Overall, however, it should be apparent that while financials – and to a lesser extent resources - continue to dominate our share market, we’ve enjoy a range of success stories in other areas such as technology, health and consumer goods. It’s just a shame the latter don’t play as big a role in our overall market!

 

 

At the whim of that man

Wednesday, June 27, 2018

By David Bassanese

Try as we might, we just can’t seem to get away from thinking and worrying about Donald Trump. In all my years analysing global markets, never have I had to worry so much about the erratic actions of the most important person in the world, the President of the United States of America.

Today we all do.

The shame is that global economic indicators are otherwise doing fairly well. Indeed, the best global macro news in recent months is the fact that US wage and price inflation has remained fairly contained, such that it still seems likely the US Federal Reserve will not need to ratchet up interest rates too far, nor too fast, anytime soon.

Meanwhile, thanks in part to Trump’s tax cuts late last year, the US earnings outlook remains robust. Strong earnings and the pull back in share prices since January have left equity valuations at more comfortable levels. To my mind, stocks would be poised to shake off their recent correction and re-test old highs were it not for the lingering risks surrounding that man.

As I stated a few months ago, my base case has been that Trump would not be boneheaded enough to persist with his trade crusade were it to start to seriously risk the US economy and/or the share market. But that view is beginning to be seriously tested, because China and Europe have promptly retaliated, and Trump has upped the ante by threatening even more tariffs.

As Trump may be now discovering, unlike in the sphere of business where companies will suck it up if their opponent presses an advantage and it makes financial sense to do so, countries are ruled by politicians where national pride usually take precedence - even at the risk of short-term economic costs.

As a result, China and Europe are not buckling and seem prepared to see if Trump is bluffing.  Although China exports more to America than it imports (so can’t levy as many tariffs) it can still frustrate US trade in far more effective and insidious ways through investment restrictions or more onerous red tape on US companies operating within its borders.

As for Europe, all it needs to do is surgically impose tariffs on goods from politically sensitive US regions, like Harleys and Whisky. Already, Trump has started picking a fight with Harley Davidson, who says it may shift some production to Europe to avoid new European tariffs.

This trade war is not so easy to win after all.

As I’ve long maintained, America has legitimate trade and national security concerns (as do we) that do require careful review of investment policies and vigorous pursuit of restrictive practises in negotiated trade deals. But while seemingly popular with his political base, blanket tariffs are the wrong way to go and hurt America has much as their trade allies. Indeed, despite what Trump says, it’s not foreign countries that pay US tariffs – it’s US consumers and business.

At this stage, it’s not the tariffs per se that pose risks to the global economy – given they still cover only a relatively small portion of total trade flows between these major economies. But it’s the persistent negative headlines and ongoing uncertainty over just how and when the tit-for-tat dispute will end, that is causing the greatest risk to both business and investor sentiment.

What’s especially frustrating for markets is that Trump has just unilaterally imposed tariffs, while issuing vague complaints about restrictive trade practises in China and Europe. It would help if he listed specific grievances that could at least be the focus of negotiations at agreed meetings on specific dates.  But markets as yet have no specific meetings or dates to focus on.

Trump can change, and often on a dime. After copping some political heat, he promptly abandoned his policy of forced separation of children from their asylum-seeking parents at the Mexican border. And he’s now great friends with the leader of North Korea.  I still hold out hope that sanity will eventually prevail on trade as well.

But until such time as there is greater clarity over a possible negotiated settlement it will be hard for markets to make any gains, and the risk of a steeper drop intensifies.

Sometimes, unfortunately, markets conditions need to get worse – so as to goad politicians into corrective action – before they have a chance of getting much better.

 

Will further global growth be a bad thing?

Wednesday, June 13, 2018

 

There are many in the market who fear that global and Australian economic growth could speed up over the coming year, causing an undue rise in inflation and interest rates.  These are the gold bugs and those that would have you buy inflation-indexed bonds or even Bitcoin.

At the same time, there are those who continue to constantly fear global recession is just around the corner, and prefer holding cash or even low yielding fixed-rate government bonds.

Where do I stand?  What I’m about to say Is somewhat less exciting, but it’s probably the best news that investors could possibly hear this far into a long post financial crisis global economic expansion and equity bull market.

My answer is: none of the above. Indeed, perhaps the word that best describes the current economic environment is “gradualism”.  There’s a good chance that we’re be able to enjoy a “steady as she goes” growth path that promises to get neither too hot not too cold for some time to come.

And to my mind, a key reason will be a rotation in growth from what has been based on low productivity and employment, to higher productivity and business investment as labour markets tighten around the world. 

According to the International Monetary Fund, global growth reached 3.8% last year, the strongest since 2011.  Growth is both robust and reasonably broad based, with the United States, Europe, Japan and China all doing well. But the IMF does not expect global growth will accelerate much further.  Indeed, it expected global growth of 3.9% both this year and in 2019.

That’s consistent with what RBA Deputy Governor Guy Debelle noted in a recent speech “while the [global] recovery is synchronised, to date we haven't seen it accelerate in any meaningful way.”

And that’s a bit different than what history would suggest.

As Debelle added, “synchronised growth cycles have tended to be self-reinforcing, leading to a continuing pick-up in growth. Today, growth in most economies is good, often a little above trend. But no economy is growing that much above trend.”

What’s holding growth back? Debelle believes it’s due to lingering business caution with regard to investment following the devastating global financial crisis.  I’d add the fact that potential rates of economic growth also appear to have slowed – reflecting subdued labour productivity and slowing work-force growth to population ageing.

Indeed, moderate global growth in recent years has still seen rates of unemployment decline to an extent that spare labour capacity in many markets has dried up.

Of course, as some fear, emerging worker shortages could lead to higher inflation as companies compete for scarce labour.  But this is where the great rotation kicks in.

So far at least, what appears to be emerging is not a strong lift in wages but a steady lift in investment. To an extent this may reflect investment in labour saving technologies – or “capital deepening” as business themselves find they can’t raise prices as easily they used to pay for a higher wage bill.  Indeed, global business investment did finally pick up last year and was major factor behind the acceleration in global growth.

Stronger investment and productivity could still end up boosting wages, but in a much more beneficial way for economic growth that need not create undue upward pressure on consumer price inflation.

Australia is not immune to these trends. Indeed, over recent months employment growth has started to slow even as there are gathering signs of a lift in non-mining business investment.  Indeed, last week’s national accounts revealed an encouraging lift in non-mining investment, particularly areas like health care. 

A rotation in economic growth – some areas slowing, while others speed up – could help prolong both the Australian and global economic expansions.  It may be less exciting but likely more beneficial to investor portfolios.

 

 

China is the biggest risk to Australia's economy

Wednesday, May 30, 2018

What is the single greatest risk facing the Australian economy over the next 10 to 20 years?

Some might argue its climate change, or population ageing.  Some might even say house prices, or household debt – yet again.

But as I contemplate our future, I can’t help coming back to a sobering conclusion: it’s China.

Reserve Bank Governor Phillip Lowe recently outlined many of the immediate financial risks facing China given its continued strong growth in debt. 

This debt has largely reflected growth in credit from lesser regulated parts of the financial system, once household savers became freer to chase higher returns outside of the formal banking sector. Much of the money has gone back to the usual suspects – state owned enterprises and local governments desperate for funds to keep their loss-making activities afloat. And some of the money has still come via state owned banks, albeit in more indirect ways.

As has been the case in other countries, the first stages of financial deregulation can often give rise to an explosion in leverage and asset bubbles due to the early inexperience of both borrowers and lenders. China’s challenges are all the greater because of the strong lingering role state owned banks and enterprises and their dulled economic incentives.        

Indeed, given this debt has been important in driving China’s economic growth, it’s far from clear China can reign in it in and transition the economy to less debt-intensive economic activity (like private services) all while retaining strong overall political control.

Lowe remains hopeful that China could rise to the challenge, but he nonetheless noted “the experience is that the build-up of financial risks like those seen in China is almost always followed by a marked slowdown in GDP growth or a financial crisis.” 

Of course, Lowe offered that China at least had the benefit of being able to “learn from the experiences of other countries” – including Australia, which had its own corporate debt bubble in the late 1980s after the financial system was first deregulated. But he added China task was also  “more complicated” due to the structural need to also shift financing from large State owned enterprises and local government to more privately run small and medium enterprises.

More broadly, therefore, the key concern appears to be that state owned enterprises, and Government direction of economic activity still play a major role in China.  And in case anyone hasn’t noticed, the Chinese Communists party’s grip on not only political power, but the levers of economic activity has recently been getting tighter, not looser.

And while this continued heavy reliance on top-down direction is probably irresistible in a one-party State, it does seem increasingly at odds with the need for a more flexible, dynamic and entrepreneurial economy.  Indeed, the need for greater bottom-up dynamism is becoming increasingly important as living standards rise, and China loses its low cost competitive edge as the “workshop of the world.” It’s a challenge that has often been called the “middle income” trap faced by other developing economies, and many have failed to make this leap forward.

 It’s this tension that I fear will gradually build over time and potentially reach breaking point. No country in history has managed to combine dynamic efficient capitalism with one party control.  I hope China can become the exception, but history does not given me a lot of confidence. 

What’s more, should China ever move toward a more democratic system smoothly or otherwise – and I’m not necessarily advocating it should – it would likely lead to years of wrenching economic and social upheaval not unlike we’ve seen across Eastern Europe, Russia and even the Middle East.

China's leaders are understandably worried about letting the democratic genie escape the bottle! 

One risk is that if the economy does gradually falter, China’s political elite will attempt greater nationalist diversions, such as sabre rattling across the Pacific. Another risk is a Trump-like tightening of its already imposing trade barriers.

All up, while Australia is right to engage with and hope for China’s continued economic progress, we should not be blind to the risks and challenges this latest “miracle economy” will increasingly face in the years ahead. 

 

The reality of Australia's economic growth story

Wednesday, May 16, 2018

 

Both the Federal Treasury and the Reserve Bank of Australia have recently released updated outlooks for the Australian economy which continue to paint a fairly encouraging picture.

The good news is that the growth we’ve seen has come from a variety of sources.  The bad news is, that has still not been enough, given all who want decent jobs with decent wages. What’s more, to my mind there still seems more downside to the upward risks to growth as we head into the new financial year, despite the cheerleading from our leading economic boffins.

Note both the Treasury and RBA estimate the economy is likely to have grown by 2.75% in the 2017-18 financial year, which is about to end in just over a month’s time.  That’s a nice step up from the measly 2.1% growth in 2017-16, and reflects both a modest accelerating in consumer spending growth (from 2.6% to 2.75%), and stronger business investment (from a decline of 4% in 2016-17 to growth of 4.5% this financial year) as the decline in mining investment slowed, and non-mining investment finally rebounded. 

Meanwhile, growth in exports, dwelling construction and public demand actually slowed this financial year.

Indeed, one of the surprise developments over recent months has been an upward revision to consumer spending in 2017 – households were actually spending up a bit more than we initially thought. That seems a little more in keeping with the very robust pace of employment growth last year.

As Treasury noted in the Budget papers, a record 415,000 net new jobs were created in 2017, three-quarters of which were full-time jobs.  Digging deeper, one third of these jobs were created in the health care and social assistance sector (Australia’s biggest sector employer), reflecting strong growth in aged-care services due to population ageing and the rollout of the National Disability Insurance Scheme (NDIS).

The construction sector accounted for one fifth of the new jobs, reflecting ongoing high levels of home building activity, public sector infrastructure projects (roads, rail and the NBN), and a lift in construction of hotels (responding to strong tourism), aged-care facilities (population ageing), and offices in the strongest states of New South Wales and Victoria.   

Despite tales of woe in the retail sector, it was actually the third strongest sector in terms of new jobs growth last year – adding almost as many new workers as the construction sector.  In turn, that also likely reflects ongoing strength in tourism.

 

Source: Budget Papers, May 2018

In essence, the economy has been enjoying a diverse range of growth drivers – tourism, home building, aged-care, disability services, and public infrastructure. But thanks to rising labour force participation, strong immigration, and the fact many new jobs are being created in the lightly unionised service sectors like retailing and social assistance, all this growth has not been enough to see a decent decline in underemployment, and a decent rise in wage growth.  And even today, both the Treasury and RBA can only point to “pockets” of labour market tightness in areas like construction and technology, suggesting broader based wage gains seem unlikely anytime soon.    

Of course, the good news is that this means the RBA is also unlikely to raise interest rates anytime soon, and the economy still has good capacity to growth even more strongly without causing undue inflation.

On this score, our economic boffins do reckon conditions could get even better next year – Treasury expect growth of 3% in 2018-19, and the RBA is even more bullish with growth of 3.25%.

Only Treasury provide more detail on their economic forecasts – and their numbers suggest much of the extra strength will come from higher exports (services, LNG and iron-ore) a brief rebound in housing construction (reflecting stronger approvals in mid-2017), and a further slowing in the rate of decline in mining investment. 

Notably, public demand and non-mining business investment are both expected to slow a little next financial year, while consumer spending (most critically) is expected to keep up the reasonably solid pace of growth seen this financial year.   

Where are the risks? Business confidence is strong, so non-mining investment could surprise on the upside.  Meanwhile, probably the biggest downside risks remains consumer spending and housing construction.  Consumer spending could easily slow with weaker expected employment growth, and especially give the ongoing softening in Sydney and Melbourne house prices.  A post-Royal Commission tightening in bank lending standards could also undermine both house prices and housing construction.

 

 

Do the latest inflation figures mark the end to this bull market?

Wednesday, May 02, 2018

Be alert but not alarmed.  Slowly but surely, it appears that inflation pressures in the hottest and most important country on the planet – the United States – are finally starting to lift.

Only last week it was reported that America’s employment cost index grew by a slightly stronger than expected 0.8% in the March quarter, to be up 2.7% over the past year. It was the fastest annual pace of growth since the financial crisis.

At the same time, the US Federal Reserve’s target measure of inflation – the core private consumer deflator – lifted to an annual rate of 1.9% in March from only 1.6% in February. That’s tantalisingly close to the Fed’s target of 2% inflation. And overnight, a key manufacturing gauge revealed a continued very strong pace of activity and a leap in cost pressures – the latter partly blamed on new steel tariffs affecting some imports.

If this gets out of hand anytime soon, it could easily spell the end of the long global bull market we’ve enjoyed since emerging from the financial crisis of 2008.

The reason is that higher inflation will force the hand of the United States Federal Reserve into raising rates more aggressively than it is currently promising. In turn, that would place downward pressure on Wall Street equity market valuations – which have been allowed to linger at above-average levels in recent times only because of exceptionally low interest rates.  Higher interest rates would also help slow the economy and corporate earnings.

All up, a more aggressive Fed would bring on a classic “inflationary” end to an economic expansion and bull market – the likes of which we’ve not seen since the 1980s.

Fearing this prospect, US 10-year government bond yields have already leapt from around 2.5% at the start of the year to a recent breach of 3%.  Amercia’s S&P 500 price-to-forward earnings ratio has scaled back from the lofty height of around 18.5 in mid-January (compared to an average since 2003 of 14.7) to around 16.5 as at end-April.

Wall Street would have fallen further in recent months were it not for the strength in corporate profits over the first quarter of this year, thanks in large part to the Trump tax cuts.

So how bad is the current situation and what are the risks?

The good news is that, so far at least, the rise in both US wage and prices pressures has remained fairly gradual. As seen in the chart below, annual growth in America’s employment cost index – especially for the private sector – has been grinding higher for several years. Wage inflation on this measure is still below the rates of around 3.5% seen just before the 2008 recession.  That said, based on its current trajectory, wage inflation could reach that pace around this time next year.  

 

Similarly, although consumer price inflation has spiked higher of late, it has been more volatile over recent years with as yet no clear upward trend.  But again, were inflation to consistently push beyond 2% - as last seen over 2006 and 2007 – the Fed would likely decide it needs to not only take its foot off the accelerator a little more quickly, but possibly tap on the brakes.    

My view remains that these are more risks for 2019 than 2018, but it underlines the importance that investors need to keep a close eye on the US inflation outlook over coming months.

One way or another, all bull markets eventually end and US inflation seems as likely a culprit as any other to cause the next downturn.

 

Will the RBA raise rates later this year?

Wednesday, April 18, 2018

Could the Reserve Bank be planning an interest rate hike later this year, perhaps on the day that traditionally stops everyone across the nation except those on the RBA Board – Melbourne Cup Day?

Maybe, just maybe.  

Indeed, just when every economist around the country was prepared to write-off yesterday’s release of the RBA’s minutes from its recent policy meeting as nothing new, the Bank saw fit to drop an added line into the commentary – and one that Governor Lowe has been at pains to raise in recent months.

Just so there’s no confusion, the Bank indicated “[Board] members agreed that it was more likely that the next move in the cash rate would be up, rather than down.

What could cause the RBA to lift rates?  It was indicated in the very next sentence ”as progress in lowering unemployment and having inflation return to the midpoint of the target was expected to be only gradual, members also agreed that there was not a strong case for a near-term adjustment in monetary policy.

In short, what we’ll need to see is further declines in the unemployment rate – potential to around 5%, and ideally some lift in inflation to at least be comfortably at or above the RBA’s 2 to 3 % target band.  

Yet based on the RBA’s current forecasts, it’s still hard to see a strong case for a rate rise this year. In its February Statement on Monetary Policy, the RBA forecast the unemployment rate would end the year only a bit lower, at 5.25% (from around 5.5%), and that annual underlying inflation would hold steady at around 1.75%. 

Underlying inflation has averaged only 1.6% on an annualised basis over the past two quarters.

Yet the Bank only indicated it saw no need to lift rates in the near term.  What’s the near term?  One year, two years or six months?  It’s hard to know for sure.

One explanation for the RBA’s warning is that it’s very conscious that it has not raises rates in a very long time - seven years to be exact.  And so as the Governor himself acknowledged recently, when that fateful day does arrive it will “come as a shock to some people”.

What the RBA may be trying to do is jawbone very early to minimise this risk, or at least reduce the risk of any unwary borrowers taking on a lot of debt in the mistaken belief that interest rates will stay low forever. 

The RBA is telling us, ‘don’t say you weren’t warned”.

Along these lines it’s also likely that the RBA is very encouraged by the so far orderly correction in once red-hot Sydney property prices – even without it having to touch the interest rate lever.  It’s probably hoping this correction continues and it would be uncomfortable if cheaper prices and less frenzied buying conditions quickly goaded a lot more supposed “bargain hunters” back into the market.  Indeed, recent home lending numbers suggests there’s already been some stabilisation in investor property demand so far this year.

Supporting this view is the RBA’s willingness to warn of further property declines ahead. Indeed, in the minutes the Bank noted Sydney prices “had declined by a little under 5 per cent since their peak in mid 2017.” But it added “members also noted that declines in housing prices of around 10 per cent in some cities had occurred several times over the preceding 15 years.”

Of course, if the economy is stronger than expected this year, a rate rise is still possible – especially if higher US interest rates and weaker iron ore prices finally cause the $A to fall closer to around US70c.  But I’m still not counting on it at this stage. I still feel that despite the RBA’s recent rumblings, persistently weak wage growth and intense competition on retail prices will keep inflation contained and the Bank sidelined this year. 

The RBA is barking, but I still doubt it will bite anytime soon.

 

Is Trump's 'trade war' careful economic planning?

Wednesday, April 04, 2018

It’s just as well that United States President Donald Trump is creating mayhem for markets with his erratic Twitter outbursts and threats to the world trading system.

After all, this is preventing global equities from simply 'melting up' in what would otherwise be a purple patch for the world economy, given synchronised global growth, strong corporate earnings and still low inflation and interest rates.

Trump is providing pit stops for still doubting investors to get on board before the bull market roars ahead for another lap.

Of course, I’m being slightly flippant – but the fact is that were it not for the Trump tirades, global markets would still be looking for another excuse to pause for breath after a furious rally over the past year.

Indeed, for a brief moment in January, in light of the Trump tax cuts passing Congress, it appeared everyone was suddenly bullish and we were finally entering into a potentially dangerous 'melt up' scenario for stocks.

That eventually ended when we did get one (non-Trump) related macro scare two months ago –a surge in US wages growth in the January payrolls report.  

But the February report suggested that was just a rogue number and US wages remained fairly benign.  We’ll get an update on US wages for March this Friday, but I reckon they’re likely to remain contained due to reduced worker bargaining power caused by globalisation and technology. 

That brings us to Trump. Just when it seemed stocks would regain their mojo, the world’s most important person saw fit to escalate trade tensions through tariffs on steel and Chinese imports.

It begs the question: is Trump truly crazy enough to think he could win a protracted trade war (which he can’t), or is his merely part of a negotiating strategy to effect change his way – or at least be seen to be effecting change amongst his rust-belt support base?  

In a sense, Trump is right to target China – it’s been dumping its persistent steel glut on global markets for years, which has indirectly lowered global prices and hurt US producers. And American patents, brands and trademarks are routinely copied by Chinese producers in flagrant disregard for world trade rules. 

As have other Presidents, Trump could have ignored this – out of fear of upsetting China. Or he could have quietly sought legal redress through the World Trade Organisation – which might take years and achieve very little.

That’s not his style.  Irrespective of whether his concerns are sincerely held or merely political grandstanding, the WTO route could not achieve his aims.

But unless he is completely unhinged, he must also know a protracted dispute with China could sink stocks and the economy – and do more damage than good for him politically.

That’s why I suspect that – as we’ve seen with North Korea of late – he’ll soon try to open a dialogue with China on trade issues and attempt to claim at least some type of victory. 

As for this hardline advisers, they could be merely part of his attempt to make his threats appeal real.  

In short, to believe Trump will risk derailing the bull market and America’s glorious economic expansion with an escalating trade war (for marginal long-term economic benefit) is to believe he is truly irrational. That’s possible, but certainly counter to his career so far. We can fault his methods, but let’s not forget he is a billionaire and did win the US Presidency having never held political office in his life.

Assuming Trump’s not crazy, then it must be the case that this latest threat to the bull market will also soon pass.  That would then leave US inflationary pressure as the greatest lingering risk to the bull market – but a risk which I also don’t think will flash red until at least mid/late 2019 at the earliest.

 

 

How will Labor's tax changes affect Australia?

Wednesday, March 21, 2018

There are many implications that arise from the Labors party's policy proposal to abolish the cash refunds on dividend imputation credits, though the overall effect on the share market and economy may not be as great as some people claim. 

For starters, Labor's desire to further tinker with the already overly complex superannuation system is further evidence that "regulatory risk" in this area remains a persistent problem for Australians trying to plan for their retirement.  

Simply put, no-one should rely on the current - admittedly still relatively favourable - tax treatment of retirement earnings to continue indefinitely.  The revenue cost to the budget as the population ages - not to mention other pressures on the budget - will simply prove too great over time.

Of course, we can complain loudly about this, but I fear it will be to no avail.  

Indeed, even before Labor let fly with its latest proposal, we know the Treasury was actively considering ways of reigning in the cost of dividend imputation.  

And even the Turnbull Government has not been above slugging retirees with higher taxes, though the $1.6 billion cap on super balances that can earn a tax free income.  It also lowered the amount of assets retirees can have before they lose access to the pension.

To politicians, Australia's retirement system is like a large piñata filled with revenue - and every now and again they belt it with a stick to draw out a few more dollars.

How will Labor's policy affect the economy? For starters, for the vast bulk of Australian investors, the benefits of dividend imputation credits will remain in place - as credits can still be used to reduce tax that would be otherwise payable.  

Even if we accept Labor's figures that cash refunds cost the budget around $5.6 billion a year, the total cost of dividend imputation credits is around $30 to 40 billion.  

So we're talking about a tax change that affects around 15% of the dividend imputation system.  What's more, some suggest Labor's proposed budget savings are likely an over estimate, as it ignores the probability that many investors will be able to restructure their finances to still make maximum use of imputation credits where possible.

One obvious move is it ensures any investments attracting dividend imputation credits are held outside of the $1.6 million tax-free super cap if funds are sufficient - as they can still be used to reduce tax payable elsewhere. 

Due to this limited impact, and the still attractive income returns available on Australian shares, I also don't buy the argument that Labor's proposed change will lead to drastic changes in savings behaviour.  

Some suggest, for example, that it will encourage more Australians to invest offshore, or invest in riskier high-yield bonds. Yet dividend yields on international shares are still generally a lot lower than in Australia, even without the benefit of dividend imputation. Ditto -the yield available on most even high risk corporate "junk bonds."   Emerging market and high yield global corporate bond exchange traded funds (ETFs) available in Australia currently offer a yield to maturity of just over 5%. 

What's more, even if investors did make the switch, it's not clear to me that investing in a diversified bond fund - even one exposed to emerging market or higher risk corporates - would be significantly more riskier for those in retirement than investing in equities. 

In terms of the economy, moreover, there's an argument that our system of dividend imputation may not be as favourable as some suggest.  

Sure, it does remove the double taxation of corporate profits. And it does mean investing in shares is attractive for many investors and thereby gives Australian companies a ready pool of available capital.  

But by making dividend payments so attractive to investors, it also effectively increases the "hurdle rate" required for companies to justify retaining profits and investing in further growth of the company.  

As it stands, dividend payout ratios in Australia are now relatively high by global standards.  

In a speech last year, Deputy RBA Governor Guy Debelle noted a lift in corporate conservatism in recent years and suggested "there appears to be a desire to have 'excess' capital returned to shareholders through buybacks and dividends, rather than utilising that capital for investment with uncertain returns." 


 

As regards Labor’s policy, however, its focus on abolishing cash refunds appears to be based on the argument that while corporate profits should not be double taxed, they should at least be taxed once. The current policy of offering cash refunds effectively means a chunk of corporate profits – paid to those without offsetting tax liabilities – is not taxed at all. 

The problem with Labor’s policy, however, is that by seeking to focus on cash refunds, it effectively discriminates against those retirees on still relatively low incomes that have benefitted from these handy ATO cheques – whereas those retirees with higher incomes and tax payable won’t be affected.  In that sense it’s unfair, as a few case studies in our national papers can attest.  

And the fact that other case studies reveal how generous the current system is for those retirees on high incomes does not negate this inherent new unfairness in Labor’s policy. 

All up, Labor’s latest whack at retirees only highlights the need for a complete review of Australia’s tax and retirement system to shore up its fairness and cost sustainability – rather than the current piecemeal “whack the piñata” approach.

Only in this way may retirees have greater certainty over the retirement policies they’ll face in the future. 

 

Why we should abolish the company tax rate

Wednesday, March 07, 2018

Having supported the case for corporate tax cuts only a fortnight ago, I was intrigued by an intervention into the debate by none other than Magellan Financial Group’s Hamish Douglass this week at the Australian Financial Review’s latest Business Summit. 

Even more interesting was the response by the CEO of BHP Billiton Andrew Mackenzie sitting right next to Douglass, which only highlighted just how hard decent corporate tax reform in this country will prove to be.

To my mind, their exchanges only solidified my long-held view that we need to think much more boldly in Australia before it’s too late, and scrap the archaic concept of corporate income taxation altogether.

But first to Douglass.

As I’ve previously conceded, on balance the research evidence suggests that a corporate tax cut from 30% to 25% as advocated by the Turnbull Government would likely be a net benefit to the economy.  According to modelling, the net gain for gross national income of around 0.6% or $450 in per capita income. 

Fair enough, but Douglass reckons the change in tax rates would remain so relatively incremental that he doubted it would lead to much profound change in business behaviour – such as lifting business investment and (most critically) wages.  On that score, I’d have to agree.   Although on paper we’d all on average be a little bit better off, we’d probably hardly notice it.

Instead, Douglass’ idea is a dual corporate tax system which gives business the choice of either sticking with the current system, or accepting a cut in tax to 15% in exchange for giving up the ability to offer dividend imputation credits to their shareholders.

As Douglass noted, foreign companies – to the extent their shareholders are offshore – benefit little from the dividend imputation system. And these are just the companies Treasury modelling is counting on to lift investment in Australia as a result of a tax cut.  How much better would their response be if we offered them the chance to half their tax rate to 15%? 

Indeed, in today’s globalised world, dividend imputation is far less relevant in attempting to attract foreign investment.  What’s more, even the Reserve Bank is growing concerned that our thirst for dividends may be perversely hurting business investment to the extent it is encouraging many local corporations to distribute a lot more of their profits back to shareholders rather than keep as retained earnings.

Of course, Australian investors – especially those in retirement which are able to enjoy tax-free income (thanks to Peter Costello) – have grown to love the imputation system.  Not only are the dividends received tax free (up to a point), but the Australian Tax Office will actually send many a check for the tax paid by companies on dividends prior to distribution. 

Current estimates suggest the ATO is mailing out around $5 billion in cheques each year – unheard of anywhere else in the world.

All up, it may surprise some to know that because of our lovely dividend imputation system, the net revenue collected from corporate taxation (after tax saved from imputation credits claimed by dividend recipients) appears somewhere between one half to one third less than the gross corporate tax revenue reported in the Budget papers.  In 2016-17, even a conservative estimate would place the annual revenue cost of dividend imputation at around $20 billion. 

Based on Douglass’ suggestion above, he reckons the cost to revenue is closer to one half of gross corporate tax revenue, or around $34 billion last financial year.

So why not go with Douglass’s suggestion?  A journalist asked BHP’s Mackenzie (who had earlier waxed lyrical over the need to cut the corporate tax rate) before I had the chance.

And his response?

Words to the effect that.. “I don’t really want to get into that debate as I know many of my shareholders enjoy their imputation credits.”

In short, killing dividend imputation while keeping the current corporate tax system in place would appear to hurt too many investors – particularly retirees – who enjoy its benefits.

That’s why I reckon we need to leap frog the world and simply abolish corporate income taxation altogether – especially as it is increasingly easy to shift it to low tax jurisdictions around the world in any case.  Left with higher post-tax profits, companies would be left the choice to boost dividends to offset any loss of imputation benefits.

Meanwhile, it’s really hard for the rest of us to complain about the loss of imputation credits on company tax that is no longer paid.

How would be finance the net loss in revenue from zero corporate taxation, or around $35 b per year?  We could clamp down on the black economy though a move to a cashless society and then place a (small) tax on the trillions in electronic transactions each year.  We could also explore a simpler cash flow or domestically sourced revenue tax on companies, which could also better help claw back lost tax from Amazon, Google and Facebook who cleverly send most of their true profits offshore.

I agree with Hamish Douglass.  A cut in corporate tax rates to 25% is trivial and won’t shift the dial. We need to be far bolder.

 

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