Investment Background Briefing – 27th April 2016
What’s happened recently?
Chris Richardson of Deloitte Access Economics (DAE) published a thought provoking paper covering the history of Treasury forecasts of budget outcomes in recent years as well as DAE’s view of the likely outcome for key budget parameters in the next few years.
- Richardson has urged the Federal Treasury and Finance Departments to “stand up and be counted” by publishing a realistic Pre Election Fiscal Outlook (PEFO) in the run up to the next Federal election, which comes after next week’s Federal Budget and is likely to be held on 2 July 2016.
- A realistic PEFO would make clear that there is not much likelihood of a rapid recovery in Australia’s Terms of Trade or in Federal Government revenue from corporate taxes. With limited political scope for either major cuts in expenditures or major increases in effective tax rates, budget deficits are set to continue at current levels or higher.
- In the 2013 PEFO, the Treasury forecast a return to surplus by 2017-2018 based on expenditure growth being limited to 2% p.a. in real terms. This was always going to be hard to achieve with demographics driving escalating costs of providing for the needs of older Australians (aged pensions and healthcare) and children (education and child care), made worse by the more rapid inflation of healthcare costs.
- In its paper, Deloitte Access Economics forecasts Federal government spending to rise from below 25% of GDP to over 26% of GDP while the share of total tax paid by companies falls from over 20% of the total to below 18%. Net debt owed by the Federal Government is likely to stabilise around 20% of GDP rather than fall.
- While it is doubtful that the DAE paper has had an immediate impact on financial markets (as opposed to the current marathon election campaign), it has some important implications in the medium to longer term.
- If DAE are right (and we think that they probably are), their analysis means that Federal Deficits will continue for some time, providing a measure of economic stimulus. This is fundamentally a positive for the non-resources side of the Australian equity market.
- It also means that there will be continued substantial issuance of Australian Government Bonds. While this ought to be negative for returns on fixed interest, it may turn out that the relative attractiveness of Australian Government Bonds to international investors more than offsets the effect of greater supply. Australia is one of just seven countries with a triple A rating from all three major rating agencies. Australian ten year Federal Government bonds offer a yield of 2.66% p.a. while the other six AAA issuers all offer less than 2% p.a. with some as low as 0.26% p.a. (Germany) or even minus 0.27% p.a. (Switzerland). Hence the attraction of Aussie bonds, with demand from foreigners also pushing up the value of the Australian Dollar (which they need to settle the purchases).
- Continued low, long-term bond yields make the future cash flows of Australian industrial and financial businesses more valuable in present value terms. If the cash flows also receive support from continued government deficits, even better value emerges.
- The political debate in coming weeks about debt and deficit and what to do about it will, to quote Shakespeare (whose 400th anniversary we celebrated last Saturday) will resemble “a tale told by an idiot, full of sound and fury, signifying nothing” as far as the bond and equity markets are concerned. What matters more is the underlying stimulus to the economy, supporting equity earnings outside of the resource sector and the continued attractiveness of bonds issued by a government that still has an enviably low net debt to GDP ratio by international standards.
- The strength in the Australian dollar due to demand from international bond investors is currently offsetting the weakened terms of trade from lower commodity prices. This is likely to continue, especially with some short term factors pushing up oil prices (the Kuwaiti oil workers strike) and iron ore prices (the recent restocking of inventories by Chinese steel mills). While the short run surge in key commodity prices may peter out, the international chase for yield by major global investors will continue to push down on Aussie bond yields and up on the Aussie exchange rate. Exporters including the major resource companies will face a longer-term headwind from a stronger than expected Aussie dollar and so may not share in the growth in earnings of the industrial sector (especially if the most recent commodity price surge indeed proves to be relatively short lived). Continued caution including profit taking is still warranted with major Australian resource stocks.
- Meanwhile the central bankers continue to shoulder most of the burden of providing increases in economic stimulus. The US Federal Reserve meets this week but the focus is on a possible rate rise in June rather than this month.
- The Bank of Japan also has a board meeting this week. If it acts at all to change its policy setting, it is likely to increase stimulus by cutting its key interest rate further into the negatives and possibly increasing its security purchases under its Quantitative Easing Program. The program has resulted in the Bank of Japan purchasing enough equity assets to make them one of the largest shareholders in over 90% of the companies in the Nikkei 225 index. Mr Kuroda, the head of the Bank of Japan, says that there should be no concern about this as it represents only 1.6% of the total capitalisation of all listed companies in Japan.
- The RBA meets next week and will likely continue its relatively dull policy (by international standards) of keeping its official rate at an all-time low of 2% p.a. despite inflation tracking at 1.7% p.a. which is below its stated target range of 2% p.a. to 3% p.a. Its style is to preserve its scope for action should the global situation deteriorate.
- Last week, the finance ministers and central bankers of the G20 met in Washington, noting that global growth prospects have dimmed and called for more fiscal stimulus. Once back in their home political environments, those same Finance Ministers will feel constrained to not increase fiscal deficits or stimulus, particularly with spending on infrastructure where the pay back periods greatly exceed the typically short electoral or political cycle. The world needs politicians who are statesmen, who believe in life after (their) political death.
- In the absence of such creatures, investors need to be more practical and invest on the basis of slow growth, low inflation, continued central bank intervention and low interest rates.
Key takeouts and implications for investment portfolios
- The low inflation and interest rate scenario is supportive of most equity prices outside of energy companies and banks. Equity markets may well track lower by enough to warrant an increase in allocation to an overweight position, based on a longer-term view.
- At this stage we still prefer to wait and watch. We see no reason to change the previously stated investment strategy of a neutral weight to equity assets.
Planning Perspective Gold Coast Pty Ltd is a Corporate Authorised Representative of Madison Financial Group Pty Ltd | AFSL No. 246679 |
ABN 36 002 459 001 http://www.madisonfg.com.au
This information is of general nature only and neither represents nor is intended to be specific advice on any particular matter. We strongly suggest that you seek professional financial advice before acting.