Olivers Insights

  Download PDF copy

Here they go again

Political dysfunction around fiscal policy is a regular occurrence in the US, with regular bouts of uncertainty over government shutdowns, debt ceiling increases, etc. The annoying thing for me is that often they take place when I have gone on holidays, and the shutdown that commenced last week was no exception! Such conflicts invariably arise because different political parties to the President control part or all of Congress. At present it’s the Republican controlled House against the Democrat controlled Senate and President Obama. Such conflicts seem worse lately because the GFC and the response to it seems to have polarised many politicians to extreme positions.

The current dispute is around the failure to pass a new budget for the financial year beginning October 1 (hence the shutdown) and the need to raise the US Government’s debt ceiling (which is expected to be reached by October 17). It has its origins in the Republican dislike for President Obama’s health care reforms (Obamacare) and the failure of the fiscal cliff resolution early this year to embrace a ‘grand bargain’ reducing America’s long term budget deficit by closing tax loopholes and cutting back on the growth of entitlements.

Obviously the consequences of the US not increasing its debt ceiling and defaulting on its debt would be bad – many have said catastrophic. Failure to make a debt servicing obligation will see the US sovereign rating lowered to ‘Selective Default’ (according to Standard and Poors) as Greece was recently. Such an event would likely see a sell-off in US Government bonds, a flow on to the borrowing costs of all US corporates and a stigma that may take the US years to recover from – as Argentina and Russia have found. And of course not increasing the debt ceiling would mean the budget deficit of 4% of GDP would have to be eliminated immediately resulting in massive fiscal drag. All of which would affect confidence and hence economic growth.

However, the odds strongly favour a solution being found and a debt default being avoided, but the next few weeks could be uncertain

Shutdowns are nothing new in the US

US Government shutdowns are far from new and arise when Congress fails to pass laws funding Government spending. In fact there were 17 shutdowns between 1976 and 1996, lasting an average 7.4 days, with the median shutdown lasting 4 days.

Since they involve non-essential government services (ie, not the whole Government as many items of spending have separate streams of funding) their economic impact is small.

Source: Bloomberg, Ned Davis Research, AMP Capital

The current shutdown is estimated to be costing the US economy around 0.1% of GDP a week. But this will be significantly reversed once the shutdown ends and Government spending plays catch-up and currently furloughed workers get back pay. A return to work of around 350,000 civilian defence workers will also reduce the impact. This means only 450,000 Federal workers will remain on furlough, not the 800,000 referred to last week.

Interestingly the impact on share markets is mixed: US shares fell through 8 of the last 15 shutdowns (affecting market trading days) and rose through 7 including the longest in 1995-96. Shares experienced above average gains once shutdowns ended though.

The debt ceiling is a greater risk

The risks are a bit greater this time though as the US economy is somewhat fragile. More importantly, the budget debate is rolling into the need for Congress to increase the US Government’s debt ceiling later this month. The US Government will reach its $US16.7trn debt ceiling on October 17 and will run out of an estimated remaining $US30bn in cash by November 1, when it has roughly $US67bn in Social Security and Medicare payments due.

Given that the US Government is running a budget deficit equal to around 4% of GDP, if the debt ceiling is not increased spending would have to be cut back to be in line with revenue. As a result there are obvious fears that this may result in the US defaulting on its debt servicing obligations. On this front the US Treasury has about $US30bn in debt interest payments due on November 15.

However, there are several points to note on all this. First, we have been here before and solutions have always been found. The debt ceiling has been increased 17 times since 1993, most recently in August 2011 when the debt ceiling was last increased but at the last minute and after a round of brinkmanship. And it is worth noting that at Christmas last year the prospects for heading off the fiscal cliff of spending cuts and tax hikes looked bleak only to see agreement reached in the early hours of New Year’s Day.

Second, both sides of US politics are aware of the longer term consequences of the US defaulting on its debt servicing. House Speaker John Boehner has repeated that he won’t allow this to happen, even if it involves relying on Democrat votes, albeit it will likely require measures to reduce the long term growth in debt. And while President Obama has said he won’t negotiate on the debt ceiling, it’s hard to see him wanting his legacy marred by letting the US default while on his watch. So a last minute solution remains the most likely outcome for the debt ceiling.

Third, while a last minute solution will likely be found it’s a bit too early for it just yet as the political pressure is not great enough. On this front, while it would be good for the shutdown to end soon, the longer the shutdown lasts the greater the odds the Republicans will cave in earlier on the debt ceiling as it’s likely they will be politically weakened as Americans will probably mostly blame them for the shutdown. Similarly if President Obama is to back down and negotiate on the debt ceiling he probably won’t do so until the very last minute.

However, there are some positive noises starting to appear with some on both sides of politics raising points of negotiation that may lead to a solution. There is further to go though. But after playing hardball for a while (to appease their extremes) Republicans and Democrats are likely to arrive at a solution for the shutdown and debt ceiling that involves some tax reform in return for the start of a process of slowing the growth in entitlements and removing the medical devices tax that is part of Obamacare.

An alternative approach now being considered by the US Senate is to allow President Obama to increase the debt ceiling unless Congress voted against it by a 2/3rds majority in each chamber. Such an approach would allow the Republicans to vote against it but the debt ceiling to be raised anyway as they would not have a 2/3rds majority.

Fourth, even if the debt ceiling is not increased in time, the US Treasury is almost certain to prioritise debt servicing so a partial debt default is very unlikely. In other words the 4% of GDP cut to Government spending that would be required would fall on other areas than debt servicing.

A better position than in 2011

There is no doubt that the political brinkmanship that the US regularly finds itself in has not been helping its economic recovery. As Standard and Poors recently pointed out “this sort of political brinkmanship is the dominant reason the [US sovereign] rating is no longer AAA. Fitch and Moody’s may well be tempted to similarly cut the US rating one notch.

However, it is not all bad and has been leading to a more balanced solution to America’s debt problem than would have been the case if either side of politics had complete control. We have been seeing a mix of revenue increases and spending cuts in recent years. For example, the fiscal cliff deal ultimately saw the Bush era tax cuts for high earners end and the so-call ‘sequester’ spending cuts commence. And the budget deficit has now fallen to 4% of GDP from a peak of 10% in 2010 and the ratio of public debt to GDP actually stopped increasing in the June quarter.

More importantly, it’s worth noting that there are now several positives compared to the situation around the August 2011 debt ceiling/sovereign rating downgrade in the US.

First, as already noted the budget deficit is much smaller, such that any forced and immediate budget balancing wouldn’t be as bad for the economy.

Second, Fed monetary policy is far more stimulatory with QE3 continuing whereas back in August 2011 the US was suffering from the premature ending of QE2 in June 2011.

Third, global growth is picking up as is clearly evident in an uptrend in business conditions PMIs, in contrast to the situation in August 2011 when they were falling. This included the US where there were fears of a double dip recession at the time whereas now the US seems to be on a stronger path led by private sector activity – notably housing and business investment.

Source: Bloomberg, AMP Capital

Finally, the Eurozone is no longer threatening to implode whereas back in the second half of 2011 the Eurozone crisis was at its peak.

In other words the US and the world is in a far better position today to withstand a debt ceiling crisis than it was the last time around in August 2011.

What does it mean for investors?

Even though a last minute solution remains most likely it won’t stop investors fearing the worst in the interim, so the next few weeks could see further weakness in share markets. After a long period of solid gains shares are vulnerable and October is often a messy month for shares anyway. However, while it’s too early just yet, weakness on the back of US debt ceiling fears should ultimately be seen as a buying opportunity as a last minute deal is likely to set the scene for a resumption of the bull market and the usual solid seasonal gains into year end.

Bonds are likely to benefit from safe haven buying in the short term but are likely to resume their gradual rising trend once a solution is in place.

US assets may be a relative loser in the short term as current events yet again highlight political dysfunction in the US. This could work against the $US (and boost the $A), US bonds and US shares in the short term. However, such an impact is not likely to last long as the US political system has functioned better through times of crisis than Japan or the Eurozone have.

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

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes 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 article 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 article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

  Download PDF copy

Solid returns from commercial property

The past three years have seen solid 9-10% pa returns from unlisted commercial property. This has been driven by a recovery from the GFC related slump of 2008 and 2009, moderate economic growth and more recently the desire for decent income bearing investments from investors that has pushed down investment yields across the board, but particularly for retail property. The decline in yields has been an important driver of returns as each 0.25% fall in yields translates roughly to a 4% capital gain.

Source: AMP Capital

Reflecting the search for yield listed property, or Australian Real Estate Investment Trusts (A-REITs), have been even stronger with gains of around 17% over the last year and 11% pa over the last three years.

So where to from here? What does the mixed Australian economic outlook mean for property and has the decline in property yields run its course?

Space demand and supply

The biggest drag in the short term will be the soft Australian economy. While recession is expected to be avoided, economic growth is likely to remain sub-par at around 2 to 2.5% over the next six months or so and this is likely to push unemployment up to around 6.3% by mid next year. The soft economy will in turn mean subdued space demand into next year. Retail property is perhaps most vulnerable on this front, with retail property yields nearly back to pre GFC lows suggesting little return buffer.

However, economic growth, including retail sales, is likely to start picking up through next year as the benefit of lower interest rates, the fall in the $A, rising wealth levels, the benefits of increased housing construction and reduced consumer caution start to flow through to stronger demand. So growth in space demand should pick up from 2014-15.

Over the next few years, particularly around 2015 and 2016, the supply of office space is likely to increase (partly associated with Barangaroo in Sydney). As a result average office vacancy rates are likely to remain around 10% for the next few years acting as a negative for office rental growth.

Source: AMP Capital

Rising supply at a time of sluggish demand is also likely to be a drag on industrial and retail property rents and returns in the short term.

A-REITs lead

While the near term space demand and rental growth outlook is subdued, the strength in A-REITs is a positive sign for unlisted commercial property. While A-REITs are far more volatile, they tend to provide a good lead for unlisted commercial property. This can be seen in the next chart.

* Direct property is AMP Capital core direct property fund. Source: Bloomberg, AMP Capital

The search for yield by investors has seen A-REITs come back into favour pushing their yields down and boosting their returns. This augurs well for unlisted commercial property returns ahead. Unlisted commercial property continues to offer more attractive yields than A-REITs.

Source: Bloomberg, AMP Capital

Downwards pressure on yields

While the yields available on Australian unlisted commercial property have declined over the last three years, they remain attractive relative to most other assets. The next chart shows a composite of office, retail and industrial property yields versus an average of government bond, equity and housing yields. The gap between commercial property yields and other yields remains wide suggesting yields on commercial property are relatively attractive.

Source: REIA, Bloomberg, AMP Capital

This is particularly noticeable compared to residential rental property, as can be seen in the next chart. In the 1980s the rental yield on residential and commercial property was similar, but today commercial property has a rental yield which is far higher, ie just below 7% for commercial property compared to around 3.5% for residential property. With Australian residential property over-valued on most measures – albeit less than it was – this suggests that office, retail or industrial property is far more attractive for investors than housing on a medium term horizon as it is less dependent on capital growth going forward and less at risk of a correction, when say interest rates start rising again.

Source: REIA, AMP Capital

Apart from soft near term demand and rising supply, the biggest concern regarding commercial property is probably that bond yields back up sharply as global growth improves. In fact bond yields have already backed up this year – with the 10 year government bond yield in Australia rising from 3.3% at the start of the year to 3.9% currently.

However, despite the back up in government bond yields the risk premium offered by commercial property over bonds remains well above average. The next chart shows a proxy for this. It assumes that rental and capital growth will average 2.5% pa over time (ie, in line with average inflation) and adds this to the average non-residential property yield to give a guide to potential total returns. The 10 year bond yield has been subtracted to show a property risk premium. It can be seen that even though it has fallen slightly recently it still remains at levels that are well above its historical average.

Source: REIA, Bloomberg, AMP Capital

The bottom line is that while rising bond yields on the back of recovering global growth may act as a bit of a constraint, the huge yield advantage commercial property offers over government bonds and other yield bearing assets like residential property suggests that investor demand is likely to remain strong. In fact this is a key message from surveys of global institutional investors.

It’s worth noting commercial property has been a beneficiary of investor flows during periods of rising bond yields in the past. This happened during the bond crash of 1994 and the more gradual backup in bond yields that occurred prior to 2007 as investors simply switched out of bonds into assets like commercial property that offered higher yields. Property only became vulnerable in 1990 and 2007 when the property risk premium in the previous chart had fallen to far less attractive levels than is currently the case.

Return outlook

The net result of these conflicting forces is that while soft demand and rising supply may result in average unlisted commercial property returns slowing to around 7.5% over the year ahead, they are likely to remain solid on the back of investor demand for the relatively attractive yields commercial property offers. Returns are likely to pick up from 2014-15 if economic growth improves as expected.

Within unlisted commercial property the main opportunities are likely to be in industrial property reflecting its relatively attractive yields and quality retail property in strong population corridors. Retail property in low growth areas is vulnerable and office property is likely to underperform thanks to rising supply and subdued office space demand. A-REITS having outperformed over the last few years are likely to perform in line or even lag unlisted property going forward. Distribution yields have fallen to 5.5% as they have benefitted the most from falling bond yields.

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

  Download PDF copy

In what has perhaps been the biggest positive policy surprise for investors this year, the US Federal Reserve decided not to start tapering its quantitative easing (QE) program and leave asset purchases at $US85bn a month. This followed four months of almost constant taper talk which had led investment markets to factor it in. As a result the decision not to taper combined with very dovish language from the Fed has seen financial markets celebrate. This note looks at the implications.

Ready, set…stop

With the Fed foreshadowing from late May, that it would start to slow its asset purchases “later this year”, financial markets had come to expect that the Fed would start tapering at its September meeting. In the event the Fed did nothing. Several factors explain the Fed’s decision:

• The Fed always indicated that tapering was conditional on the economy improving in line with its expectations whereas recent data – particularly for employment and some housing indicators – has been mixed.

• Second, the Fed has become concerned that the rapid tightening of financial conditions, mainly via higher bond yields, would slow growth.

• Third, the upcoming budget and debt ceiling negotiations (with the risk – albeit small – of a Government shutdown or technical default) and accompanying uncertainty appear to be worrying the Fed.

• Finally, the Fed may have concluded that any forward guidance it would have provided to help keep bond yields down may have lacked sufficient credibility given the coming leadership transition at the Fed.

Observing the run of somewhat mixed data lately and the back up in bond yields, I and most others concluded that the Fed would address this by announcing a small tapering, ie cutting back asset purchases by $US10bn a month, and issue dovish guidance stressing that rate hikes are a long way away in order to keep bond yields down. However, it turns out that the Fed is more concerned about the risks to the growth outlook from higher bond yields at this point than we allowed for particularly given the US budget issues.

The Fed’s announcement is ultra-dovish with tapering delayed till “possibly” later this year and the Fed further softening its guidance. For example, the mid 2014 target for ending QE is gone and the 6.5% unemployment threshold for raising interest rates has been softened with Bernanke saying rates may not be increased till unemployment is “substantially” below 6.5%. The median of Fed committee members is for the first rate hike to not occur until 2015, and for the Fed Funds rates to hit only 1% at the end of 2015 and 2% at the end of 2016.

The key message from the Fed is very supportive of growth. They won’t risk a premature tightening in financial conditions via a big bond sell off and tapering won’t commence until there is more confidence that its expectations for 3% growth in 2014 and 3.25% growth in 2015 are on track.

Given that we also see US growth picking up tapering has only been delayed, but there is considerable uncertainty as to when it will commence. The Fed’s October 29-30 meeting looks unlikely as there is no press conference afterwards and US budget concerns may not have been resolved by then. The December 17-18 meeting is possible as it is followed by a press confidence but is in the midst of holiday shopping. So it could well be that it doesn’t occur till early next year.

Perhaps the main risk for the Fed is that by not tapering (when it had seemingly convinced financial markets that it would) it has created a lack of clarity around its intentions which will keep investors guessing as to when it will commence. This will likely add to volatility around data releases and speeches by Fed officials.

The US economy and inflation

In a broad sense though, the Fed is right to maintain a dovish stance:

• Growth is on the mend thanks to improving home construction, business investment and consumer spending but it’s still far from booming and is relatively fragile as the private sector continues to cut debt ratios. This is also evident in the mixed tone of recent economic indicators with strong ISM business conditions readings but sub-par jobs growth and some softening in housing indicators on the back of a rise in mortgage rates to a still low level of around 4.6%.

• Spare capacity is immense as evident by 7.3% official unemployment, double digit labour market underutilisation and a very wide output gap (ie the difference between actual and potential growth).

Source: Bloomberg, AMP Capital

• A fall in labour force participation has exaggerated the fall in the unemployment rate. At some point participation will start to bounce back slowing the fall in unemployment.

• Inflation is low at just 1.5%. There is absolutely no sign of the hyperinflation that the Austrian economists and gold bugs rave on about.

So while some will express annoyance that the Fed has confused them, at the end of the day the economic environment gives the Fed plenty of reason to be flexible.

Implications for investors

The Fed’s decision to delay tapering for now and its growth supportive stance is unambiguously positive for financial assets in the short term and this has been reflected in sharp falls in bond yields, gains in shares and commodity prices and a rise in currencies like the $A.

The sharp back up in bond yields since May when the Fed first mentioned tapering had left bonds very oversold and due for a rally. This could go further as market expectations for the first Fed rate hike push back out to 2015. However, the Fed has only delayed the start of tapering and as the US/global growth outlook continues to improve the upswing in bond yields is likely to resume, albeit gradually. This and the fact that bond yields are very low, eg 10 year bonds are just 2.7% in the US and just 3.9% in Australia, suggests that the current rally will be short lived and that the medium term outlook for returns from sovereign bonds remains poor.

For shares, the Fed’s commitment to boosting growth is very supportive. QE is set to continue providing a boost to shares going into next year even though sometime in the next six months it’s likely to start to be wound down. But it’s now very clear that the Fed will only do this when it is confident that economic growth is on track for 3% or more and this will be positive for profits. This is very different to the arbitrary and abrupt ending of QE1 in March 2010 and QE2 in June 2011, that were associated with 15-20% share market slumps at the time. See the next chart.

Source: Bloomberg, AMP Capital

With shares no longer dirt cheap, it’s clear that the easy gains for share markets are behind us. But by the same token shares are not expensive either and an “easy” Fed adds to confidence that profit growth will pick up next year driving the next leg up in share markets.

Bloomberg, AMP Capital

Shares are also likely to benefit from long term cash flows as the mountain of money that has gone into bond funds since the GFC is reversed gradually over time with some of it going into shares. See the next chart.

Source: ICI, AMP Capital

However, while the broad cyclical outlook for shares remains favourable, there will be some speed bumps along the way. The coming government funding and debt ceiling negotiations in the US could create uncertainty ahead of the usual last minute deal. And investors will now be kept guessing about when the first taper will come which means any strong economic data or hawkish comments from Fed officials could cause volatility. The May-June share market correction was all about pricing in the first taper and that process might have to commence all over again at some point.

For high yield bearing assets generally, eg bank shares, the Fed’s inaction and the rally in bonds will provide support. However, underperforming cyclical stocks, such as resources, may ultimately be more attractive as they offer better value and will benefit as the global and Australian economies pick up.

For emerging world shares, the Fed’s inaction takes away some of the short term stress, but it’s likely to return as US tapering eventually comes back into focus with current account deficit countries like India, Indonesia and Brazil remaining vulnerable.

Finally, the Fed’s decision not to taper does make life a bit harder for the Reserve Bank of Australia in the short term in trying to keep the $A down. It has added to the short covering bounce that has seen the $A rise from $US0.89 this month and so adds to the case for another interest rate cut. However, the rebound in the $A is likely to prove temporary as the Fed is expected to return to tapering some time in the next six months.

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

  Download PDF copy

It’s over, at least for now

Pretty much as the opinion polls and betting agencies had foreshadowed, Australia now has a new Liberal/National Government. While it’s dangerous to ascribe too much in terms of their economic impact to elections in Australia as either side of politics are not radically different from each other in their core beliefs – there was perhaps more riding on this election than usual given the difficult period of minority government over the past three years and the more uncertain environment the Australian economy has now found itself in. This note looks at what is expected in terms of changes to policies and implications for the budget, the economy and the share market.

Policy change

Based on their election platform, key policy changes under the Coalition Government will include the following:

• the abolition of the mining tax;

• the abolition of the carbon tax/Emissions Trading Scheme and its replacement with a direct action plan where companies will be paid to reduce emissions;

• a 1.5% cut in the company tax rate, although companies with income above $5m per annum will see this offset by a levy to pay for a paid parental leave scheme;

• a refocussing of government spending towards infrastructure and away from hand-outs like the “Schoolkid’s Bonus”;

• a delayed increase in the superannuation contribution;

• a reduction in the size of the public service;

• reduced spending on the National Broadband Network;

• various other savings such as reduced foreign aid, removal of carbon tax compensation payments, cancelling the low-income super contribution, ending the instant asset write-off;

• undertaking inquiries into the labour market, taxation, productivity & competition, the financial sector and infrastructure funding and an audit of government which will potentially pave the way for smaller government, reduced regulation & reinvigorated economic reform; and

• a greater focus on returning the budget to surplus

Taken together and assuming the policies are implemented, this should lead to smaller government, less regulation and over time improved productivity and growth in the economy.

Impact on the budget

Prior to the election, policy costings released by the Coalition indicated a cost to the budget over four years of just over $33bn, which is more than offset by budget savings of around $42bn. This results in net savings to the budget of just over $6bn on a cash basis over four years. Allowing for debt interest savings the total saving may be a bit more than this.

While the Coalition has not committed to the latest budget projections contained in the Pre-Election Economic and Fiscal Outlook (PEFO) they give a rough guide to the impact of the Coalition’s proposed savings to date. The table below shows the latest PEFO budget balance projections in the first row, with a return to surplus not occurring until 2016-17 under the previous Labor Government’s policies. The Coalition’s net savings (second row) help improve the budget balance over time but only marginally, by just 0.1 to 0.2% of GDP per annum and a surplus is still not achieved until 2016-17 (third row). In other words, on current policies the Coalition essentially has the same overall budget strategy as the previous Labor Government!

Source: Federal Treasury, Federal Coalition, AMP Capital

Now of course, under the new Government these projections are likely to change. In particular, the starting point for the budget projections may have deteriorated further and this may be accentuated by more conservative economic growth assumptions. As a result, there is a high risk the new Government will adopt more aggressive savings measures in order to meet its election commitments but at the same time ensure a return to surplus by 2016-17.

This is pretty much what the Howard Government did following its election in 1996. A mini-budget coinciding with the Mid Year Economic and Fiscal Outlook in November, and possibly after an audit of government spending has reported, may contain more aggressive budget savings.

Implications for financial markets

Putting aside the usual global influences it’s likely that over time the response in financial markets to the change of government will be positive, particularly for the share market. There are several reasons for this. Firstly, over the last 30 years Australian shares have generally risen after Federal elections. This is evident in the next chart which shows Australian share prices from one year before till six months after Federal elections since 1983. This is shown as an average for all elections (but excludes the 1987 and 2007 elections given the 1987 global share crash and the start of the global financial crisis in 2007). What is clear is that after elections shares tend to rise more often than they fall.

Source: Thomson Financial and AMP Capital

The next table shows that after 8 out of 11 elections since 1983 the share market was up 3 months later with an average gain of 5.4%, which is above the 1.8% average 3 monthly gain from shares over the whole period.

Source: Bloomberg, AMP Capital

Secondly, over the post World War Two period the average annual return from Australian shares (capital growth plus dividends) under Coalition Governments has been 13.2% pa as opposed to 9.9% pa under Labor Governments.

Source: Thomson Financial, AMP Capital

Some might argue though that the Labor Governments led by Whitlam and Rudd/Gillard had the misfortune to be affected by the global stagflation of the 1970s and the GFC. The reformist Hawke/Keating period from 1983 to 1996 certainly defied conventional perceptions that conservative governments are always better for shares. However, it can be seen that Liberal/National governments have seen solid and reasonably stable average returns from shares and this may reflect a more business friendly policy approach.

Thirdly, we have now seen the end of a period of destabilising and uncertain minority government in Australia which has not been good for confidence.

Finally, Coalition policies with a focus on cutting taxes, refocussing government spending on productivity enhancing infrastructure, smaller government and less regulation promise to be business friendly, which should be positive for confidence and the economy. This is particularly so given that business confidence is running at sub-par levels.

Overall, this suggests a favourable reaction from investment markets.

What are the risks?

But, there are qualifications. First, the strong performance of Australian shares in August relative to global shares may have already partly factored in the change in Government. Second, the favourable boost to confidence and longer term growth may be offset in the months ahead if the new Government chooses to go hard in terms of cutting spending.

Finally, and most importantly, the Senate may thwart the Government’s program. Whilst the Coalition clearly won control of the House of Representatives, the Senate won’t necessarily respect any claims that it has a “mandate”. The current Senate that sits until June next year is controlled by Labor and the Greens and is very unlikely to pass legislation to abolish the carbon and mining taxes. Vote counting for the new Senate that will sit from July is yet to be finalised, but it looks like the Coalition will need the support of a variety of independents and minor parties with varying views to get its program through. With most of the minor parties to the right of the Coalition, the new Government has some chance of success. But hopefully this won’t lead to a bunch of concessions and giveaways that are not in the national interest. Failure to reach agreement could mean a double dissolution election, although that is looking a bit less likely.

But on balance, the reaction from financial markets to the new Government is likely to be positive, with shares likely to be stronger than would otherwise have been the case, notwithstanding the usual gyrations driven by forces such as global developments. Share market sectors and companies likely to benefit include the miners (from the abolition of the mining & carbon taxes), heavy carbon emitters, engineering and contracting companies (from the infrastructure program), companies that provide salary packaging and car leases (as car FBT changes won’t proceed) and small businesses.

The $A may also be a beneficiary, although given the need for a lower $A to help the economy adjust as the mining sector slows this would only bring forth more RBA rate cuts which would offset any positive impact on the currency. A boost to consumer confidence may also boost the recovering housing market. This was perhaps evident on the weekend with auction clearances surging in both Sydney and Melbourne, albeit helped by lower listings owing to the poll.

Concluding comments

A whole range of factors influence financial markets with elections playing a relatively minor role. In the short term these include the threat of US military intervention in Syria, the US Federal Reserve’s taper decision, US Congressional negotiations regarding the US Government’s debt ceiling and worries about the emerging world and the mining slowdown locally. However, given the unstable policy environment of the last few years in Australia partly associated with minority government, the relatively subdued levels of business and consumer confidence and the business friendly policies of the Coalition there is likely to be a favourable reaction to the change of Government evident over time.

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

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes 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 article 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 article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

  Download PDF copy

Over the last year there has been much commentary warning of an impending collapse in the Australian economy. Much of this has come from foreign commentators sure that the mining boom is the only thing keeping Australia going. Consistent with this there was much fear going into the just concluded June half profit reporting season with many expecting another round of big earnings downgrades.

Although the profit results were not flash and growth is below trend, so far it has not been the disaster feared and there are reasons for optimism.

Profits not good, but not disastrous either

The June half profit results marked the second financial year in a row of falling profits for the market as a whole and the fourth year in five of falling profits. See the next chart.

Source: UBS, Deutsche Bank, AMP Capital

Prior to the reporting season the fear was that results would lead to more earnings downgrades. This hasn’t happened.

• The first thing to note is that thanks to a steady stream of earnings downgrades from around March, consensus earnings expectations for 2012-13 had already been revised down from around 12% growth to around flat. In other words a lot of bad news had been factored in.

• Results were actually a little bit better than expected with 39% of companies exceeding analyst expectations, which is down on the December half results but better than seen over most of the last three years.

Source: AMP Capital

• 63% of companies have seen their profits rise from a year ago and 60% of companies have increased their dividends from a year ago as against only 12% which have cut them. As a result of increased dividends from resources stocks, dividends rose by a strong 10% last financial year. Strong dividend growth reflects both a degree of comfort with the profit outlook along with pressure from shareholders for increased dividends.

• While revenue growth was weak, cost control remains intense cushioning any further blow to profits.

• While corporate outlook comments have been subdued, the fact they haven’t been too gloomy is a good sign.

Source: AMP Capital

Consequently, and because the bad news had already been factored in we haven’t seen the earnings downgrades some had feared. Earnings expectations for 2012-13 are little changed from where they were before results started to flow in late July at -0.5% (with resources earnings down around 21% but with earnings for the rest of the market up by around 6%). And for 2013-14 earnings growth expectations remain around 13%, made up of a 35% gain for resources and 8% growth for the rest of the market.

Reflecting the better than feared results and increasing dividends, 54% of companies saw their share price outperform the market on the day their results were released. Moreover the Australian share market returned 2.5% in August despite global shares losing around 2%.

Cost cutting remains intense and will provide strong leverage for growth once revenue improves. The key going forward will be what happens to the economy.

Growth well below trend, but some hope

Since the June quarter 2012 Australian economic growth has been poor, averaging around a 2.5% annualised pace. June quarter growth this year was no different coming in at 0.6% or 2.4% annualised. This is well below the level necessary to absorb workforce entrants and hence unemployment has risen from 5% to 5.7%. The sub-par growth reflects weak consumer spending and a slowdown in business investment as mining investment has peaked.

The outlook for investment remains a big negative. A conventional interpretation of investment intentions from Australian businesses, by adjusting them for the average gap between actual and expected investment points to a 1% contraction in investment this financial year. However, an alternative approach based on comparing the latest estimate of investment for the current financial year to the corresponding estimate made a year earlier points to a deeper fall. See the next chart.

Source: ABS, AMP Capital

The initially tepid response to interest rate cuts reflects a combination of factors including post GFC caution, the initial tentative nature of rate cuts by the RBA, the failure of the $A to fall until recently, the limited pass through of rate cuts by banks, fiscal tightening and falling household wealth levels. However, while post GFC caution remains, some of these negatives are lifting. Specifically:

• interest rates have at last fallen to past cycle lows.

Source: RBA, AMP Capital

• the $A has fallen 15% from pre May average levels; and

• household wealth is up over the last year reflecting the rising share market and rising house prices.

Moreover, the normal play out from rate cuts to stronger growth seems to be gradually unfolding:

• House prices have started to rise

• This is sending a signal to home builders to build more homes with building approvals rising which is likely to see rising house construction levels.

Source: Bloomberg, AMP Capital

• Partly reflecting this consumer confidence is trending up.

• At the same time, the lower $A should start to boost demand for local goods and services, whether it be cars, education and tourism.

• Rising house construction is likely to drive a pick up in retail sales.

• The turn is likely to help non-mining investment

All of this will take time to unfold, but we do appear to have reached the third point mentioned above, which provides some grounds for confidence. To ensure that this process continues the $A needs to fall further (to around $US0.80) and to ensure this occurs the RBA will possibly need to cut the official cash rate a bit further (to around 2.25%).

Overall, while the next six months or so may still see sub-par growth around 2.5% as the economy transits from strong mining investment to more balanced growth, signs of an improvement are gradually appearing. This augurs reasonably well for a pick up in profit growth over the year.

Outlook for Australian shares

As has often been the case, the local share market has run ahead of profits, with all of the recent gains being driven by an increase in price to earnings multiples. However, the forward price to earnings multiple for Australian shares is still only around its long term average.

Source: Bloomberg, AMP Capital

Moreover, while there will be a few bumps along the way with a high risk of a short term correction, with earnings growth set to improve this should underpin further gains in the local share market over the year ahead. Our June 2014 target for the ASX 200 is 5500.

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

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes 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 article 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 article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.