Olivers Insights

The Federal Election

Some might be forgiven for thinking the wheels have fallen off Australian politics over the past decade with the same number of PM changes as Italy, a fractured Senate and “minority government” at times making sensible visionary long-term policy making hard. With the May 18 Federal Election offering a starker than normal choice political uncertainty may see another leg up. Polls give Labor a clear lead, albeit it’s narrowed a bit.

Elections, the economy & markets in the short term

There is anecdotal evidence that uncertainty around elections causes households and businesses to put some spending decisions on hold – the longer the campaign the greater the risk. Fortunately, this time around it’s a relatively short campaign at five weeks. However, hard evidence regarding the impact of elections on economic indicators is mixed and there is no clear evidence that election uncertainty effects economic growth in election years as a whole. In fact, since 1980 economic growth through election years averaged 3.6% which is greater than average growth of 3.1% over the period as a whole.

In terms of the share market, there is some evidence of it tracking sideways in the run up to elections, which may be because investors don’t like the uncertainty associated with the prospect of a change in policies. The next chart shows Australian share prices from one year prior to 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 global share crash in late 1987 and the start of the global financial crisis (GFC) in 2007), and the periods around the 1983 and 2007 elections, which saw a change of government to Labor, and the 1996 and 2013 elections, which saw a change of government to the Coalition. The chart suggests some evidence of a period of flat lining in the run up to elections, possibly reflecting investor uncertainty, followed by a relief rally.

Source: Thomson Reuters, AMP Capital

However, the elections resulting in a change of government have seen a mixed picture. Shares rose sharply after the 1983 Labor victory but fell sharply after the 2007 Labor win, with global developments playing a role in both. After the 1996 and 2013 Coalition victories shares were flat to down. So based on historical experience it’s not obvious that a victory by any one party is best for shares in the immediate aftermath, and historically the impact of swings in global shares arguably played a bigger role than the outcomes of federal elections.

The next table shows that 9 out of the 13 elections since 1983 saw shares up 3 months later with an average gain of 4.8%.

(Based on All Ords index.) Source: Bloomberg, AMP Capital

The next chart shows the same analysis for the Australian dollar. In the six months prior to Federal elections there is some evidence the $A experiences a period of softness and choppiness, which is consistent with policy uncertainty, but the magnitude of change is small. On average, the $A has drifted sideways to down slightly after elections.

Source: Thomson Reuters, AMP Capital

Political parties and shares

Over the post-war period shares have returned 12.7% pa under Coalition governments and 10.7% pa under Labor governments. It may be argued that the Labor governments led by Whitlam in the 1970s and Rudd and Gillard more recently had the misfortune of severe global bear markets and, if these periods are excluded, the Labor average obviously rises to 15.8% pa, although that may be taking things a bit too far. But certainly, the Hawke/Keating government defied conventional perceptions that conservative governments are always better for shares. Over the Hawke/Keating period from 1983 to 1996 Australian shares returned 17.3% pa, the strongest pace for any post-war Australian government.

Once in government, political parties are usually forced to adopt sensible macro-economic policies if they wish to ensure rising living standards and arguably there has been broad consensus on both sides of politics in recent decades regarding key macro-economic fundamentals – eg, low inflation and free markets.

Policy differences starker than since the 1970s

However, after narrowing in the 80s and 90s with the rationalist reform oriented agenda kicked off by Hawke and Keating, in recent years the policy differences between the Coalition and Labor have been intensifying again to the point that they are now arguably starker than they have been since the 1970s (when there used to be more of a focus around “class warfare”). In part this is consistent with rising interest in populist policies globally which in turn reflects angst over low wages growth, widening inequality, globalisation and automation. Each side of politics is now offering very different visions on the role and size of government. And so the policy uncertainty around this election is greater than usual.

The Coalition is focussed on containing government spending and encouraging economic growth via infrastructure spending, significant personal tax cuts (to return bracket creep and cap taxation revenue at its long term high of around 24% of GDP) and mild economic reforms.

By contrast Labor is focussed on spending more on health and education and in the process allowing the size of the public sector to increase. This is proposed to be funded by “tax increases” including:

• cancelling the Coalition’s middle and upper income personal tax cuts scheduled for next decade and reimposing the 2% Deficit Repair Levy on incomes above $180,000;

• restricting negative gearing to new residential property (and no other assets) and halving the capital gains tax discount from January 1 2020;

• stopping cash refunds for excess franking credits;

• and a 30% tax rate on distributions from discretionary trusts;

It’s not proposing to spend all the extra revenue this will raise with some earmarked for higher budget surpluses (ie paying down public debt). It’s also promising a sharp lift in the minimum wage towards being a “living wage”, some labour market re-regulation, far more aggressive climate policy (with a 45% reduction in emissions on 2005 levels by 2030, which is almost double the Coalition’s policy) and in relation to superannuation key changes are likely to include a resumption of the increase in the Super Guarantee, lower non-concessional contributions and a lower income threshold for the application of the 30% tax rate on super contributions. Intervention in the economy is likely to be higher under a Labor government.

Perceptions that a more left leaning Labor government will mean bigger government, more regulation and higher taxes and hence act as a drag on productivity and be less business friendly may contribute to more nervousness in shares and the $A than usual around this election. More specifically there are a number of risks:

• There is a danger that relying on tax hikes on the “top end of town” will dampen incentive in that Australia’s top marginal tax rate of 47% is already high – particularly compared to our neighbours: 33% in NZ; 20% in Singapore; and 15% in HK. Australia’s income tax system is already highly progressive: 1% of taxpayers pay 17% of the total personal income tax take (with an average tax rate of 42%) & the top 10% pay 45% of tax compared to the bottom 50% who pay around 12% (with an average tax rate around 11%).

• The proposed changes to franking credits even though they only impact around 8% of taxpayers are potentially a negative for stocks with high-franked dividends.

• The proposed changes to capital gains tax and negative gearing have been estimated to cause a 5 to 12% decline in home prices & a boost to rents of 7 to 12%. This is risky as the property market is already weak. This could further impact construction/property stocks, banks & retail shares.

• Higher minimum wages and some labour market re-regulation risk higher unemployment, a less flexible labour market and are a negative for hospitality and retail stocks.

• The focus on economic reform needed to boost productivity looks to have fallen by the wayside in the face of populism – eg, why aren’t we considering injecting more competition into the health sector along with spending more on it?

That said there are some offsets in relation to ALP policies that investors need to allow for:

• Some ALP policies may not pass the Senate, including those around negative gearing and repealing the middle & upper income tax cuts that have already passed into law.

• Labor is planning bigger budget surpluses which is positive.

• Labor policies encouraging “build to rent/affordable housing” are positive, but it’s unclear how much impact they will have.

• Labor policies focussed on greater spending and tax cuts more targeted to lower saving low income earners may provide more of a short-term boost to economic growth.

• Labor has a track record of taking sensible advice & responding quickly to help the economy in a crisis (think 1983 and in the GFC). In the short term, this could include a First Home Buyer grant to mute the property downturn.

Concluding comment

The now wider left right divide in Australian politics suggests greater uncertainty going into this election potentially affecting all asset Australian classes. But the bigger concern is the dwindling prospects for productivity enhancing reform, which could be an ongoing dampener on growth in living standards.

Source: AMP Capital 11 April 2019

Important notes: 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)  (AMP Capital) 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 and must not be provided to any other person or entity without the express written consent of AMP Capital.

The 2019-20 Budget had three aims: to cement the Government’s fiscal credentials by delivering the long-awaited return to budget surplus; to provide fiscal stimulus to an ailing economy; and to help get the Government re-elected. It looks on track for the first thanks to a revenue windfall, this has provided room for fiscal stimulus and of course time will tell whether it makes a difference in the May election. Of course, while whoever wins the election will provide stimulus next financial year its timing and precise makeup won’t really be known for some time which makes the Budget a bit academic.

Key budget measures

The goodies include:

• Income tax cuts from July focussed on low to middle income earners of an additional $10 a week (following last year’s announced tax cut of around $10/week) which is mainly achieved by doubling the Low & Middle Income Tax Offset.

• More generous tax stimulus in later years especially for higher income earners (which builds on the tax changes announced in last year’s budget), starting in 2022 with an expansion in the 19% rate tax bracket and a reduction in the 32.5% rate to 30% in 2024.

• Expansion of the small business instant asset write off by $5,000 to $30,000 until 2020 (which is also now extended to medium-sized businesses) and a drop in small business company tax to 25% earlier than expected.

• A $75 to $125 cash payment to 3.9 million pensioners and other welfare recipients.

• Greater flexibility for 65 & 66 year olds to top up their super.

• Spending on energy efficiency measures including an equity injection of $1.4bn on the Snowy Hydro project.

• An extra $25bn in infrastructure spending over the next decade including $2bn for a rail from Geelong to Melbourne, and a large allocation to NSW transport projects.

Stronger revenue, but tax cuts

Thanks to stronger corporate revenue, better personal tax revenue thanks to higher employment and reduced spending the 2018-19 budget deficit is projected to come in at $4.2bn compared to $5.2bn in the Mid-Year review. The Government has assumed that this revenue boost is only temporary (see the “parameter changes” line in the table below) and has only used some of it to fund tax cuts and other measures. The net result is that the budget is projected to continue to reach a surplus in the next financial year, albeit its still only small at $7.1bn or 0.4% of GDP. The move to higher surpluses is slowed slightly by the fiscal easing from policy changes (predominately tax cuts).

However, note that the fiscal stimulus proposed for 2019-20 is actually bigger than that shown in the table below under “policy changes” as $3bn in tax cuts were already allowed for in the Mid-Year Review and if the already legislated tax cuts are allowed for in total its around $9bn or 0.5% of GDP. That said this is still relatively small and not enough to offset low wages growth and the negative wealth effect from falling house prices.

Source: Australian Treasury, AMP Capital

The already legislated tax cuts for higher income earners next decade are designed to satisfy the Government’s commitment from the 2014 Budget to cap tax revenue at 23.9% of GDP (or total revenue with dividends at 25.4% of GDP) on the grounds that this is around the historic highs. This cap is now projected to be reached in 2021-22.

Source: Australian Treasury, AMP Capital

Economic assumptions

The Government’s growth forecasts look a little bit on the optimistic side, particularly the assumptions for wages growth. It remains hard to see wages growth rising significantly over the next few years given unemployment is not expected to fall and on our forecasts is expected to rise to 5.5%.

Source: Australian Treasury, AMP Capital

Assessment and risks

Like last year’s this is an upbeat Budget. First the near-term tax cuts for low to middle income earners will help households at a time of soft wages growth, falling home prices and tightening lending standards. But while roughly two times bigger than planned a year ago, this will still be relatively small though at around $20 a week (enough for 3 rounds of coffee and a muffin!). Second, the Budget continues to recognise that we cannot rely on bracket creep to cut public debt. The Australian tax system is already highly progressive and is becoming more so with the top 10% of earners accounting for roughly 45% of income tax revenue, up from 36% two decades ago. Compared to other comparable countries the top marginal tax rate is both relatively high and kicks in at a relatively low multiple of average earnings. In fact only the top 20% of income earners pay more tax than they receive in government benefits. If this is not limited it risks dampening incentive and productivity. Third, the continuing focus on infrastructure is good for short term growth, productivity and “crowding in” private investment. It will help to keep the economy growing.

Source: ATO, AMP Capital

Finally, thanks to constrained spending growth and the surge in revenue in recent years the outlook for surpluses is positive.

Source: Australian Treasury, AMP Capital

However, we have still seen a record run of 11 years of budget deficits. While our net public debt to GDP ratio is low at 19% compared to 78% in the US, 70% in the Eurozone and 156% in Japan, comparing ourselves to a bad bunch is dangerous. The run of deficits swamps those of the 1980s and 1990s and this was without a deep recession! Rather we have achieved this thanks to a combination of ramping up spending at the time of the GFC and then not reining it in again. Unlike prior to the GFC we have nothing put aside for a rainy day and there is a risk that the revenue surprise will prove temporary if global growth slows or more likely Australian growth and employment disappoints.

While the Government’s revenue growth assumptions for the years ahead are modest partly due to tax cuts and they are relatively conservative in assuming that the iron ore price falls back to $US55 a tonne, a big risk remains that wages don’t accelerate as assumed leading to a resumption of poor personal tax collections.

Finally, the budget strategy and fiscal stimulus comes with greater than normal uncertainty given the coming election in May and whether the tax measures pass parliament. A Labor Government would likely also undertake a similar sized stimulus but there may be a greater focus on government spending and the timing may be delayed as a new government would likely have a mini-budget in the second half of the year.

Implications for the RBA

While this Budget should provide some boost to household finances and confidence – the fiscal boost to the economy and household income is still relatively modest and uncertainty around its timing and details may dampen any positive announcement effect. So while it will help the economy it’s not enough to change our view that the RBA will cut interest rates twice by year end taking the cash rate to 1%.

Implications for Australian assets

Cash and term deposits – with interest rates set to fall, returns from cash and bank term deposits will remain low.

Bonds – a major impact on the bond market from the Budget is unlikely. With Australian five-year bond yields at 1.4%, it’s hard to see great returns from bonds over the next few years albeit Australian bonds will likely outperform US/global bonds.

Shares – the boost to household spending power could be a small positive for the Australian share market (via consumer stocks) and there is an ongoing boost for construction companies. But it’s hard to see much impact on shares.

Property – the Budget is unlikely to have much impact on the property market. We expect Sydney and Melbourne home prices to fall further.

Infrastructure – continuing strong infrastructure spending should in time provide more opportunities for private investors as many of the resultant assets are ultimately privatised.

The $A – the Budget alone won’t have much impact on the $A. With the interest rate differential in favour of Australia continuing to narrow the downtrend in the $A has further to go.

Concluding comments

The 2019-20 Budget has a sensible focus on providing support to households at the same time as returning the budget to surplus. However, the actual fiscal stimulus is pretty modest – particularly for a pre-election budget – and comes with greater than normal uncertainty given the upcoming election.

Source: AMP Capital

Important notes

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) (AMP Capital) 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 and must not be provided to any other person or entity without the express written consent of AMP Capital.

The past week has seen a renewed intensification of concerns about global growth. Bond yields have plunged and associated growth worries have weighed on share markets. This note looks at the global growth outlook, why shares are vulnerable to a pullback and why it’s unlikely to be a resumption of last year’s downtrend.

Background

But first some perspective. At their lows back in December global shares had fallen 18% from their highs with US shares down 20% and Australian shares down 14% and many were convinced that recession was around the corner. Since then share markets have staged an impressive rebound with global shares rising 18%, US shares up 21% and Australian shares up 14%. So the 2% or so fall in shares seen in the past few days is a bit of a non-event.

Source: Bloomberg, AMP Capital

Late last year investor sentiment had become very negative and since then many of the fears that had depressed shares have faded: the Fed has become more dovish and less threatening to the US growth outlook; other central banks have actually eased notably in China and Europe; the Chinese authorities have shifted from cutting debt to stimulating growth; the US partial government shutdown has ended; the US and China look to be heading towards a trade deal; and fears around recession faded. And so shares rebounded.

However, after a 20% plunge as seen in US shares last year it’s unusual to have a deep V rebound like that since December, shares had become technically overbought & some measures of investor sentiment have become complacent. More fundamentally, there are several “worries” that could impact share markets – notably around growth. And this is being reflected in plunging bond yields & an inverted US yield curve. This has all left shares vulnerable to a short term pull back.

Growth worries and plunging bond yields

The problem now is that while some of the worries from last year have faded, global growth looks to be continuing to slow. Particularly disappointing in this regard were March business conditions PMIs which showed falls in the US and Europe and continuing weakness in Japan (and Australia).

Source: Bloomberg, AMP Capital

The weakness in growth indicators along with the “great retreat” back to dovishness and monetary easing by central banks aided by falling inflation has seen a renewed plunge in bond yields.

Source: Global Financial Data, AMP Capital

This has seen US yields fall to levels not seen since 2017, German and Japanese bond yields go negative again and Australian bond yields fall to a record low.

The decline in US bond yields has added to growth fears by pushing various measures of the yield curve to flat or negative. A negative, or inverted, US yield curve – ie when long-term bond yields fall below short-term rates – has preceded US recessions so it’s natural for investors to be concerned. The gap between the US 10-year bond yield and the 2-year bond yield has now fallen to just 0.22%, the gap between the 10-year bond yield and the Fed Funds rate has fallen to just 0.02% and the gap between the 2-year bond yield and the Fed Funds rate has fallen to -0.02%.

Source: NBER, Bloomberg, AMP Capital

But there are several things to allow for before getting sucked into the current frenzy around an inverted yield curve. First, the yield curve can give false signals (circled on the chart).

Second, the lag from an inverted curve to a recession has been around 15 months. So even if it becomes decisively inverted now recession may not come till mid next year. Historically the share market has peaked 3-6 months before recessions, so it’s too far away for markets to anticipate. After US yield curve inversions in 1989, 1998 and 2006 US shares first rallied more than 20%.

Third, various factors may be flattening the US yield curve which may not be indicative of an approaching US recession including the Fed’s new-found dovishness, negative German and Japanese bond yields holding down US yields, the realisation that central banks won’t be dumping their bond holdings and high investor demand for bonds post the GFC as they have proven to be a good diversifier – rallying every time shares have a major fall.
Fourth, other indicators suggest that US monetary policy is far from tight – the real Fed Fund rate is barely positive, and the nominal Fed Funds rate is well below nominal GDP growth and both are far from levels that have preceded US recessions.

Finally, we are yet to see the sort of excesses that precede US recessions: wages growth is still moderate, inflation is benign, there has been no boom in consumer spending, investment or housing construction, and private debt growth overall has been modest. It may also be argued that President Trump will do whatever he can to avoid recession next year as US presidents don’t get re-elected when unemployment is rising.

So while the US yield curve may be flashing a warning sign and should be watched its short comings need to be allowed for and other indicators are not foreshadowing a US recession. This is important because the historical experience tells us that what happens in the US is critical to how deep share market falls get. Deep (“grizzly”) bear markets are invariably associated with US recession. Our view remains that US recession is not imminent and last year’s share market falls are unlikely to be the start of a deep bear market.

More broadly, global growth is likely to pick up into the second half reflecting policy stimulus & reduced trade war fears. Signs of green shoots in terms of global growth include Chinese credit and investment, US data for retail sales, capital goods orders and consumer confidence and Eurozone industrial production.

But what about the risks around global trade, Brexit and the Mueller inquiry?

These could cause a share market pullback but none look significant enough to cause a resumption of last year’s falls:

• US and China trade negotiations continue to see argy bargy but look to be on track to a significant deal in terms of reducing trade barriers and protecting intellectual property as it’s in both sides’ interests (particularly Trump’s who doesn’t want a trade war depressing the economy and shares and ruining his 2020 re-election prospects). But a deal with China would beg the question of whether Trump will then turn his attention to trade with Europe starting with auto tariffs. However, our assessment is that he probably won’t: America’s trade deficit with Europe is small compared to that with China; public and Congressional support for a trade war with Europe is low; most of Trump’s advisers are against it; the EU would retaliate and this would badly affect states that support Trump that export to Europe; it would be a new blow to confidence and share markets ahead of Trump’s 2020 re-election campaign.

• The Brexit soap opera continues to create huge risks for the UK but it’s a second order issue globally. 46% of UK exports go to the EU but only 6% of EU exports go to the UK, so Brexit means far more for the UK economy that it does to the EU! Given the threat to the UK economy, the issue around the Irish border and that the 2016 Brexit vote was around immigration and sovereignty but not free trade with the EU, a soft Brexit or no Brexit (after another referendum) is more likely than a hard or no deal Brexit. What happens in the Eurozone though is far more significant than Brexit.

• Finally, despite the hopes of Democrats it looks like the Mueller inquiry has failed to come up a smoking gun significant enough to see Trump removed from office. 

What about Australian bond yields at a record low?

The plunge in Australian bond yields to a record low of 1.78% (below 2016’s low of 1.81%) reflects a combination of weak economic data locally causing the fixed interest market to price in RBA rate cuts and falling bond yields globally. We remain of the view that Australian bonds will outperform global bonds (reflecting RBA easing at a time of the Fed holding) and that the Australian share market will continue to underperform global shares (as earnings growth locally lags that globally in response to weaker economic conditions in Australia). We continue to see the RBA cutting rates twice this year.

Concluding comments

Share markets are due a correction or pullback after rallying strongly since their December lows and worries about inverted yields curves and the growth outlook could provide the trigger. But US and global recession still looks to be a fair way off and we continue to see this being a reasonably good year for shares. The continuing fall in bond yields is not necessarily inconsistent with rising share markets (in 2016 shares bottomed in February and bond yields didn’t bottom till July/August!) but it does highlight that the post GFC environment of constrained growth and inflation and low rates remains alive and well.

Author: Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist, AMP Capital Sydney, Australia

Source: AMP Capital 26 March 2019

Important notes: 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) (AMP Capital) 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 and must not be provided to any other person or entity without the express written consent of AMP Capital.

When I was in my early 20s I thought socialism might be the way to go. Two things happened. One I studied economics which led me to the conclusion that socialism/heavy state intervention doesn’t lead to the best outcome in terms of living standards for most. Second, I had the benefit of a trip to the USSR before it and the eastern bloc disintegrated. It must have been Paul McCartney’s faux Beach Boys’, “Back in the USSR” that got me interested! Sure the history and scenery were fantastic and I like the fact that I saw it before the wall came down – but economically it was a mess. And trying to spend excess roubles before we left the USSR was a struggle (nothing but off chocolate to spend them on). “Socialism” seemed to work a bit better in the Deutsche Democratic Republic – but not really and it was a relief to come through Checkpoint Charlie knowing decent food (McDonald’s) was waiting.

So I ended up gravitating to the centre with the view that the best approach is to allow a market economy with the government providing a good safety net, education and intervening where there are market failures. But a wise man told me when I was young that it’s best to start off on the left when you are young otherwise you will end being like Attila the Hun, as you move to the right as you age. Given the tendency for the young to start off on the left its no surprise to see younger generations favour a bigger role for government in what The Economist magazine has dubbed “millennial socialism”. 

Source: Pew Research Center

If the millennials and Gen Z follow the normal pattern they will shift to the right as they age like their forebears. So nothing new! Well maybe but there is a big difference now compared to the 1980s. Back in the 1980s the political pendulum (or technically the median voter) was moving to the right. So my ageing was in tune with a big picture political cycle. Now the pendulum is swinging left. We first looked at this three years ago (see “The political pendulum swings to the left”, Oliver’s Insights, June 2016). Since then it’s become more evident. This note looks at what’s driving it and what it means for investors.

Political cycles beyond elections

Just as the weather, economies and financial markets go in cycles so it is with politics, even beyond standard electoral cycles. This has been clearly evident over the last century:

1930s-1970s – the Great Depression gave rise to a fear of deflation and high unemployment and a scepticism of free markets. The political pendulum swung to the left and culminated in the economic disaster of the high tax, protectionism, growing state intervention and the welfare state of the late 1960s and 1970s that gave rise to stagflation.

1980s-2000s – stagflation and the failure of heavy government intervention gave rise to popular support for the economic rationalist/right of centre policies of the 1980s. Thatcher, Reagan and Hawke and Keating ushered in a period of deregulation, freer trade, privatisation, lower marginal tax rates, tougher restrictions on access to welfare, measures to reign in budget deficits and other supply side economic reforms designed to boost productivity. The middle class didn’t support higher taxes on the rich because they aspired to be rich. This was all helped along by the collapse of communism and the integration of the old USSR and China into global trade. The political pendulum swung to the right and there was talk of “The End of History” with general agreement that free market democracies were the way to go.

2010 – ? – but post the global financial crisis (GFC) it seems the pendulum is swinging to the left again and support for economic rationalist policies seems to be fading if not reversing.

What’s pushing the political pendulum to the left?

This reflects a range of factors, in particular: 

• the feeling that the GFC indicated financial de-regulation had gone too far; 

• constrained and fragile economic growth in recent years; 

• stagnant real wages and incomes for median households;

• high household debt levels preventing individuals from taking on more debt as a way to boost living standards; 

• rising levels of inequality and perceptions that “it’s unfair”;

• the perceived failure of the baby boomer generation of political leaders to do much about climate change;

• examples of big business doing the wrong thing;

• a backlash against immigration in some countries; and 

• a backlash against globalisation.

Of course, it’s being aided by a dimming of memories of stagflation of the 1970s and its causes and the failures of socialism as highlighted by the USSR (although Venezuela provides a current example). So government related solutions or socialism seem more attractive. Allied to this are economic theories like Modern Monetary Theory (or rather, Magic Mushroom Theory) that contends governments can borrow and spend freely in the current environment of spare capacity globally spurred along by the crazy argument that quantitative easing did not cause hyper inflation and higher interest rates so why should bigger budget deficits.

Of these rising inequality and perceptions of stagnant living standards are the big ones. The next chart shows the Gini coefficient, which is about the best measure of income inequality, calculated on incomes after taxes and transfers. It ranges from zero or perfect equality to one indicating perfect inequality with one household/individual, receiving all income.

Source: OECD, Standardised World Income Inequality Database, AMP Capital

The key point is that there has been a general trend higher in inequality during the past 30 years. This is particularly evident in the emerging world but also the US, UK and Australia. Rising levels of income inequality also appears to have come with increase in wealth inequality. Rising inequality may have been more bearable or “masked” in the 1990s and 2000s as nominal income was rising faster and households took on debt to boost their living standards. But in recent times this has become harder and so rising inequality is leading to a backlash.

The political response

In this environment (often populist) politicians have been able to easily tap into voter anger and argue the case for greater public sector involvement in the economy.

• This was evident in support for self-declared socialist Bernie Sanders and Donald Trump in the US in 2016 (although Trump’s focus on deregulation and tax cuts look like a temporary deviation right). It’s now even more evident in the Democrats with the Green New Deal (that plans to rid the US of carbon emissions – and planes & cows – in a decade) and 2020 Democrat presidential aspirants adopting variations of Bernie Sanders’ policies, with proposals for wealth taxes and a 70% tax rate for income above $10 million (which is supported by 59% of Americans). It’s also evident in less US public concern about rising public debt.

• It’s been evident in the Brexit vote in the UK which represented a backlash against globalisation and the left wing turn in the British Labour Party under Jeremy Corbin. 

• In Australia, we are seeing an intensification of the left right divide not seen since 1970s. The ALP is far from the economic rationalist policies of Hawke and Keating. Policies of higher taxes for the “big end of town” (bringing back the Budget Repair Levy and winding back various tax concessions), significantly increased spending on health and education, some reregulation of the labour market and talk of raising the minimum wage to become a “living wage” all suggest a populist focus reflecting a change in voter preferences. The same pressures are also evident in some ways in proposed intervention in the energy sector. 

Qualifications

Of course, there are various qualifications to this leftward shift. First, it’s most evident in Anglo countries because it’s here that the swing to the right and economic rationalism was most pronounced in the 1980s and 90s and where inequality is more of an issue. Europe never fully bought into the supply side revolution of Thatcher and Reagan and inequality has not risen much. In fact, France under Macron looks to be embarking on its own version of Thatcherism (with the yellow jacket protests proving nothing more than that Macron is actually doing something) which should augur well for its long-term prospects if Macron stays the course. Second, it’s arguable that if the Democrats are to win the US presidential election next year they have to win the mid-west and a socialist presidential candidate may not cut it there. Third, even many on the left are sceptical of ever larger budget deficits – eg in Australia the ALP has been talking of a stronger budgetary position. Finally, there is an argument that a modest move left is necessary to curb the rise in inequality and so save capitalism – much as Keynesian economics “saved” it after the Great Depression.

But what does it all mean for investors?

The risk over time is that a more left leaning electorate will mean a tendency towards bigger government, bigger budget deficits, more regulation, higher effective top marginal tax rates, less globalisation and tougher rules on immigration in some countries. Or it may just mean a stalling in economic reforms. The risk is that it will act as another constraint on productivity and economic growth and eventually see higher inflation if the supply side of the economy suffers.

It’s worth putting this in context. The swing in the political pendulum to the right and the economic rationalist/supply side policies – of deregulation, privatisation, smaller government, tax cuts, low inflation, globalisation – that followed along with the peace dividend from the collapse of communism and attractively high starting point dividend yields and bond yields created a powerful tail wind that drove strong returns in shares and bonds starting in the early 1980s.

Now the environment is very different. Starting point investment yields are ultra-low for most assets and a reversal of economic rationalist policies in favour re-regulation, higher taxes and more government risk slowing productivity growth and eventually resulting in higher inflation.

The key point is that the powerful tailwind from the economic rationalist policies (deregulation, smaller government and globalisation) is now behind us and is contributing along with a range of other factors to a much more constrained return environment for investors. Our medium-term projection for the investment return from a balanced mix of assets have been steadily declining in recent years and is now running around 6.4% pa, which is down from over 10% a decade ago.

In this environment, there is a strong case to focus on investment strategies targeting the achievement over time of goals defined in terms of returns, investment income or whatever is required and using a flexible approach to do so as opposed to relying solely on set and forget strategies that depend heavily on market-based returns. There is also a case to look out for assets that may buck the trend of constrained returns as support for economic rationalist policies recede. French shares may be worth looking at!

Source: AMP Capital 14 March 2019

Important notes: 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) (AMP Capital) 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 and must not be provided to any other person or entity without the express written consent of AMP Capital.

Much has been made of Australia’s nearly 28 years without a recession. Despite many seeing recession as inevitable in response to the 1997 Asian crisis, the 2000-2003 tech wreck, the GFC and the “end” of the mining boom Australia has seemingly sailed on through each of these regardless. This has been thanks to a combination of economic reforms in the 1980s and 90s, the floating $A that falls whenever there is a major global problem providing a shock absorber, strong growth in China, desynchronised cycles across industry sectors and states, strong population growth and good luck. The question now is whether Australia’s luck has run out with housing turning down (and less economic reform in recent times)? While we see a constrained period for Australia as housing turns down, we still don’t see recession (albeit it’s a risk).

Australian growth has slowed again

December quarter GDP growth was just 0.2% quarter on quarter, with a fall in housing investment, weak consumer spending and business investment and a detraction from trade only partly offset by solid public demand.

Source: ABS, AMP Capital

Coming on the back of just 0.3% growth in the September quarter this is not good news. It means growth has slowed to 2.3% over the year to December and, even worse, annualised growth over the last six months has slumped to just 1%. It also means Australia has slipped into a “per capita” recession with GDP per person now falling for two quarters in a row, for the first time since 2006.

Housing downturn to be a significant drag on growth

The bad news is that growth is likely to remain under pressure as the housing downturn intensifies. Approvals to build new homes have fallen sharply. And while auction clearance rates have bounced at the start of the year we doubt this is the start of a recovery in house prices given the long list of negatives for house prices including: tight credit; the switch from interest only to principle and interest loans; record unit supply; issues around new building quality; an 80% or so collapse in foreign demand; fears that negative gearing and capital gains tax arrangements will be made less favourable if there is a change of government; and falling prices feeding on themselves. We see Sydney and Melbourne home prices falling another 15% or so as part of a total top to bottom fall of around 25% out to next year, which will see national average home prices have a top to bottom fall of around 15%. So far we are only about half way there.

We estimate that the housing downturn will detract around 1 to 1.5 percentage points from growth this year with:

• a direct detraction from growth as the housing construction cycle turns down. This is likely to amount to around 0.4 percentage points per annum (which was what it added on average during the construction boom).

Source: ABS, AMP Capital

• reduced demand for household equipment retail sales as dwelling completions top out and decline.

• a negative wealth effect on consumer spending of around 1-1.2% pa. Rising housing wealth helped drive decent growth in consumer spending in NSW and Victoria as households reduced the amount they saved as their housing wealth rose. This is now likely to go in reverse detracting around 0.7 percentage points from GDP growth.

• there could also be a feedback loop into further bank credit tightening if non-performing loans and defaults rise as unemployment starts to rise.

The east coast drought could also act as an ongoing drag on growth with a “mild” El Nino hanging around although this may be mild at around a 0.2 percentage point growth detraction.

The weakness in relation to the domestic economy is evident in in weak profit results for domestically exposed companies in the recent December half year profit reporting season. While results were better than feared enabling shares to rise, the ratio of upside surprise to downside was its weakest since 2009, only 59% saw profits rise from a year ago and only 52% raised their dividends from a year ago which (notwithstanding “special” dividends from a few companies) indicates a lack of confidence in the outlook. While consensus expectations for profit growth for this financial year held at 4%, this was only because of an upgrade to resources profit growth to 14% with profit growth in the rest of the market falling to just 1%.

Source: AMP Capital

Five sources of support for the economy

The risks to the economy from the property downturn are significant – particularly if unemployment rises sharply driving mortgage defaults and forced selling. However, there are five sources of support for the economy which should mean that a traditional (as opposed to a per capita) recession is unlikely:

• First, the drag on growth from slumping mining investment (which averaged around 1.5 percentage points per annum) is fading as mining investment is close to the bottom.

Source: ABS, AMP Capital

• Second, surveys point to a recovery in non-mining investment. Business investment plans for next financial year are well up on plans a year ago.

Source: ABS, AMP Capital

• Third, public infrastructure spending is rising solidly.

• Fourth, demand for our exports is likely to improve through this year as global growth picks up led by China in response to stimulus measures and a likely fading of trade war risks. 

• Finally, policy stimulus is likely to help with the April Budget and election outcome likely to see some combination of tax cuts or increased spending (under Labor) from July and the RBA likely to cut interest rates. 

Given the cross currents, we have revised our growth forecasts down to around 2-2.5% over the next year or so. So we see some pick up from the dismal second half 2018 pace and no recession but growth will still be well below potential and RBA forecasts.

Implications – higher unemployment/lower inflation

Growth around 2-2.5% won’t be enough to further eat into spare labour market capacity let alone absorb new entrants to the workforce so we see unemployment rising to around 5.5% by year end. This is consistent with slowing job vacancies already becoming evident. This in turn points to wages growth remaining weak. Meanwhile, it’s hard to see much uptick in inflationary pressure. The latest Melbourne Institute Inflation Gauge points to ongoing weakness in underlying inflation.

Source: ABS, Melbourne Institute, AMP Capital

RBA on track to cut rates

Against the backdrop of soft growth and inflation we continue to see the RBA cutting the cash rate to 1% this year. Rate cuts won’t be aimed at reinflating the property market but supporting households with a mortgage to offset the negative wealth effect. And banks will likely have no choice but to pass the cuts on given the bad publicity of not doing so.

Implications for investors

For investors this all means: bank deposit rates will remain poor; Australian bonds will continue outperforming global bonds; Australian shares are likely to remain relative underperformers compared to global shares as the housing downturn weighs; and with the RBA likely to cut and the Fed on hold the $A is likely to fall into the high $US0.60s.

Source: AMP Capital 6 March 2019

Important notes: 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)  (AMP Capital) 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 and must not be provided to any other person or entity without the express written consent of AMP Capital.

Prior to the 1960s most share investors were long-term investors who bought stocks for their dividend income. Investors then started to focus more on capital growth as bond yields rose relative to dividend yields on the back of rising inflation. However, thanks to an increased focus on investment income as baby boomers retire, interest in dividends has returned. This is a good thing because dividends are good for investors in more ways than just the income they provide.

Australian companies pay out a high proportion of earnings as dividends. This is currently around 65% compared to around 45% for global shares. However, some argue that dividends don’t matter – as investors should be indifferent as to whether a company pays a dividend or retains earnings that are reinvested to drive growth. Or worse still, some argue that high dividend pay outs are a sign of poor long-term growth prospects, that they are distraction from business investment or that they are often not sustainable. And of course, some just see dividends as boring relative to speculating on moves in share values. My assessment is far more favourable.

Seven reasons why dividends are cool

First, dividends do matter in terms of returns from shares. For the US share market, it has been found that higher dividend payouts lead to higher earnings growth¹. This is illustrated in the next chart, which shows that for the period since 1946 when US companies paid out a high proportion of earnings as dividends (the horizontal axis) this has tended to be associated with higher growth in profits (after inflation) over the subsequent 10 years (vertical axis). And higher profit growth drives higher returns from shares. So dividends do matter and the higher the better (within reason). There are several reasons why this is the case: when companies retain a high proportion of earnings there is a tendency for poor hubris driven investments; high dividend payouts are indicative of corporate confidence about future earnings; and high payouts indicate earnings are real.

Source: Global Financial Data, Thomson Reuters, AMP Capital

Second, dividends provide a stable contribution to the total return from shares, compared to the year-to-year volatility in capital gains. Of the 11.7% pa total return from Australian shares since 1900, just over half has been from dividends.

Source: Global Financial Data, AMP Capital Investors

Third, the flow of dividend income from a well-diversified pool of companies is relatively smooth. As can be seen below, dividends move in line with earnings but are smoother.

Source: Thomson Reuters, RBA, AMP Capital

Companies like to manage dividend expectations smoothly. They rarely raise the level of dividends if they think it will be unsustainable. Sure, some companies do cut their dividends at times, but the key is to have a well-diversified portfolio of sustainable and decent dividend paying shares.

Fourth, investor demand for stocks paying decent dividends will be supported as the ranks of retirees swell.

Fifth, with the scope for capital growth from shares diminished thanks to relatively high price to earnings ratios compared to say 40 years ago, dividends will comprise a much higher proportion of total equity returns. More than half of the total medium-term return from Australian shares is likely to come from dividends, once allowance is made for franking credits.

Sixth, dividends provide good income. Grossed up for franking credits the annual income flow from dividends on Australian shares is around 5.7%. That’s $5700 a year on a $100,000 investment in shares compared to $2150 a year in term deposits (assuming a term deposit rate of 2.15%).

Source: Bloomberg, RBA, AMP Capital

Finally, while Australian shares are still 10% below their 2007 high, once reinvested dividends are allowed for (ie looking at the ASX 200 accumulation index) the market is well above it.

Source: Bloomberg, AMP Capital

Another way to look at dividend income

How powerful investing for dividend income can be relative to investing for income from interest is illustrated in the next chart. It compares initial $100,000 investments in Australian shares and one-year term deposits in December 1979.

Source: RBA, Bloomberg, AMP Capital

The term deposit would still be worth $100,000 (red line) and last year would have paid $2,200 in interest (red bars). By contrast the $100,000 invested in shares would have grown to $1,111,435 as at December last year (blue line) and would have paid $47,792 in dividends last year (blue bars). Or around $62,240 if franking credits are allowed for. Over time an investment in shares can rise but a term deposit is fixed.

But don’t dividends crimp capex?

This issue has been wheeled out repeatedly since the GFC. But it’s ridiculous. First the rise in dividends this decade has mainly come from cashed up miners and it’s hard to argue they should invest more after the mining investment boom. Second the dividend payout ratio is not high historically. Third the reasons for poor business investment lie in: business sector caution after the GFC & the rise in the $A above parity, which squeezed competitiveness; the fall back to more normal levels in mining investment; and the shift to a capital lite economy based around IT and services. Don’t blame dividends for poor capex.

Source: Thomson Reuters, RBA, AMP Capital

Why dividend imputation is so important

Dividend imputation was introduced in the 1980s and allows Australians to claim a credit against their tax liability for tax already paid on their dividends in the hands of companies as profits and boosts the effective dividend yield on Australian shares by around 1.3 percentage points. However, over the years it has been subject to claims that it creates a bias to invest in domestic equities, that it biases companies to pay dividends and not invest and that it benefits the rich. This is all nonsensical as dividend imputation simply corrects a bias by removing the double taxation of company earnings – once in the hands of companies and again in the hands of investors. The removal of dividend imputation would not only reintroduce a bias against equities but would also substantially cut into the retirement savings and income of Australians, discourage savings and lead to lower returns from Australian shares.

Labor’s proposal to make franking credits in excess of a taxpayer’s tax liability non-refundable could be argued to remove an anomaly in the tax system as dividend imputation was designed to prevent the double taxation of dividends, not to stop them being taxed at all. But a problem is that many Australians have planned their retirement around receiving such refunds. This is a subject for another note. But it is worth noting that Labor’s proposal does not affect at least 92% of taxpayers who will continue receiving franking credits as they have a sufficient income tax liability (as will pensioners who will be exempted). If it sets off a broader wind back of franking credits, then it would be a bigger concern.

Concluding comments

Dividends provide a great contribution to returns, a degree of protection during bear markets and a great income flow. For investors needing income the trick is to have a well-diversified portfolio of companies paying high sustainable dividends.

¹See R.D.Arnott and C.S.Asness, “Surprise! Higher Dividends = Higher Earnings Growth”, Financial Analysts Journal, Jan/Feb 2003. Of course, it’s a bit complicated in the US as the tax system encourages buy backs.

Source: AMP Capital 27 Feb 2019

Important notes: 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) (AMP Capital) 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 and must not be provided to any other person or entity without the express written consent of AMP Capital.