Olivers Insights

The threat of a full-blown trade war has escalated in the last few weeks with the G7 meeting ending in disarray over US tariffs on imports of steel and aluminium from its allies and more importantly President Trump threatening tariffs on (so far at least) $US450bn of imports from China, and China threatening to retaliate. Our base case remains that a negotiated solution will ultimately be reached, but the pain threshold in the US is clearly higher than initially thought and the risks have increased.

Background on trade wars and protectionism

A trade war is a situation where countries raise barriers to trade, with each motivated by a desire to “protect’’ domestic workers, and sometimes dressed up with “national security” motivations. To be a “trade war” the barriers need to be significant in terms of their size and the proportion of imports covered. The best-known global trade war was that of 1930 where average 20% tariff hikes on most US imports under Smoot-Hawley legislation led to retaliation by other countries and contributed to a collapse in world trade.

A basic concept in economics is comparative advantage: that if Country A and B are both equally good at making Product X but Country B is best at making Product Y then they will be best off if A makes X and B makes Y. Put simply free trade leads to higher living standards and lower prices, whereas restrictions on trade lead to lower living standards and higher prices. The trade war of the early 1930s is one factor that helped make The Great Depression “great”. As RBA Governor Philip Lowe has observed “Can anyone think of a country that’s made itself wealthier or more productive by building walls?”

Access for US exports to China and stronger protection of US intellectual property. His comments at the recent G7 meeting where he proposed completely free trade suggest he secretly does support free trade (although it’s a bit hard to know for sure!)

Most of these issues were covered in more detail here.

Where are we now?

Fears of a global trade war were kicked off in early March with Trump announcing a 10% tariff on aluminium imports and a 25% tariff on steel imports. US allies were initially exempted but China was not and the exemptions for Canada, Mexico and the European Union expired on June 1. But tariffs on steel and aluminium imports are minor at around 1.5% of total US imports. There is a risk of escalation though as the affected countries retaliate.

However, the main focus remains China. On March 22, in response to the Section 301 intellectual property review (alleging theft by China), Trump proposed 25% tariffs on $US50bn of US imports from China and restrictions on Chinese investment in the US. At the same time, the US lodged a case against China with the World Trade Organisation. China then announced “plans” for 25% tariffs on $US50bn of imports from the US with a focus on agricultural products. Then Trump threatened tariffs on another $US100bn of imports from China in proposed retaliation to China’s proposed retaliation to which China said it would retaliate.

These tariffs were put on hold after a May 19 agreement between the US and China under which China agreed to import more from the US, reduce tariffs and strengthen laws to protect intellectual property, with negotiations around the details to come. Trump initially cheered the outcome, but after domestic criticism did a backflip and announced that the $US50bn in imports from China to be subject to a 25% tariff would be finalised by June 15, which they were (with a July 6 start date set for $US34bn) and that investment restrictions would be finalised by June 30.

After China said that the May 19 deal was no more and that it would match US tariffs, Trump upped the $US100bn to a 10% tariff on $US200bn of imports and said that if China retaliates to that it will do another $US200bn. This brings the tariffs on US imports from China to $US450bn which covers 90% of America’s total annual imports from China. Along the way Trump has also announced consideration of automobile tariffs – with the outcome yet to be announced.

Rising risk of a full-blown trade war

Clearly the escalating tariff threats have added to the risk of a full-blown trade war between the US and China, and with an escalation possible between the US and its allies. The initial tariffs on steel and aluminium and proposed for $US50bn of imports from China amount to a still small 3% or so of US imports or just 0.5% of US GDP so only a trivial impact and hardly a trade war.

But if there are tariffs on $US450 of imports it’s about 18% of total US imports and will have a bigger impact. On this scale it’s inevitable that consumer goods will be impacted. And with China only importing $US130bn from the US annually, it’s proportional retaliation to US tariffs will have to move into other areas like tougher taxation and regulation of US companies operating in China and selling US Treasury Bonds (although this will only push the Renminbi up which will make things worse for China).

And of course, with US allies preparing retaliation against US tariffs on steel and aluminium (eg EU tariffs on US whiskey and Harley Davidsons) there is a danger that conflict escalates here too as the US counter-retaliates. And then there’s potentially auto tariffs.

There is also the danger that President Trump’s flip flops on policy (particularly after the May 19 agreement with China) and the confusion as to who is handling the US negotiations (whatever happened to Treasury Secretary Mnuchin who declared that the trade war had been put on hold?) has damaged Trump’s and US credibility.

Economic impact

The negative economic impact from a full-blown trade war would come from reduced trade and the disruption to supply chains that this would cause. This is always a bit hard to model reliably. Modelling by Citigroup of a 10% average tariff hike by the US, China and Europe showed a 2% hit to global GDP after one year, with Australia seeing a 0.5% hit to GDP reflecting its lower trade exposure compared to many other countries, particularly in Asia which will face supply chain disruption. At present we are nowhere near an average 10% tariff hike (the average proposed tariff on $450bn of Chinese imports is 12% which across all US imports is around 2%). So this would need much further escalation from here.

It might also be argued that the US is best placed to withstand a trade war because it imports more from everyone else than everyone else imports from it and the negative impact from the proposed tariffs (which is running around $60bn in tax revenue out of the economy) is swamped by the $300bn in fiscal stimulus boosting the US economy. Trump also feels empowered because there is a lot of domestic support in the US for taking a tougher stance on trade (particularly amongst Republicans) and his approval rating has risen to 45% – the highest in his Presidency.

And the current situation mainly just involves the US and China (in terms of significant tariff announcements), so arguably Chinese and US goods flowing to each other could – to the extent that there are substitutes – just be swapped for goods coming from countries not subject to tariffs, thereby reducing the impact.

Some reasons for hope

So far what we have really seen is not a trade war but a trade skirmish. The tit for tat tariffs triggered in relation to US steel and aluminium imports are trivial in size. All the other tariffs are just proposals and the additional tariffs on $US200bn of imports from China plus another $US200bn would take months to implement, much like the initial tariffs on $US50bn. Trump is clearly using his “Maximum Pressure” negotiating approach with US Trade Representative Lighthizer saying on Friday that “we hope that this leads to further negotiations”. If the US didn’t really want to negotiate, the tariffs would no longer be proposals but would have been implemented long ago. And while Trump is riding high now as he stands tough for American workers, a full-blown escalation into a real trade war with China come the November mid-term elections is not in his interest. This would mean higher prices at Walmart and hits to US agricultural and manufacturing exports both of which will hurt his base and drive a much lower US share market which he has regarded as a barometer of his success. US Congressional leaders may also threaten intervention if they feel Trump’s tariff escalation is getting out of hand. So negotiation is still the aim and China, given its May agreement, is presumably still open to negotiation. So our base case is that after a bit more grandstanding for domestic audiences, negotiations recommence by early July allowing the July 6 tariffs to be delayed as negotiations continue, which ultimately lead to a resolution before the tariffs are implemented. Share markets would rebound in response to this.

But given the escalation in tension and distrust of President Trump we would now only attach a 55% probability to this. The other two scenarios involve:

• A short-lived trade war with say the tariffs starting up on July 6 and maybe some more but with negotiations resulting in their eventual removal (30% probability). This would likely see more share market downside in the short term before an eventual rebound.

• A full-blown trade war with China with all US imports from China subject to tariffs and China responding in kind, triggering a deeper 10% decline in share markets on deeper global growth worries (15% probability).

What to watch?

Key to watch for is a return to negotiation between the US and China by the end of June. The renegotiation of NAFTA and proposed retaliation from the EU against US steel and aluminium imports are also worth watching.

Why are Australian shares so relaxed?

Despite the trade war threat Australian shares have pushed to a 10 year high over the last few days helped by a rebound in financial shares, a boost to consumer stocks from the likely passage of the Government’s tax cuts (even though these are trivial in the short term) and strong gains in defensives. Given that China takes one third of our exports the local market would be vulnerable should the trade war escalate significantly. But if our base case (or even a short-lived trade war) plays out the ASX 200 looks on track for our year-end target of 6300.

Source: AMP Capital 21 June 2018

Author: 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.

Here’s my forecast: “The global economy is going to have a significant downturn and record levels of debt are going to make it worse.” Sound scary enough? Put it in the headline and I can be assured of lots of clicks! I might even be called a deep thinker! The problem is that there is nothing new or profound in this. A significant economic downturn is inevitable at some point (it’s just the economic cycle), debt problems are involved in most economic downturns and such calls are a dime a dozen.

A standard scare now is that memories of the role of excessive debt in contributing to the GFC have worn thin and total global debt has pushed up to a new record high of over $US200 trillion – thanks largely to public debt in developed countries (with more to come in the US as Trump’s fiscal stimulus rolls out), Chinese debt and corporate debt (and household debt in Australia of course). Also, that its implosion is imminent and inevitable as interest rates normalise and that any attempt to prevent or soften the coming day of reckoning will just delay it or simply won’t work. However, in reality it’s a lot more complicated than this. This note looks at the main issues.

Global debt – how big is it and who has it?

Total gross world public and private debt is around $US171 trillion. Adding in financial sector debt pushes this over $US200 trillion but that results in double counting. Either way it’s a big and scary number. But it needs to be compared to something to have any meaning or context. A first point of comparison is income or GDP at an economy wide level. And even here new records have been reached with gross world public and private non-financial debt rising to a record of 233% of global GDP in 2016, although its fallen fractionally to 231% since. See the next chart.

Source: IMF, Haver Analytics, BIS, Ned Davis Research, AMP Capital

The next table compares total debt for various countries.

Source: IMF, Haver Analytics, BIS, Ned Davis Research, AMP Capital

The next chart shows a comparison of developed world (DM) and emerging world (EM) debt – both public and private.

Source: Haver Analytics, BIS, Ned Davis Research, AMP Capital

It can be seen that the rise in debt relative to GDP since the GFC owes to rising public debt in the developed world and rising private debt in the emerging world. Within developed countries a rise in corporate debt relative to GDP has been offset by a fall in household debt, so private debt to GDP has actually gone down slightly. And a rapid rise Chinese debt (particularly corporate) has played a role in the emerging world.

Of course, it needs to be mentioned that measures of gross debt exaggerate the total level of debt. For example, because of government holdings of debt instruments via sovereign wealth funds, central bank reserves, etc, net public debt is usually well below gross debt. In Norway net public debt is -91% of GDP and in Japan it’s 153% of GDP. But as an overview:

• Japan, Belgium, Canada, Portugal and Greece have relatively high total debt levels;

• Germany, Brazil, India and Russia have relatively low debt;

• Australia does not rank highly in total debt – it has world-beating household debt but low public & corporate debt;

• Emerging countries tend to have relatively lower debt, but rising private debt needs to be allowed for particularly in China, where corporate debt is high relative to GDP.

The bottom line is that global debt is at record levels even relative to GDP so it’s understandable there is angst about it.

Seven reasons not to be too alarmed about record debt

However, there are seven reasons not to be too alarmed by the rise in debt to record levels.

First, the level of debt has been trending up ever since debt was invented. This partly reflects greater ease of access to debt over time. So that it has reached record levels does not necessarily mean it’s a debt bomb about to explode.

Second, comparing debt and income is a bit like comparing apples and oranges because debt is a stock while income is a flow. Suppose an economy starts with $100 of debt and $100 in assets and in year 1 produces $100 of income and each year it grows 5%, consumes 80% of its income and saves 20% which is recycled as debt and invested in assets. How debt, debt to income & debt to assets evolves can be seen in the next table.

Debt ratios over time
 

Source: AMP Capital

At the end of year 1 its debt to income ratio will be 120%, but by the end of year 5 it will be 173%. But assuming its assets rise in line with debt its debt to asset ratio will remain flat at 100%. So the very act of saving and investing creates debt and {% rising debt to income ratios. ¹ China is a classic example of this where it borrows from itself. It saves 46% of GDP and this saving is largely recycled through banks and results in strong debt growth. But this is largely matched by an expansion in productive assets. The solution is to spend more, save less and recycle more of its savings via investments like equity. 

Third, the rapid rise in private debt in the emerging world is not as concerning as they have a higher growth potential than developed countries. Of course, the main problem emerging countries face is that they borrow a lot in US dollars and either a sharp rise in the $US or a loss of confidence by foreign investors causes a problem. This has started to be a concern lately as the $US is up 7% from its low earlier this year.

Fourth, debt interest burdens are low and in many cases falling as more expensive, long maturity, older debt rolls off. And given the long maturity of much debt in advanced countries it will take time for higher bond yields to feed through to interest payments. In Australia, interest payments as a share of household disposable income are at their lowest since 2003, and are down by a third from their 2008 high. There is no sign of significant debt servicing problems globally or in Australia.

Fifth, most of the post GFC debt increase in developed countries has come from public debt & governments can tax and print money. Japan is most at risk here given its high level of public debt, but borrows from itself. And even if Japanese interest rates rise sharply (which is unlikely with the BoJ keeping zero 10-year bond yields with little sign of a rise) 40% of Japanese Government bonds are held by the BoJ so higher interest payments will simply go back to the Government.

Sixth, while global interest rates may have bottomed, the move higher is very gradual as seen with the Fed and the ECB, Bank of Japan and RBA are all a long way from raising rates. What’s more, central banks know that with higher debt to income ratios they don’t need to raise rates as much to have an impact on inflation or growth as in the past.

Finally, debt alone is rarely the source of a shock to economies. Broader signs of excess such as overinvestment, rapid broad-based gains in asset prices and surging inflation and interest rates are usually required and these aren’t evident on a generalised basis. But these are the things to watch for.

Concluding comment

History tells us that the next major crisis will involve debt problems of some sort. But just because global debt is at record levels and that global interest rates and bond yields have bottomed does not mean a crisis is imminent. For investors, debt levels are something to remain alert too – but in the absence of excess in the form of booming investment levels, surging inflation and much higher interest rates, for example, there is no need to be alarmed just yet.   

^{1.↩  [My favourite example of the complex relationships between income, saving and debt came from Bank Credit Analyst Research. Suppose there is an island with 100 people, each making 100 coconuts a year. Here’s three possibilities.}

Case 1: Output is 10,000 coconuts with each person consuming 100. Saving and investment are zero and no debt is created.
Case 2: Each person consumes only 75 coconuts a year, selling the remainder to a plantation who buys them with a bank loan and plants them resulting in 2500 new coconut trees. Consumption is 7500 coconuts. Savings and investment are 2500 and debt has gone up by 2500 coconuts.
Case 3: Each person consumes 125 coconuts, by importing 25 each from foreign islands. Consumption is now 12,500 coconuts, savings is -2500 coconuts, investment is zero and the current account deficit is 2500. External debt goes up by 2500. This gets risky if the other islands want their coconuts back!

So debt can rise even if an economy lives within its means & invests for the future. ]↩ 

Source: AMP Capital 19 June 2018

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.

It seems there is constant hand wringing about the risks around the Chinese economy with the common concerns being around unbalanced growth, debt, the property market, the exchange rate and capital flows and a “hard landing”. This angst is understandable to some degree. Rapid growth as China has seen brings questions about its sustainability. And China is now the world’s second largest economy, its biggest contributor to growth and Australia’s biggest export market so what happens in China has big ramifications globally. But despite all the worries it keeps on keeping on and recently growth has been relatively stable. This note looks at China’s growth outlook, the main risks and what it means for investors and Australia.

Stable growth, benign inflation

Chinese growth slowed through the first half of this decade culminating in a growth and currency scare in 2015 which saw Chinese policy swing from mild tightening towards stimulus. This has seen pretty stable growth since 2016 of around 6.8% year on year. Consistent with this, business conditions PMIs have also been stable (see the next chart) and uncertainty around the Renminbi has fallen & capital outflows have slowed.

Source: Bloomberg, AMP Capital

April data saw industrial production and profits accelerate but investment and retail sales slow a bit. Electricity consumption, railway freight and excavator sales have lost momentum from their highs. But the overall impression is that growth is still solid.

Source: Bloomberg, AMP Capital

While there is a need for China to rebalance its growth away from investing for exports, the slowdown in investment growth to below that for retail sales, imports growing faster than exports and the shrinkage in China’s current account deficit from 10% of GDP to 1% of GDP suggests this occurring.

Meanwhile, inflation in China is benign with producer price inflation around 3% and consumer price inflation around 2%.

Source: Domain, AMP Capital

Policy neutral

Chinese economic policy has been relatively stable recently. There has been some talk of boosting domestic demand and bank required reserve ratios have been cut. But the latter appears to have been to allow banks to repay medium term loan facilities, interest rates have been stable and growth in public spending has been steady at 7-8% year on year.

Growth and inflation outlook

We expect Chinese growth this year to slow a bit as investment slows further to around 6.5% and consumer inflation of 2-3%.

Key risks facing China

There are four key risks facing China. First, the policy focus could shift from maintaining solid growth to speeding up medium-term economic reforms and deleveraging (or cutting debt ratios) that could threaten short-term economic growth. Some expected this to occur after the 19th National Congress of the Communist Party was out of the way late last year. And the removal of term limits on President Xi Jinping could arguably make him less sensitive to a short-term economic downturn. However, so far there is no sign of this and the authorities seem focused on maintaining solid growth.

Second, China’s rapid debt growth could turn sour. Since the Global Financial Crisis, China’s ratio of non-financial debt to GDP has increased from around 150% to around 260%, which is a faster rise than has occurred in all other major countries.

Source: RBA, AMP Capital

This has been concentrated in corporate debt and to a lesser degree household debt and has been made easier by financial liberalisation and a lot of the growth has been outside the more regulated banking system in “shadow banking”. An obvious concern is that when debt growth is rapid it results in a lot of lending that should not have happened that eventually goes bad. However, China’s debt problems are different to most countries. First, as the world’s biggest creditor nation China has borrowed from itself – so there’s no foreigners to cause a foreign exchange crisis. Second, much of the rise in debt owes to corporate debt that’s partly connected to fiscal policy and so the odds of government bailout are high. Finally, the key driver of the rise in debt in China is that it saves around 46% of GDP and much of this is recycled through the banks where it’s called debt. So unlike other countries with debt problems China needs to save less and consume more and it needs to transform more of its saving into equity rather than debt. Chinese authorities have long been aware of the issue and growth in shadow banking and overall debt has slowed but slamming on the debt brakes without seeing stronger consumption makes no sense.

Third, the risk of a trade war has escalated with Trump threatening tariffs on $50-150bn of imports from China and restrictions on Chinese investment in the US and China threatening to reciprocate. While “constructive” negotiations have commenced and have seen China commit to buying more from the US & to strengthen laws protecting intellectual property which saw the US initially defer the tariffs and restrictions, Trump has indicated that they will be implemented this month which looks to be aimed at prodding China to move rapidly (and appeasing his base). Ultimately, we expect a negotiated solution, but the risks are high and a full-blown trade war with the US could knock 0.5% or so off Chinese short-term growth.

Finally, with the Chinese residential property market slowing again there is naturally the risk that this could turn into a slump. It’s worth keeping an eye on but absent an external shock looks doubtful. The “ghost cities” paranoia of a few years ago – it first aired on SBS TV way back in 2011 – has clearly not come to much. It’s doubtful China ever really had a generalised housing bubble: household debt is low by advanced country standards; house prices haven’t kept up with incomes; and while there’s been some excessive supply, this is not so in first tier cities; and the quality of the housing stock is low necessitating replacement. So, I think the property crash fears continue to be exaggerated and the latest bout of weakness in prices looks to be just another cyclical downswing in China of which there have been several over the last decade.

Our assessment remains that these risks are manageable, albeit the trade war risk is the hardest for China to manage given the erratic actions of President Trump. The Chinese Government has plenty of firepower to support growth though, so a “hard landing” for Chinese growth remains unlikely for now.

The Chinese share market

Since its low in January 2016 the Chinese share market has had a good recovery. But Chinese shares are trading on a price to earnings ratio of 12.8 times which is far from excessive.

With valuations okay and growth continuing, Chinese shares should provide reasonable returns, albeit they can be volatile.

Implications for Australia – not yet 2003, but still good

Solid growth in China should help keep commodity prices, Australia’s terms of trade and export volume growth reasonably solid. This, along with rising non-mining investment and strong public investment in infrastructure, will offset slowing housing investment and uncertainty over the outlook for consumer spending and will keep Australian economic growth going. However, with strong resources supply (and still falling mining investment) we are a long way from the boom time conditions of last decade and growth is likely to average around 2.5-3%. Rising US interest rates against flat Australian rates suggests more downside for the $A, but solid commodity prices should provide a floor for the $A in the high $US0.60s.

Key implications for investors

• Chinese shares remain reasonably good value from a long- term perspective, but beware their short-term volatility.

• Solid Chinese growth should support commodity prices and resources shares

Source: AMP Capital 04 June 2018

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.

So far this year geopolitical developments have been having a significant impact on investment markets. Most of these revolve in some way around President Trump and the US: with the threat of a trade war between the US and China (although “constructive” talks between the two add to confidence that a trade war will be averted); the Mueller inquiry concerning his campaign’s links to Russia (but like many such inquiries seems to be looking at other things too); the US decision to reimpose sanctions on Iran (and a resultant rise in oil prices); and recently (mostly) good news regarding North Korea.

Away from the US the other major geopolitical risk on investors’ radars at present concerns Italy. Last year the big concern was that the 2016 Brexit vote and Trump victory presaged a surge in support for populist Eurosceptic parties in elections in the Netherlands, France, Germany and Austria and that an independence vote in the Catalan region of Spain would also pose a threat, all contributing to increased risk of an eventual Eurozone break up. In the end no such thing happened. This year the concern is that the formation of a populist coalition government in Italy with Eurosceptic leanings will drive crisis in Italy and potentially threaten the Euro. I must admit that while I wasn’t worried about last year’s Eurozone elections the risks around Italy are greater. But a break up of the Euro triggered by Italy still looks very unlikely. And in the meantime, Eurozone shares remain attractive. This note looks at the main issues.

Populists take over in Italy

While the populists did not fare as well as many predicted in Europe last year the populist left-leaning Five Star Movement (5SM) and populist far-right Northern League (NL) were the big winners in the Italian elections in March. While neither won a majority on their own and a coalition between them was seen as the worst possible scenario given their background of Euroscepticism and support for irrational economic policies, despite their political differences they have agreed to do just that. They are proposing amongst other things: big tax cuts (with just two rates of 15% and 20% for companies and individuals); a basic income for the less well off; a roll back of pension reforms; and a review of European Union budget rules.

The resultant budget deficit blow out will create tensions with the EU at a time when Italian public debt at around 130% of GDP is the second highest amongst Eurozone countries and its budget deficit at around 1.6% of GDP is the third highest.

Source: IMF, AMP Capital. Note: Greek public debt looks worse than it is as Eurozone assistance has lengthened its maturity at very low rates.

Which in turn risks significant upwards pressure on Italian bond yields. Northern League leader Matteo Salvini has naively bragged that “The spread [between Italian and German bond yields] is going up – do you remember the spread?”. Investors do and the gap between Italian and German bond yields has risen by 0.63% this month so Italy now pays 1.85% more than Germany to borrow for 10 years. This has put some upwards pressure on Spanish and Portuguese bond yields, although none are near the extremes of the 2011-2012 Eurozone crisis.

Source: Bloomberg, AMP Capital

This is also now weighting on Italian shares which after being outperformers over the last year as the Italian economy improved are now down 3.7% this month. Market and economic realities may eventually force 5SM and NL to water down their policies in government – which may explain why the leader of neither wants to be PM! In some ways this has echoes of Syriza in Greece that once promised extreme populist policies and an exit from the Euro but became just another centrist European political party. So it may turn out to be a non-event but it could still impose significant risk along the way (as the noise in Greece did) and suggests a cautious stance towards Italian assets – particularly shares and bonds.

Three reasons not to be too concerned about an Itexit

Given 5SM and NL’s background in Euroscepticism an Italian push for an exit from the Euro (Itexit) could emerge as an issue when Italy and the Eurozone next have an economic downturn. However, there are three reasons not to be too concerned about an Itexit and contagion to the rest of the Eurozone.

First, its not an imminent threat in Italy because while support for the Euro there is not as strong as it is elsewhere in the Eurozone, a majority of Italians support the Euro (with support actually rising from a year ago) and 5SM and NL only did well because they backed away from policies to exit the Euro.

Source: Eurobarometer, AMP Capital

Second, as Syriza and Greece have found exiting the Euro is easier said than done and would involve: currency redenomination; a probable sharp collapse in the value of the “new” Lira; a run on the banks, capital flight and a sharp rise in Italian bond yields as depositors, individuals, companies and investors try to move into harder currency; harsh fiscal austerity as funding for Italy’s 1.6% of GDP general budget deficit would evaporate; and a return to recession. This would likely see a 5SM/NL coalition government back away from an Itexit before it went too far – just as we saw Syriza do.

Third, the risk of contagion to the rest of the Eurozone is far less than it was earlier this decade:

• other vulnerable countries like Spain, Ireland, Portugal and even Greece are now in much better shape (with lower budget deficits, stronger growth and falling unemployment);

• more broadly, Eurozone break up risk may have peaked with the high point of the Eurozone debt crisis – when unemployment & fiscal austerity were at their peak in 2013. But unemployment has now fallen from 12% to 8.5% and fiscal austerity has ended. An end to the migration crisis may help too with sea arrivals collapsing since 2015; and

• popular support for the Euro is solid at around 70% across the Eurozone and various countries showed by their elections last year they aren’t interested in exiting the Euro.

​While a break up in the Euro is unlikely, a populist coalition in government in Italy, which is the Eurozone’s third largest country, along with a deterioration in its budgetary position will keep fears of a threat to it alive (after they subsided following last year’s elections) and this will weigh on the Euro. Particularly in the short term until investors get a clearer handle on what a 5SM/NL coalition government in Italy will do.

Eurozone shares remain attractive

While question marks remain over Italy and this will weigh on the Euro, there is good reason to be optimistic regarding Eurozone shares. First, Eurozone shares are not expensive. They are trading on a price to forward earnings multiple of 14 times which is around its long-term average. And their cyclically adjusted price to earnings ratio which compares share prices to a ten-year moving average of earnings (often called a Shiller PE) is around 17 times compared to 32 times in the US. This is largely because Eurozone shares underperformed US shares in the post GFC period. Adjusting for relatively lower bond yields in Europe makes Eurozone shares even more attractive.

Source: Global Financial Data, AMP Capital

Second, the European Central Bank is still pumping cash into the economy and is a long way from rate hikes. Italian risk may keep it easier for longer. This contrasts to the Fed which is engaging in quantitative tightening and raising interest rates.

Third, the Euro is now falling. A rise in the Euro through last year – as Eurozone growth surprise on the upside relative to the US and political risk declined in the Eurozone relative to the US – harmed Eurozone shares. This is now reversing as US growth has started to accelerate relative to the Eurozone.

Finally, while Eurozone growth has slowed a bit it’s still good and thanks to ongoing monetary stimulus and a now falling Euro is likely to remain so. In turn this is good for profit growth.

Source: Bloomberg, AMP Capital

Key implications for investors

There are several implications for investors. Firstly, a populist coalition government in Italy is negative for Italian assets.

Second, it’s another drag on the Euro which along with relatively easier monetary policy and slower growth compared to the US is likely to see more downside against the US dollar (which probably means it tracks sideways against the $A).

Finally, Eurozone shares are likely to be relative outperformers notably versus US shares thanks to more attractive valuations, easier monetary policy and a falling Euro.  

Source: AMP Capital 22 May 2018

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.

Investing can be frustrating and depressing at times, particularly if you don’t understand how markets work and don’t have the right mindset. The good news is that the basics of investing are timeless, and some have a knack of encapsulating these in a sentence or two that is both insightful and easy to understand. In recent years I’ve written insights highlighting investment quotes that I find particularly useful. Here are some more.

Having a goal and a plan

“Financial peace isn’t the acquisition of stuff. It’s learning to live on less than you make, so you can give money back and have money to invest. You can’t win until you do this.” Dave Ramsey

The only way to be able to build wealth is to save and invest and you can only do this if you spend less than you earn. That is, you have to start with a savings plan.

“Put time on your side. Start saving early and save regularly. Live modestly and don’t touch the money that’s been set aside” Burton G Malkiel

In investing time is your friend and the earlier you start the better. This is the best way to take advantage of the magic of compound interest. The next chart – my favourite – shows the value of $1 invested in various Australian asset classes since 1900 allowing for the reinvestment of any income along the way. That $1 would have grown to just $234 if invested in cash, $866 in bonds but a whopping $529,293 if invested in shares.  

Source: Global Financial Data, AMP Capital

While the average share return since 1900 is only double that in bonds, the huge gap in the end result between the two owes to the magic of compounding returns on top of returns. A growth asset like property is similar to shares over long periods in this regard. Short-term share returns bounce all over the place and they can go through lengthy bear markets (shown with arrows on the chart). But the longer the time period you allow to build your savings the easier it is to look through short-term market fluctuations and the greater the time the compounding of higher returns from growth assets has to build on itself.

“If you fail to plan, you plan to fail.” Often attributed to Benjamin Franklin

Having a clear understanding of your investment goals – like saving for a home or retirement or generating income to live on – and a plan to get there is critical. If you don’t have a clear plan you will be subject to all sort of distractions which can blow you a long way from where you want to get with your investments.

The investment cycle

“Bull markets don’t die of old age but of exhaustion.” Anon

Bear markets are invariably preceded by excess in the economy – over investment, high levels of debt growth, high levels of inflation and tight monetary conditions – and excess in the share market in the form of overvaluation and investor euphoria. It’s this excess which drives exhaustion and hence the end of a bull market, not its age.

“The stock market has predicted 9 of the past 5 recessions.” Paul Samuelson

In the short term the share market moves all over the place with each significant plunge eliciting calls for an impending recession and a deep bear market. But most of the time it’s just noise providing an opportunity for investors before a rebound. For example, over the past 50 years in the US there has been 21 episodes of 10% or greater share market falls, but only seven saw recessions and bear markets.

Risk

“The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. Not only is the mere drop in stock prices not risk, but it is an opportunity.” Li Lu

Risk is often portrayed as market volatility when in reality it’s a whole lot more: the risk of capital loss; the risk of not having enough investment income; the risk of not having enough to last through retirement. It’s also perverse – the risk of capital loss is lowest after a period of high volatility and vice versa.

Contrarian investing

“The day after the market crashed on 19^th October 1987, people began to worry that the market was going to crash” Peter Lynch

This is perhaps a bit flippant, but it goes to the heart of crowd psychology and why it’s best to go against the crowd at extremes. When times are good the crowd is relaxed, happy and fully invested. So everyone who wants to buy has. This leaves the market vulnerable to bad news because there is no one left to buy should prices drop. Similarly, after a sharp fall the crowd gets negative, sells their investments to the point that everyone who wants to sell has and so the market sets up for a rally when some good or less bad news comes along. So the point of maximum risk is when most are euphoric, and the point of maximum opportunity is when most are pessimistic.

Pessimism

“It is easier being sceptical, than being right.” Benjamin Disraeli

The human brain evolved in a way that it leaves us hardwired to be on the lookout for risks. So a financial loss is felt more negatively than the beneficial impact of the same sized gain. Consequently, it seems easier to be sceptical and pessimistic. As a result, bad news sells and there seems to be a never-ending stream of warnings regarding the next disaster. But when it comes to investing, succumbing too much to scepticism and pessimism doesn’t pay. Historically, since 1900 shares have had positive returns seven years out of 10 in the US and eight years out of 10 in Australia.

“A pessimist sees the difficulty in every opportunity, an optimist sees the opportunity in every difficulty.” Winston Churchill

This is what stops many investing after big falls – all they see are the reasons the market fell. Not the opportunity it provides.
 

“Without a saving faith in the future, no one would ever invest at all. To be an investor, you must be a believer in a better tomorrow.” Jason Zweig

If you don’t believe your term deposit is safe, that borrowers will pay back their debts, that companies will see good profits and that properties will earn rents then there is no point in investing.

Psychology

“An investment said to have an 80% chance of success sounds far more attractive than one with a 20% chance of failure. The mind can’t easily recognise that they are the same.” Daniel Kahneman

Beware of tricks that your mind plays on you when investing. Numerous studies show that people suffer from lapses of logic – eg, assuming the current state of the world will continue, being overly confident and assessing the risk of certain events by how they are presented. The key for investors is to be aware of these biases and try to correct them.

Noise

“Stock market news has gone from hard to find (in the 1970s and early 1980s), then easy to find (in the late 1980s), then hard to get away from.” Peter Lynch

The information revolution has given us access to an abundance of information and opinion regarding investment markets. The danger is that it adds to the uncertainty around investing resulting in excessive caution, a short-term focus, a tendency to overreact to news and to focus on things that are of little relevance. The key is to recognise that much of the noise and opinion around investing is ill informed and of little value.

“The ability to focus is a competitive advantage in the world today.” Harvard Business Review

The key in the face of this information and opinion onslaught is to turn down the noise and focus.  

“If you can keep your head when all about you are losing theirs…If you can wait and not be tired by waiting… If you can trust yourself when all men doubt you…Yours is the Earth and everything that’s in it.” Rudyard Kipling, If, as quoted by Warren Buffett 

Keeping your head and remaining calm is critical in times of extreme – when the crowd is convinced the path to instant riches has been revealed or when the crowd is convinced that economic disaster is upon us. These periods throw up great temptation to buy when you should be selling and vice versa. But you will only get it right if you keep your head & stay calm.

Forecasting

“I believe that economists put decimal points in their forecasts to show that they have a sense of humour.” William Gillmore Simms

The dismal track record of precise forecasts regarding things like economic growth, share prices and currencies indicates that relying on them when investing can be dangerous. There is often a big difference between getting some forecasts right and making money. Good experts will help illuminate the way and put things in context, so you don’t jump at shadows but don’t over rely on expert forecasts – particularly the grandiose ones.

Having a process

“I am going to reveal the grand secret to getting rich by investing. It’s a simple formula that has worked for Warren Buffett, Carl Icahn and the greatest investment gurus over the years. Ready? Buy low, sell high.” Larry Kudlow

Yep it’s that simple. Or it should be, but many do the exact opposite and buy high after a lengthy period of strong returns convinces people it’s a great investment (but the risks point down), and then sell low after fall in the price of an asset leads people to believe that it’s a bad investment (but that’s when the risks point up). The key to is do the opposite – buy low, sell high and it’s very helpful to have an investment process to do that.

“Three simple rules – pay less, diversify more and be contrarian – will serve almost everyone well.” John Kay

This helps bring the essentials of investing together. They stand to reason: the less you pay for an investment the greater the return potential; just having one or two shares leaves you very exposed should the news turn bad regarding those shares but if you diversify across a range of shares you can reduce the risk of a fall in your overall portfolio; and doing the opposite to the crowd means you can avoid the points of maximum risk in markets when most are fully invested and take advantage of periods of maximum opportunity when most have sold.

“Success consists of going from failure to failure without loss of enthusiasm.” Winston Churchill

As with all things we need to recognise that to learn we need to make mistakes and to be persistent.

Balance

“A calm and modest life brings more happiness than the pursuit of success combined with constant restlessness” Albert Einstein

This applies to life in general, but it also applies to investing – don’t jump around all over the place and keep it simple.

“A man should make all he can, and give all he can.” Nelson Rockefeller

It’s not financially possible for everyone but consider giving a bit away for good causes if you can – and not just for the tax deduction as you will feel good and it will bring good karma.

“The trouble with doing nothing is that you don’t know when you have finished.” Cafe blackboard in Byron Bay

…so it’s always good to do something and investing is something worth doing (and worth doing well)!

Source: AMP Capital 17 May 2018

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.

The 2018-19 Budget will be the last before the next election (due by May 2019) and so had to provide pre-election goodies but in a way that keeps the return to surplus on track. Thanks to an improvement in the budget position since the Mid-Year review, of around $7bn per annum, this has been made relatively easy. A modest fiscal stimulus will help households, but the main risk is that the revenue boost proves temporary.

Key Budget Measures

As always, most of the measures in the Budget were pre-announced or leaked. The goodies include:

• Income tax cuts from July for low to middle income earners of up to $10 a week which is mainly achieved by lifting the Low Income Tax Offset and raising the $87,000 tax threshold to $90,000.

• A plan for broader tax cuts starting in 2022, which from 2024 includes removing the 37% tax bracket and having the 32.5% tax bracket go all the way up to $200,000.

• Dropping the planned 0.5% Medicare levy increase.

• Ongoing commitment to cut the corporate tax rate to 25% for large companies by 2026-27.

• Extension of the small business instant asset write off.

• Increased spending on home aged care, various concessions for older Australians related to superannuation contributions and work tests, more hospital funding and new products listed on the Pharmaceutical Benefits Scheme.

• An extra $25bn in infrastructure spending including the Melbourne rail link, Bruce Highway, Gold Coast/Brisbane M1, road and rail in WA and North-South Corridor in SA.

This is only partly offset by various savings including an illicit tobacco tax and the usual tax integrity measures to target the black economy and multinational tax avoidance.

Stronger revenue, but tax cuts

Thanks to stronger corporate revenue (due to reduced tax losses and higher commodity prices), stronger personal tax revenue thanks to higher employment and reduced spending the 2017-18 budget deficit is projected to come in at $18.2bn compared to $23.6bn in the Mid-Year review. The Government has assumed that much of this revenue boost will continue (see the “parameter changes” line in the table below) but has only used a bit of it to fund tax cuts and other measures. The net result is that the budget is projected to continue to track to a surplus – which is now expected to be reached one year earlier in 2019-20 albeit its only wafer thin at $2.2bn or 0.1% of GDP. The move back to surplus is slowed slightly by the fiscal easing from policy changes (predominately tax cuts). For example the 2018-19 deficit is projected to fall to $14.5bn but it would have fallen to $13.8bn were it not for the fiscal easing. That said the fiscal easing is small at 0.1 to 0.3% of GDP over the next few years and the progressive shift from deficit to surplus will mean that it will take more out of the economy than its putting back in.  

Source: Australian Treasury, AMP Capital

The planned 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 once dividends are allowed for as shown in the chart below at 25.4% of GDP) on the grounds that this is around the historic highs (reached in the Howard resources boom years). This cap is now projected to be reached in 2021-22.

Source: Australian Treasury, AMP Capital 

Economic assumptions

Most of the assumptions look reasonable, except that the 3% growth assumption is a bit on the optimistic side and it remains hard to see wages growth rising to 3.5% over the next four years given unemployment is not expected to fall much.

Source: Australian Treasury, AMP Capital

Assessment and risks

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. This will be very small though at $10 a week (a sandwich and milkshake!) and will be slightly dampened because the majority of the benefit will come when taxpayers do their 2018-19 tax return sometime after June next year. Second, the Budget recognises 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 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. 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 much of the revenue surge being saved the budget remains on track to return to surplus, in fact a year earlier than previously projected.

Source: Australian Treasury, AMP Capital

The main risks though are that we still be seeing a record run of 11 years of budget deficits. While our net public debt to GDP ratio is low at 19% compared to 81% in the US, 69% in the Eurozone and 153% in Japan, comparing ourselves to a bad bunch is dangerous and they are all a bit different with Europe and Japan borrowing from themselves and the US benefitting from its reserve currency status. The run of deficits being projected in the Budget still swamps those of the 1980s and 1990s. And this is without the deep recessions of the early 1980s and 1990s! Rather we have achieved this thanks to a combination of ramping up spending on a whole range of things without facing up to how they will be paid for. Unlike prior to the GFC we have nothing put aside for a rainy day (when net public debt was negative) and there is a risk that the revenue surprise seen lately will prove temporary if global growth or employment slows. This may particularly be a risk around 2020 if the global economy starts to slow again in response to Fed tightening.  

We continue to rely on assuming strong revenue growth. Of course, bracket creep helps, but even with the tax cut plan the Budget’s projections for average revenue growth of a 5.6% per annum over the next four years seem a little high when nominal growth is forecast to run around 4.5%. The biggest risk remains that wages don’t accelerate as assumed leading to a resumption of poor personal tax collections.

Implications for the RBA

While this Budget should provide some boost to confidence – for which the next two months’ confidence figures should be watched closely, the fiscal boost to the economy and household income is modest with the latter only showing up sometime in second half 2019. So it’s unlikely to be enough to speed the economy up. As such, we see no reason to change our view that the RBA will remain on hold out to 2020.  

Implications for Australian assets

Cash and term deposits – with interest rates remaining low, 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 2.4%, 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 potential boost to confidence from this Budget could be a small positive for the Australian share market. But it’s hard to see much impact on shares.

Property – the Budget is unlikely to have much impact on the property market. Interesting to note that the 2017 budget saw an effort to encourage retirees to sell the family home whereas this year there are measures to help them stay in it! 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 2018-19 Budget has a sensible focus on providing a small boost to households (with the full impact of tax cuts not occurring until next decade) and to infrastructure at the same time as maintaining a return to surplus. The main risks are around whether the recent revenue windfall to the budget proves temporary and the assumptions for continued strong revenue growth.

Source: AMP Capital 9 May 2018

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.