Olivers Insights

I am now getting very wary about going on holidays because invariably markets hit a rough patch whenever I do. That has certainly been the case over the past week with both a sharp pull back in Chinese shares and an intensification of uncertainty regarding Greece.

Two weeks ago it looked like Greece was heading for a deal with its creditors. Then at the last minute Greece’s Prime Minister, Alexis Tsipras, decided he didn’t like what was on offer from the Eurozone, the IMF and the ECB and called a referendum on it. This has seen Greece miss a June 30 €1.5bn payment to the IMF (which the IMF so far has called being in “arrears” albeit a declaration of “default” is likely by the end of July) and its banks shut with limits on ATM withdrawals (as Greeks have naturally been taking their money out for fear their deposits will be redenominated into a less valuable currency than the Euro) and on the verge of insolvency if something is not resolved soon.

The referendum has now been held and the No vote has won, with roughly a 60% of the vote. This note provides an update on what it means and the key things to focus on regarding Greece.

Implications of the No vote

The No vote means significantly increased uncertainty around Greece. At a high level it either means:

• Back to the negotiating table for a deal – this is not impossible, with worsening bank related chaos in Greece providing an incentive for Greece to reach some sort of agreement. So back to the negotiating table is likely to be the first (at least attempted) step. But it’s hard to see the creditors relenting easily particularly given the lack of trust they have of the current Greek Government and the desire to avoid a precedent by appearing too easy with Greece.

• Greece continuing to default with a €3.5bn payment to the ECB on July 20 but remaining in the Euro. Just because Greece defaults would not automatically mean that it will leave the Euro. Much would depend on how supportive the ECB will be of Greek banks. But in the absence of any prospect of a deal and growing bank insolvency risk this is likely to be cut off, particularly once Greece defaults on its July 20 payment to the ECB.

• Exit the Euro (Grexit) – in order to avoid even more aggressive austerity (as in the absence of support from the rest of Europe Greece will have to start slashing public spending as tax revenue is now plunging) and support its banks Greece will likely decide at some point that it needs to start printing its own money (which would probably have a value 50% below that of the Euro). Since it can’t do this in the Euro it would have to exit. This may take several months to unfold and it could be very disorderly and very bad for stability in Greece.

So the No vote means a worsening chaos for Greece and more Greek related uncertainty for global markets.

What really matters

The bottom line is that uncertainty around Greece is set to drag on for a while. But while the plight of Greece is terrible there are several reasons not to be too alarmed in terms of the global implications.

First, Greece is a very small economy that has been getting even smaller. It’s just 0.25% of global GDP, it takes just 0.5% of Eurozone countries’ exports and it’s a trivial market for Australian exports. So the direct impact on the Eurozone, the global economy and Australia is virtually non-existent. Rather the relevance comes via Greece’s membership of the Eurozone common currency and its potential to de-stabilise it. On this front the threat is substantially reduced from several years ago – see the next few points.

Second, the Greek crisis is now nearly six years old and private exposure to Greek public debt is now very low at just €50bn, with 80% of Greek public debt held by the IMF, the rest of the Eurozone and the ECB. Similarly the exposure of the global banking system to Greece is now low having fallen from $US300bn in 2008 to $US54bn last year. So the exposure and risks are well known with the result that a GFC/Lehman style shock – where global lending markets seize up as financial organisations worry about counterparty risk – is unlikely.

Third, other vulnerable Eurozone countries – namely Portugal, Ireland, Spain and Italy – are all now in much better shape than was the case when Greece triggered the Eurozone sovereign debt crisis over the 2010-12 period:

• Budget deficits have fallen substantially in Portugal, Ireland, Spain and Italy, with average public debt to GDP levels starting to trend down.

Source: IMF, AMP Capital

• Portugal and Ireland have now successfully come off bailout support programs and are financing their budget deficits in bond markets.

• Portugal, Ireland and Spain have moved from current account deficits averaging around 8% of GDP in 2008 to current account surpluses which means their economies are no longer dependent on external financing.

• All these countries have made significant progress in terms of economic reform (and political reform in Italy’s case – note Berlusconi’s absence!) and are seeing much improved growth indicators. Spain and Portugal have seen a sharp reduction in their unit labour costs relative to Germany and the Spanish and Irish economies are amongst the strongest growing economies in the Eurozone.

Fourth, defence mechanisms to support troubled Eurozone countries are now much stronger than was the case in 2010-12 and investors are aware of this. This includes: a strong bailout fund (the European Stability Mechanism or ESM); the provision of cheap ECB funding for banks via TLTRO (targeted long term refinancing operations); a banking union and recapitalised banks; the ECB’s quantitative easing program which entails €60bn/month in debt purchases; the ECB’s Outright Monetary Transactions program which can be used to buy individual country bonds which backs up ECB President Mario Draghi’s commitment to do “whatever it takes” to preserve the Euro; and the threat the ECB might use “new instruments” if needed. All this should help keep bond yields in peripheral countries from being pushed too far above levels in Germany.

Finally, the economic and financial chaos that Greece has descended into will likely turn voters off supporting anti-austerity parties promising easy salvation in other countries. Most relevant in this regard is left wing Podemos in Spain given that Spain has a general election due at year end. In fact, support for Podemos peaked late last year.

The last three points mean that there is a much reduced chance that a Greek default and eventual exit from the Euro will prompt investors to look for other countries that may do the same – and so cause an excessive blowout in their bond yields.

In fact it increasingly looks like Greece is “the odd man out” in Europe so to speak. It set the wheels in motion of the Eurozone sovereign debt crisis in 2009, it triggered each of the crises that unfolded in 2010, 2011 and 2012, it has not been able to sustainably tap back into international debt markets unlike Portugal and Ireland and despite Herculean efforts has not been able to come through a mix of austerity and reforms without major political ructions unlike several other Eurozone countries. As such, it should really be seen as a special case.

Consistent with this – along with the improvement seen in other peripheral countries and the strengthening of defence mechanisms against contagion – it is noteworthy that the latest Greek crisis has not triggered anything like the financial market ructions in other peripheral countries seen through 2010-12:

• Bond yields in peripheral countries are a faction of the Eurozone crisis highs (as is their spread to German yields).

Ten year bond yields, now and then

Source: Bloomberg, AMP Capital

• The spread between Eurozone interbank lending rates and the expected ECB short term policy interest rate remains around normal levels, which is around one quarter that seen in July 2012 indicating that there is minimal stress in Eurozone short term money markets.

So while Greek related risk has further to play out and a Grexit would not set a good precedent as other countries could do the same (mind you I always thought they could if they really wanted to!), the probability of Greece causing a major crisis in Europe that threatens the global economy and financial markets appears to be low. As the Greece saga drags on investment markets will likely just get used to it as they have with the Ukraine conflict since early last year. If (or when) it does finally come down to a Grexit investors may just celebrate as the long running thorn in the side of the Eurozone is finally gone. So just bear that in mind next time you see the endless footage of understandably concerned Greeks lining up at their ATMs.

So what does this mean for investors?

First, Greece will likely cause more short term volatility in markets.

Second, investors should keep an eye out for the opportunities this throws up – notably in peripheral Eurozone country bonds and Eurozone shares, which on our analysis remain cheap.

Source: Bloomberg, AMP Capital

Finally, while global and Australian shares have been undergoing a correction, partly due to Greece, the Greek drama is unlikely to derail their broad rising trend.

About the Author

Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP Capital is responsible for AMP Capital’s diversified investment funds. He also provides economic forecasts and analysis of key variables and issues affecting, or likely to affect, all asset markets.

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.

Introduction

It’s now coming up to six years since Greece first revealed that it had understated its true level of public debt. And this is the fourth year in which it has seemingly held global financial markets to ransom as a result of its excessive public debt level. To be honest it’s becoming a bit of a drag. Greece should never have made it into the Euro, but of course getting it out again is easier said than done. Greece is now rapidly approaching another moment of truth, and this has been causing increasing angst in investment markets with the risk of more to come. This note looks at the key issues.

What is the current state of negotiations?

In February Greece and its creditors (the IMF, EU and ECB) agreed to extend its current bailout program to end June. Since then the two sides have been negotiating the release of €7.2bn of funds under that program. Negotiations have not gone well with Greece’s new Syriza led Government hoping to extract something more favourable. The size of the targeted primary budget surplus (ie the surplus excluding interest payments), pension and labour reforms have been sticking points along with Greece’s desire for a reduction in its debt level.

Greece is now coming up to a crunch point as it needs to make a payment to the IMF of €1.5bn by June 30. It will also have trouble paying pensions and public servants through July and is due a €3.5bn payment to the ECB on July 20. So it’s become urgent that funds are released under the current bailout program. Similarly at the end of June Greece’s loan program expires and it is easier to negotiate a new one in the context of this one rather than starting all over again.

Developments in the last few days have been positive with a new proposal from Greece representing a significant move towards the position of the creditors in terms of pensions, tax, spending and the budget. It has been greeted positively by European officials and leaders so there is now a good chance a deal will be agreed this week at a European leaders’ summit, albeit there is still more work to do which could upset this and cause bouts of market volatility. And then it will have to pass various parliaments starting with Greece. The latter could prove interesting as some Syriza parliamentarians may not support it so the Government may have to rely on other moderate parties.

While the June 30 IMF payment is the next key date to watch, there is probably still a bit more time into July. An actual default will not come till the IMF writes a letter informing Greece it’s in default. Furthermore, if an agreement is reached but it’s not all signed sealed and delivered in time for the June 30 payment the creditors may simply agree to delay payment until any necessary parliamentary votes and referendums occur.

Why has a deal taken so long?

The negotiations on a “reform for funding” deal for Greece have been long and acrimonious for several reasons. On the Greek side: Syriza was elected on an anti-austerity, anti-reform mandate and it’s likely that its more radical members could quickly desert the Government if a deal gives away too much. The new Government is also very inexperienced and more prone to belligerence that the European way of compromise.

For the Eurozone: being too lax with Greece is seen as just as risky as being too tough. This is because giving in too easily could embolden support for the populist party Podemos in Spain and similar parties elsewhere which would in turn threaten reforms designed to bring about convergence in the Eurozone and so weaken its medium term stability.

Is a deal still likely?

Despite this our assessment is that a deal is more likely than not for the simple reason that it’s in in the interest of both sides to reach agreement. For Greece it’s to avoid the economic mayhem that would follow default and a forced exit which would include a banking crisis and associated credit crunch, a huge loss of confidence, further austerity as a rising budget deficit forces more aggressive spending cuts and a likely 50% or so collapse in the new currency Greece adopts. With 70% or so of the Greek population wanting to remain in the Euro such an outcome would likely lead to the demise of the Government led by Tsipras and Syriza.

For the creditors the reasons to reach a deal are to preserve their roughly €300bn exposure to Greece, to head off any blow to confidence and perceived threat to other peripheral countries via “contagion” and to avoid the perception that membership of the Euro is reversible which could weaken integration long term.

In this regard, the war of words around Greece that escalated last week is very similar to that amongst US politicians ahead of its various debt ceiling deadlines, all of which ended in a deal. So our assessment remains that a deal will be reached and the positive developments seen so far this week are consistent with that. Once Greece actually signs up and starts delivering on reforms some form of debt relief is likely to be offered.

What is the problem with Greek banks?

With uncertainly running high in Greece, its citizens naturally fear they will wake up one day and their Euro bank deposits will have been redenominated into a new Drachma worth 50% less. So they have been taking their money out in droves with the outflows escalating to around €1bn/day lately. So the banks have been relying on emergency liquidity assistance (ELA) from the ECB. However, if there is no deal the ECB may curtail or cut this off. This in turn would likely force the closure of Greek banks and the imposition of controls on withdrawals. Which in turn would likely set off a credit crunch. All of which is further increasing the pressure on the Greek Government.

What if there is no deal? Will default lead to Grexit?

If there is no deal Greece will not be able to meet its June 30 IMF payment and if no deal is in prospect, Greece will be declared to be in default sometime in July. There would be two scenarios here: default but no exit from the Euro; or default leading to Grexit. Just because Greece defaults would not automatically mean that it will leave the Euro. Much would depend on how supportive the ECB would be of Greek banks after a default. Any continued support though may be limited and this plus the loss of confidence and the likely downwards spiral of the Greek economy would likely add pressure on the Greek Government to sign up to a deal.

But if ECB support for Greek banks evaporates and no deal eventuates then in order to avoid even more aggressive austerity and support its banks Greece may decide that it needs to start printing its own money. Since it can’t do this in the Euro it would have to exit. This may take several months to unfold and it could be very disorderly which would be bad for financial markets in the interim and be very bad for stability in Greece.

What is the risk of contagion if there is no deal?

The risk of a contagion if Greece defaults like that seen in the Global Financial Crisis where financial institutions stopped lending to each other because of fear that the counterparty might be exposed to sub-prime debt or Lehmans or whatever resulting in a freezing up of global lending markets is very low. After various debt haircuts private sector exposure to Greek public debt is very low at around €50bn with more than 80% of Greek public debt held by the EU, ECB and IMF and after more than five years the risks are well known. And because private ownership of Greek debt is so small Greece may not default on this preferring to try and keep potential access to the private markets open. Of course, this does not mean a hedge fund does not have a leveraged position but the risks are low.

Rather the main concern is that a Greek default followed by an exit from the Euro prompts investors to look for other countries that may follow suite leading to a contagion which could become self-fulfilling. This is what started to happen in 2010-12 till the ECB put an end to it with President Mario Draghi’s commitment to do “whatever it takes” to keep the Euro together. The risks are clearly there, but there are several reasons to believe the risks are now low. First, peripheral Europe is now in far better shape than was the case in 2010-12.

• Portugal and Ireland are now both off bailout support.

• Budget deficits are coming under control in Portugal, Ireland, Spain & Italy. The average deficit in these countries was around 4% of GDP in 2014, versus 14% in 2010. This is set to see average public debt levels fall this year.

Source: IMF, AMP Capital

• Economic reform has been underway. One guide is unit labour costs which reflect productivity growth and labour costs. Spain and Portugal have made significant progress in cutting costs relative to Germany.

• Another guide is the ease of doing business. The ranking of peripheral countries relative to Germany in the World Bank’s Doing Business Survey has improved significantly. Eg, Spain has gone from 38 countries behind Germany to 19. 

Second, defence mechanisms to support troubled countries are also stronger with a strong bailout fund, a banking union and a more aggressive ECB. The ECB’s €60bn/month in debt purchases and the threat of buying individual country bonds (under its Outright Monetary Transactions program) should help keep bond yields in peripheral countries from being pushed too far away from levels in Germany. To this end it’s noteworthy that 10 year bond yields in Spain and Italy at around 2.2% are a long way from the 7% plus level they reached in 2012.

What is the relevance to Australia?

Greece is only 0.25% of global GDP and a trivial market for Australian exports. So the direct impact on Australia is virtually non-existent. Rather the relevance comes via Greece’s membership of the Eurozone and its potential to de-stabilise it and hence European economic growth. And here the impact is via investor sentiment and hence share market volatility and also via China since Europe is China’s biggest export market.

What about Eurozone assets?

A “reform for funding” deal that avoids a real default and at the same time does not bend over so much to Syriza that it emboldens Podemos in Spain would likely be greeted positively by Eurozone shares and peripheral country bonds, as seen by the reaction this week to news that a deal is in prospect. By contrast a default leading to a Grexit would initially be taken badly. However, even here the fall out is likely to be limited as Eurozone shares are cheap and the ECB is now aggressively undertaking quantitative easing. In fact, financial markets might ultimately celebrate were Greece to leave the Euro.

Source: Bloomberg, AMP Capital

About the Author

Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP Capital is responsible for AMP Capital’s diversified investment funds. He also provides economic forecasts and analysis of key variables and issues affecting, or likely to affect, all asset markets.

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.

Introduction

Tax reform is a hot topic in Australia with lots of strongly-held views. There are three main reasons. First, despite the tax reforms of the 1980s, 1990s and 2000s the Australian tax system is still far from ideal. This is highlighted by the Government’s Tax Discussion Paper. Second, some see tax reform as a way to plug the budget deficit; in other words tax reform is actually a euphemism for boosting the tax take. Third, some see various aspects of the tax system as being significant causes of problems in the economy. 

Four “tax concessions” in particular seem to be readily in the headlines: negative gearing, the capital gains tax discount, franking credits and superannuation. The common arguments put up for curtailing them are that they cost the Government revenue, create distortions in the tax system and hence in economic and financial activity, and that their dollar benefits fall disproportionately to high-income earners. This note takes a look at each of these and points out that they really need to be seen in the context of the overall income tax system.

Negative gearing

Every time Australian residential property prices take off, calls erupt for negative gearing on investment property to be restricted or scrapped as many see it as being to blame for high house prices. Such a move would clearly adversely affect property investors as it will effectively reduce the amount investors can borrow. However, such a move is of dubious merit from a range of perspectives.

First, negative gearing is not the reason housing affordability is so poor in Australia. It has been in place for a long time and Australia is not alone in providing some form of “tax assistance” to home owners as most comparable countries do. Americans can even deduct interest on the family home from their taxable income. And yet our house price-to-income ratios are much higher.

Removing or curtailing negative gearing could even make the situation worse by reducing the supply of rental accommodation at a time when rental yields are hardly attractive for investors.

Rather, the real driver of poor housing affordability has been a lack of supply. In a well-functioning market when demand goes up, prices rise and this eventually is met with increased supply. Residential construction is now picking up, but this follows more than a decade of undersupply that has to be made up. What we really need to do is to make it easier to bring new homes to the market – release land for development faster, relax (within reason) development controls, reduce tax and other impediments to the supply of new dwellings and develop a long-term plan to decentralise away from our major cities. This would be the best way to help first home buyers and cool speculative interest in housing. Curtailing negative gearing is not the solution.

Second, removing or restricting the deductibility of interest expenses incurred in property investment will cause a distortion in the tax system. As the Tax Discussion Paper points out, negative gearing is not actually a tax concession specific to property investment, but arises because of the way the tax system works in allowing deductions for expenses incurred in earning income. So removing or curtailing the tax deductibility for interest costs incurred in property investment will create a distortion in the tax system as it will still be available for investment in other assets. As a result, the tax system would then have a bias against property and in favour of assets like shares.

Finally, while the dollar value of negative gearing rises with income levels (which is to be expected) the majority of tax payers that negatively gear property (around 650,000 people) are actually middle-income earners.

The capital gains tax discount

The capital gains tax discount was introduced in 1999, allowing investors to halve their taxable capital gain on an asset provided they hold it for more than a year. This was arguably a simpler arrangement than the prior approach of allowing capital gains to be adjusted for price inflation and has the effect of encouraging somewhat longer-term investment horizons. Against this, though, it may be argued that the discount is excessive particularly when inflation is low and that it therefore provides an inducement to earn income as a capital gain as it’s taxed at half the rate and that one year is not really long enough to encourage long-term investing.

In fact, it’s arguably the capital gains tax discount that distorts investment flows into residential property as opposed to negative gearing. This is because when negatively gearing an asset an investor is realising loss year to year in the hope that the capital gain on sale will ensure that the investment ultimately generates a decent positive return. Paying tax on only 50% of the capital gain therefore helps make this stack up.

So in this sense, there is a case to consider removing the capital gains tax discount and returning to the pre-1999 approach of adjusting the capital gain to be included in taxable income for price inflation.

Dividend Imputation

The dividend imputation system introduced in 1987 basically gives a tax credit to Australian investors for tax already paid on company profits when they are distributed as dividends. However, both the Financial System Inquiry and the Tax Discussion Paper have questioned the merits of the system. Commonly-expressed concerns are that it creates a bias for Australian investors to invest in domestic equities, adversely affects the development of the corporate bond market, may encourage firms to pay out too much of their earnings rather than invest them and that approaches used by other countries seek a similar outcome but may come with lower compliance costs.

Most of these concerns are misplaced, though, and ignore the benefits of the imputation system:

First, dividend imputation actually corrects a bias against equities by removing the double taxation of earnings – once in the hands of companies and again in the hands of investors as dividends. Therefore, it actually puts shares onto a level footing with, say, a corporate debt investment.

Second, flowing from this, it means that the cost of equity capital to firms is not penalised (ie pushed up) relative to the cost of debt capital so it has reduced the incentive of Australian firms to excessively rely on debt financing. This stands in contrast to, say, US companies that are incentivised to borrow and buy back shares.

Third, it also encourages corporates to pay decent dividends to shareholders as opposed to irrationally hoard earnings. The higher payout ratio of Australian companies has led to superior capital discipline within companies and a superior capital allocation between them as it has put power back in the hands of shareholders who can then decide whether dividend reinvestment plans warrant their participation. It has certainly not hampered the long-term returns from the Australian share market. Since dividend imputation was introduced in 1987, Australian shares have returned 10% pa compared to 7.4% pa for global shares (in local currency terms).

Fourth, dividend imputation removes a bias for private business owners to stay unincorporated to avoid getting taxed twice on their profits.

Finally, while franking credits create a bias for Australian shareholders in favour of Australian shares over global shares where franking does not exist, this is not an argument to return to the double taxation of dividends.

While better alternatives to dividend imputation may be worth considering if they exist, the system has served Australia well and so there is a very strong case to retain it. It should also be recognised that franking credits add nearly 1.5% pa to the return from Australian shares, so removing them will cut into the investment returns and hence retirement savings of Australian investors.

Superannuation concessions

Superannuation contributions, earnings and benefits to those over 60 are taxed concessionally because saving through super is compulsory and the savings are “locked up” for use in retirement. Apart from the benefit to the economy from having a large pool of patient capital keen on investing in Australia, the aim of compulsory superannuation was to improve retirement incomes and reduce reliance on the age pension. With just 30% of people of age pension age being self-funded, and this not projected to decline by 2050, some have questioned whether the superannuation system is working. Of course, it’s not quite so bad as the proportion getting a part pension relative to full rate pensioners is expected to increase. But still the question remains as to whether more can be done to ensure that retirees rely on accumulated superannuation funds before accessing the pension, as opposed to viewing superannuation as being for wealth generation and funding bequests. The move by the Government to reduce the asset threshold for accessing the pension is partly aimed at this.

More broadly, a common criticism of superannuation is that the rules around super are regularly changing and this generates uncertainty. It can be seen in the Westpac – Melbourne Institute Consumer survey finding that despite the tax concessions only 5.2% of surveyed Australians regard super as the wisest place for savings, well behind bank deposits, real estate, paying down debt and shares. So any future changes need to allow for this and ideally have a long phase-in time so those who have acted within the current rules don’t feel hit by overnight changes.

The overall tax system

Finally, and very importantly, calls to end or curtail these “tax concessions” need to be assessed in the context of the whole individual income tax system. Australia already has a relatively high reliance on income tax and the current top marginal tax rate at 49% is above the median of comparable countries (and compares to 15% in Hong Kong, 20% in Singapore and 33% in New Zealand) and kicks in at a relatively low multiple of average weekly earnings of 2.3 times – compared to 4.2 times in the UK and 8.5 times in the US. This gets a tick in terms of fairness but could be working against Australia’s long-term interest to the extent that it discourages work effort and hence productivity.

As a result, the Australian individual tax system is highly progressive and this is reflected in the fact that in 2011-12 just over 2% of taxpayers accounted for 26% of income tax revenue and just less than 17% of taxpayers accounted for over 63% of income tax revenue. This is likely to have become even more skewed since then due to the Budget Repair Levy.

Curtailing access to any or all of the “tax concessions” mentioned earlier will only add to the burden on this relatively small group and act as a disincentive for work effort at a time when we should be doing the opposite. Ideally, we should be looking to reduce the reliance on income tax. If we did this the interest in strategies like negative gearing would likely decline.

About the Author

Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP Capital is responsible for AMP Capital’s diversified investment funds. He also provides economic forecasts and analysis of key variables and issues affecting, or likely to affect, all asset markets.

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’s part of human nature to give more weight to the short term rather than the long term. The desire for instant gratification is being accentuated by the immediacy provided by modern technology. This in turn is making it even harder to turn down the noise surrounding investment markets. But doing so is essential for successful investing. With this in mind, this note looks at longer term themes that will likely impact investment markets over the medium term, say the next 5-10 years.

Ageing and slowing populations

Ageing and slowing populations have been long talked about and they are now starting to have a big impact. Thanks to medical advances people are living longer healthier lives (eg average life expectancy in Australia has risen from 77 years in 1990 to 83 years now and is projected to rise to 89 years by 2050). And reduced fertility rates are leading to lower population growth.

The impact is more significant in some countries, which are seeing their populations slow and age faster (eg Japan and Italy) than others (eg Australia, where immigration and higher fertility is providing an offset) and others still where population growth remains rapid (eg India, Africa and the Middle East).

Source: Intergenerational Report, AMP Capital

Implications – at the macro level this means: slowing labour force growth which in turn weighs on potential economic growth; increasing pressure on government budgets from health and pension spending and a declining proportion of workers relative to retirees; a “war for certain types of talent”; and pressure to work longer.

At the industry level it will support growth in several industries including healthcare and leisure. At the investment level it will likely see a focus on strategies aimed at generating income (yield) while at the same time providing for “more stable” growth to cover longevity.

Slower growth in household debt

Some have named the surge in household debt relative to incomes seen in the decades prior to the GFC as the “debt super cycle”. This was fuelled by low starting point debt levels, financial de-regulation and the shift from high to low interest rates but it now appears to have run its course as the GFC and constrained economic growth have left consumers wary of adding to already high debt levels and bank lending standards have toughened.

This has seen growth in debt slow and households running higher savings rates than prior to the GFC.

Implications – slower growth in household debt likely means slower growth in consumer spending, lower interest rates and central banks having to ease more to achieve a desired stimulus. Slower credit growth may also be a drag for banks.

The commodity super cycle has turned down

The surge in the supply of commodities in lagged response to last decade’s commodity price boom is now combining with somewhat slower growth in China and emerging countries to result in a downtrend in commodity prices. Notwithstanding, cyclical bounces, this could have further to go consistent with the long term pattern seen since 1900.

This will act as a constraint on inflation and on growth in commodity producing countries (eg, South America, Russia, Australia) but benefit commodity user regions (the US, Asia, Europe and Japan).

Source: Global Financial Data, Bloomberg, AMP Capital

Implications – favours traditional global shares (dominated by commodity users) over emerging market and Australian shares and suggests that the downtrend in the $A has more to go and helps keep interest rates low.

Technological innovation & automation

Technological innovation is having an ever increasing impact. It seems everything is getting connected to the internet. 75% of the world’s population has access to a mobile phone and by 2030 50% will access the internet. The work environment is being revolutionised enabling companies to increasingly locate parts of their operation to wherever costs are lowest and increasingly to automate and cut costs via robotics, nanotechnology, 3D printing, using GPS systems to manage logistics, etc.

The intensified focus on labour saving is likely good for productivity and profit margins but ambiguous for consumer spending to the extent it may constrain wages and worsen inequality. There is also the complication that with so many “free” apps (eg my phone has a navigator that would have cost several thousand dollars in my car a few years ago), growth in activity (ie GDP and hence productivity) is being under measured/inflation overestimated and consumers are doing a lot better than weak wages growth implies.

Implications – another reason for inflation to stay low and profit margins to remain high. But also a potential positive for growth.

Globalisation and offshoring

There is nothing new in globalisation, but it is set to continue as companies under ongoing pressure to cut costs look to emerging countries with lower wages and high education levels to feed into their production chains. While this was once limited to manufacturing, it has now shifted into services and going up the value chain (from call centres to areas like medicine, research and finance). Technology is the key enabler.

Implications – positive for companies that can shift functions across boundaries. Will help keep inflation down.

Asian ascendancy (but messy emerging countries)

Given relatively lower levels of urbanisation, income and industrialisation the emerging world offers far more growth potential than the developed world. However, while favouring emerging over advanced countries was easy 15 years ago it’s now more complicated as big parts of the emerging world have dropped the ball on reforms (with Brazil and much of South America returning to the populist policies of their past) and Russia wanting to go back to its Soviet glory days.

They all need another reform stimulating crisis. However, the reform and growth story remains alive in Asia – from China to India.

Source: Angus Madison (2001, 2005), AMP Capital

Implications – favour non-Japan Asian shares (allowing of course for risk).

The environment and social values

While the GFC slowed momentum on global carbon pricing, consciousness of the impact on the environment is continuing to grow. At the same time higher social standards are being demanded of governments and corporates. This reflects a range of developments including increasing scientific evidence of the impact on the environment from human activity and the long term welfare consequences, younger generations demanding higher social and environmental standards and social media that can destroy reputations in a flash.

Implications – this will favour companies that adhere to high environmental, social and governance standards.

The energy revolution

This is real. Renewables account for more than 30% of power produced in Europe. This will only grow as alternatives like solar continue to collapse in cost and solar energy storage becomes mainstream. Likewise advances in battery technology are seeing a massive expansion in the use of electric cars which will feed on itself as this drives more charging stations.

Implications – this has huge negative implications for oil and coal and will accentuate the commodity price downtrend.

Backlash against free markets

Francis Fukuyama’s declaration of the “End of History” with a global consensus in favour of liberal democracy seems a distant pipedream now. Since the GFC in particular we have seen a backlash against unfettered free markets with left of centre parties vacating the middle ground and moving to the left and a general focus on more regulation and more taxes. Witness the calls to end or curtail tax concessions in Australia. Rising inequality may add to the pressure on governments to impose more onerous personal tax rates.

Implications – backsliding on reform could slow growth rates.

Geopolitical tensions

A multi-polar world – the end of the cold war and the stabilising influence of the US as the dominant global power helped drive globalisation and the peace dividend post 1990. Now the relative decline of the US, the relative rise of China, Russia’s attempt to hang on to its Soviet past and efforts by other countries to fill in the gap left by the US are all creating tensions and a more difficult environment geo-politically – what some have called a multi-polar world.

This is evident in: increasing tension in the Middle East between (Sunni) Saudi Arabia and (Shia) Iran; Russia’s intervention in Ukraine; and tensions between China & Japan and in the South China Sea.

Implications

Of course there are more megatrends than this – education and obesity to name a few – but I have focussed on the main macro themes. (For those interest in thematic investing see “Thematic investing – principles for long-term investing”, by Andy Gardner, AMP Capital Insights Papers, November 2014).

At a general level there are several implications for investors.

• First – several of these trends will help keep inflation low, eg the commodity price downtrend, automation and globalisation.

• Second – several are also consistent with constrained economic growth, notably ageing and slowing populations, slower growth in debt, the backlash against free markets and geopolitical tensions. This is not universal though as increasing automation is positive for profits and the commodity price downtrend is positive for commodity users.

• Taken together this is all consistent with ongoing relatively low interest rates (albeit there will still be a cycle in rates) and relatively constrained medium term investment returns.

• Finally, several sectors stand out as winners including health care, leisure and multinationals. Producers of energy from fossil fuels are potential losers.

About the Author

Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP Capital is responsible for AMP Capital’s diversified investment funds. He also provides economic forecasts and analysis of key variables and issues affecting, or likely to affect, all asset markets.

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.

Introduction

Ever since the mining boom ended around 2011/2012 there have been constant predictions of doom for Australia. Foreign commentators and investors seem to have been particularly bearish on this front. I seem to constantly come across an ad on the internet titled “Australian Recession 2015 – Why it’s coming, what to do and how you can profit. FIND OUT MORE”. Never mind that last year the same ad referred to 2014! The mining collapse is still unfolding and growth has not been great, but the bust for the Australian economy many have been foreshadowing has not occurred. This note looks at the latest growth figures and seven reasons not to be too gloomy.

First the bad news – growth is too slow

March quarter GDP growth in Australia was much stronger than expected at 0.9% quarter on quarter.

Source: ABS, AMP Capital

However, on an annual basis it has slowed to just 2.3%, which is well below potential growth of around 3-3.25%. What’s more, inventories contributed 0.3 percentage points to growth and net exports contributed 0.4 percentage points so domestic final demand was actually flat in the quarter or just 1.1% year on year. While home construction has picked up (+9.2% year on year) and consumer spending is okay (+2.6% year on year), public demand is weak (-0.2% year on year) and business investment is falling sharply (-6.1% year on year) led by mining investment. Business investment (or capex) plans from ABS surveys point to more weakness ahead. Comparing the latest estimate of investment for 2015-16 with that made a year ago for 2014-15 points to a 25% fall in business investment in 2015-16 (see the next chart) and another approach points to a 23% fall.

Source: ABS, AMP Capital

Mining investment is now falling rapidly back to 2% of GDP as large projects complete. To offset this we need to see growth in other parts of the economy pick up and we have seen some success with housing and consumer spending. However, nonmining investment remains disappointing; with capex plans pointing to renewed weakness in the year ahead (see the next chart). This in turn is threatening growth.

Source: ABS, AMP Capital

More broadly, several factors seem to be behind continued subpar growth in the economy including: steeper than expected falls in commodity prices that have cut into nominal growth (nominal GDP growth was just 1.2% over the last year); the ongoing threat of more budget austerity; understandable household reluctance to take on more debt post the GFC; the $A remaining too high; and non-mining companies understandably taking a while to turn around from the battering they took through the mining boom (thanks to the strong $A, high and interest rates and competition for labour).

Against this backdrop an even lower $A is probably still needed (expect it to fall in $US 0.70 by year end) and to ensure this occurs the RBA needs to continue trying to jawbone it lower and, if need be, cut rates again. The chance of another rate cut is now around 50/50 with the August RBA meeting at which it will next review its economic forecasts being the one to watch.

Seven reasons not to get too gloomy

While growth is sub-par and growth in domestic demand is particularly weak it’s not the recession some continue to fear. There are seven reasons for optimism.

• First, borrowing rates are at generational lows. Interest payments on a $350,000 mortgage are now around $730 a month below what they were four years ago. While those relying on bank deposits have lost income, Australians owe the banks $1.2 trillion more in debt than the banks owe them via deposits, so the household sector is a net beneficiary of low rates. Some of this freed up income is being spent.

• Second, rising wealth levels are benefiting spending. Over the year to May average capital city home prices are up 9% (although skewed to Sydney), the Australian share market has returned 10% and average balanced growth superannuation funds have returned around 14%.

• Third, while petrol prices have bounced back from the lows seen earlier this year, they remain well down on the highs seen over the last few years, providing savings to businesses and households.

Source: AMP Capital

• Fourth, the household savings rate remains relatively high at 8.3% and has scope to drift down further supporting spending.

• Fifth, the lower $A is a big positive for manufacturing, tourism, education, services, farming and mining. The boost is evident in education and tourism exports which took a hit when the $A went above parity, but are now at record levels. It’s also worth recalling the comment from BlueScope CEO Paul O’Malley from earlier this year: “As the $A gets into the 70s we get competitive, and with a year or two of that…you start to get the confidence to invest.” The point is that it takes a while for this to feed through so we shouldn’t be too depressed as non-mining companies take their time to get more confident on this front.

Source: ABS, AMP Capital

• Sixth, export volumes are continuing to rise strongly (+8.1% year on year) on the back of completed resource projects and as the lower $A makes exports more competitive. Reflecting this, the current account deficit as a share of GDP is around its lowest in the last 30 years, despite plunging prices for resources exports.

Source: ABS, AMP Capital

• Finally, Australia has arguably managed the boom a bit better than it has in the past when booms led to inflation or trade deficit blow-outs or both and all sectors of the economy boomed together and so went bust together. This time there was no major build-up of imbalances in the economy and sectors suppressed by the mining boom have the potential to bounce back and are starting to.

So while growth remains sub-par, the risk of a recession remains relatively low and growth should start to move back to around trend at some point next year. In other words there is no reason to get overly gloomy on Australia.

Implications for investors

With the commodity tailwind now a headwind for the Australian economy and the Australian dollar likely to remain under downwards pressure it makes sense for Australian investors to have more in offshore investments than was the case a decade or so ago. Interest rates are also set to remain very low.

However, there is no need to get too gloomy on the outlook for Australian assets. The economy is likely to avoid recession or a severe slump as growth continues to gradually rebalance. And the yields on Australian bonds, shares, commercial property and infrastructure remain relatively attractive globally.

While the Australian share market ran ahead of itself earlier this year and has been in correction mode for the last few months, by year end it should be able to push up to the 6000 level.

About the Author

Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP Capital is responsible for AMP Capital’s diversified investment funds. He also provides economic forecasts and analysis of key variables and issues affecting, or likely to affect, all asset markets.

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.

There is even talk of lenders managing their exposure by focussing on postcodes. This is all in response to increasing pressure from the banking regulator APRA (the Australian Prudential Regulation Authority) demanding that the 10% cap on property investor lending growth that it announced last December be adhered to.

Those who have been around for a while might wonder what is going on. Isn’t this what used to happen in the dim dark days before the enlightenment of financial de-regulation in the 1980s? The answer is yes and the term “macro prudential regulation” – in reference to using prudential controls on lending to influence the economic cycle – is just a fancy term for what went on in the past.

So why has it made a comeback?

The focus on varying prudential controls to achieve macro-economic outcomes was quite common up until the early 1980s but went the way of the dodo when it was concluded that it was only leading to distortions in the financial system, as people found a way around them. So while financial system regulators, like APRA, continued to ensure that prudential standards were met, from the mid 1980s varying interest rates to control the housing and economic cycle became the norm. And this worked reasonably well.

The last major boom in Australian property prices ended around 2004. This was a cracker and saw: average home prices around Australia rise an average of nearly 15% per annum over the five years to the end of 2003; a massive surge in housing related credit with property lending growing 21% and property investor lending growing 30% in 2003; this in part was fuelled by property spruikers running property investment seminars on a grand scale; and there was little doubt that house price gains were being extrapolated off into the future in investors’ minds and that this in turn was driving more property investment.

Source: CoreLogic RP Data, AMP Capital

The surge into 2003 took the property price to household income ratio from around three times to around five to six times and saw real property prices go from well below trend to well above.

As a result concern about a property bubble and poor housing affordability came to the fore. It was “cooled down”, not by prudential controls but by a combination of “jawboning” by then RBA Governor Ian Macfarlane warning against the dangers of property speculation and then the start of an interest rate tightening cycle as the economy improved. The collapse of a high profile property spruiker’s business and poor housing affordability also helped.

But while the prudential regulator made sure that lending standards were being maintained, prudential controls were not varied to achieve macro-economic outcomes.

This time is a bit different for several reasons.

• First, property price gains are nowhere near as strong – over the last five years average capital city home prices have risen at just 3.5% pa. For Sydney it’s just 6.5% pa.

• Second, the gains are not broad based – while Sydney home prices are up 14.5% over the year to April, for the other capital cities the gain is just 1.7%.

• Third, credit growth is running at a fraction of what was seen in 2003 with total housing related credit up 7.2% over the year to April and investor credit up 10.4%.

Source: RBA, AMP Capital

• Finally, unlike in 2003 and 2004 the economy is much weaker. Back then growth had been picking up after a soft patch and was being helped by a super low $A, households happy to take on more debt – remember the line about households having an ATM in their living room – and the start of the mining boom. Now the economy has been sub-par for several years as the mining boom is unwinding. In fact, the rest of the economy needs very low interest rates.

But of course it is never that simple as the RBA and regulators are aware that expressed relative to household income both home prices and household debt levels are already very high as is the ratio of house prices compared to their long term trend – having never really unwound from the surge into 2003-04. See the next chart. And so they are fearful of letting low interest rates drive home prices much higher given the risk to the financial system and economy should they then fall sharply.

Source: RBA, ABS, AMP Capital

So to balance all these cross currents there has been a return to using macro prudential controls in order to allow the low interest rates that the economy as a whole needs but at the same time to keep a lid on the property market.

Will it work?

Only time will tell on this one. APRA is pretty adamant that it wants to see growth in property investment lending slow into the second half of the year and if lenders don’t tow the line then tougher action is likely. So my feeling is that it probably will work and we should expect to see a slowing in the availability of credit for property investors and as a result some slowing in home price growth in Sydney (maybe back to around 8% pa) and to a lesser degree Melbourne over the next year. However, a downturn in property prices will likely have to await the start of interest rate hikes and that’s unlikely until 2017.

However, there are several risks around this. APRA’s 10% “cap” on property investor lending growth could prove too lax and on the other side it’s hard to know when such regulatory tightening has gone too far in which case the property market could slow more than expected. There is also a danger that it hits cities that are weak anyway (basically all the capital cities except Sydney and Melbourne). And longer term, lenders and borrowers may try to find a way around such prudential controls.

But hopefully by then the economy will have returned to normal and we can go back to relying on interest rates to control the property cycle.

In the meantime, the use of macro prudential controls helps provide the RBA with flexibility to keep interest rates down and if necessary to cut them again if needed. In fact, after the latest figures on the business investment outlook another interest rate cut is now looking increasingly likely.

About the Author

Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP Capital is responsible for AMP Capital’s diversified investment funds. He also provides economic forecasts and analysis of key variables and issues affecting, or likely to affect, all asset markets.

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.