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It’s over, at least for now

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

Policy change

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

• the abolition of the mining tax;

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

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

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

• a delayed increase in the superannuation contribution;

• a reduction in the size of the public service;

• reduced spending on the National Broadband Network;

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

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

• a greater focus on returning the budget to surplus

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

Impact on the budget

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

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

Source: Federal Treasury, Federal Coalition, AMP Capital

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

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

Implications for financial markets

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

Source: Thomson Financial and AMP Capital

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

Source: Bloomberg, AMP Capital

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

Source: Thomson Financial, AMP Capital

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

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

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

Overall, this suggests a favourable reaction from investment markets.

What are the risks?

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

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

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

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

Concluding comments

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

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

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

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

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

Profits not good, but not disastrous either

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

Source: UBS, Deutsche Bank, AMP Capital

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

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

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

Source: AMP Capital

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

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

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

Source: AMP Capital

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

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

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

Growth well below trend, but some hope

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

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

Source: ABS, AMP Capital

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

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

Source: RBA, AMP Capital

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

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

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

• House prices have started to rise

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

Source: Bloomberg, AMP Capital

• Partly reflecting this consumer confidence is trending up.

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

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

• The turn is likely to help non-mining investment

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

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

Outlook for Australian shares

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

Source: Bloomberg, AMP Capital

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

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

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.