It’s a tough budget with all Australians told to bear the burden. According to Federal Treasurer Joe Hockey, “the economy is growing at less than normal speed and the time to fix the budget is now.”

For families, there is a focus on healthcare and education; for high income earners, a new tax just for them; for pensioners – new eligibility rules; and for the rest of us – a little bit of extra super.

5 top areas of focus in Budget 2014

1. High income earners levy

A 2% levy will apply to those earning an income above $180,000. The impost is for three years only from 1 July 2014 to 30 June 2017 and means that those earning above $180,000 will pay the extra 2% levy on all income in excess of $180,000.

That is if you are earning $200,000 you will be faced with an additional 2% on $20,000 – a total levy of $400, or if you are earning $300,000 you will be paying a 2% impost on $120,000 – or $2400.

2. Healthcare to cost more

From 1 July 2015, previously bulk-billed patients can expect a charge of $7 per visit towards the cost of standard GP consultations and out-of-hospital pathology and imaging services.  For concessional patients and children under 16 years, the contribution will be limited to the first 10 visits each calendar year.

The Medicare levy will increase from 1 July 2014, to fund DisabilityCare, which was announced in last year’s budget.

3. Higher education – good and bad

On the one hand the Government has announced it will deregulate the higher education sector and from 1 January 2016 will allow higher education providers in Australia to set their own tuition fees.  This is likely to increase the cost of education in Australia. The Government will continue to provide students a way to defer costs of study through HELP and graduates will begin to repay the debt only once their income reaches $50,638 from 1 July 2016.

On the other hand, from 1 July 2014, a tertiary loan system will be extended to TAFE students who will have access to 4-year concessional trade support loans to help them complete their trade course.

4. Business gains and losses

The Government remains committed to cutting the company tax rate by 1.5% from 1 July 2015. For large companies this will offset the cost of the Government’s Paid Parental Leave Levy. For the small businesses it will provide a boost to profits. The Government has also reinforced its promise to repeal the Minerals Resource Rent Tax and Carbon Tax.

5. Focus on pensions

• Pension payments will have the asset and income test thresholds frozen for 3 years from 1 July 2017.
• The Government will index pensions to inflation rather than wages from September 2017, this is expected to reduce pension increases.
• The pension age will be increased to age 70 by 1 July 2035, building on the former Government’s move to increase the pension age to 67 by 1 July 2023.

We will be contributing more super

The Super Guarantee will increase from 1 July 2014 to 9.5%. It will then remain frozen for 4 years, after which it will increase 0.5% a year until it reaches 12% in July 2022.

And when you have to keep working…

The Government has acknowledged that for older Australians to find jobs there needs to be a culture change towards older Australians. They are offering up to $10,000 to businesses that employ Australians aged over 50 years who have been on unemployment or disability benefits for more than 6 months.

Questions?

We welcome you to contact our offices to discuss the implication of the Budget for your personal situation.

Changes in the indices representing the asset classes depicted below were very minor for the most part and as a result here have been comparatively modest moves in the assessed valuations for all three of the equity asset classes. An exception to this however was Listed Property which has continued to rally since December 2013. This stronger performance has actually moved the asset class valuation from Fair Value to the lower end of what we assess to be Fair Value.

With the benefit of hindsight, a deal between internet company AOL and media company Time Warner has come to be known as the death knell for the technology led market boom that ended in early 2000. At the time it was reported: “In a stunning development, America Online Inc. announced plans to acquire Time Warner Inc. for roughly $182 billion in stock and debt Monday, creating a digital media powerhouse with the potential to reach every American in one form or another.”¹ It was at the time the largest deal in history, and what was significant was that the acquirer AOL had only just  become profitable,  but nonetheless would represent 55% of the combined company shares despite the fact that Time Warner would contribute 70% of the combined company’s profits.

Many of you will have seen this chart in recent presentations, for those that haven’t it shows companies that have listed in the US for the first time via an Initial Public Offering or IPO. What it actually shows is the proportion of those companies that have not yet become profitable. Late last year this measure showed that 74% of companies that undertook an IPO had negative earnings. The peak for this measure was in 2000, around the time of the AOL Time Warner merger.

Last week there were two headlines, “The Megadeal Makes a Comeback” in the Wall Street Journal and “Megadeals Drive Takeover Activity Past $1 Trillion Mark for 2014” in Bloomberg. Not yet included in that trillion dollar figure is, amongst others, a proposed deal between pharmaceuticals companies Pfizer and AstraZeneca, in which the former would acquire the latter for US$100 billion. The market value of AstraZeneca is right now sitting at US$99 billion as the share price has run up from US$47 mid last year to US$79, or in other words AstraZeneca is now worth about US$40 billion more than in June 2013.

Only time will tell if indeed Pfizer is getting value, or if in fact some of the purchase price will in due course need to be written down. What suggests that at least some of the purchase price will indeed be wasted is the increasing prevalence of using inflated stock prices to make acquisitions by issuing more shares rather than using cash. As the WSJ article notes,

cash only deals, by dollar volume, fell to 48% year to date, the lowest percentage since 2001.

There is mounting anecdotal evidence to confirm the quote, in the long term there will be no lessons learnt by most investors from the last financial crisis, or indeed earlier crises such as the technology led equities market bubble that popped in early 2000. Following these exploits vicariously will be interesting, perhaps even exciting at times, but as a wise person once said: if investing is exciting, you’re doing it wrong.

AUSTRALIA

We are a couple of weeks away from seeing the detail of the first federal budget handed down by Treasurer Joe Hockey, but as has become the norm in recent years we are well into the ‘ground softening’ period of leaking key details of the expected policy measures. These have been extensively covered, including increases to the qualifying age for eligibility to the age pension, a temporary levy / tax on higher income earners to address the budget deficit, and some sales of publicly owned assets. The long term plan is to return the budget to a surplus equivalent to 1% of GDP within a decade, a significant task from the current position in which the budget deficit is equivalent to 3% of GDP.

With the caveat that we should hold off on forming conclusions until the detail is available, economists have pointed out that this greater fiscal tightening has the potential to hold back our economic growth, which continues to be slightly below long term trend growth rates. Estimates² are that the deficit reduction levy could raise as much as $6 billion in 2014/15 which would represent a drag of around 0.4% on GDP, and that the levy may be in place for up to four years. Growth in the Australian economy had been expected to accelerate beyond 3% over the remainder of the current year and into 2015, though sub trend growth may persist for longer if this policy tightening is enacted.

In simple terms, and no matter whether it is called a levy or a tax, the effect of such policy will be to remove money from the economy that otherwise would have gone to either spending or savings. Any changes in the latter option is one that will be worth following closely in coming years, as the rate of household savings in Australia has remained relatively high following the financial crisis.

This chart³ from the RBA shows a steady decline in the savings ratio for households had continued for the better part of two decades, before ending abruptly when the financial crisis beset economies and financial markets in late 2008 and early 2009.

One possible scenario is that households in time are able to maintain spending levels by offsetting the impact of any increased taxes with a reduction in savings. In the short term however that appears unlikely and recent data confirms that consumer confidence has reacted to this uncertainty with a sharp fall in April, suggesting savings will be at least maintained amid the short term uncertainty.

As with many things, it will be important not to react to short term moves, but rather to keep our focus on a longer term horizon.

UNITED STATES

We start our United States discussion in a somewhat unusual manner, and will focus initially on a single company known to all of us, Apple Inc. The maker of the iPod, iPhone and iPad has grown to become the largest technology company in the world and is valued at just over half a trillion US dollars. To give some context to this number, Apple has a market capitalisation that is just about equal to the combined value of BHP Billiton and all four of our major banks. Another illustration of the scale of this business is that the cash alone it holds of US$151 billion is worth far in excess of any one of those four major banks, and is in fact not far shy of the total market cap of BHP Billiton which stands at approx. US$180 billion.

Perhaps not surprisingly given this pile of cash, the company has of late come under pressure from some activist minded shareholders to either deploy it by making investments or acquisitions, or return it to investors via dividends. What Apple has in fact decided to do is to buy back their own shares and they will spend up to US$90 billion doing so. This is a perfectly valid course of action if in the opinion of Apple management there are no alternative investment opportunities that would provide a superior return to shareholders, and we have seen historically high levels of share buybacks being carried out over a wide range of business and industries in the last few years.

What is interesting in this case however is that Apple isn’t using its US$151 billion of cash to complete the buybacks, instead they are issuing debt in the form of corporate bonds at very cheap interest rates. The reason is simple, most of the cash that Apple holds (about 88%) is held offshore from the United States, and as the incoming Chief Financial Officer said recently: “To repatriate our foreign cash under current U.S. tax law, we would incur significant tax consequences and we don’t believe this would be in the best interests of shareholders.”

Technology companies in particular have been able to exploit the global nature of their operations in recent years by shifting income to lower taxing locations. JP Morgan estimates “that US$1.7 trillion in foreign earnings is being held overseas by more than 1,000 firms, yet to be taxed by the [US] federal government.”⁴ To provide another example, a US Senate investigative committee “found that from 2009 to 2011, Microsoft was able to shift offshore almost half of its net revenue from US retail sales, or roughly $21 billion, by transferring intellectual-property rights to a Puerto Rican subsidiary. As a result, the subcommittee found that Microsoft saved up to US$4.5 billion in taxes on products sold in [America].”⁴

Returning to Apple, what stands out about the bond issuance is how cheaply they have been able to issue the debt, because investors are scrambling to earn income in an environment where official interest rates are effectively 0%. We have spoken recently about the pendulum of value between investors buying bonds and companies issuing them being very much in favour of the issuing companies. Whilst thankfully it is occurring to a much lesser extent in Australia, we do however reiterate our views that the prices being paid right now, and hence the rate of income that will be generated, are not wholly representative of the risks being assumed by investing in corporate bonds and other fixed income investments.

The metaphor of a pendulum is one we use frequently, and one that works well when we look at investments and markets with a long term time frame. In time more favourable valuations and better future performance will become available as the pendulum swings back to investors.

SOURCES:
1. Tom Johnson. That’s AOL Folks. CNN Money. 10-Jan-00.
2. ANZ Research. Australian Economics Update. 29-Apr-14.
3. Reserve Bank of Australia, Chart Pack. Released 2-Apr-14.
4. JL Yang, Post analysis of Dow 30 firms shows declining tax burden as a share of profits. Washington Post. 27-Mar-13.

DISCLAIMER: The information in this commentary has been provided for publication by Implemented Portfolios (ABN 36 141 881 147. AFSL Number 345143). The information has not been verified by Implemented Portfolios or Adapt Wealth Management Pty Ltd (ABN 76 821 231 362 Corporate Authorised Representative of Paragem Pty Ltd AFSL 297276) but is believed to have come from reliable sources as noted in the acknowledgements. No Liability is accepted by Implemented Portfolios, or Adapt Wealth Management Pty Ltd, its Directors, officers, employees or contractors for any inaccurate or incorrect information. The information is a broad commentary and there is no intention that a client should act on the information without seeking professional assistance from their own advisers (legal, tax, accounting, financial planning) for suitability in respect of their unique circumstances.

Future performance is a function of current price, and so it should be no surprise given the recent declines that our forecasts have increased across the range of asset classes shown below.

Returns in share markets for January 2014 stand in stark contrast to the same month just a year earlier.

In Australia the ASX200 index has declined by a tick over 3% in January, and around half that loss again has been subtracted from the index in the first week of February. This time last year the index had just recorded a rise of 4.9% for January, which would be followed in February by another 4.6% making for a very strong start to the year. We spoke often last year about the tremendous strength in the local banks, and this is borne out in the same comparison for the Financials sector, which advanced by more than 14% in the first two months of 2013 and which has thus far fallen by 6.4% in the calendar year to date.

The outcome was similar in other share markets around the world; the United States added 6.2% in the first two months of 2013 and has lost 5.2% in the first five weeks of 2014. In China, the Shanghai Composite added 9.4% at the start of 2013, and a year later has fallen back by 7.8%. Japan again provides an outlier result, but the pattern remains consistent with the extraordinary early gains in 2013 coming in at 21.7% as opposed to falling by 9.7% so far in 2014.

UNITED STATES

The second tranche of tapering has been agreed by the US Federal Reserve, as Ben Bernanke hands the Chairmanship of the Fed to his former deputy Janet Yellen. These two moves represent the first steps in the process to normalise monetary policy in the United States. To quickly recap, the economy was in such a dire state following the financial crisis that the unprecedented action of taking interest rates to zero was not deemed sufficient to turn things around. As a result, along came the extraordinary monetary policies known as Quantitative Easing (QE), which involved the Fed buying bonds and other assets ultimately at the rate of US$85 billion a month, in order to inject more liquidity into the economy. The tapering that we mention above has now been adopted at the last two meetings of the Fed, taking the rate of extraordinary liquidity support down by $10 billion each time. The best analogy for this action is still one of merely easing off the accelerator of additional support, rather than applying the brakes to the economy.

Importantly, what accompanied these recent moves was more definitive forward guidance as to the likely level of interest rates. That is to say, Bernanke made clear that interest rates would stay very low for an extended period and this news served to mollify investors that otherwise may not have liked the tapering. Essentially the Fed has deemed that the American economy has shown sufficient signs of recovery to warrant less extraordinary support, however to employ their parlance any decisions as to additional tapering in coming months will be ‘data driven’.

EMERGING MARKETS

Moving now to Emerging Markets, let us start with the promised clarity on the label itself. For ease of communication more than anything else, we split the International Equities asset class into Developed and Emerging Markets, with the former very broadly comprising North America and Europe.

When the first hints of tapering from the Federal Reserve came out, there were significant declines in the currencies and share markets of several countries, notably India and Indonesia. These economies run a current account deficit, which in simple terms means they rely on funds from foreign investors to finance the growth in their economy. For many years, foreign investors that were receiving essentially 0% return on funds in places like the United States were happy to invest in India and Indonesia. However, if interest rates started to increase in the US, then it was deemed likely that less funds would flow to these countries, sparking fears of what impact this might have on future growth. At the end of January the Indian Finance Ministry sought to directly counter these concerns, providing assurances that the government and the Reserve Bank of India would ensure stability and that they were prepared for any impacts of the tapering.

By contrast, the emerging markets of China (including Hong Kong), South Korea and Taiwan run a current account surplus, have sound economies that we expect to grow comparatively strongly in coming years and importantly are trading at valuations which look very attractive. Many of you will have heard us say before that a large part of the reason we look out over long forecast periods is that over that longer term it is fundamentals that dominate returns. In shorter periods, sentiment can be the prevailing force for short term returns, even if the reasons for the change in sentiment relate to other markets.

AUSTRALIA

In its first meeting for 2014 the Reserve Bank of Australia left interest rates at 2.5%. This much was widely expected, though the language in the accompanying statement did reflect a change in stance. The board considered that monetary policy was appropriate to balance supply and demand in the economy, whilst inflation is contained within its target range of 2% to 3%. Following on from the generally positive economic news we highlighted in last month’s commentary, the statement² by Governor Glen Stevens said “information becoming available over the summer suggests slightly firmer consumer demand and foreshadows a solid expansion in housing construction. Some indicators of business conditions and confidence have shown improvement.”

However, he then went on to note that the transition to the next stage of the resources boom would require that other sectors of the economy replace past mining activity and jobs. The statement concluded “the most prudent course is likely to be a period of stability in interest rates” giving a clear indication that we will remain at 2.5% for many months, and perhaps some further indication that as we suspect the next move in rates might eventually be an increase.

DISCLAIMER: The information in this commentary has been provided for publication by Implemented Portfolios (ABN 36 141 881 147. AFSL Number 345143). The information has not been verified by Implemented Portfolios or Adapt Wealth Management Pty Ltd (Corporate Authorised Representative of Paragem Pty Ltd AFSL 297276) but is believed to have come from reliable sources as noted in the acknowledgements. No Liability is accepted by Implemented Portfolios, or Adapt Wealth Management Pty Ltd, its Directors, officers, employees or contractors for any inaccurate or incorrect information. The information is a broad commentary and there is no intention that a client should act on the information without seeking professional assistance from their own advisers (legal, tax, accounting, financial planning) for suitability in respect of their unique circumstances.

The All Ordinaries index of Australian Equities continues to move between the upper range of our Cheap valuation assessment and the lower range of Fair Value. With some weakness in the first weeks of January, we are now back in Cheap territory.

The Australian share market added 15% for calendar year 2013, increasing to 20% when the value of dividends is included for the ASX200 index. In the United States, the same numbers are 30% and 33% for the S&P500, while in London the market was up 14%, in Germany it was 25% and in France 18%. Moving to Asia, Japan was a standout performer on the promise of reforms announced by new Prime Minister Abe, who returned to office in December 2012. The Nikkei was up 57% for 2013, though the growth slowed in the second half of the year as the promise of reform met the reality of implementation.

Index returns were modest in the other major Asian markets including South Korea (1%), Taiwan (12%), Hong Kong (3%) and the Shanghai Composite in China, which actually fell by 7%. However returns were bolstered for Australian investors that were not currency hedged (as is the case in the Exchange Traded Funds we use), as the Australian dollar weakened over the course of 2013. In US Dollar terms the exchange rate fell from $1.04 to $0.89, a drop of 14%, similar to the Chinese currency where the Australian dollar declined by 17% and the 15% fall against the South Korean Won.

Before we move on to the regional discussion, it is worth noting the potential for disruption from what has been, at least by recent standards, a somewhat more benign geopolitical environment. There are some positive developments, including news that the first shipment of chemical weapons has left Syria, pursuant to a multi-lateral agreement reached in September last year. Whilst this does represent progress, bringing an end to the civil war and humanitarian tragedy is still to be achieved. Iterations of the struggle between Sunni and Shia occur all over the region, and will doubtless be something about which we need to be attentive for many years to come.

Also positive are signs of an initial thawing in diplomatic relations between Tehran and Washington, as evidenced by the former agreeing to oversight of their nuclear facilities in exchange for some relaxation of economic sanctions. This is but the first step in a very long process, but nonetheless a welcome one. Looking west there is a more troubling development in the Iraqi town of Fallujah where Al Qaida forces have taken control, providing a critical test for the efficacy of the Al Maliki government in Baghdad.

Further afield there are continuing tensions between Japan and China, with each making territorial claims to the uninhabited Senkoku islands. On returning to power, Prime Minister Abe reviewed defense policy, and the latest announcement references: “Japan’s concerns about what it calls Beijing’s attempts to change the status quo with force, the guideline says Japan will ‘respond calmly and resolutely to the rapid expansion and step-up of China’s maritime and air activities.’”¹

CHINA

We wrote in our November commentary about the extensive reforms announced in China which gave a clear indication of the intent of the leadership to implement significant change to address imbalances in the Chinese economy. Subsequent to these announcements there have been two conferences, the first was the Central Economic Work Conference which reiterated the ‘decisive role’ the market is to play in China’s industry and resource allocation, as well as echoing the call for an increase in social security such as pensions and healthcare. Some expect² that the GDP growth target for 2014 will be lowered to 7.0%, which is the target rate for the current Five Year Plan. However, as growth has already averaged 8.2% for the first three years of this period, it would seem the tradition of under promising and over delivering is set to continue. We will hear of any change in March at the National People’s Congress.

Among other priorities identified was to contain local government debt, which has been quantified in a recent extensive audit. Prior to the release of the audit, estimates of central and local government debt ranged between RMB10 and RMB50 trillion, and one of the key concerns expressed was that a low number would not be seen as credible. After the release, there is no apparent skepticism about the numbers, which are RMB20.7 trillion for direct government debts, rising to RMB30.3 trillion with the inclusion of contingent liabilities. The latter are defined as debts that the government guarantees or debt that the government may need to bail out in time. The chart3 above provides a global context for the Chinese government debt position.

In the early days of 2014 China has given authority to local governments to issue bonds to enable them to roll over existing debts as they mature, and to avoid defaults. “The National Development and Reform Commission said bonds would also help local governments reduce their financing costs because they could be issued at lower rates and for longer maturities than some of the short-term high-interest loans relied on in the past.”⁴

The second event was the Central Urbanisation Work Conference, over which President Xi Jinping presided. Again the reforms from the Third Plenum were emphasised including the ‘hukou’ reforms to urban labour registration and the importance of continued urbanisation in small to medium sized cities. This is undoubtedly an ongoing and significant challenge to fund enhanced social security access for some 260 million people who are unregistered migrants in China’s cities. There is clearly strong recognition from the Chinese leadership of the imbalances in their economy, and the challenges to implement reforms, but equally the President and Premier have made clear their intent.

AUSTRALIA

We remain optimistic about the Australian economy successfully making a transition to the next stage of the mining boom, and are encouraged that non-mining sectors are providing evidence of this. By way of example, below are the headlines from publications of the ANZ Economics Research team for the first two weeks of January.

• Australia: housing finance rebound points to stronger credit growth
• Further signs of stabilisation in Australian job advertising
• Australian Economics Weekly: low interest rates are supporting non-mining economic activity
• Australian retail sales strengthen further in November
• Australia: dwelling approvals foreshadow a pick-up in building activity
• Australian job vacancies point to a stabilisation in labour demand
• Australia’s trade deficit narrows
• Australia: house price momentum remains strong
• Australia: private sector credit momentum builds

We wish our followers and clients a happy and prosperous 2014, and thank you for your ongoing support.

SOURCES:
1. K Takenaka, Japan’s defense plans focus on China and islands dispute. Reuters. 11-Dec-13.
2. L Li-Gang, Z Hao. Central Economic Work Conference Ends: Lower Growth Target Likely. ANZ Research. 31-Dec-13.
3. L Li-Gang, Z Hao. China’s First Release of Total Government Debt Levels. ANZ Research. 30-Dec-13.
4. S Rabinovitch, China gives local governments go-ahead to roll over debt. Financial Times FT.com. 2-Jan-14.

DISCLAIMER: The information in this commentary has been provided for publication by Implemented Portfolios (ABN 36 141 881 147. AFSL Number 345143). The information has not been verified by Implemented Portfolios or Adapt Wealth Management Pty Ltd (ABN 76 821 231 362 Corporate Authorised Representative of CHPW Financial Pty Ltd AFSL 280201) but is believed to have come from reliable sources as noted in the acknowledgements. No Liability is accepted by Implemented Portfolios, or Adapt Wealth Management Pty Ltd, its Directors, officers, employees or contractors for any inaccurate or incorrect information. The information is a broad commentary and there is no intention that a client should act on the information without seeking professional assistance from their own advisers (legal, tax, accounting, financial planning) for suitability in respect of their unique circumstances.