On Wednesday 6 November 2013, the Treasurer, the Hon Joe Hockey MP, and the Assistant Treasurer, Senator the Hon Arthur Sinodinos AO, announced the Government’s decision to abandon some of the previous Government’s tax and superannuation proposals.  The following will be consigned to the rubbish dump:.

• imposing a cap on deductions for work related self-education expenses
• amendments to the fringe benefits tax treatment of car fringe benefits
• imposing a tax on investment earnings above $100,000 per annum for superannuation assets supporting retirement income streams
• Repealing the Low Income Superannuation Contribution (LISC).  The LISC was a government contribution to people earning under $37,000 per year that ensured that they would not pay more tax on their compulsory superannuation contributions than they do on their income.  This contribution will no longer be available from the 2013-14 income year and onwards.

If you think that any of these changes may apply to you and wish to seek further clarification, please give me a call to discuss further.

The valuations for the asset classes below are based on our long term forecasts, and as we have said many times before – over the long term fundamentals are what matter. In the short term, changes in sentiment are often the dominant influence on price moves.

Obama’s credit card problem

To explain the situation in the US at the moment, I thought I would use an analogy to compare the US Government’s cashflow problems to the financial situation of an individual. Barak Obama was given a credit card by the US Congress to pay the bills of the Government. He needed this because he was spending more than he was earning. Barak used the credit for the day to day expenses including salaries of staff, healthcare and defence. He also used the credit card to pay interest on longer term loans (let’s call this his home loan).
But the Congress were unhappy with Barak’s spending. They put him on a short leash so that he had to keep coming back to them each time he wanted more funds. Finally when Barak decided he wanted to spend a whole lot of money on fixing the medicare system (Obamacare), the Republicans in the Congress had enough! They told him that he could only use his credit cards for essential services and all non-essential spending was to be halted immediately. This Government Shutdown means that around 800,000 of the 2.1 million employees have to stay at home and take unpaid leave. On the positive side, no gun permits are issued and all tax audits are suspended during the shutdown. There is a bright side to everything!

The Credit Card Limit (Debt Ceiling)

If the shut-down is about restricting use the credit card, the debt ceiling is about the credit card limit. By October 17, the Congress needs to lift the credit card limit so that Barak can continue to pay his bills, even if it is only the essential items! Most importantly, Barak needs to pay the interest on home loan (long term debt) to the bank (Bond Holders). If the home loan can’t be paid, then the bank will not only be unhappy, but will make it extremely difficult for anyone else to borrow money. After all, if the US Government can’t be trusted to pay its loans – who can be?
The US Government defaulting on it’s debts is not a situation which has occurred before and the ramifications are extremely hard to predict. However, the markets expect that the credit card limit will be increased and a crisis averted.

What is the Impact on Investment Markets?

We are likely to see significant volatility on investment markets whilst this is an issue. We have said for a while that the US sharemarket as a whole is highly priced with expected long term returns of only around 5% (refer to our Tipping Point chart below). We see the Australian sharemarket is reasonably priced, with expected long term returns of between 9 and 10% but likely to be volatile in the short to medium term. Therefore for clients putting new money into the market, we will be investing gradually rather than in one go so we can take advantage of lower prices should they occur. Please do not hesitate to contact us to discuss your personal situation further.

Generally some modest moves higher across the equities asset classes depicted below. The impact from the RBA cutting cash rates to 2.5% in early August has not yet shown up in longer dated term deposit rates, hence our risk free threshold remains at 4.4%. We do however expect that in coming weeks that term deposit rates will adjust lower, and will update you next month as to the effect this has on the valuation ranges outlined below.

We will start with a review of the regions we discussed last month, those being the United States and China, before moving to Europe and Australia where upcoming elections command our attention.

UNITED STATES

The labour market is one of two areas, along with inflation, monitored closely by the Federal Reserve as they contemplate moving interest rates up from zero, where they have been since late 2008. Long term readers will recall that in earlier notes we have focused on labour and also housing for signals of the strength of the economic recovery in the US. On the latter the recent data has been strong, though the improvements have come off a very low base, and in some instances, at least anecdotally, there are some troubling signs. Recently economist Robert Shiller noted that “the cities that bubbled in the past are bubbling again.”¹

Of greater note though is that the housing recovery is thus far not contributing to a recovery in employment. As the yellow line shows whilst the unemployment rate has come down, the red line shows that total employment in the US economy has been essentially flat since late 2010.

An optimistic outlook would require that not only those that have been discouraged from seeking work would resume their search for a job, but also those that are working part time involuntarily being able to find full time positions. Taken together, it seems unlikely that the Fed’s threshold of unemployment falling below 6.5% is met any time soon. Note that this does not preclude the gradual paring back of the bond purchase program; rather this threshold and an outlook for inflation exceeding 2.5% are criteria for considering moving interest rates above the current levels of between 0% to 0.25%.

Making the task that much harder, further sequestration spending cuts set to be enacted by the Federal Government have been predicted by the non-partisan Congressional Budget Office² to cost 1.6 million jobs by the end of 2014.

CHINA

Early signs are that the policy efforts from Beijing to gain more transparency over the shadow banking system in China, and to slow the rapid growth in this sector of the economy, are starting to take effect. A recently announced audit of debt, particularly in the potentially troublesome local government finance vehicles. This will provide a measure of clarity that hasn’t been available up to this point, and is being interpreted as the authorities seeking to prevent further rapid increases in credit, rather than enforcing any sharp contraction.

“Local government borrowings are ultimately China’s fiscal liability. Even under the most aggressive assumptions discussed in the marketplace, China’s total gross public sector debt, including local and central governments, is still not excessively high compared with that of most countries. Moreover, the Chinese government also owns vast amounts of assets. Therefore, the net debt situation is easily manageable, especially considering the country’s very high domestic savings rate.”³

Occasionally an article or presentation reminds us of the unprecedented scale of the transformation in the Chinese economy over the last several decades. Recently though this brief video prompts us to contemplate the scale of the transformation still to come. The New York Times⁴ provides some graphical context to accompany an article that discusses the 250 million people still to be urbanized in China.

EUROPE

Unfortunately, the scale of the problems that still confront Europe are also profound, notably including the condition of the labour market. The unemployment rate in the Euro Area stands at 12.1%, and but for a brief respite in 2011 this rate has climbed steadily in the years following the financial crisis. Of course some individual countries are much worse, notably Greece and Spain where the unemployment rate is 27.6% and 26.3% respectively and significantly worse when youth rates are considered.

The austerity policies once thought to be the only path to salvation for indebted nations are perhaps best represented by Ireland, which embraced the ‘take your medicine’ approach imposed by Brussels and is still suffering as a result of having done so. These two charts show the annual GDP growth rate has recently fallen below zero again, and that despite the genuine hardship inflicted on the Irish the level of debt compared to GDP has only increased. One suspects the Irish would be skeptical about OECD forecasts for debt to plateau from this point forward.

Chancellor Angela Merkel is expected to be returned at the September elections in Germany, and there is thinking that a widely held desire to see this happen, and more lately the traditional August holiday period, has led to a period of comparative calm in Europe. A widely read and respected commentator nonetheless highlights the ongoing issues still to be resolved, including joblessness, fatigue to ongoing austerity especially in the absence of improvements, along with even more fatigue to any prospect of further bailouts and private enterprises still struggling to access credit markets. He concludes as follows:

All of this adds up to a sad reality for Europe. Despite hopeful blips in an economic indicator here and there, too many countries lack both immediate growth and longer-term growth engines. As a result, debt overhangs will remain problematic. Owners of private capital that could be allocated to productive investment will remain hesitant. And societies will continue to lack the jobs and capital investment that are essential for durable prosperity and general well-being.⁵

Some valuations and prices in parts of Europe look historically cheap, though this is for good reason, and as a result we will continue to be interested observers rather than investors for the time being.

AUSTRALIA

The most recent Statement on Monetary Policy from the RBA provided a subdued interpretation of the short term outlook for the Australian economy. Whilst inflation will remain in check, modest employment growth is expected to lead to a slight increase in the unemployment rate, though this measure was steady at 5.7% for August. Not surprisingly, much of what occupies the RBA’s thinking is how our economy will manage the process of mining investment making a smaller contribution to our GDP.

Over the next few years a strong contribution to GDP is expected from the export of bulk commodities, mainly coal and iron ore. This will be helped in part by the lower Australian dollar but driven mainly by the large capital investment in recent years that has significantly increased capacity. Of course, prices for these commodities will be critical in determining the final contribution to GDP, and at least of late there has been some resilience in iron ore prices though coal prices have weakened.

The RBA also notes that as the investment phase comes to an end in the near future, the actual size of the impact on our GDP will not be as great as around half of the investment has been on imported capital goods. Activity in the mining sector is inherently difficult to forecast, as the outlook can change very quickly based on very large scale projects either going ahead or being postponed.

We finish with some observations from the economists at ANZ Bank⁶, who note that recent trends in the NSW economy are supportive of the transition away from the mining sector. Having underperformed the broader Australian economy for a decade given it has substantially more exposure to financial services, insurance, IT and media and telecommunications, the NSW economy is now leading other states in some respects. Economic activity has been above trend for the last year, and strong results have also been recorded in employment growth and the housing market. We will continue to watch this closely, however at this stage it provides an encouraging view of our ability to manage the transition required in our economy, extending to the outlook for companies that prosper when the domestic economy is resilient, notably including our major banks.

SOURCES:
1. Quoted in “Housing market heats up but not at boiling point yet” – J Schoen, cnbc.com. 30-Jul-13.
2. Eric Painin, CBO Says Sequester Part II Could Cost 1.6m Jobs. The Fiscal Times. 26-Jul-13.
3. BCA Research, “China: More Tightening On Local Government Debt?” 6-Aug-13.
4. Graham Roberts, “In China, a Staggering Migration” New York Times. 15-Jun-13.
5. Mohamed El-Erian, Europe’s Fake Normal. Project Syndicate. 5-Aug-13.
6. Warren Hogan, et al. NSW Recovery May Underpin The Transition From Mining Boom. ANZ Research. 7-Aug-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 ( 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.