“It’s not what you own that gets you into trouble, but what you owe.”

Excessive debt tends to be at the centre of most scare stories regarding the investment outlook – whether they relate to China, public debt in developed countries, corporate debt in the US or Australian household debt. The standard debt related scare story runs something along the lines of “we have lived beyond our means. Any attempt to prevent a debt implosion won’t work or will just delay the inevitable. Divine retribution will get us in the end!” One big debt scare that gets wheeled out is that total global debt outstanding has reached a new record high of nearly $US200 trillion and either that on its own or in combination with any significant rise in global interest rates will trigger the next crisis. To be sure problems with debt or a desire to reduce it are part and parcel of most financial crises and economic downturns. And total global debt has indeed reached record levels. But that’s not the same as saying another financial crisis is imminent. This note looks at the main issues.

Global debt – first some facts

Excluding the debt of financial companies like banks (to avoid double counting) total gross world public and private debt is around $US170 trillion. That is a record high big scary number but it’s meaningless unless it’s compared to something. An obvious comparison is to income levels and the best guide to that at an economy wide level is GDP. Again new records have been reached with gross world public and private non-financial debt rising to a record of 235% of global GDP.

Since the global financial crisis (GFC) the climb in overall debt has been due to rising public debt in the developed world (DM) and rising private debt in the emerging world (EM). The rise in developed world public debt reflects GFC related stimulus programs and the failure to turn budget deficits into budget surpluses post the GFC.

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

The next table compares total debt for various countries.

Total gross non-financial debt outstanding, % GDP

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

There are some qualifications to the table. For example, because of public investments in debt via sovereign wealth funds, central bank reserves, etc, net public debt is usually well below gross debt. In Norway net public debt is -274% of GDP and in Japan its 128% of GDP. So gross debt data exaggerates the total level of debt. But as an overview:

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

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

• Australia does not rank highly in total debt – it has very high household debt but its offset by low public & corporate debt;

• Emerging countries tend to have relatively lower debt, but China is an exception given a high level of corporate debt.

But the bottom line is that global debt is at record levels even adjusted for GDP. As a result some fear that any rise in interest rates will immediately derail global growth. Excessive debt can also be associated with slower growth and a higher risk of a financial crisis. Of course it’s not that simple.

Debt, savings and income dynamics

Firstly, the relationship between income, savings and debt is more complicated that often portrayed. The Global Investment Strategy service of Bank Credit Analyst Research (a Canadian research house) recently illustrated this using some simple examples. Suppose there is an island with 100 people, each producing 100 coconuts a year. Here are three possibilities.

Case 1: Output is 10,000 coconuts with each person consuming 100. Saving and investment are zero and no debt is created.

Case 2: Each person consumes only 75 coconuts a year, selling the remainder to a plantation who buys them with a bank loan and plants them resulting in 2500 new coconut trees. Consumption is 7500 coconuts. Savings and investment are 2500 and debt has gone up by 2500 coconuts.

Case 3: Each person consumes 125 coconuts, by importing 25 each. Consumption is now 12,500 coconuts, savings is -2500 coconuts, investment is zero and the current account deficit is 2500. External debt goes up by 2500. This is arguably more risky if foreign islands decide they want their coconuts back!

The point is that debt can rise in an economy even if it lives within its means and invests for the future as Case 2 illustrates. No need for divine retribution here!

Reasons not to be too alarmed about record debt

There are several reasons not to be too alarmed by the rise to record debt levels.

First, the level of debt has been rising ever since debt was invented. This partly reflects greater ease of access to debt over time. But it also reflects the fact that the level of debt is a stock while income is a flow. Suppose an economy starts with $100 of debt and $100 in assets and in year 1 produces $100 of income and in each year it grows by 5%, consumes 80% of its income and saves 20% which is recycled as debt. At the end of year 1 its debt to income ratio will be 120%, but by the end of year 5 it will be 173%. But assuming its assets rise in line with debt its debt to asset ratio will remain flat at 100%. So the very act of saving and investing creates debt and rising debt to income ratios.

Second, China has led the surge higher in private debt in recent years but is an example of Case 2 where it borrows from itself. The main problem in China is that it has a very high savings ratio of nearly 50% of GDP and this saving is largely recycled through the banking system (partly because of a less developed share market) and this results in strong debt growth. But not much of this has gone into the Chinese property market (household debt is low) – rather it finds its way into corporate debt and investment. But this is largely matched by an expansion in productive assets and is really a reflection of fiscal policy and is subject to government support if there’s a problem.

Third, the rise in private debt in the emerging world is not that concerning as they, like younger workers, have a higher growth potential going forward than developed countries. Of course the main problem emerging countries face is that they borrow too much in US dollars and either a sharp rise in the $US or a loss of confidence by foreign investors causes a problem. But there are no signs of the latter and emerging countries seem to have weathered the rise in the $US since 2014 pretty well.

Fourth, debt interest burdens are low and in many cases still falling as more expensive long maturity older debt rolls off. For example despite the recent rise in bond yields US public debt interest payments are less than 3% of US GDP – well down from 4.5% in 1991. And given the long maturity of much debt in advanced countries it will take time for higher bond yields to feed through into actual interest payments. In Australia, interest payments as a share of household disposable income are at their lowest since 2003, and are down by more than a third from their 2008 high. See the next chart. Moreover there is no sign of significant debt servicing problems globally or in Australia – unlike in relation to US sub-prime debt just prior to the GFC.

Source: RBA, AMP Capital

Fifth, most of the debt increase in recent years in developed countries has come from public debt and governments can tax and print if worse comes to worse. Japan is perhaps most at risk here given its very high level of public debt but it has borrowed from itself (Case 2 again) and Japan remains one of the world’s biggest creditor nations. And even if Japanese interest rates do rise sharply (which is unlikely with the BoJ maintaining zero 10 year bond yields) 40% of Japanese Government bonds are held by the BoJ so higher interest payments to it will simply be paid back to the Government.

Sixth, when it comes time to raise interest rates central banks will adopt a gradual approach knowing that in an environment of higher debt they don’t need to raise rates as much to have an impact on inflation or growth as had been the case in the past. The gradual approach is currently evident at the Fed.

Finally, increased debt of itself is rarely the source of a shock to economies. Some sort of trigger is required – usually much higher interest rates or rising defaults as economies sour or after a big deterioration in lending standards – as was evident in the US sub-prime crisis. At present these seem unlikely.

Concluding comment and investment implications

None of this is to say there’s nothing to worry about. History tells us that the next major crisis will involve debt problems of some sort. But just because global debt is at record levels and that global bond yields have moved higher does not mean a crisis is imminent. For investors, debt levels are something to keep an eye on – particularly if there is a broad based surge in debt in the context of surging asset prices. At present, apart from pockets of concern (eg, Sydney & Melbourne property markets) there is no sign of this on a generalised basis globally.

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

The cooling in the Sydney and Melbourne property markets evident in late 2015 in response to macro prudential tightening deployed by APRA has proved ephemeral. Price gains have reaccelerated and auction clearance rates & lending to property investors have rebounded. Over the last five years Sydney dwelling prices have risen a ridiculous 73% and Melbourne prices are up 47%. As a result the Australian housing market continues to cause much angst around poor affordability and high household debt. This note looks at the main issues.

Source: CoreLogic, AMP Capital

Is Australian housing overvalued?

On most measures Australian housing is overvalued:

• On the basis of the ratio of house prices to rents adjusted for inflation relative to its long term average Australian houses are 39% overvalued and units 13% overvalued.

• According to the 2017 Demographia Housing Affordability Survey the median multiple of house prices in cities over 1 million people to household income is 6.6 times in Australia versus 3.9 in the US and 4.5 in the UK. In Sydney it’s 12.2 times and Melbourne is 9.5 times.

• The ratios of house prices to incomes and rents are at the high end of OECD countries.

Source: OECD, AMP Capital

Why is it so expensive and household debt so high?

There are two main drivers of the surge in Australian home prices over the last two decades. First, the shift from high to low interest rates has boosted borrowing and hence buying power. This has taken Australia’s household debt to income ratio from the low end of OECD countries 25 years ago to the top end. Second, there has been an inadequate supply response to demand. The following chart shows a cumulative shortfall relative to underlying demand had built up by 2014 and is still yet to be worked off despite record construction lately.

Source: ABS, AMP Capital

Consistent with this, while vacancy rates have increased they have only increased to around average long term levels. In Sydney vacancy rates are below average.

What about investors and foreign buyers?

A range of additional factors may be playing a role in accentuating demand beyond that implied by population growth. These include negative gearing and the capital gains tax discount, foreign buying and SMSF buying. Negative gearing is just part of the normal operation of the Australian tax system. However, the interaction with the capital gains tax discount by enhancing the after tax return available to property investment may be resulting in higher investment activity than would otherwise be the case. This may particularly be the case when past property price gains have been strong encouraging investors to think future gains will be too. While commitments to lend to property investors slowed in 2015 after APRA tightened macro prudential controls, this has since worn off.

Source: ABS, AMP Capital

Foreign buying is likely also impacting – with indications that it is around 10-15% of demand – but it is also concentrated in particular areas and SMSF buying appears to be relatively small. But like lower interest rates, all of these should have a less lasting impact if the supply response was stronger.

Is a crash likely?

The surge in prices and debt has led many to conclude a crash is imminent. But we have heard that lots of times over the last 10-15 years. In 2004, The Economist magazine described Australia as “America’s ugly sister” thanks in part to a “borrowing binge” and soaring property prices. Most recently the OECD has warned of the risks of a property crash. However, the situation is not so simple:

• Firstly, we have not seen a generalised oversupply and at the current rate we won’t go into oversupply until 2018 and in any case approvals suggest supply will peak this year.

• Secondly, mortgage stress is relatively low and debt interest payments relative to income are around 2003-04 levels.

• Thirdly, lending standards have not deteriorated like they did in other countries prior to the GFC. In recent years there has been a reduction in loans with high loan to valuation ratios and interest only loans are down from their peak.

• Finally, generalising is dangerous. While prices have surged in Sydney and Melbourne, they have fallen in Perth to 2007 levels and seen only moderate growth in other capitals.

To see a general property crash – say a 20% plus average price fall – we need to see one or more of the following: a recession – which looks unlikely; a surge in interest rates – but rate hikes are unlikely until 2018 and the RBA will take account of the greater sensitivity of households to higher rates; and property oversupply – this would require the current construction boom to continue for several years. However, the risks on the supply front are high in relation to apartments.

What can be done to fix it?

Recent RBA commentary strongly hints that more macro prudential measures to tighten lending standards are on the way. These could include a further lowering in the 10% growth cap on the stock of lending to investors and tougher debt serviceability tests. This is in part about reducing the risks to financial stability when it’s too early to consider raising rates.

More fundamentally, policies to help address poor housing affordability should focus on boosting new supply, particularly of standalone homes which have lagged. This includes relaxing land use restrictions, releasing land faster, speeding up approval processes and encouraging greater decentralisation. This is largely a state issue. Policies designed to make better use of the existing housing stock (eg, by relaxing constraints on empty nesters downsizing) could also help.

Policies that are unlikely to be successful include increased first home owner grants (as in periods of high demand they just result in higher prices) and allowing first home buyers to access to their super (again this will just result in even higher prices unless supply is fixed before and will mean less in retirement).

Tax reform should ideally be part of the package and include replacing stamp duty with land tax (again a state issue), removing the capital gains tax discount that is a distortion in the tax system and lower income tax rates to discourage use of negative gearing as a tax avoidance strategy. Piecemeal cuts to stamp duty targeted at FHBs will just result in higher home prices. Abolishing negative gearing would just inject another distortion in the tax system and could adversely affect supply (although I can see a case to cap excessive benefits).

What is the outlook?

Generalised price falls are unlikely until the RBA starts to raise interest rates again and this is unlikely until later in 2018, which after a few hikes will likely trigger a 5-10% pullback in property prices as was seen in the 2009 & 2011 cycles:

• Sydney & Melbourne having seen big gains are most at risk.

• Prices are likely to fall further in Perth and Darwin this year, but they are close to bottoming and should rise next year.

• The other capitals are likely to see continued moderate growth this year and a less severe down cycle around 2019.

• But units are at much greater risk given surging supply and this could see unit prices in parts of Sydney & Melbourne fall by 15-20% as investor interest fades as rents falls.

What are the risks to the economy?

Slowing momentum in building approvals points to a slowdown in the dwelling construction cycle ahead. This combined with a slowing wealth affect from rising home prices means that the contribution to growth from the housing will slow. However, as this is likely to coincide with a fading in the detraction from growth due to falling mining investment and higher commodity prices it’s unlikely to drive a slowing in the economy. However, a likely decline in rents (as the supply of units hits) will constraint inflation helping keep interest rates low for longer.

Source: REIA, AMP Capital

A property crash would have bigger impact given the exposure of banks, but as noted above such a development is unlikely.

Implications for investors

• While there is a strong long term role for residential property in investors’ portfolios at present their remains a case for caution. It is expensive on all metrics and offers very low net income (rental) yields of 2% or less. This leaves investors highly dependent on capital growth.

• But it is dangerous to generalise. Apartments in parts of Sydney and Melbourne are probably least attractive. Best to focus on areas that have lagged behind.

• Finally, investors need to allow for the fact that they likely already have a high exposure to Australian housing. As a share of household wealth it’s nearly 60%.

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

The long running soap opera around whether the Eurozone will break up is now into its eighth year! In 2015 all the focus was on the latest Greek tantrum and last year the big fear was that the populist/nationalist Brexit vote and Trump victory would lead to a surge in support for populist parties across Europe and drive a Eurozone break up. There was no sign of this in Spanish and Austrian elections, but this will be put to the test again with elections this year in the Netherlands, France, Germany and maybe in Italy. The fear is that a Eurozone break up will plunge the world’s third biggest economic region into recession and financial chaos, which would adversely affect the global economy and Australia. Such a fear may be exaggerated – the UK hardly imploded after Brexit – but that’s the worry.

The big picture

There are several reasons why Europe differs to the UK and US. Firstly, it doesn’t have the issues with inequality that drove the anti-establishment backlash in the US and UK. The Gini coefficient which measures income inequality is below average.

After taxes and transfers. Source: OECD, AMP Capital

Secondly, Eurozone break up risk may have peaked with the high point of the Eurozone debt crisis – when unemployment & fiscal austerity were at their peak in 2013. But unemployment has now fallen and fiscal austerity has ended. An abatement of the migration crisis may help too with sea arrivals slowing from over 200,000 a month in October 2015 to around 5000 recently.

Thirdly, despite the media frenzy the Eurozone populist parties are not really doing any better than a few years ago (mostly anyway). See below in relation to Marine Le Pen in France.

Further, leaving the Euro is not as simple as leaving the European Union as it would entail currency redenomination, the anticipation of which would drive a likely exit of foreign investors fearful of getting paid back in depreciated currency.

Finally, support for the Euro remains high in the Eurozone at around 70%. So to attain power the populists invariably have to renounce their anti-Euro policies as Syriza did in Greece.

Source: Eurobarometer, AMP Capital

But a chain is only as strong as its weakest link and there are risks at the individual country level, to which we now turn.

The Netherlands (parliamentary election March 15)

There are 28 parties contesting the parliamentary elections and 14 could enter parliament. Gert Wilders’ populist Eurosceptic Freedom Party may get a greater share of the vote and more seats than any other party but support has slipped from around 20% of the vote and seats to around 17% in recent polls. It won’t be able to form government, which will ultimately come from a group of centrist parties (which have rejected working with Wilders). Support for the Euro is very high at around 77%.

France (presidential elections on April 23 and May 7 and parliamentary elections on June 11 and 18)

The presidential election is a two round contest with the two highest placed candidates in the first round on April 23 then facing a run-off on May 7. Polling indicates that Marine Le Pen of the National Front (whose policy is to reinstate the Franc for domestic purposes, redenominate public debt into the Franc, allow the Bank of France to finance budget deficits and undertake a big round of public spending) is likely to “win” the first round (in the sense of getting more votes than anyone else with polls running around 26% support compared to around 24% for her nearest rival, Emmanuel Macron). And her chances of winning the second round have been boosted by allegations the Republican Party’s candidate Francois Fillon used public money to pay his family when he was a parliamentarian for fake work and rioting in the Paris suburb of Aulnay-sous-Bois.

However, several considerations work against a Le Pen victory in the second round. Firstly, support for Le Pen actually peaked several years ago and has since fallen back to around 26%. This suggests that the real issue is not the rise of Le Pen, but weakness in the conventional parties, ie the Socialists thanks to President Hollande and the Republican’s problems with Fillon. Le Pen also has similar allegations against her to those against Fillon, although so far this isn’t having much impact.

Source: IPSOS, AMP Capital

Secondly, French support for the Euro is relatively strong at 67%, whereas Le Pen advocates an exit from the Euro.

Thirdly, while Fillon is in trouble, former economy minister now running as an independent, Emmanuel Macron has been seeing increased poll support and on some recent polls has been running just ahead of Le Pen for the first round. What counts though is the final round. Polling currently shows that if the second round is between Macron and Le Pen – which looks most likely – then Macron will win by around 20 to 25%. If it’s between Fillon and Le Pen then Fillon is ahead by around 14%. And these margins are much wider than was the case in relation to opinion polls at the same point ahead of the US election when it was around 3% in favour of Clinton.

The bottom line is that current polling indicates Le Pen will not win the second round. However, France is not without risk. For example, more race related rioting in French suburbs or a major terrorist attack would play into the hands of Le Pen. The leaking of Russian hacks into Macron’s campaign may also do the same – as Russia stands to benefit from a Le Pen win.

However, even in the event of a Le Pen victory, it’s doubtful she would be able to implement her policies in relation to the Euro because her National Front is very unlikely to win a majority in the June parliamentary elections and leaving the Euro would require an act of parliament. In any case a panic in the French bond market upon a Le Pen victory (as investors fear getting paid back in devalued Francs) would likely force Le Pen to back down much as occurred with Syriza in Greece.

Finally, note that Macron (and Fillon) is pro Euro and economic reform oriented, which is just what France needs. So a Macron victory by either would be positive for France.

Germany (election September 24)

German Chancellor Angela Merkel is at some risk of losing to the centre-left Social Democrat Party whose new leader Martin Schulz is polling well. But while there may be a bit of market angst if Merkel is defeated, this would soon be forgotten as Schulz is more pro Europe than Merkel so even if he does win it could actually mean a stronger Eurozone as he and the SPD are likely to undertake German fiscal reflation (which could help countries like Italy). The populist Alternative for Deutschland is stuck at around 10% support, reflecting Germans’ 80% support for the Euro. So Germany is not really an issue.

Italy (possible election around September)

Perhaps the country at greatest risk is Italy. The next election is not due to 2018, but Matteo Renzi who is still the leader of the governing Democratic Party (PD) is keen on having it earlier – possibly September – given the ongoing softness of the Italian economy. However, there is a high risk that the Eurosceptic Five State Movement (5SM) will win. Eurosceptic parties are polling in line with establishment parties in Italy, support for the Euro in Italy has fallen to around 53% and a possible split in the governing PD party will add to support for Eurosceptic parties. However, even if the 5SM “wins” in the next election and successfully forms a coalition government (it’s unlikely to win a majority in parliament) a move towards an exit from the Euro (Itexit) would likely drive a market panic leading to sharply higher Italian bond yields which in turn would adversely affect the Italian economy and most likely cause 5SM to backdown.

Greece

Greece remains a risk given the state of its economy and tough negotiations with its creditors. But there is no longer a populist Eurosceptic party for the Greeks to turn too. In fact if there were an early election the pro-Euro New Democracy party would win.

Spain – Catalonia

Finally, the Catalonia region of Spain looks likely to have another independence referendum around September. But for most Catalonians this seems to be more about more autonomy from Spain than actually wanting independence. Turnout is likely to be low again and without recognition from Spain (or EU support) it’s unlikely to go anywhere even if “yes” wins again.

Risks

Our base case is that the Eurozone stays together, but there are two main risks around this. Firstly, if the migration crisis ramps up again or terrorist attacks escalate which could drive broader based support for populists. Secondly, weak centrist coalition governments risk turning the populist Eurosceptics into the main opposition and leave their countries vulnerable to a populist take over the next time there is a significant economic downturn. Alternatively, if the European economy continues to recover – and gripes around immigration and EU bureaucracy are dealt with – support for the populists may decline over time.

Key implications for investors

There are several implications for investors. Firstly, various elections will no doubt keep Eurozone break-up fears alive causing periodic short term investment market volatility.

Second, while the Eurozone economy looks stronger political risk maintains pressure on the European Central Bank to keep its quantitative easing program going out to year end, delay announcing any “tapering” in it and remain dovish. This will maintain downwards pressure on the Euro.

Finally, if we are right and the Eurozone continues to hang together then bouts of financial turmoil triggered by break-up fears are buying opportunities – just as we have seen since the Eurozone debt crisis began in 2010.

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.

For the last few years we have heard constant predictions of a recession in Australia as the mining boom turned to bust and a housing bust was seen to follow. Some even went so far as to say that an imminent recession was “unavoidable”. Those fears intensified after the September quarter GDP data showed the economy going backwards. But a 1.1% rebound in December quarter growth highlights that yet again it hasn’t happened. The December quarter rebound was on the back of stronger consumer spending, housing investment, business investment, public demand and export volumes. So where to from here?

Source: ABS, AMP Capital

The Australian worry list

To be sure, aside from global threats, Australia has its own worry list. The key threats and constraints are as follows:

• Business investment plans point to mining investment continuing to fall at the rate of 30% or so a year.

• Housing construction activity is likely to peak this year, a large supply of apartments will hit various cities, affordability is poor and household debt levels are very high.

• The Australian dollar arguably remains too high and has risen more than 10% from early last year. (That said most countries want a lower currency these days.)

• Unemployment and underemployment at a combined 14% are high. The combination in the US is 9.4%.

• Inflation is too low and risks staying below the 2-3% target for longer reflecting record low wages growth, a rising $A, competitive pressures and weak rents as new supply hits.

• Our political leaders seem collectively incapable of undertaking productivity enhancing economic reforms

That said, most of these concerns are not new and have been discussed endlessly. Endless whinging about them is distracting from the good news.

Reasons to be upbeat on the outlook for Australia

In fact, there remains good reason to be upbeat on Australia.

• Firstly, at now 102 quarters without a recession, Australia is on track to take out the Netherland’s record of 103 quarters without a recession. This owes a bit to statistical luck, but it also reflects the benefits of the economic reforms of the 1980s and 1990s that made the economy more flexible and sensible macro-economic management that meant that when the mining boom ended it enabled other sectors of the economy to take over in driving growth. This included housing and services exports like tourism and higher education.

Source: ABS, AMP Capital

• Secondly, reflecting this, the south eastern states of NSW, Victoria and ACT are continuing to perform strongly in reversal of the so-called two speed economy.

• Thirdly, while mining investment is continuing to decline, it’s now a smaller share of the economy so its decline is having a diminishing impact and it’s nearing the bottom anyway. At its peak in 2012 it was 7% of GDP whereas its now less than half that so a 30% annual decline is having half the impact on the economy. What’s more mining investment intentions indicate that by mid next year it will have fallen back to around its long term norm of about 1.5% of GDP. Engineering construction – which has been dominated by mining activity – has already fallen back to its long term trend. This means a slowing in housing investment is less of a threat because it will be offset by a lessening in the detraction by falling mining investment.

Source: ABS, AMP Capital

• Fourthly, we are continuing to benefit from the third phase of last decade’s mining boom, which is the surge in resource export volumes as new projects complete – notably gas projects this year.

• Fifthly, the blow to national income from the slump in commodity prices has reversed as prices for iron ore, metals and energy have rebounded. While a new commodity price boom is a long way away the rebound is pushing up national income. Amongst other things, this along with booming export volumes is leading to a dramatic shrinkage in Australia’s current account deficit which could soon be in surplus for the first time since the 1970s and the associated surge in resource company profits could knock $8-10bn pa off the Federal budget deficit.

• Sixthly, public infrastructure investment is ramping up strongly, in response to state infrastructure spending particularly in NSW and the ACT much of which is financed from the privatisation of existing public assets.

• Finally, there are signs of life in non-mining investment. In terms of fundamental drivers borrowing costs have been low for some time but business confidence is reasonably high, profits for non-resource companies are growing around 5% per annum and capacity utilisation is up from its lows. While mining investment plans for the financial year ahead are around 30% below such plans a year ago, plans for non-mining investment are actually up 7%.

Source: National Australia Bank, Westpac/MI, AMP Capital

Overall, recession is likely to continue to be avoided and economic growth is likely on its way back to near 3% this year.

Interest rates on hold

There remains a case for another RBA interest rate cut: the $A remains too high, slowing housing investment at a time when mining investment is still falling risks slower economic growth, banks are under pressure to raise rates out of cycle and inflation risks staying lower for longer as wages growth remains weak. But against this, growth has bounced back nicely in the December quarter, national income is up and RBA concerns about the threat to household financial stability that may flow from more rate cuts imply a high hurdle to cutting rates again. As a result we are removing the rate cut we had expected for May and now expect rates to be on hold this year. That said if the RBA is to do anything on rates this year a cut is more likely than a hike. A rate hike is unlikely until later next year.

Profit growth goes back to positive

The Australian December half profit reporting season confirmed a very strong return to profit growth. However, this dramatic turnaround has been driven by resources stocks with more modest growth for the rest of the market. In terms of some key statistics: 45% of companies results have exceeded earnings expectations which is around the long term norm, 59% of companies have seen profits up from a year ago with a median gain of 4% year on year and the focus has remained on dividends with 80% of companies either increasing or maintaining their dividends which is a positive sign of corporate confidence in the outlook.

Consensus profit expectations for the overall market for this financial year were revised up by around 2% through the reporting season to a strong 19%. The upgrade has all been driven by resources companies which are on track for a rise in profit of 150% this financial year reflecting the benefits of higher commodity prices and volumes on a tighter cost base. Profit growth across the rest of the market is likely to be around 5% with mixed bank results and constrained revenue growth for industrials. Outlook comments have generally been positive and as a result the proportion of companies seeing earnings upgrades has been greater than normal. While the bounce in resource profits will slow, profit growth for industrials is likely to pick up reflecting stronger economic growth.

Source: UBS, AMP Capital

Implications for investors

A return to reasonable growth underpinning reasonable profit growth is positive for Australian assets. With Australian shares up 12% since the US election and trading on a forward price to earnings multiple of 15.5 times which is above the long term average, the market is vulnerable to a further short term consolidation or correction. However, the improvement in profits – which is likely to broaden to industrials – should underpin a rising trend in the market on a 6-12 month horizon.

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.

A year ago there was a long global worry list and high on that list was China. A nearly 50% collapse in Chinese shares, uncertainty about the Renminbi, slowing Chinese growth, fears of a massive oversupply of residential property and uncertainty about the intentions of Chinese policy makers had left many convinced China was heading for the long predicted “hard landing”. But since then it seems China worries have receded. So what happened? Put simply the Chinese economy stabilised. But what’s the outlook for China now? And what does this mean for investors and Australia?

Chinese growth has stabilised and inflation is back

The continuing growth slowdown in China through 2014 and 2015 caused much angst and as a result Chinese economic policy swung from mild tightening towards stimulus with rate cuts, fiscal stimulus and an easing in measures designed to cool the property market. This worked. As can be seen in the next chart Chinese growth stabilised through 2016 at 6.7% and perked up to 6.8% year-on-year in the December quarter. Business conditions PMIs point to solid Chinese growth continuing into this year.

Source: Bloomberg, AMP Capital

Industrial production and consumer spending have been stable. While investment has been softer, it looks likely to surge this year reflecting a jump in infrastructure projects. Excavator sales and power consumption have perked up.

Source: Thomson Reuters, AMP Capital

While there is a perennial debate about how reliable Chinese growth data is, a strong rebound in commodity prices from their lows around a year ago (iron ore up 140%, copper up 43%, oil up 100%) – while partly also due to other things – supports the notion of solid Chinese growth.

With this turnaround has also come an upswing in Chinese inflation, with CPI inflation rising to 2.5% year on year and producer price inflation rising to 6.9% up from -5.9% through 2015. While producer price inflation will likely slow back down again unless commodity prices continue to rise at the same rate, deflationary pressures have clearly faded in China.

Source: Bloomberg, AMP Capital

Finally, the Chinese residential property market has swung from a mild slump in 2014-15 through another boom which is now starting to cool again. The “ghost cities” paranoia of a few years ago has clearly not come to much with property demand returning once the property cooling measures of a few years ago were relaxed and prices taking off again.

Source: Bloomberg, AMP Capital

Policy swings back to modest tightening

With the stabilisation in growth and rise in inflation the focus of Chinese policy makers has swung back to containing debt and home prices. Over the last six months property cooling measures have been ramped up again, government spending has slowed down and the PBOC has put through a modest mostly 0.1% lift in short term money market rates.

Growth and inflation outlook

Policy tightening is likely designed to keep a lid on a further acceleration in economic growth but it is unlikely to get tight enough to slow growth substantially. We expect Chinese growth this year of around 6.5% and consumer inflation of 2.5 to 3%.

Key risks facing China

There are four key risks facing China. First, the Chinese policy tightening now underway could lead to another scare regarding the Chinese growth outlook. By the same token though the experience of the last few years tells us that the Chinese leadership’s tolerance for a significant growth slowdown is low. This is particularly likely to be the case with the Government wanting to look good ahead of the 19th National Congress of the Communist Party later this year.

Second, with the residential property cycle starting to slow again, fears may return that the property market is at last heading into a crash. Time will tell but it’s debatable as to whether China has really had a generalised housing bubble: household debt is low at around 40% of GDP; house prices haven’t kept up with incomes; and while there’s been excessive supply in some inland cities this is not so in first tier cities where there is an undersupply of affordable housing and the quality of the housing stock is low necessitating replacement. So the property crash fears continue to be exaggerated I think.

Thirdly, concern remains regarding China’s rapid debt growth. While it has slowed to around 15%, it’s still excessive relative to growth in the Chinese economy. However, several considerations suggest the risks are manageable. First, strong growth in debt reflects China’s near 50% savings rate with savings mainly being recycled via the banks and hence as debt. The solution is to consume more and channel a greater share of saving into equities rather than through banks. This will take time. Second, China is only borrowing from itself not from foreigners. Finally, high corporate debt reflects an element of fiscal policy and would be subject to Government support.

Finally, the risk of a trade war – which would be bad for China – has risen under President Trump. So far though Trump is talking of a “constructive relationship” and “mutual benefits” with China which is a positive sign.

Our assessment remains that these risks are manageable. The Chinese Government has plenty of firepower to support growth. So a hard landing in growth remains unlikely at this stage.

The Chinese share market

Since its low in January last year the Chinese share market has recovered around 20%. But it is still far from expensive. Chinese mainland shares (or A shares) are trading on a forward price to earnings multiple of 13 times and Chinese shares listed in Hong Kong (or H shares) have a forward PE of just 8 times.

Source: Thomson Reuters, AMP Capital

With valuations looking reasonable and growth set to continue, Chinese shares should provide reasonable returns. However, a shift to policy tightening will constrain the rate of capital growth.

Why has the iron ore price surged higher?

After falling 80% from its high of $US192/tonne in 2011 to its low of $US38 in November 2015 the iron ore price has surprised most and surged to more than $US90. A range of factors have played a role in this including: stronger construction demand in China; a switch to higher quality iron ore to cut down on coking coal usage; reduced lower grade iron ore output from Chinese mines due to capacity closures, and; some supply disruptions and speculative activity on Chinese commodity exchanges. Some of these will reverse on a 12 month horizon but the surge does have a fundamental element and, with Chinese infrastructure projects still ramping up, the iron ore price could have more upside in the short term to maybe $US100 before the price settles a bit lower. A sign of the top may be when resource analysts raise their iron ore price forecasts above the current spot price. With consensus forecasts around $US60 they are a long way from that just now.

Implications for Australia – it’s not 2003 but still good

The surge in the iron ore price along with other commodity prices has pushed up Australian export prices and pushed the trade surplus to record highs. This is unlikely to lead to the sort of boost the economy saw last decade where surging resource commodity prices year after year led to surging Federal taxation revenue (and annual tax cuts) and a massive mining investment boom. This time around tax cuts are less likely due to tougher budgetary conditions, mining companies are just recovering from the last mining investment boom, the $A is starting from a much higher level than at the start of last decade ($US0.77 versus $US0.48) – and so the constraint on the non-mining part of the economy is much higher now – and finally we are unlikely to see year after year of bulk commodity price increases given structurally lower growth in China and a surge in the supply potential of commodities. Nevertheless, rising national income is better than falling national income and it supports the view that the hit to the economy from the mining boom collapse has largely run its course. All of which should help a return to GDP growth around 3%. The iron ore price at $US90/tonne will also knock nearly $9bn off the annual Federal budget deficit.

Key implications for investors

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

• The stabilisation in Chinese growth and higher commodity prices is positive for Australia’s economy and assets.

Source: AMP Capital 16 Feb 2017

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 now a decade since the first problems with US sub-prime mortgages started to appear and nearly eight years since share markets hit their global financial crisis lows. From those lows in 2009 lows US shares are up 239%, global shares are up 167% and Australian shares are up 80% (held back by relatively higher interest rates, the absence of money printing, the plunge in commodity prices from their 2011 highs and the high $A). An obvious question is how close the next downturn is, which ultimately relates to where we are in the investment cycle.

The long US cyclical bull market

Where we are in the investment cycle is particularly pertinent in relation to the US. The cyclical bull market in US shares that started in March 2009 will be eight years old in March. It’s the second longest cyclical bull market since World War Two in terms of time and the third strongest in terms of percentage gain. See the next table.

Cyclical bull markets in US shares since WW2

click to enlarge

I have applied the definition that a cyclical bull market is a rising trend in shares that ends when shares have a 20% or more fall (ie, a cyclical bear market). Source: Bloomberg, AMP Capital.

Similarly, according to the US National Bureau of Economic Research the current US economic expansion that started in June 2009 at 92 months old is the fourth longest since 1929 and compares to an average expansion of 70 months. With the US cyclical bull market and economic expansion both now long in the tooth, some fear that US shares are vulnerable to another bear market and by implication given the direction setting influence of the US share market, global and Australian shares would be vulnerable too. A related concern is that, with the US economic expansion already longer than normal, any stimulus that President Trump may provide risks overheating the US economy and much higher interest rates which could bring on a bear market.

The investment cycle

The next chart shows a stylised version of the investment cycle where the thick grey line represents the economic cycle.

The investment cycle

Source: AMP Capital

A typical cyclical bull market in shares has three phases:

• Scepticism – Phase 1 normally starts when economic conditions are still weak and confidence is poor, but smart investors start to see value in shares helped by ultra easy monetary conditions, low interest rates and low bond yields.

• Optimism – Phase 2 is driven by strengthening profits as economic growth turns up and investor scepticism gives way to optimism. While monetary policy may start to tighten, it is from very easy conditions and will remain easy as inflation remains low. Therefore, bond yields may drift higher but not enough to derail the cyclical bull market in shares.

• Euphoria – Phase 3 sees investors move from optimism to euphoria helped by strong economic and profit conditions which pushes shares into overvalued territory. Meanwhile, strong economic conditions drive signs of economic excess – overinvestment, full capacity utilisation, surging private sector debt, high and surging inflation – which forces central banks to move into tight monetary policy, in turn pushing bond yields significantly higher. The combination of overvaluation, investors being fully loaded up on shares and tight monetary policy sets the scene for a new bear market.

Typically the bull phase lasts 3-5 years. But it varies depending on how quickly recovery precedes, excess builds up, inflation rises and extremes of overvaluation and investor euphoria appear. As a result “bull markets do not die of old age but of exhaustion”.

So where are we now in the investment cycle?

So right here the big question is: are we in the “euphoria” phase that ultimately leads to the “exhaustion” of the cyclical bull market in shares and the next bear market? The best way to look at this is to look at economic conditions, monetary conditions, share market valuation and investor sentiment and positioning:

Firstly, in terms of economic conditions it’s hard to argue we are in the “euphoria” phase. There are few signs of economic excess:

• While headline inflation is rising globally this largely reflects the bounce in oil prices. Core inflation in major countries ranges between zero (Japan) to 1.7% (US), i.e. far from out of control.

• After years of below trend growth globally, spare capacity still remains and this will constrain core inflation. Similarly wages growth remains depressed even in the US (at around 2.5% year on year) despite a tighter labour market.

Source: Bloomberg, AMP Capital

• There is no sign of overinvestment globally – in fact there has been too little investment. While the US recovery is further advanced, even here business investment (excesses in which preceded the tech wreck) and residential property investment (excesses in which preceded the GFC) are around or below their long term averages relative to GDP.

Source: Thomson Reuters, AMP Capital

• Overall private sector debt growth is modest in most countries (except for corporate debt in the US and China).

Secondly, global monetary conditions remain easy and in the absence of broad based excess (in growth, debt, or inflation) look likely to remain so. Yes the Fed is likely to hike rates more aggressively this year but it’s still from a very easy base and other central banks (including the RBA) are either on hold or easing. So a shift to tight money that brings an end to the economic cycle looks a fair way off.

Thirdly, share market valuations are mostly okay. Sure, measured in isolation against their own history shares are no longer cheap. In fact, forward price to earnings multiples in the US and Australia are above long term averages. However, once the gap between share market earnings yields and still low bond yields is allowed for, shares are fair value to cheap depending on the market (next chart).

Source: Bloomberg, AMP Capital

Fourthly, while short term investor sentiment is excessively bullish long term measures of positioning are not. In the US the huge investor flows into bond funds over the last few years have yet to reverse in favour of shares. In Australia sentiment towards shares as a wise destination for savings remains low and investors still prefer bank deposits. No euphoria here.

Source: Westpac/Melbourne Institute, AMP Capital

Finally, while the US cycle is more advanced, it could be argued that the 19% fall in US shares in mid-2011 was a bear market. So the bull market in US shares is perhaps not so old after all! Moreover, major non-US share markets and Australian shares did have a bear market in both 2011 and 2015-16 so their cyclical bull markets are not old at all. In this regard European and Japanese share markets are relatively attractive thanks to cheaper valuations and still dovish central banks.

Overall, we are still not seeing the signs of excess, euphoria and exhaustion that typically come at cyclical economic and share market peaks. So barring some sort of external shock, the cyclical bull market in shares looks like it still has further to go – particularly if global economic growth returns to more normal levels which in turn will help earnings.

With regard to any Trump fiscal stimulus, this analysis suggests there is still a bit of room for it before it causes the US economy to overheat. Particularly if the US dollar continues to trend higher, which takes some off the pressure of the Fed to raise rates. In any case it’s looking likely that fiscal stimulus in the US won’t hit till late this year and will unlikely to be more than 1% of US GDP given the constraints Congress is likely to impose. In fact the focus is more likely to be on providing a boost via economic reforms – deregulation, tax reform and inducements to invest – rather than traditional stimulus.

Investment implications

First, while corrections should be anticipated – with Trump and upcoming Eurozone elections being potential triggers – we still appear to be a long way from the peak in the investment cycle.

Second, non-US share markets and economies – notably Japan and Europe – are less advanced in their cycles and so provide opportunities for investors.

Source: AMP Capital 9 Feb 2017

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.

Since the US election last November US and global shares rallied around 8% and Australian shares rallied around 12% to their recent highs. Related to this the US dollar, bond yields and some commodity prices also pushed significantly higher. Optimism regarding Donald Trump’s pro-growth policies were not the only factor playing a role in this rally – global economic indicators have improved significantly in most regions – but it certainly played a role. With Trump now inaugurated as President we are at the point where that optimism is being tested.

Donald Trump has only been President for two weeks but it seems that he has already done a lot with numerous major announcements. So far the key moves relate to: minimising the economic burden of Obamacare; reviewing new regulations; preventing non-government organisations that perform abortions from receiving Federal funding; withdrawing the US from the Trans Pacific Partnership free trade deal; freezing Federal hiring; moving towards approving the Dakota and Keystone XL oil pipelines; speeding up approvals for high priority infrastructure projects; reducing regulatory burdens facing manufacturers; directing the construction of a wall with Mexico; support for a “border adjustment tax”; and various restrictions around immigration – in particular a 90 day ban on travellers to the US from seven majority Islamic countries.

While these moves are basically consistent with his campaign policies, some have created considerable consternation in the US and globally. And Trump and his teams’ “thin skin” has led to various distractions – eg, around how many people attended his inauguration and “alternative facts”.

Initially investment markets reacted favourably after Trump’s inauguration as many of his orders were pro-business, but the travel ban has seen uncertainty creep in around whether the new administration knows what it is doing (the ban seems to have been poorly thought through in terms of implementation and legalities as it was not vetted by the bureaucracy first) and around how isolationist Trump is prepared to take the US. Quite clearly Trump is a different kind of US President to the norm. This note looks at the main issues of importance to investors.

Risks under President Trump

Donald Trump’s presidency comes with a number of risks:

• He could make a major policy mistake – for example, some of his recent announcements don’t appear to have been well thought through (eg, the travel ban).

• He could trigger a major global trade war which could adversely affect global growth. Or, in targeting countries with which the US runs a trade deficit and its NATO allies for not “paying their fair share”, he could threaten the flow of cheap funding that the US benefits from.

• He could go the way of Nixon (impeachment, resignation) who was known for his thin skin and paranoia regarding the media – Trump seems to be making an enemy of much of the media who are no doubt likely to try and do their best to discredit him eg, around conflicts with his business interests, the Russian link or whatever.

• His proposed fiscal stimulus risks a further budget and public debt blow out. When Ronald Reagan took over US public debt was 30% of GDP, now it’s over 100% and the budget deficit is likely to deteriorate in the years ahead thanks to the aging population. Or it could overstimulate the US economy causing a far more aggressive Fed.

• Alternatively, Congressional constraints could mean that any fiscal stimulus is underwhelming and/or that he fails to relax the Dodd-Frank financial regulations. Achieving tax and spending changes will be easier for Trump as the Republicans have simple majorities in both houses of Congress which is all that’s required, but measures outside of the budget require 60 out of 100 Senate votes which will necessitate support from some Democrats.

• His jawboning of US companies to keep production in the US could backfire leading to low US productivity. The track record of governments trying to direct companies is not great. But this will only become apparent over the long term and if production does remain in the US it will increasingly be dominated by robots anyway.

Assessing Trump

These risks are real but shouldn’t be exaggerated. In assessing Trump there are several key things investors need to allow for.

First, all new administrations make mistakes initially reflecting inexperience and the bureaucracy not yet in sync with the President. And with Trump and his team less experienced than most and the bureaucracy perhaps even less on side than normal, the mistakes are likely to be greater than normal. But as the process improves with the bureaucracy moving into line with the Trump administration, policy announcements should look smoother and more considered.

Second, he is not a traditional Republican president. Some of his policies are classic Republican – lower taxes, deregulation – but some borrow from the left – infrastructure spending or even old fashioned protectionism. Despite some comparisons to Ronald Reagan he lacks Reagan’s consistent ideology. He will follow his own course.

Third, his support base is middle America. Supporting them with jobs and higher wages is critical. Getting stuck in a trade war with China and Mexico that just pushes prices up at Walmart by 20% won’t go down well with his support base.

Fourth, he has a loud and more direct approach to communication – what some call a huge mega phone. And he has no constraint in using it against politicians or companies who get in his way. Related to this his open mouth approach is prone to reversal – think about his comments about locking Hilary Clinton up, border adjustment tax (initially “too complicated” but now working on it) and torture (initially supporting it and then leaving it to his Defence Secretary). We have to get used to a lot more noise coming out of Washington, but the key is that much of it will be just that: “noise”.

Fifth, he is a businessman who prides himself on his negotiating skills. So for example the imposition of a tariff on imports from China or Mexico may just be the opening gambit in a negotiation designed to extract a better trade deal for the US rather than necessarily being the final outcome.

Finally, his time to get his legislative agenda through Congress is limited. The President’s party normally loses control of it in the mid-term elections (as Obama did after his first two years) – so he doesn’t want to waste too much time.

On balance

Given all this I remain of the view that despite the rough start the pragmatic growth focussed Trump will ultimately dominate the populist Trump. But we have to allow that it will take a while for pro-growth policies to be legislated – eg, the President and Congress may not agree a tax reduction package until later this year – and that fears of trade war are likely to get worse before they get better as Trump embarks on a tough negotiating stance. This should ultimately be supportive of US/global growth but there will be volatility (and noise) along the way.

Implications for investment markets

After their large gains from around the US election, share markets, the US dollar and bond yields all entered 2017 with a degree of vulnerability. Shares, for example, had become technically overbought, and short term measures of investor sentiment had risen to levels of optimism that are often associated with a correction. See the next chart for US shares which tracks a measure of short term investor sentiment based on surveys of investor optimism and demand for option protection against the US share market.

Source: Bloomberg, AMP Capital

Since Trump’s election played a part in the rally, it was always likely that a period of uncertainty about what Trump would do – whether we get the pragmatist or the populist – could drive this, and this seems to be the case. This in fact is not out of line with the historical experience where US shares in the first February of new presidents have had an average decline of 4% since Hoover in 1929. Of course other factors played a role: with the Great Depression for Roosevelt; the start of the tech wreck for G W Bush; and the tail end of the GFC for Obama exaggerating the declines they saw. But the pattern of an initial period of uncertainty, often around communication mistakes, is apparent.

Source: Thomson Reuters, AMP Capital

However, despite the likelihood of a bout of short term market turbulence we see share markets trending higher over the next 6-12 months helped by okay valuations, continuing easy global monetary conditions, some acceleration in global growth, rising profits in both the US and Australia, and as Trump’s pro-growth policies start to impact.

A brief comment on border adjustment tax

Debate about a “border adjustment tax” in the US is heating up, but what is it? Basically many countries including Australia and Europe have a consumption tax – which only taxes goods and services consumed in the country. So imports are taxed and exports aren’t. The US has state based sales taxes but these are not the same as a consumption tax. In part to address the imbalance and at the same time lower America’s corporate tax rate from a globally high 35%, House Republicans have been working to move the US corporate tax system to only tax activity relating to goods and services consumed in the US. This would entail taxing imports and rebating tax on exports, ie, undertaking a “border adjustment”, just like when tourists show up at the airport when leaving Europe for a tax refund on goods they have bought there. Such an approach would make it harder for companies to lower their taxable income (via transfer pricing), redress the imbalance where the US does not have a consumption tax but other countries do, and because America imports more than it exports it would enable a lower corporate tax rate with talk of a 20% rate.

Trump initially rejected the idea as being “too complicated” but appears to have come round to it lately. However, it’s not clear Republican senators would support it and there is a long way to go. But if it does get up it would be a huge boost for US exporters (eg, Boeing) and a huge negative for importers (eg, Walmart) and would put significant upwards pressure on the $US which could then \/home\/clientcomm2018budget\/public_htmlify the border adjustment. Of course it may also be subject to a World Trade Organisation challenge (although the US may argue most other countries do the same with their consumption taxes) and it would put significant pressure on other countries to move to the same system.

At the very least a 20% US corporate tax rate would only add to the pressure on Australia to lower its corporate tax rate.

Source: AMP Capital 02 Feb 2017

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.