Global economic pressures and the impact on Australian investors

The Australian economy is moving forward at a reasonable pace – however, we are not immune to global pressures. Asked recently about his outlook for the global economy, Claudio Borio, Head of the Monetary and Economic Department at the Bank for International Settlements was positive in the short term. Indeed, global growth is reasonable, especially in the US, and stock markets (in the developed world at least), continue to make new highs was positive in his short-term global economic outlook.

There are however, issues lurking in the background

These include increased protectionism and possible trade wars, driven principally by the US; geopolitical tensions, such as those between the US, Russia and China; and increasing global debt-to-GDP levels, which are higher now than they were during the global financial crisis GFC.

World policy interest rates are still low, partly as a result of over-reliance on monetary policy to escape from the GFC. Our view in the years since is that not enough effort has been made on dealing with large fiscal deficits and structural economic issues such as poor productivity growth, low wage growth, high levels of household debt, and a lack of infrastructure. As the US continues to lift interest rates in response to its own positive economic outlook, some of these imbalances are starting to cause tensions in the rest of the world.

As the interest rate differential grows between the US and other nations (and partly as a reaction to fears of trade wars and geopolitics) the US dollar is strengthening, causing problems in various markets, in particular for some emerging market currencies.

Things look okay, at least in the short run; yet Australia is not immune to global pressures

In Australia, our economy is moving forward at a reasonable pace, the stock market is close to all-time highs, unemployment is steady and interest rates are low. However, our dollar is steadily weakening as a result of global pressures. Tightening US dollar liquidity driven by the rolling back of quantitative easing, increased US Treasury issuances, and a repatriation of overseas profits from the likes of Apple and Google, is having the flow-through effect of raising our mortgage rates as banks’ funding costs increase – despite the Reserve Bank of Australia (RBA) holding its cash rate steady.

This rise in borrowing costs comes at a time when our housing market is slowing, particularly in Sydney and Melbourne. This slowdown has, to an extent, been engineered by the RBA and the Australia Prudential Regulation Authority through tightening lending standards. Falling house prices, increased mortgage costs, slow wage growth, high levels of household indebtedness, and a weakening Australian dollar are not encouraging signs for an economy that is heavily reliant on consumer spending – we have stressed households and high debt.

The tumultuous political landscape in Australia will have some influence

In our view, if Labor is voted in at the next election, as the odds currently suggest, there may be two likely government policy changes (leaving aside the recent political leadership spectacle). These are the winding back of negative gearing and the reduction or removal of the capital gains discount on property. While there are no doubt negative gearing causes distortions in our housing market (why else are gross rental yields in Sydney and Melbourne around three per cent?), its wind-back and the removal of capital gains relief will reduce the attraction of buying property at a time when the market is already slowing.

While removing distortions in the housing market and the taxation system have merit in the long run, from an investor’s point of view, enacting these policies in the current environment could prove to have negative effects. These are likely to be seen on property values, the demand for credit and therefore bank earnings, and quite possibly consumer spending as a result of a reduced wealth effect – possibly partly balanced by lower earner tax relief. Accordingly, we remain cautious about bank earnings and exposure to consumer spending. We believe that the Australian dollar will continue to weaken, and remain in favour of US dollar earnings and currency exposure.
 

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Patrick Broughton

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With 25 years’ global investment banking experience in a broad range of financial markets, including equities, fixed income, hybrids and convertibles and foreign exchange, Patrick Broughton is charged with chairing the Dixon Advisory Investment Committee.

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