28 May 2019 | Tracey McNaughton
We recently moved to reduce the amount of risk in our model portfolios. This followed the escalation in US-China trade tensions after President Trump increased the tariff rate on $200b worth of Chinese imports. We moved to an underweight position in US equities and closed out our overweight position in emerging markets. Together with our underweight in European equities, this left us with a more overweight position in cash and fixed income. Importantly, we left our position in Australian equities unchanged preferring domestic over international equities.
Australia over the rest of the world
There are five reasons for why we are more upbeat on Australian equities relative to international equities. First, the prospect of official interest rate cuts beginning next week will see mortgages re-price providing some relief to mortgage holders. At the same time, lower interest rates will boost our international competitiveness through a lower dollar. The rate cuts would also provide a cushion against possible shocks to household income arising from a rise in the unemployment rate.
Second, an easing in macroprudential policy in the form of a relaxation of mortgage serviceability tests would also support the housing market by freeing up the supply of funding to potential home buyers.
Third, the surprise win by the Coalition in the federal election will boost sentiment in the housing market as investors price out the prospect of changes to negative gearing and discount on capital gains tax.
Fourth, the prospect of near term fiscal stimulus for low to middle income groups will boost disposable income and help re-dress the somewhat unusual situation where tax paid by households has increased at a much faster rate than income. This lift in income should partly flow through to consumption spending.
Finally, while Australian exports will undoubtedly feel the heat if growth in China slows as a result of the trade war, it is important not to over-state the impact on the broader economy. Exports are an important part of our economy but at 21.3% their significance pales when compared to Germany at 47.1% or South Korea at 43.1%. In fact Australia is less open than the majority of the G20. The UK, France, Canada, Italy and Germany are all more exposed to global trade than Australia.
Monetary policy can no longer afford to be the only game in town
Australia is in a fortunate position in that we have room to stimulate the economy through fiscal policy. Among the developed economies in the G20, Australia’s fiscal balance as a percentage of GDP is the second best, beaten in our frugalness only by Germany.
G20 Fiscal Position (% GDP)
The federal budget was given a boost recently by the jump in iron ore prices (mostly due to the dam disaster in Brazil reducing supply). Iron ore has risen 45 percent since last November. Iron ore is currently trading at about $US93 a tonne in the spot market, its highest price in almost two-and-a-half years. Sensitivity analysis shows that for every $US10/tonne change in the iron ore price above the $US55 forecast in the Federal Budget is worth an extra $1.2 billion to the Government this year and $3.6 billion next year.
Some of this windfall will be used to ease the tax burden on income earners. The Government's longer-term tax cuts, mainly targeted at higher income earners, do not kick in until 2024. The tax rebate for low-to-middle income earners, worth $7.5b, applies from July this year. This is equivalent to a 50 basis point rate cut from the RBA.
No time for complacency
While some fiscal stimulus is pending, there is room to do more. The impact of the second worst downturn in housing in the last 100 years is still making its way through the domestic economy. The unemployment rate has risen to 5.1% from 4.9% over the past two months and leading indicators such as job vacancies suggest the upward trend will continue for a while yet. This will impact consumer spending so watching where the household saving ratio goes from here will be critical.
With the election now out of the way, it is time for the Government to undertake serious reform, especially on tax. The last time we had any serious tax reform in Australia was in 2000 with the introduction of the GST. The Henry Tax Review is now almost 10 years old. Very few of the recommendations were actually implemented.
Tax revenue (% GDP)
For obvious reasons Australia is often compared to New Zealand. It is interesting to note that while the top personal tax rate in New Zealand is 33% (compared to Australia’s 45%), total tax revenue as a percentage of GDP is higher in New Zealand than in Australia (32% vs 27.8%). Two main reasons for this are, first, the New Zealand GST rate is set at 15% compared to our 10%. This is roughly half the average rate of other developed economies. Second, Australia’s coverage ratio of the GST is relatively low at 47% compared to the OECD average of 55% and New Zealand at 96%.
There is no doubt, Australia’s revenue base has eroded. Tax revenue as a percentage of GDP in Australia is among the lowest in the OECD (chart). We need to broaden the GST base and we need to think about taxing heavy the activities we want to discourage, such as CO2 emissions, and taxing light the activities we want to encourage such as employment. Norway is good example of how tax can change behaviour. For the first time ever, electric cars in Norway outsold gas and diesel vehicles. This is the direct result of the government waving the 25% VAT on electric vehicles.
In terms of our asset allocation, we remain near-term cautious with an overweight position in cash and fixed income. In terms of equities we prefer Australia over the rest of the world given the prospect of greater fiscal and monetary stimulus domestically.
Head of Asset Allocation Tracey McNaughton
Tracey has over 20 years’ experience and is well known within Australia and internationally for specialising in investment strategy, across both fixed income and multi-asset .
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