30 September 2017
Themes For September
Global equity markets put in a solid performance during September led by Europe up by 3.2% and Japan 3.6%. The performance of stocks in both of these regions has been assisted by the continuation of expansionary monetary conditions, which has boosted financial asset prices. The German market was up by an impressive 6.4% as an endorsement of the re-election of Angela Merkel to her 4th term as Chancellor albeit in coalition with minor parties. The US market advanced by 1.9% on positive economic data and optimism that the much heralded US tax cuts will provide a positive fiscal stimulus to growth. The local market continues to struggle and was basically flat for the month with positive contributions from healthcare, energy, REIT’s and financials offset by a sharply weaker performance from telco’s and utilities. Over the past 12 months Australian shares have underperformed global shares by around 9% reflecting structural difficulties with the Australian economy and the absence of policy stimulation that we have discussed in previous months. Fixed interest markets were weaker with 10 year Australian bond yields 24bp higher producing a negative return of 0.3% for the month. This could be a harbinger for future bond market returns, which will face head winds from the gradual reduction in global monetary accommodation measures. Commodities produced a mixed bag of results with the mini-boom in iron ore prices coming to an abrupt end with a 12% decline as Chinese steel mills cut production by up to 25% as part of the environmentally driven pre-winter wind down. The oil price improved by 7.2% to finish at the critical price resistance level of $US 50 barrel beyond which US shale supply comes on stream and dampens further price appreciation. In currency markets, the USD was stronger against the JPY, flat against the EUR and about 1 cent stronger against the AUD, which traded consistently below 80 cents for the first time in recent weeks.

The US Fed to commence reversing QE

One of the major initiatives used by central banks after the GFC to stabilise the global financial system and kick-start economic growth was the introduction of “quantitative easing” measures, better known as QE. In addition to reducing interest rates to encourage more borrowing to stimulate investment and consumption, the quantity of money in the financial system was boosted by global central banks purchasing assets such as government bonds and mortgage backed securities thereby injecting liquidity into the financial system. While the US Federal Reserve led the way with 3 separate rounds of QE, central banks in Europe, Japan and the UK soon followed suit. While it has been the subject of much economic debate about whether QE has been effective in stimulating economic activity and inflation, there is little doubt that it has been hugely successful in boosting the asset prices of both shares and bonds. With the balance sheet of the US Fed swelling to around US $4 trillion, late last year the Fed announced they would be discontinuing QE and last month announced measures to slowly reduce their balance sheet holdings by not reinvesting the proceeds of maturing securities. The balance sheet run-off will commence this month at only $10 billion per month gradually increasing to a maximum of $50 billion per month. The shrinking of the Fed’s balance sheet effectively equates to quantitative tightening (or QT) which in combination with gradual increases in US cash rates represents a reduction in the level of monetary accommodation for the US financial system.

So if QE was so beneficial to asset prices, wouldn’t QT be negative? Not necessarily, not for some time anyway and certainly not for shares. Firstly, the reason the Fed are pursuing QT is that the US economy is now performing well under its own steam and doesn’t require the additional assistance from excessive monetary accommodation. This will be positive for corporate profits and therefore share prices but not so positive for bonds as tighter policy and the lack of Fed buying of treasuries will ultimately push bond prices lower. The second reason is to look at the impact on global liquidity by aggregating QE programs around the world. While the ECB will commence tapering QE early in 2018, they are still expanding their monetary base while Japan are showing no sign of winding back their QE program. Even accounting for the impact of QT in the US, global central banks in aggregate will continue to stimulate the global financial system until at least 2019 which will support financial assets and shares in particular.

Chart 1

US Tax Reform getting closer

One of the major factors driving the US share market higher following the November 2016 Presidential election was the promise of pro-growth policies by the incoming Trump administration. Central to this was the promise of an overhaul of the US tax system including substantial cuts to both personal and corporate taxes. With the failure of the Republican (GOP) controlled Congress to pass legislation to overhaul the troubled Affordable Care Act, many pundits have questioned the ability of the GOP to pass comprehensive tax reform. In recent weeks President Trump has outlined the broad parameters of his tax plan, which includes reducing the number of tax brackets from 7 to just 3 with marginal rate thresholds to be set at 35%, 25% and 12%. The top marginal rate under the current system is 40%. Corporate tax rates are to be reduced from the current rate of 35% down to 20%, a little higher than the 15% mooted during the election campaign. In addition to this, a reduced tax rate of 10% is proposed to be applied to the repatriation of the estimated $US2.6 trillion in offshore profits as an incentive to entice US companies to redeploy cash back into the US economy. The lack of specific detail on proposed changes to deductions or spending cuts makes it impossible at this stage for the Congressional Budget Office to effectively assess the impact on the budget. Rest assured though, in the short term the tax plan will increase the deficit which is currently running at $US20 trillion or 77% of GDP placing further short term pressure on bond prices. The reality is that tax cuts are almost never fully funded, relying on a boost to economic growth to organically raise revenues as was the case for the large tax cuts in the first term of the Reagan administration in the early 1980’s.

While there is no doubt the plan will be strongly opposed by the left-leaning Democrats, there will be considerable negotiation within the fractured Republican ranks around the specifics of the plan with a particular focus on the budget impact from the fiscally conservative “Freedom Caucus”. Unlike the health care reform bills, tax cuts are at the core of the GOP’s philosophical belief set and is likely to galvanise the various factional interests of the party. With growing electoral discontent over Congress’s inability to pass key legislation, the GOP are under extreme pressure to register a major success ahead of the mid-term elections in November 2018. While the GOP holds a comfortable 46 seat majority in the House of Representatives, the more powerful Senate is finely balanced at 52-48. President Trump and the GOP will be desperate to maintain control of Congress for the second half of the current Presidential term to avoid the legislative roadblocks experienced by President Obama who lost control of Congress after just 2 years in office. As the saying goes, when in doubt always back self-interest, so expect the GOP to pass Tax reform in early 2018.

Investment Outlook

We are becoming increasingly confident about the outlook for the global economy, which is providing a solid backdrop for corporate profits and share prices. While this will lead to a gradual reduction in monetary accommodation, the absence of any inflation risk means the process will be gradual and not enough to significantly disrupt equity markets. While recovery is most tangible in the US, we continue to favour the cheaper valuations in Europe and hold and overweight position in this region. We are less confident about the Australian share market as profit growth will be constrained by a struggling local economy having difficulty rebalancing post the mining boom. Low wages growth and high levels of household debt in particular are hampering personal consumption. The absence of any significant policy stimulus and a stubbornly high $A are all limiting factors which will keep the RBA from increasing interest rates until at least mid-2018.