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The Experts

David Bassanese
+ About David Bassanese

David Bassanese is one of Australia’s leading economic and financial market analysts, who has authored several investment books and works in a number of advisory roles.

David is Chief Economist at BetaShares, which involves providing economic and investment portfolio advice to both retail and institutional investors. David is also an economic advisor to the National Institute for Economic and Industry Research.

Prior to these roles, David was Economics Commentator with The Australian Financial Review, where is regular “Bassanese” column appeared three times per week, as well as monthly in Smart Investor Magazine.

David’s analysis and commentaries cover local and international economic trends, interest rates, the exchange rate, and share market analysis.

Prior to becoming a Fairfax business columnist in 2003, David spent several years in financial markets as a senior economist and interest rate strategist at Bankers Trust and Macquarie Bank. David started his career at the Federal Treasury in Canberra, after which he spent several years as a research economist at the Organisation for Economic Cooperation and Development in Paris, France.

David has authored two e-books: The Australian ETF Guide: cheap and easy investment strategies using exchange traded funds (ETFs), and The Australian Investor’s Guide to Asset Allocation.

David has a first class honours degree in Economics from the University of Adelaide, and a Master in Public Policy from the J.F Kennedy School of Government at Harvard University.

Why we should abolish the company tax rate

Wednesday, March 07, 2018

Having supported the case for corporate tax cuts only a fortnight ago, I was intrigued by an intervention into the debate by none other than Magellan Financial Group’s Hamish Douglass this week at the Australian Financial Review’s latest Business Summit. 

Even more interesting was the response by the CEO of BHP Billiton Andrew Mackenzie sitting right next to Douglass, which only highlighted just how hard decent corporate tax reform in this country will prove to be.

To my mind, their exchanges only solidified my long-held view that we need to think much more boldly in Australia before it’s too late, and scrap the archaic concept of corporate income taxation altogether.

But first to Douglass.

As I’ve previously conceded, on balance the research evidence suggests that a corporate tax cut from 30% to 25% as advocated by the Turnbull Government would likely be a net benefit to the economy.  According to modelling, the net gain for gross national income of around 0.6% or $450 in per capita income. 

Fair enough, but Douglass reckons the change in tax rates would remain so relatively incremental that he doubted it would lead to much profound change in business behaviour – such as lifting business investment and (most critically) wages.  On that score, I’d have to agree.   Although on paper we’d all on average be a little bit better off, we’d probably hardly notice it.

Instead, Douglass’ idea is a dual corporate tax system which gives business the choice of either sticking with the current system, or accepting a cut in tax to 15% in exchange for giving up the ability to offer dividend imputation credits to their shareholders.

As Douglass noted, foreign companies – to the extent their shareholders are offshore – benefit little from the dividend imputation system. And these are just the companies Treasury modelling is counting on to lift investment in Australia as a result of a tax cut.  How much better would their response be if we offered them the chance to half their tax rate to 15%? 

Indeed, in today’s globalised world, dividend imputation is far less relevant in attempting to attract foreign investment.  What’s more, even the Reserve Bank is growing concerned that our thirst for dividends may be perversely hurting business investment to the extent it is encouraging many local corporations to distribute a lot more of their profits back to shareholders rather than keep as retained earnings.

Of course, Australian investors – especially those in retirement which are able to enjoy tax-free income (thanks to Peter Costello) – have grown to love the imputation system.  Not only are the dividends received tax free (up to a point), but the Australian Tax Office will actually send many a check for the tax paid by companies on dividends prior to distribution. 

Current estimates suggest the ATO is mailing out around $5 billion in cheques each year – unheard of anywhere else in the world.

All up, it may surprise some to know that because of our lovely dividend imputation system, the net revenue collected from corporate taxation (after tax saved from imputation credits claimed by dividend recipients) appears somewhere between one half to one third less than the gross corporate tax revenue reported in the Budget papers.  In 2016-17, even a conservative estimate would place the annual revenue cost of dividend imputation at around $20 billion. 

Based on Douglass’ suggestion above, he reckons the cost to revenue is closer to one half of gross corporate tax revenue, or around $34 billion last financial year.

So why not go with Douglass’s suggestion?  A journalist asked BHP’s Mackenzie (who had earlier waxed lyrical over the need to cut the corporate tax rate) before I had the chance.

And his response?

Words to the effect that.. “I don’t really want to get into that debate as I know many of my shareholders enjoy their imputation credits.”

In short, killing dividend imputation while keeping the current corporate tax system in place would appear to hurt too many investors – particularly retirees – who enjoy its benefits.

That’s why I reckon we need to leap frog the world and simply abolish corporate income taxation altogether – especially as it is increasingly easy to shift it to low tax jurisdictions around the world in any case.  Left with higher post-tax profits, companies would be left the choice to boost dividends to offset any loss of imputation benefits.

Meanwhile, it’s really hard for the rest of us to complain about the loss of imputation credits on company tax that is no longer paid.

How would be finance the net loss in revenue from zero corporate taxation, or around $35 b per year?  We could clamp down on the black economy though a move to a cashless society and then place a (small) tax on the trillions in electronic transactions each year.  We could also explore a simpler cash flow or domestically sourced revenue tax on companies, which could also better help claw back lost tax from Amazon, Google and Facebook who cleverly send most of their true profits offshore.

I agree with Hamish Douglass.  A cut in corporate tax rates to 25% is trivial and won’t shift the dial. We need to be far bolder.

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Company tax: Are the big corps cheating the system?

Wednesday, February 21, 2018

The debate over cutting company tax has received a lot of attention of late, with some good and some not so good arguments being put forth.

It’s time I guess that I chime into the debate and share with you my own opinions.

For starters, I think we should lose little time complaining about companies that legally avoid paying tax.  Let’s remember: company management have no inherent social responsibility to pay more in tax than they legally need to. Who would?

In fact, company management would seem to be obligated to maximise after-tax shareholder returns – and if they don’t, they should either be replaced by directors or that very company risks being taken over by enterprising raiders that will insist taxes are no more than necessary.

As Kerry Packer once famously said in 1991 (after an ABC report into his tax affairs) “of course I’m minimising my tax, and if anybody in this country doesn’t minimise their tax they want their heads read.”

What of the case of Qantas that was has been identified in recent weeks as not having paid tax in years?  The reality, as CEO Alan Joyce eloquently explained, is that it had accumulated tax liabilities from during the financial crisis that could be used to offset against any future tax losses for some time.

There’s no point complaining to Qantas about this – if you want to complain, direct your ire at politicians for potentially leaving the corporate tax code more lenient than it should be.  The same goes for global tech companies that still appear to all too easily legally minimise local taxes by recording profits in offshore tax havens.  It not their fault, it’s ours.

What then of the broader argument over whether corporate taxes should be cut at all – given some suggestions that it won’t do much to lift employment and wages, as politicians would have us believe.

On this score, the critics are on firmer, but still fragile, ground. The “trickle down” of corporate tax cuts to households is indeed long and tortuous.  And given the multitude of factors that can affect the economy over any given time period, it perhaps not surprising that it’s often hard to find strong historical or cross-country correlations between the behaviour of business investment and wages and the level and changes in company tax rates over time. No-one should expect to find such simple direct one-to-one correlations.

Instead economists try as best they might to allow for these myriad factors through broader (“general equilibrium”) models of the economy.  And according to Treasury, the best guess on this more rigorous basis is that cutting the corporate tax from 30% to 25% - even allowing for an  increase in personal income taxes to make up for the net revenue shortfall – is to raise the level of GDP eventually by 1%. 

Does this all go to foreign investors? According to Treasury, foreign investors do make off with 40% of this gain, leaving a net increase of gross national income (or “GNI”) of 0.6%.  But by the same token, our companies tend to benefit when other countries cut their taxes also. It’s a case of swings and roundabouts. And after all, its the boost to after-tax returns for foreign investors that helps generate the lift in local business investment and worker productivity that the tax cut is designed to achieve.

You may scoff at a 0.6% increase in national income. But it’s still better than nothing – and it does suggest that cutting corporate taxes (even in a revenue-neutral sense) is at least a net-benefit to the country. In today’s dollars, that equates to around $11 billion, or a $450 increase in annual per capita income.

What’s more, Treasury estimates suggest the vast bulk of this income gain accrues to households – through higher wages and employment – rather than shareholders.  But even here, I’d note most households are also shareholders anyway through the superannuation system.  

Is this the best use of tax payer funds? Some might prefer we throw even more money into health and education – but the international evidence that ever more bucketfuls of money in these areas leads to better outcomes is even more dubious.  Finland spend less on education and has better results than we do – while America spends more on health for worse results.

And like it or not, the competitive downward pressure on corporate tax rates across the world suggests we may not have the luxury to simply retain the status quo. The goal posts are shifting.  

Of course, I’d rather see a corporate tax cuts as part of a wholesale reform of company and personal income taxation – with lower rates and less exemptions, and also potentially higher tax rates on wealth and not just income.

And I’m also uncomfortable – as is Reserve Bank Governor Phil Lowe – that billions are being promised on future corporate tax cuts before we’ve really tackled our lingering budget deficit problem.  But if the choice is earmarking future revenue for tax cuts to boost economic growth - or throwing more into our already inefficiently run health and education systems - I’d still take the former over the latter.

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The bull market still stands strong

Wednesday, February 07, 2018

A lot of ink has been spilt over the share market rout in recent days and for the sake of completeness I guess of should offer my own perspective.

For starters, I agree with Peter that this is probably just a short-term market correction that will prove to be a good buying opportunity within weeks or months – if not days.  Indeed, in many respects this was the “correction we had to have.”

Of course, one often hears that markets are “overbought” or “oversold” in the short-term. What exactly does this mean and how can we tell? 

It basically means markets have rallied so hard within a few days or month that buyers are exhausted – many short-term traders are keen to take profits and new money is reluctant to get into the market unless prices drop back a little.

One common technical measure of this is known as the relative strength index or “RSI”. Without going into the details, this tells us that a market is overbought when it breaks over 70 or so, and oversold when it drops to 30 or less. As seen in the chart below, after a super charged lurch higher in stock prices during January, the daily RSI indicator hit almost 90 on Friday, January 26 – one week before last Friday’s rout.  Indeed, it was the highest RSI reading at least since when the late 1980s.

On this basis, the market was clearly “overbought” – big time. 

Indeed, we had a similar ugly decline in the market in August 2015, which at the time was blamed on China’s collapsing share market, Greek debt problems and concerns the Fed was inching closer to raising interest rates for the first time since the financial crisis (which it eventually did in December). Note, however, the market was much less “overbought” in 2015 than it was before this year’s rout.

In 2015, the worst of the rout was over within 5 days with the S&P dropping 11% (and the RSI touching and “oversold” 17).  The markets then staged a recovery before succumbing to a collapse in oil prices and European financial jitters in early 2016. Apart from tremors associated with Brexit and Trump’s victory, the market has since rarely looked back.

One take-away from all this is that the longer market rallies last, and the more that volatility is crushed to very low levels, then like a wound spring, the deeper and faster is the inevitable correction.  That makes sense: the more investors bet on low volatility continuing, the bigger the unwinding of positions needs to be when turbulence again rears its ugly head.

So where are we now? Following Monday’s market slump on Wall Street, the S&P 500 was down almost 8 per cent from its closing high on January 26 and the RSI had touched 30.  That’s still not as big as the 2015 share decline and given the extremely good market run with low volatility in recent months, chances are more pain will be needed in the short-run before markets are capable of stabilising.

Meanwhile, all market declines are driven by fears over the fundamentals – and its only if those fears prove misplaced are markets able to rebound. After all, if Europe and/or China did implode – as then feared a few years ago – market would clearly not have rebounded in the way they did.

Today the fear is that US wage and price inflation is finally taking off given tight labour markets, which if true would tend to suggest America’s long economic expansion is finally exhausting itself.  This would be a classic of end of cycle inflation burst – more reminiscent of the 1950s to early 1970s - that central banks typically feel the need to snuff out with higher interest rates, which inevitably creates the next recession and bear market in stocks.

That may well be what eventually kills this bull market – but due to extreme competitive price pressures, my hunch is that we’re still at least a year or two away from this possibility. Having spiked higher last month (partly due to statistical quirks and one-off factors), I suspect US wage inflation within the February payrolls report will ease back down again, providing some relief to nervous investors. And even if it did start to gradually creep modestly higher, it would be no bad thing if this helps support consumer spending (and in turn corporate earnings) whilst leaving consumer price inflation still reasonable well contained.

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A warning to central banks

Wednesday, January 24, 2018

To paraphrase a former United States President, today’s investors seems to have nothing to fear but that lack of fear itself.  At least over the short-run, this is very encouraging – but a lack of fear can lead to complacency and a build-up in excess risk taking as the International Monetary Fund has recently pointed out.

Like a tightly wound spring, the greater we wind it up today the stronger the eventual recoil maybe when things start to unravel.

While most investors direct their concern to equity valuations, these risks are building most notably in the (corporate) bond market.  Indeed, it turns out traditional global bond indices – the type typically tracked by active fixed income managers and exchange traded funds (ETFs) - may not provide as much downside protection in the next equity bear market as one might expect. 

First the good news.

In its latest economic outlook, the IMF upgraded its global growth outlook, reflecting accelerating growth in Europe, Japan and emerging markets and the recently passed US tax cuts.  Critically, business investment across the global is starting to pick up – reflecting a tightening in labour markets – which could help boost still flagging productivity and give the global economic expansion extra momentum.

The IMF expects the global economy will grow by 3.9% in both 2018 and 2019 after growth of 3.7% in 2017.  That would mark the best global growth outcome since the 5.4% in 2010 and 4.3% in 2011, when the world was just emerging from the financial crisis.

US economic growth is expected to step up to 2.7% this year after reasonable 2.5% growth in 2017.  In the Euro-zone and Japan growth is expected to ease modestly, but remain relatively robust (relative to their potential) with growth of 2.2% and 1.2% respectively.  

Growth in emerging markets is expected to accelerate from 4.7% in 2017 to 4.9% this year – even though Chinese growth is expected to slow – helped by major turnarounds in India, South America and the Middle East/Africa.

In terms of equity markets, the corporate earnings outlook remains robust. And while price to earnings valuations are above average in many markets, they’re not that richly valued compared to the still very low level of bond yields.   

Low interest rates have been an elixir that has help the global economy and equity markets stage an impressive recovery in recent years.

But low interest rates have arguably had even stronger and more insidious effects in the bond market. For starters, with central banks buying up government bonds and keeping interest rates quite low, corporate borrowing has exploded – enabling companies to leverage up and buy back shares (helping boost earnings per share growth) and also satisfy investor’s thirst for yield. 

In the United States, this has seen leverage ratios among major listed companies rise to near record levels.


Associated with this debt boom, the weighting of lower investment grade (e.g. BBB rated) corporate bonds in traditional bond indices tracked my both active and passive bond fund managers has increased.  Given these bonds tend to be less liquid in a financial crunch than government bonds or more highly rated corporate bonds, it can add to liquidity risk come the next downturn. 


Source: IMF

Around one fifth of the Bloomberg Global Aggregate Bond Index, for example, is now comprised of BBB rated corporate bonds. 

Another issue is the fact that emerging markets are, once again, being showered in cash. According to the IMF, non-resident inflows of portfolio capital into emerging markets may have reached around $300 billion last year, more than twice the total observed during 2015–16 and on par with the strong pace of inflows from 2010–14.  These strong flows into emerging market government and corporate bonds is probably one of the reasons the $US was surprisingly weak last year – to an extent the $US remains a ‘safe haven’ and so easily sold off as investors search for better yielding returns in riskier corners of the world.

Despite this debt build up, corporate and emerging market credit spreads remains very low – as would be expected given this has been a “demand” driven surge in bond issuance.

This is why central banks need to be very careful – but nonetheless resolute – in unwinding extreme monetary stimulus.  Their actions arguably helped the global economy get itself out of the last financial crisis, but if they’re not careful will help sow the seeds for the next one. 

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3 things that will affect the stock market in 2018

Wednesday, January 10, 2018

Apart from the usual “geo-political” risks that persistently swirl around financial markets, the fortunes of investors typically turn on more mundane macro-economic forces such as growth and inflation.

Heading into 2018, I’ve tried to identify the key economic issues which will have the most bearing on the local stock market. I’ve tried hard to keep the list manageable. Indeed, I’ve indentified three key factors.

Firstly, is the performance of the Australian economy itself. On this score, I don’t think we can anticipate any major change in the still relatively soft outlook for mining investment. And while the outlook for non-mining investment (i.e. in factories and offices) is improving, it’s unlikely to ramp up quickly this year. Instead, the main swing variable will be housing construction.

Although home building approvals appear to have passed their peak, it’s fair to say they’ve not so far slumped in the way many (including myself) have feared – indeed, they continue to show feisty resistance, as evident by the 11.7% rise in approvals in November reported yesterday, driven by another 30% surge in (volatile) approvals for apartments. Housing is unlikely to be a major contributor to growth or employment this year, but the economy’s downside will be protected is we can stave off the enviable building decline for at least another year. So far so good.


Another key swing variable for the economy will the fate of consumers. Again despite persistent hopes, I suspect wage growth will remain quite soft this year and house prices will be lot flatter – meaning household income and wealth perceptions will again be challenged.

Household Saving Ratio


Whether households keep spending- which is critical for the economy given this accounts for just over half of GDP – will in turn depend on whether they can keep running down their saving ratio. As evident in the chart above, consumer spending would have been a lot weaker in recent years were it not for reduced saving, but by late 2017 it appeared household’s recourse to this means of spending has been tapped out. What happens to the saving ratio in 2018 will be critical – my hunch is that it will flatten out, which will keep consumer spending relatively subdued.

Globally, perhaps the single biggest swing variable will be US wage inflation. Again momentum in the US economy remains fairly strong, and it’s likely the already low unemployment rate will ratchet down further – probably to below 4%. Whether the party can last will depend on whether this apparent labour market tightness leads to an upsurge in (still relatively dormant) wage inflation, which in turn would make the US Federal Reserve more aggressive about raising interest rates. A pick-up in inflation driven by capacity constraints is the greatest threat to the impressive US economic expansion and equity bull market.

My hunch is that we will see a moderate lift in US wage inflation – with annual growth in average hourly earnings rising from around 2.5% to 3% by year’s end. But that should still only support three to four US rate hikes, which won’t be enough to kill the economy. Higher wage growth meanwhile – implying better balanced income growth – should also support US consumer spending.

Last but not least is the outlook for iron ore and coal prices. Oddly enough, prices have been sustained over the past year by China’s attempt to clamp down on steel production, due to excess capacity and excess pollution. Given persistent underlying steel demand, this has boosted steel prices and the profitability of those Chinese producers who manage to avoid bureaucratic shutdown. It’s also supported demand for higher quality imported resources, such as from Australia.

How this dynamic plays out in 2018 remains to be seen. But to my mind, it still seems likely the overall negative demand effect of China’s steel slowdown will eventually outweigh the current positive “substitution” effect of cleaner Australian resource inputs replacing China’s dirtier local alternatives. That said, I’m no longer anticipating a major commodity price slump – rather an easing back in iron ore prices, for example, from current level of $75/tonne to $US 50-55. Along with still rising production volumes and lowered costs, that should still mean local miners can punch out decent profits.

Overall, I remain optimistic the mix of these variables can keep global equity prices aloft this year, but Australia’s market may well not be among the global leaders once again.

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Where the budget is heading

Wednesday, December 20, 2017

By David Bassanese

I’m starting to get a little peeved with the almost exclusive focus on long-term economic and financial forecasts by the Federal Government and the Reserve Bank alike. The reason is that they increasingly seem to leave our policy makers unaccountable for the results they actually achieve in real time. 

It’s a classic shell game – keep excitingly pointing to the future and hope the punters won’t notice the present.  

Take the latest Mid-Year Economic and Fiscal Review (MYEFO) from the Turnbull Government.  The headlines naturally focused on the near-term improvement to the budget bottom line, and the still reasonable prospect that the Budget could return to surplus by 2020-21. 

Indeed, the underlying budget balance will now be in deficit by “only” $23.6 billion this financial year, or around $6 billion less than expected in the May Budget. What’s more, the surplus in 2020-21 is now projected at a tidy $10.2 billion, or $3 billion more than expected in May.  

But rather than leave this money on the table for the Labor Opposition to promise spend (as it surely would), the Government is now hinting there’s enough fat in the budget projections to potentially fund another “milkshake and a sandwich”  income tax cut. We’ll likely hear more about this in the May 2018 Budget. 

That’s one immediate problem with long-term budget projections – in what appears a scorched earth policy to deny the Opposition any money to play with, Governments of the day are now quick to commit to spend anything that leave more than a threadbare surplus over the forward estimates. That’s despite the fact overall public debt is still elevated (at least by our own standards) thanks to the legacy of the financial crisis and a fall back to earth in commodity prices. 

Another problem is that the Budget projections naturally tend to improve over time – with little extra work by the Government – due to the magic of “bracket creep”, or the increases in average taxes faced by households as rising nominal incomes lift them into higher marginal income tax brackets.  Aiding this miraculous budget improvement is the assumption that the economy will automatically step up to an above trend pace of growth so as to eradicate excess unemployment within a few years.  How very convenient! 

As seen in the chart below, the “hockey stick” budget improvement forecasts are nothing new!  Yet especially over the past few years of commodity prices declines, these forecasts have proven woefully optimistic. 


I’m not suggesting these are not reasonable assumptions – after all we need to assume something and full employment is a worthy aspiration.  Rather my concern is that these projections – which are obviously subject to considerable revision - then tend to assume undue public focus, and seemingly let Treasurer’s off the hook for current economic conditions. 

Lost in all the Budget hype, for example, is the fact that the Government actually had to downgrade its economic growth forecast for this financial year.  While many are cheering the Government’s expectation for 3 per cent growth in 2018-19 (unchanged from the May budget), the Government now expects growth of only 2.5% this financial year (down from 2.75%) and after a woeful 2% growth performance in 2016-17.  

The 3% growth forecast in 2018-19 is certainly encouraging – but it’s still just a forecast. And the Government’s recent track record in predicting better times ahead has not be great. 

One clear risk to the economic forecasts is the fact the Government is still counting on a further run-down in household saving to support consumer spending over the next year or so, even though households appear ever more cautious about their finances, and should be even more frugal as the Sydney and Melbourne house price booms subside.  Judging by international evidence, I also still seriously doubt we’ll get any decent lift in wage growth anytime soon.

That said, at least one element of good news in recent Budget announcements is that we’ve not seen the downgrades to the budget outlook seen earlier – thanks to more stable commodity prices, and improved global financial markets.  But what China and the market’s giveth, they can just as quickly taketh away. 

Yet thanks to the magic of the persistently improving Budget projections, we’re now quick to use up any Budget windfalls even before they’ve been truly earned. 

Treasurers have become accustomed to simply focusing on this automatic improvement in the budget - as if it were their work – while downplaying short-run budget overruns and/or disappointing near-term economic growth.



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Banks a buy in 2018

Wednesday, December 06, 2017

Banks stocks seem a great buy in 2018. 

Don’t laugh – I don’t mean local bank stocks, but rather their global peers due to the divergent fundamental forces each are likely to face over the coming year.  The good news for local investors, at least, is that it’s never been easier to buy exposure to global banks on the ASX through international sector exchange traded funds (ETFs).     

Locally, the story is not so great.  Given the challenges that have faced the local share market in recent times it’s a shame from an investment perspective that the financial sector – clearly the most dominant on the market – must now endure another wrenching period of regulatory risk as a hastily organised Royal Commission starts its work.

We already know two things about Royal Commissions: they are colossally expensive for taxpayers, and very slow in reaching their conclusions.  And even then, Governments are under no obligation to agree to any of their recommendations.

In the meantime, we’re likely to get a plethora of speculative headlines over what new burdens may or may not be imposed on our major banks.  In a way, it will be a bit like the nervous wait the market endured as the Australian Prudential Regulation Authority deliberated over what new capital requirements to impose on the banks so as to make them “unquestionably strong” by global standards.   

As it turned out, APRA’s new capital requirements were not as bad as feared, meaning banks did not need to raise a whole lot more shareholder dilutive equity or slash dividends.  But overall, the financial sector is now trading at lower prices then when APRA finally declared its hand back in July this year.  Negative headlines over one bank transgression after another has not helped, nor has signs of cooling in lending to the property sector – thanks to APRA’s clamp down on investor lending and interest-only loans.

The shame is to the extent that certain problems have been identified in the banking sector, specific new regulatory changes could and should have dealt with them much more quickly and at less taxpayer cost.  The problem is that Labor’s call for a Royal Commission has proven so politically irresistible than no matter what the Turnbull Government did (even having a say over executive salaries and bonuses!) was going to be viewed as too lenient in comparison. 

In short, the growth opportunities in the local banking sector – especially also given the slowing in the important Sydney property sector – appear limited. That said, given the Bank’s still strong pricing power – or ability to price mortgages at a levels comfortably above borrowing costs – they should still be able to churn out healthy steady profits and dividends.  The Big-4 banks are really modern day utilities – good for income but not much growth.

The global banking sector, however, appears to have a more positive outlook – at least over the coming year or so. For starters, the profitability of global banks in general tends to improve as longer-term interest rates rise, and especially if yield curves steepen. There’s a strong positive correlation, for example, in the relative performance of global financials and US 10-year bond yields.  As a result, the winding bank of massive bond buying programs by the US Federal Reserve – and slowly but surely the European Central Bank – should help global financials in this regard.

 Love or hate him, US President Trump is also poised to unleash a massive tax cut package which will favour relatively highly taxed US sectors such as financials, and he’s still vowing to cut back on financial regulations.

Global banks went on a tear in late 2016 when bond yields last spiked higher and Trump came to power.  They’ve since kept pace with the global equity rally so far this year but are possibly now poised to enjoy a period of outperformance once again.       


Indeed, while there’s been a lot of focus on Australia’s low exposure to the booming technology sector – and mixed performance of commodity prices – another major factor behind the underperformance of the local market against global peers this year has been the underperformance of local financials versus global banks.   This drag on local relative performance does not seem like ending anytime soon.

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Will rate rises happen soon?

Wednesday, November 22, 2017

By David Bassanese

Slowly but surely, the Reserve Bank appears to be paving the way for a lift in interest rates in the second half of 2018. In an important speech delivered in Sydney overnight, RBA Governor Philip Lowe spelt out in detail why our cherished central bank is feeling more confident about the economic outlook, and more willing to again suggest “it is more likely that the next move in interest rates will be up, rather than down.”

I also share the RBA’s optimism to some degree, but I also suspect its forecasts – or at least its “central scenario” still remains more hope than reality. My central scenario is that economic growth will remain sub-3% over the coming year and wages and inflation are likely to remain stubbornly low.

Under this view, it’s still hard to see the RBA raising rates for a good deal longer.

First the good news. After several years of decline, there is light at the end of the dark tunnel with regard to the slump in mining investment. As the Governor indicated, the “wind-down of mining investment is now all but complete”. Associated with this, economic conditions in the mining states of Western Australia and Queensland appear to have bottomed, with employment rising through much of the past year.

What’s more, there’s also tentative signs of a lift in non-mining investment. This is being supported by an infrastructure boom and ongoing growth in service sectors such as health, education and tourism.

That said, the big drag on growth remains weakness in wages and household income, which in turn has meant consumer spending remains quite soft. Indeed, Lowe was not shy in revealing how hopelessly wrong the RBA has been with regard to consumer spending, as the chart below demonstrates

Undaunted, the RBA’s hope is that the gathering strength in business investment and ongoing growth in employment will eventually lead to a lift in wages growth and consumer spending – a nice positive feedback loop, were it to occur.

And there appear tentative signs that this is happening! According to Lowe “we are hearing reports through our liaison program that in some pockets the stronger demand for workers is starting to push wages up a bit.”

Yes that’s right – wage are rising a “bit”, and in “some” sectors.

While it’s nice to be hopeful, what Lowe did not mention was that housing activity appears to have peaked earlier than the RBA expected – and this handy source of growth and employment will go missing in action in 2018. Consumer spending in Sydney and Melbourne is also increasingly vulnerable as house prices eventually turn. Recent auction clearance rates already suggest Sydney house prices are now falling.

And as the RBA also readily admits, there also remains considerable spare capacity in the overall labour market – and, as most evident in the United States, wage growth still remains dormant in countries with labour markets much tighter than our own.

While business might respond to some pockets of labour tightness by bidding up wages, there’s also a good chance they’ll react by focusing on improved productivity through labour saving investments instead. After all, companies face intense pricing pressure also, and Amazon’s attack on local business is only just getting started.

Of course, while cost cutting – due to both competitive imperatives and technological opportunities - makes sense for an individual firm, at the national level it can become self-defeating if to leads to weak household income and consumer spending (and more broadly rising income inequality).

This is the quandary Australia and much of the world now faces, and it’s why there’s a growing dichotomy between business and consumer sentiment.

For investors at least, the good news is that persistent low inflation and low interest rates means every dollar that a business is able to earn is cherished more highly – which is why share market valuations are likely to continue to push higher for some time yet. But for those getting excited about a rate rise sometime soon – I would not hold my breath.

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Is the ASX overvalued? It’s all in the numbers

Wednesday, November 08, 2017

By David Bassanese
Just when local investors could be forgiven in thinking all hope was lost, the Australian S&P/ASX 200 share market index has made a feisty lunge to 6,000 points in recent weeks.  It naturally raises the question, can these share market gains be sustained and could the market keep moving higher?

I think it can, but don’t expect runaway gains. And I still suspect our market is likely to underperform our global peers – especially technology heavy indices such as America’s NASDAQ-100 Index.

Of course, some have been quick to point out that the local market’s valuation is now elevated and we don’t have much earnings support underpinning recent gains.

As regards valuations, I’ve got news for them – most markets around the world are trading at “above average” price to earnings ratios. We are not alone.  But comparing current PE levels to history is a little misleading if the fact that global interest rates also remain well below average is ignored.

It’s like saying Australian house prices are overvalued because today’s rental yields are lower than average – but this is to be expected given the structural decline in interest rates over recent decades. The yield return on competing assets – such as term deposits and corporate bonds – has declined, so the yield on both property and shares must also decline. And the way that’s achieved is by pushing up valuations relatively to underlying earnings and rents.

Let’s put some flesh on the bones with some real numbers.  According to my estimates, with the S&P/ASX 200 trading at around 6000 points, it’s consistent with trading on a price-to-forward earnings ratio of 16.2.  Its longer-run average (which I estimate since 2003) is around 14.

So far so bad. It implies the market is 11% “overvalued”.

But today’s yield on Australian Government 10-year bonds is around 2.6%.  Its long-run average is around 4.5%, or a full 2 percentage points less.  That has to be of some relevance to the market.

In fact, if we invert the PE ratio we get what’s called the equity market’s “forward earnings yield”, which is now just around 6.2%. Subtract the 10-year bond yield of 2.6% and we get what’s called the equity premium of 3.6%.

This premium’s long-run average (i.e. since around 2003) has been 2.5% - so the premium remains higher than its long-run average. On that basis alone, it’s hard to argue the market is overvalued.

That said, if we examine even longer-run history we find the market’s equity premium has not tended to be constant over time – rather it has been higher when bond yields have been low and lower when bonds yields are high. In a sense, equity valuations don’t tend to fully adjust to reflect very low and very high bond yields – as the market suspects this level of yields is not sustainable.

As seen in the chart below, my own long-run calculations (based on patched-together estimates of earnings and valuations stretching back to the early 1970s) suggest the market is today reasonably close to fair-value.  With bond yields around 2.5% or so, a PE level of around 16 seems reasonable.

Of course, that does mean should bond yields rise from here, it should place downward pressure on equity valuations. But provided the rise in bond yields is fairly modest (which seems most likely given persistent low inflation), the downward pressure on valuations should not be too great.

By my estimates, a lift in 10-year bonds yields to 3% and 3.5% would push PE fair value down to 15.8 and 15.4 respectively – or lower prices by around 2 to 5%. Note yields at this level would still be consistent with a PE ratio that remains comfortably above its recent long-run average of 14.

And offsetting this of course should be at least a modest lift in corporate earnings, which have been sluggish for some time – plus a not to be forgotten 4% gain from dividends (plus franking credits).

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Bitcoin - is this time different?

Wednesday, October 25, 2017

By David Bassanese

As an analyst of global financial markets, it is getting increasingly hard to ignore what was once just a plaything among computer geeks – the rise of so-called crypto-currencies such as Bitcoin.

Having witnessed the rise and rise in the price of Bitcoin, and the growing chatter about its rising status in the popular press, humble analysts such as myself have been forced to confront it and decide - is it worth the hype, or is it yet another in the long line of financial bubbles?

I’m no computer expert, but I am a student of economic history. And, as I explained to Paul Rickard on the Switzer show earlier this week, if it looks like a duck and walks like a duck – chances are it’s a duck.

By that I mean the parabolic price gains for Bitcoin in recent months – and its rising popular interest – bear all the hallmarks of classic bubble. Of course, interest in Bitcoin only recently appears to have made the transition from first-mover computer geeks to the general public, so that probably means explosive price growth could last another year or so.

I can’t say when the price of Bitcoin will collapse – it could yet double and triple in value before then – but history strongly suggests collapse it likely will.

BitCoin Price in $US

Source: CoinDesk.Com

Of course, many of those buying Bitcoin today also probably expect prices to fall eventually. All they know is that prices are rising, and momentum likely means prices will rise further still. Another name for this is the greater fool theory – I’ll buy now irrespective of price, because I believe there’ll be a bigger fool that will pay even higher prices later.

Why am I a sceptic? As the believers like to point out, the supply of Bitcoin is apparently limited.

There’s now 16 million units, and supply is growing by only a few percent per year, and will be ultimately capped at 21 million units. Even at a price of $US6000, the total market value of Bitcoins outstanding is only around $US100 billion, which is still a fraction of the US money supply – much less that of the global economy as a whole.

At the same time, legitimate transactional demand for crypto-currencies is apparently high and rising. One central rational is that, unlike with national currencies run by governments and complicit central banks, there’s apparently less risk of monetary debasement though the printing press. It’s also seen as relatively cheap and easy to make international payments than with global currencies, and transactions can be made with greater anonymity (which is apparently a social good?).

But all bubbles start with some fundamentals behind then. And as with the internet itself, the deregulated blockchain technology that keeps account of crypto-currency transactions will likely become a fundamental part of the economy of the future.

That said, whether we actually need competing crypto-currencies to take the place of fiat currencies is highly questionable. After all, there’s now enough evidence to suggest modern democratically elected governments don’t easily seek to debase their currencies – indeed, inflation remains stubbornly low across the globe. International electronic transactions using traditional credit cards and national currencies are getting easier and cheaper by the day. I also I retain a lot more confidence that the $US and the $A will remain at least as widely acceptable as a means of payment and retain their store of value (i.e. won’t depreciate up to the usual 90% seen in the aftermath of bubbles).

As we’ve seen in China, it also seems likely governments will eventually crack down on allowing crypto-currency transactions if its leads to concerns over monetary stability, tax avoidance and/or terrorism funding. And it’s hard to believe many of these so-called currencies won’t be subject to massive cyber attack.

But the death knell to the crypto-currency craze will be supply – which is what eventually kills most financial bubbles. America built too many houses during its housing bubble, and launched too many dotcom companies during its dotcom bubble. The Dutch grew too many tulips.

In this regard, I’d be dubious about claims of fixed crypto-currency supply – especially as Bitcoin (apparently decentralised power structure) already itself appears to be creating a number of offshoots, such as Bitcoin Cash and soon even Bitcoin Gold. Apart from Bitcoin, moreover, there’s now a multitude of alternative crypto-currencies vying for attention, such as Ethereum.

My message: enjoy the ride while it lasts, but don’t say you weren’t warned when the mania eventually ends. This time is never different.

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