Tuesday 28 August 2018 by Craig Swanger Opinion

Political environment continues to have an oversized impact on investment markets in 2018

Political risk is rising. The surprising Liberal party shenanigans last week are part of a broader discontent. Craig analyses the impact for investors.

scottmorrison

Last week’s extraordinary events are a good reminder that, sadly, political events can have an impact on investment markets and the real economy.  By “political events” I mean actions by politicians that have more to do with the personal interests and ambitions of the politicians themselves and less to do with what they are paid to do.

Right now we have politics having a major impact on Australian investors in a far more significant way that we have seen in recent history.  Events in Australia, the US and the UK are all impacting currency, interest rate and equity markets, and have the potential to have much larger impacts going forward. 

Starting with Australia, last week’s events were nothing short of a shameful reminder of the exposure our economy has to the self interests of a tiny minority.  This isn’t about right or left, conservative or middle, it is about the unacceptable impact on business and consumer confidence, and confidence from international investors that worsens every time we have one of these leadership spills.

As investors, last week probably achieved only two likely outcomes: an increased probability of a Labor win in May 2019 and therefore the likely loss of some, if not all ,of franking benefits and a shift in the rhetoric about job creation toward small to medium businesses. 

SMEs win, big banks lose

Scott Morrison has long advocated for more support for small to medium sized enterprises (SMEs).  When the company tax rate was defeated last week, the immediate response was an acceleration of the already legislated company tax rate cut for companies under $50 million per annum turnover.  That is an easy win for the new PM and very hard for Labor to oppose.

More challenging for Morrison, but probably a necessary tactic, is for him to come down very hard on the financial services sector following the Royal Commission’s final reports.  The Commission’s findings will be published during Morrison’s term and well before the next election, with the first round of findings drafted and released last week.  The challenge for Morrison is that he was opposed to the Commission, but he cannot be seen to do nothing given the shocking conduct and clear disregard for consumers across the most senior levels of management.

The most likely measures, absent of the company tax rate being revived, is a charge for the deposit guarantee or a funding charge for the regulators.  Either way, the impact on bank earnings from last week’s events will be worse, not better. 

Franking credit impact on retirees

Labor will no doubt pivot around the new Liberal PM’s policy shift, but assuming that they stick with their proposed cut to franking credits, the impact on the return from Australian shares will be down around 1.3%pa. 

A retiree with $800,000 in pension assets, 40% of which are in equities, would be around $5,485 worse off per annum under the Labor proposal.  While Labor is targeting the “rich”, the impact of larger retiree balances would be proportionally less due to the $1.6m cap on pensions.  A $4m retiree portfolio, using the same assumptions as above, would by impacted by $9,428 per annum.

The likely impact: A lot of SMSF money shifting from equities to other asset classes, namely property and fixed income. 

The only likely winners are investors in coal-related industries as the PM needs to find something to appease the Dutton/Abbott conservatives, and aged care which has been  mentioned regularly by Mr Morrison.  Farmers will be in the headlines, but there is actually a lot already pledged to farmers, so this is more about the headlines than any real changes. 

US Political risk worsening, but the world economy is the loser

The Trump administration has had a positive impact on the US economy so far, much as predicted.  His company tax rate, amnesty for offshore tax evasion and support for infrastructure projects would appear to be having a positive impact on the economy, at least in the near term.

But the impact of his personal politics, particularly his chasing populist tactics such as his trade tariff battles with Europe and China, harms the global economy far more than the US economy.  Trump has tapped into the inevitable backlash against global trade amongst the working class of America.  He seeks personal popularity and so he announces policies and tactics that appeal to those voters.  There are no votes lost when he alienates the global community, but the base likes it.

Global trade has always been very sensitive to populist politics.  The wave of nationalism that swept across Britain, the world’s economic leader in the 1800s, and then Europe, resulted in a 70% fall in trade between 1900 and 1940.  This came from landowners in the UK and Europe backing politicians offering to increase tariffs, and in the “New World” including the US and Australia, anti-immigration policies. 

Trump has shown a pattern of looking for more extreme distractions whenever facing more pressure personally.  The current wave of actions by the Mueller investigation will likely cause him to lash out at China, Europe or the Middle East in order to maintain popularity with his power base and distract from his personal issues.  Watch for more volatility and the potential impact on currency and equity markets in particular. 

Ultimately, global trade will win over short term political movements, but these shifts are already impacting global trade and investment flows.  We could be facing a far more volatile period for global trade and flows for as much as the next 10 to 20 years.  This was a prediction we made around two years ago when Brexit became a reality and so far the trend has been sharply toward more trade volatility since.

UK economy likely to be trapped by indecision

Once the British public voted for Brexit, the real risk was the two years post the vote in which the details of the exit were agreed.  The rational approach would have been for both sides to accept the outcome, deliver the public’s key issue relating to immigration, but maintain the mutual economic benefits of trade.  But as of today there is a very real chance of a “no deal Brexit”, meaning that Britain leaves the EU without an alternative plan set up.  This would expose British exports to much higher tariffs, creating a sudden reduction in demand.  Import prices would jump, creating inflation.  The shock to the economy would severely impact capital investment.  The most likely result is stagflation (low economic growth and high inflation). 

Financial markets have the chances of a no deal outcome at just 10%.  Deals with the EU have typically been won at the last moment.  Hopefully that is the outcome this time, but given the stakes at play, you can expect increasing volatility in the value of the GBP closer to the exit next March.

Conclusion

Ordinarily, politics causes short term blips at most.  This is because governments for the past 40-50 years have maintained a consistent pursuit of economic growth as a primary goal.  But the current wave of populist politics in the US, Europe and in Australia putting immigration as the primary goal is creating significant longer term risks for investors.  Even if you find politics boorish, as an investor you might need to become more engaged going forward.

Note after publication 

After Craig wrote this note, Agustin Carstens, Head of the BIS and known as the “Central Banker to the Central Bankers”, issued a dire warning of 'the perfect storm'.  For those of you with an AFR subscription, you can access the link here.

In short, he said, “Recent moves to reverse globalisation and to retreat into protectionism alarm me, as they no doubt alarm many of you”. He indicated that the Trump trade war could lead to US inflation, forcing interest rates in the US to rise faster, and push up the US dollar. 

You heard it here first – this has been one of our Top 5 global risks for the past two years!

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