The Predictable Market, Brexit, and Capital Gains Tax
Market and Economic Update – Week Ended 22nd February 2019
Peter Flannery CFP AFA
“If you have one economist on your team,
it’s likely that you have one more than you’ll need.”
The above chart shows where the American share market, the Dow Jones, stands over the last 12 months – note the green line (not a red line).
The above chart gives us some perspective with a five year view, highlighting the pricing correction over the fourth quarter of 2018.
So, where are we at? As you may recall (although you possibly would have missed it, if you were not watching), the fuss across the markets over the second quarter of 2018 which has not come to much, with most of the downside gone. Market prices are still not quite back to where they were at the peak, but not far from it. It seems to me, in hindsight, that the market was more confused than anything else. It did not seem to know whether to focus on Brexit, trade tariffs with China and America creating ongoing certainty, interest rate rises or anything else that it decided to take exception to over that time.
We know that those issues have not been resolved, although interest rate hikes from the US Federal Reserve Governor, Jerome Powell, appear to be slowing for now. Have you ever noticed how the market mood can become quite intense, particularly when sentiment turns negative? Well, it does not mean that those businesses listed on markets around the world are suddenly poor performers or suddenly worth less than they were from an intrinsic valuation perspective.
That said, those businesses trading on the markets of inferior quality and inflated trading prices can come unstuck in this type of environment. Sometimes their debt, that by the way, has helped to support their growth, is based on market capitalisation (the number of shares traded x the trading price), which when markets become intense, on the negative side of the ledger, their trading prices can decline quite a bit. This can see them breach banking covenants. The market does not like that but often does not recognise it until that situation is right on top of them. An obvious combination of investing in quality businesses with real intrinsic value and either tolerating or understanding why trading prices do not always represent underlying intrinsic value can help.
The above chart outlining various economic cycles, shows the US economy still in expansion mode, possibly heading towards downturn.
What’s interesting about the graph above is that, whilst normally a downturn would be close, it is difficult to know for sure, because the above chart has never captured a cycle where the significant level of quantitative easing (QE) and monetary support has been utilised to such a large extent. The US downturn is inevitable, however the timing is unclear because we do not know how the US Central Bank stimulus will impact. I imagine, barring any sudden shocks, it may extend the recovery for a longer period still. This might especially be so when we think about the fact that interest rate hikes in the US appear to be slowing down or even on hold.
The above chart shows how much each country pays out in interest as a percentage of tax revenues.
The US Federal Reserve Governor, Jerome Powell recently highlighted slowing economic growth in China and Europe as reasons to hold back on further interest rate hikes in the US. They are, of course, valid concerns, although the real issue facing the US economy, at some point in the future, is the ongoing increase in debt that the US economy must service. It appears that neither the Federal Reserve Bank nor President Trump are keen on highlighting this to the US public. I realise certain media commentators have suggested in the past that burgeoning US debt will inevitably lead to a crisis in the future. Whilst I cannot predict the future, an economy like the US is as well positioned as any in the world to deal with that event. Further, it is not in the global economy’s best interest to sit back and watch the US economy wither and struggle. That is because many countries globally, particularly the larger ones, trade with the US economy. If it is struggling, it holds then that they will also struggle. Whilst a crisis (depending on how you like to defend crisis) is possible, I do not see a collapse of the US economy because of its debt burden. The idea of economic collapse because of a debt crisis may well be valid and can be justified academically. That does not make it right.
Meanwhile on the Brexit front with only 37 days until the UK in theory leaves the European Union, the most recent meeting between Prime Minister Theresa May and Jean Claude Juncker in Brussels has not provided a breakthrough. On a lighter note, Jean Claude Juncker did advise the world that the plaster on his face was the result of an unfortunate gesture with his razor blade and was not inflicted by Theresa May!
Anyway, Theresa May told the European Commission President, Jean Claude Juncker, that she needed “legally binding changes” to the Irish backstop, if MPs were to back her Brexit deal. Interestingly, prior to the meeting, Juncker made the prediction that there would be no breakthrough in their upcoming meeting – a prediction that interestingly proved accurate. However, in what some regard as an olive branch to Theresa May, the European Union’s chief Brexit negotiator, Michel Barnier, and the secretary, Stephen Barclay, were tasked with looking into the role of ‘alternative arrangements’ and what role they could play in replacing the contested Irish backstop in the future.
Still with Brexit, a number of politicians in both main parties in Britain, led by Anna Soubry, Sarah Wollaston and Heidi Allen, who quit the Tory Party in what some are describing as an explosive new development in the ongoing Brexit negotiations. The new breakaway group’s slogan is, “Lead not leave.” They claim that there are more than 20 other politicians ready to join them. It is too early to say just what impact this will have, so let’s watch with interest. For sure, as if it could not be more difficult, this must make it yet more challenging for Theresa May. As an aside, I noticed one brief comment suggesting that the referendum did not fully explain the implications of Brexit. Is this an indication of Brexit regret?
The above chart shows historical property price rises and dips since September 2006, with a projection to December 2020.
Property price movement varies from one city to the next but is certainly in a strong downward direction in both Sydney and Melbourne. Those declining prices will settle down at some point, however it is a question of what follows and what the impact of those lower prices might mean for some homeowners and property investors in Australia. Although the media would have you believe otherwise, there does not appear to be an economic crisis on the back of declining property prices just yet. Property is without doubt a strong contributor to the Australian economy, just as it is in many economies, however the Australian economy is broader. Farming and financial services, for example, are significant contributors to economic growth across Australia.
Whilst it remains to be seen what the impact of those declining property prices will be, I suspect the impact might be more isolated, affecting individual homeowners and property investors, rather than a trigger for a severe economic recession across Australia.
BREAKING NEWS: The tax working group have just released their findings. It has only just been released and therefore more investigation is required, however what we know so far is that this capital gains tax is to apply after the sale of closely held businesses, residential property (not the family home though), direct shares, all land and buildings and intangibles, such as intellectual property and goodwill.
The rate of tax will be set at the income earner’s top tax rate (probably 33% for many). At this stage, they intend to implement the capital gains tax to gains made after April 2021. Interestingly, jewellery, personal household items, boats, art, cars and the like, may be exempt. Houses on farms and surrounding land up to 4,500 square metres are exempt from capital gains tax, calculated as a percentage of total farm value. Capital gains tax on small businesses is included but can be deferred if annual turnover is less than $5mln and the sale proceeds are invested in similar asset classes. While it is early days yet, there is bound to be much discussion.
Here’s the real question: ‘Can the Labour Party win the next election on the back of introducing capital gains tax?’
And so to China / NZ relations: Is there risk to the New Zealand economy from souring New Zealand/China relations?
There has been some banter around the media, particularly with regard to the National Party accusing the Labour Party of damaging the good relationship between China and New Zealand. The short of it is, that when you drill down more closely and take a good look, it is an important aspect for New Zealand. However, it is difficult to see significant merit behind that accusation. That is the bottom line. We all know that China is our biggest trading partner, with two-way trade worth more than $28 billion in 2018. Further, China represents by some measures, the fastest growing tourism market behind Australia. Certainly, China remains very important to the New Zealand economy, however I would need to see more evidence of a damaging rift (in which case the trade implications could be significant) between New Zealand and China. I will keep you posted…