Monthly Perspective | March 2018

While Donald Trump and his actions are back in the market’s crosshairs, locally, Bill Shorten has been making his own waves. In this issue, we discuss the possible implications of the proposed changes to the treatment of franking credits.

Volatility has continued following the structural shift in early February. While this environment seems high relative to the calm of last year, as touched on last month, this is a much more normal environment for investments.

The S&P/ASX 200 index has recovered some ground from the sell-off but remains below 6,000 points after briefly recovering above it in late February as the reporting season was broadly in-line with expectations, but lacked any real positives. Meanwhile, the US S&P 500 has recovered to within 3% of its January highs on the back of a good US reporting season, despite being rattled further by Trump’s tariffs and further turnover of key personnel in Gary Cohn and Rex Tillerson. On the other hand, the European Stoxx index has struggled to recover despite being more resilient on the way down in early February.

Meanwhile, bond yields have largely stabilised after a strong surge between December to February, culminating in the equity market correction, with the US 10-year yield holding at close to 2.9%.

The Australian Dollar has held around the US78.7c mark after falling below US78c at the start of March.

Economic overview

The Australian economy remains mixed as Gross Domestic Product (GDP) came in below expectations at 2.4%. Australian wages showed minor improvement as quarterly growth was at 0.6% for the final quarter of 2017, but retail sales growth remains disappointing as overall wage growth remains lacklustre while the debt burden continues to march ever higher.

US inflation expectations have moderated over the past month, as Consumer Price Index, personal spending and wage growth readings moderated. Positively, there were strong employment figures and increased participation rate, providing hope that the ‘Goldilocks environment’ (good growth but not enough to stir inflation) of last year still has some legs.

Meanwhile, Europe remains in-line with expectations as GDP grew 2.7% in 2017. The key takeaway for the region came from the European Central Bank (ECB) meeting. While the ECB did not make any changes to its actions, it did remove the key phrase ‘stands ready to raise the asset purchase program by size or duration’. The removal of this wording indicates that the ECB is confident that the Eurozone recovery is becoming self-sustaining without the need for further monetary stimulus, which will likely lead to a rise in European yields as the ECB continues to wind down its Quantitative Easing program and tighten monetary conditions.

In China, business surveys have indicated slower growth, but industrial production and fixed asset investment figures for the year to February came in much higher than expected. Exports and inflation figures were also much higher than expected, providing room for China to further reduce its debt burden while maintaining its growth target.

In the coming months, the market will be closely watching for any retaliation on trade, but inflationary pressures and yields are likely to remain the primary risk factor.

Federal opposition plans to abolish cash refunds of excess franking credits

This month, the Federal opposition leader Bill Shorten outlined his party’s plans to abolish the ability of investors to claim cash refunds on excess dividend imputation credits as of the 1st July 2019 if elected.

The next Australian Federal election is due to be held on or before the 18th May 2019.

This policy is new and if implemented under a Labor government, stands to significantly impact the retirement incomes of approximately 200,000 self-managed superannuants.

This policy follows in the footsteps of another major Labor policy initiative which is the planned removal of negative gearing on existing homes, if elected, from the 1st of July 2017.

Both of these policy platforms are targeted at deemed inefficiencies in the tax-system, but irrespective of their motivation, will undeniably have a significant impact on asset values and income streams of Australia’s ‘asset-owning class’.

This policy is arguably all the less forgiving to retirement investors when considered against the backdrop of collapsing cash rates and associated portfolio income.

Whilst it is impossible to call the outcome of the next Federal election this far out, the introduction of this policy, alongside the proposed repeal of negative gearing on existing property, will surely act to create greater investment uncertainty in the lead up.

There are several significant and immediate ramifications for investors, particularly those investors (largely retirees) paying a reduced or zero rate of tax.

Hybrid securities seem the most liable to disappointing investors outcomes.

The implications

Removing the value of excess franking credits to investors will have multiple impacts.

We think on average it stands to impact self-managed retirement income streams by as much as 1% per annum based upon our estimate of average ownership of Australian blue-chip shares and hybrid securities.

Private retirement investors have been highly dependent on franked income streams provided by the Australian banks and their related hybrid-securities, and on dividend income provided by other major corporates such as Telstra (TLS), Wesfarmers (WES) and Woolworths (WOW).

The value of these income streams to retirement investors is now being diminished.

At a bigger picture investment level, the implication of this policy is pro-growth and anti-income.

It is also heavily favours our bias to international shares relative to local Australian shares.

Hybrid securities

For the better part of a decade, hybrid securities (largely issued by the major banks) have formed a core part of self-managed retirement portfolio’s given their regularity of income.

Issuing banks have taken advantage of the demand from local retirement investors, and incorporated franking credits as a significant portion of the income paid given its value to these investors.

Under the newly proposed Labor tax plan, much of the hybrid investor base, being self-managed retirees, would no longer receive any benefit from the franking credit attached to these hybrid securities.

In short, the effective yield to lowly taxed investors (retirees as the prime example) would fall from approximately 5.4% currently to 3.8% per annum.

Worse, issuing banks could choose to run the currently issued securities beyond the assumed ‘call date’ to full maturity, forcing investors to hold on for, in most cases, a further 2 years before their capital is repaid.

We think this potential fall in income is significant, and we also think that since retirement investors are the dominant investor base in bank hybrid securities, that these securities will likely fall in the weeks and months ahead given the uncertainty created over the future value of these securities.

Whilst we feel there are many moving parts involved in this policy platform, we do feel it is appropriate to mitigate against the risk of a significant de-valuation in the value of these hybrid securities under a Labor Federal government, and hence would suggest investors consider partially reducing these hybrid holdings in preference for other income generative assets.

It is very difficult to establish the potential risk to hybrid security prices in the short nor medium term, but in the near term I wouldn’t be surprised to see the sector fall 3-5%, and perhaps 10% or more in the event of a Labor election victory.

Whilst this is not a direct sell call on any of the following securities, we do think that the longer-dated hybrid securities stand most at risk of a reduction in value – we have nominated the NABPD, ANZPE, ANZPG and CBAPD as potential issues to lighten in portfolios.

We would highlight that we have not recommended any of the recent hybrid issues, for as much as a year, on the grounds that we felt the risk/reward on offer in each was unattractive.

Alternative income generation

As an alternative to hybrid income we have been recommending, for some time now, the MCP Master Income Trust (MXT), Latrobe Australia Credit Fund – 12-month account (LTC0002AU), and the AMP Wholesale Australian Property Fund (NML0001AU).

We are looking closely at local infrastructure opportunities and hope to be able to offer greater detail on these in the near term.

Conclusion

This is our initial and immediate response to the recent news and will likely evolve over time as the situation plays out.

We feel the response from retirement investors will be understandable disappointment, and this will surely develop into one of the key, if not the key, election issue for 2019.

Retirement incomes are being significantly hindered already by falling cash and portfolio yields, and this potential policy change stands to further impact.

We continue to urge investors to diversify portfolios to include alternate sources of growth and income beyond that of the Australian share-market.

Whilst the above examples of alternate income generation remain some of our most preferred, we are striving even harder now to find new and appropriate income streams for portfolio investments.

Want more information?

This month’s perspective highlights that market sentiment on all asset classes is constantly changing. It is important for us to quickly recognise any threats, to preserve your investment capital or to identify early investment opportunities to maximise any return advantages. At Partners Wealth Group we don’t get complacent with the current state of play and constantly monitor investments and your portfolios.

If this article has raised questions regarding your personal situation, please contact your Partners Wealth Group advisor directly or on 1800 333 143.

This article contains information that is general in nature. It does not take into account the objectives, financial situation or needs of any particular person. You need to consider your financial situation and needs before making any decisions based on this information.