Weekly Market Update – 18th July 2014

• Despite initially falling in response to worries about Ukraine and the Middle East shares actually had a good week helped by favourable US and Chinese economic data, good earnings reports and reduced concerns regarding European banks. US shares gained 0.5%, European shares rose 0.4%, Japanese shares rose 0.3%, Chinese shares gained 0.6% and the Australian share market rose 0.8%. However, the geopolitical tensions saw bonds rally and oil rise. While the euro fell, the Australian dollar was little changed.

• Our thoughts are with those affected by the downing of MH17. We also feel very sorry for Malaysia Airlines and Malaysia generally which has lost two planes this year for reasons that look in large part beyond its control.

• It is the time of year for share market corrections (with the September quarter often being soft for shares), but the initial fall in US and European shares in response to the news regarding the downing of a plane over Ukraine and the latest Israeli/Palestinian conflict looked like an overreaction and this was reflected in the rebound in US shares on Friday. The downing of the Malaysia Airlines plane won’t necessarily increase the risks around Ukraine, it’s likely to have been in error anyway, airlines will simply no longer fly through eastern Ukraine with little impact on international travel and the Israeli/Palestinian crisis has been bubbling away for years with no broader consequences. In some ways it is just a continuation of what we have seen all year with occasional geopolitical flare ups which simply constrain share markets, but without having a major impact.

• While US Federal Reserve (Fed) Chair Janet Yellen’s comments about stretched share valuations in some sectors caused nervousness it’s noteworthy that she also said that in general “price equity ratios and other measures are not outside of historical norms”. The forward PE for the S&P 500 at 15.5 times is around its long term average and well down on its tech boom high of 24.5.

• Should new entrants to the Australian housing market buy or rent? A Reserve Bank of Australia (RBA) paper which concluded that “if house price growth were to be slower than the historical average…then the average home buyer would be financially better off renting” has created much discussion. After nearly two decades of above trend house price growth which has taken housing from being relatively cheap to relatively expensive our assessment has been that we are in for an extended period of range trading around a broadly flat trend for real house prices, which on the RBA’s analysis would point to renting as the way to go. However, it’s more complicated than this. First, the RBA’s analysis ignores the forced saving implicit in buying a house which will likely mean that even if house price growth turns out to be sub-trend home buyers will likely end up building more wealth than renters over the long term. Second, there is more to buying a house than just a financial decision, many would much rather own than rent. Finally, there is a risk to the sub-trend view of house prices if we don’t solve the housing supply shortage.

• Carbon tax no more. It’s a pity that an attempt to put a price on carbon that made sense from an environmental and economic perspective turned into such a political mess.  Just as the introduction of the carbon tax had little macroeconomic impact we can’t see its demise having much impact either. It will cause a temporary fall in inflation of around 0.75 percentage points but the RBA will look through this just as it did the temporary boost to inflation in 2012-13. More broadly the sooner the Senate returns to reality – and starts finding savings to replace the Budget cuts it is threatening to reject the better.

• Dividend imputation is not a distortion. The past week saw the interim report of the Financial System Inquiry question whether dividend imputation was creating a bias to invest in domestic equities and adversely affecting the development of the corporate bond market. The trouble is that dividend imputation actually corrects a bias by removing the double taxation of earnings – once in the hands of companies and again in the hands of investors. It also encourages corporates to give decent dividends to shareholders as opposed to irrationally hoarding earnings. Interest on corporate debt never suffered from double taxation as it is paid out of pre-tax corporate earnings. The removal of dividend imputation would not only reintroduce a bias against equities but substantially cut into the retirement savings of Australian investors and lead to lower returns from Australian shares.

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