After falling across the line at the federal election, the Government believed it had a mandate to change the superannuation rules, which it proposed in the budget and put forward to the electorate. Clearly mandates are in the eye of the beholder (or is it the eye of the government?) and can be changed on a whim – unless it is a mandate to have a plebiscite!
The scrapping of the proposed backdated $500k lifetime cap on non-concessional contributions appears sensible. The $1.6 million pension fund limit likewise seems reasonable, as does the annual non-concessional contribution limit of $100k. In aggregate, the changes appear designed to force the reasonably well off to contribute more from their after tax earnings into their superannuation fund. However, these changes will do little to address the budget problems in servicing a burgeoning public pension liability. Those that do not accumulate significant after tax earnings because of low wages will stay on the public pension.
The problem with the superannuation changes, as they affect the budget, is that they fail to consider changes to one of the holy grails of the Australian taxation system – franking. Indeed, the cost of franking credits will grow exponentially as more people retire and move to zero tax positions. Franking will eat into the budget like a cancer and ensure that our budgets are never balanced.
Consider this bizarre outcome of franking and pension funds. A happily married retired couple with a combined $3.2 million in a pension fund, could easily receive an annual $60,000 in cash-paid franking credits from consolidated revenue. Meanwhile, a relatively poor retired couple with little super will battle to receive a full combined pension entitlement of $30,000.
The superannuation changes are piecemeal and not the outcome of a considered and thorough review. The changes proposed in the federal budget in May did, however, flag the challenges that await future budgets. It is incumbent on governments to stabilize the retirement system and ensure that an appropriate social safety net exists. The superannuation system will inevitably be revisited by future Treasurers and franking rules will be changed – if only to “means test” them so that it is consistent with other entitlements applying to pension recipients.
It has been a crazy few weeks in investment markets. Bond and fixed interest markets went into a tailspin when central banks failed to add more stimuli to their monetary policies. However, a realistic assessment of bond prices would suggest that they had moved too far. Bond yields are too low and the correction was long overdue.
The chart below presents the yield of Australia’s ten year bonds over the last 12 months. The fall in yield since May (reflected by a rally in bond prices) has been extraordinary. The 1.8% yield on ten year bonds, seen in early August, was the lowest ever recorded in Australia. The rally in bonds followed the eye-watering rallies in Europe and Japan where long term yields went to negative.
Australian 10-year bond yields previous 12 months
Figure 1. Australian 10-year bond yields previous 12 months
The recent correction has been sharp but hardly severe.  Ten year bond yields moved back above 2.1%, but this level is still very low and barely above inflation. The question for investors is whether this is the end of the great bond market rally or a mere correction? The answer is uncertain, but it is clear that long term bonds do not offer a fair risk adjusted return – even after the recent correction. Investing in long bonds now would be like “picking up pennies in front of a steamroller”. The risk of capital loss is high and almost certain to occur. Recent weeks have shown that capital losses may occur very quickly.

Source: Seeking Alpha
Bond prices across the world have been influenced by rampaging traders (mainly hedge funds) front-running central bank buying programs. Thus, when central banks hesitate, the traders panic. That is what is currently happening.
The next few charts were presented in the Australian Financial Review as part of an interview with former Governor of the Reserve Bank, Glenn Stevens. They are worth reviewing to put into context the issues confronting the Australian economy.
Australia’s GDP growth remains exceptional when compared to other developed economies. The 2015/16 growth of 3.1% reflected a solid rebound in the face of weak commodity export prices. However, the growth was clearly buoyed by residential building activity with household debt continuing to rise and residential property investment peaking. The Government increased its investment program to offset a weak business investment cycle. Looking forward, it is hard to see a recession developing unless it is a world-wide event or is caused by a meltdown in residential property.
Australian GDP growth
Figure 2. Australian GDP growth
Source. RBA, ABS
The fact that Australia is growing its foreign debt each year at a lower rate than prior to the GFC may be positive, but it is not comforting. The chart below shows that our total foreign indebtedness grows relentlessly each year. The reliance on foreign borrowings by Australian banks to fund their loan books has decreased, but it was simply too high leading into the GFC. This heavy reliance took St George Bank out and all major banks were forced to refinance.
Today, the reliance on foreign equity is growing as State Governments (for instance) persist in selling off strategic public assets to foreign investors. This followed years of massive investment in resource and energy development by international companies. Australia’s net foreign indebtedness (this includes net foreign debt and equity) has breached $1 trillion and will continue to grow by $60 billion per year for the foreseeable future. It is not helped by a trade deficit that sits defiantly at about $25 billion per annum.
Australian net capital inflow (% of nominal GDP)
Figure 3. Australian net capital inflow (% of nominal GDP)
Source. RBA, Bloomberg, ABS
The next chart shows that reported inflation in Australia is at historic lows. The two key factors at play here are low oil prices (petrol) and low mortgage rates that feed into the cost of living. We observe that inflation has been low for two years and this now is flowing into wages (see below). This means that businesses which have historically pushed through annual price increases are now finding it difficult. An obvious casualty will be general and health insurers which have pushed premiums too high in an effort to grow profits.
Consumer price inflation
Figure 4. Consumer price inflation
Source. RBA, ABS
Low wages growth will have an effect on taxation receipts for government. Wages are growing at the lowest rate in over twenty years at a time when the numbers of people moving into retirement is at record levels. We reiterate our opening comments that the Australian fiscal situation needs a thorough review and piecemeal changes (like superannuation) will not address the demographic challenge.
Wage price index growth (%)
Figure 5. Wage price index growth (%)
Source. ABS
The following chart reminds us that the Government has forecast a continuing improvement in the budget outcomes through to 2020. This is highly dependent on China’s economy and our trade in bulk commodities and energy. Export prices and export related tax revenue are as important as the continuing weakness in the $A.
Australian govt. budget balance
Figure 6. Australian govt. budget balance
Source. RBA, Australian Treasury
Export commodity prices peaked in late 2011 but we have seen the first solid bounce in prices since late 2012. Most recently we have seen a moderate recovery in iron ore prices and the remarkable surge in coking coal prices. Our major export commodities are highly dependent on the direction and sustainability of policy settings in China.
RBA Index of Commodity Prices
Figure 7. RBA Index of Commodity Prices
Source. RBA
The RBA is now 5 years into a cash rate cutting cycle in response to overseas monetary policy settings. This cycle is nearing its end point with the policy settings in the US determining where our cash rates will be set from this point.
Cash rate settings across the world are too low and causing a crisis, with pension funds unable to meet their liabilities. Low interest rates have failed to stimulate economic activity and are now driving down returns from investment assets. This is a toxic mix that suggests that interest rates have fallen too far, with the adjustment mechanism to higher interest rates uncertain.
Australian cash rate
Figure 8. Australian cash rate
Source. RBA, Central Banks
The relentless growth in Australian household debt is well reported and the following charts show that the government, RBA and APRA were too slow to react to excesses in residential bank lending. The surge in investor borrowing that commenced in late 2011 was left unchecked until 2015. The effects of excessive investment in high density housing will be felt in 2017, with oversupply expected in the major cities on the East Coast.
Housing loan approvals ($b)
Figure 9. Housing loan approvals ($b)
Source. RBA, ABS
In 2015, building approvals peaked at 21k per month (250k per year). The key issue in the chart below is that higher-density housing averaged 5k per month in 2007/08 and rose to 11k per month in 2015. Completions of units are still to occur and the crackdown on foreign investors (mainly Chinese) suggests that unit prices could fall sharply in 2017. There may well be some significant residential developer problems eventuating, and creating problems for the most exposed Australian banks.
Private residential building approvals (monthly)
Figure 10. Private residential building approvals (monthly)
Source. RBA, ABS
The above charts paint a tough outlook for the Australian economy. While a recession is still a most unlikely outcome, the underlying growth profile of the economy (away from direct government stimulation) is moderate. Of course, it is not always correct to extrapolate the present into the future, but we suspect that the next few years will involve a navigation of:

  1. Lower economic growth rates;
  2. A rise in interest rates and a correction in bond prices;
  3. Volatile economic growth in China;
  4. Continuous changes to fiscal policy to create sustainable budget outcomes; and
  5. Low inflation, moderate employment growth and low wages growth.

The key conclusion from the above is to anticipate only moderate (by historic standards) investment returns. No point in picking up pennies in front of steamrollers.
Originally published by John Abernethy on StocksInvalue as ‘The View’, Wednesday 21st September 2016.