The US Government Shutdown – big concern or potential opportunity?

 The news is currently full of dire predictions as the so-called US government shutdown has entered its second week and with the Republicans showing little sign of giving in and passing a “continuing resolution” to enable the Government to continue to spend, including on affordable health care (Obama care). My view is, don’t panic, this is not as bad as it sounds unless you are a US Government employee or a tourist wishing to visit a museum or a national park. Only the 36% of US Federal spending classified as “discretionary” is affected so things like Social Security payments (broadly equivalent to things like our Age Pension), for example, continue to be made. Also, while there hasn’t been a shutdown since the days of President Bill Clinton in 1996, before that there were 17 shutdowns between 1976 and 1996. It is important to note that in each case, life as we know it eventually resumed. Most of us have forgotten that these shutdowns even occurred.

It’s difficult for Australians to understand all the fuss about something which is only approaching universal health care, something we take for granted, but the conservative “Tea Party” element of the Republican Party seems to regard it as akin to a socialist plot. As there is no election due until 2016, the Republicans have no near term opportunity to have the Affordable Care Act repealed so are using their power in Congress to effectively blackmail Obama into delaying it. He’s not budging.

Failure to raise the Debt Ceiling

Potentially more serious would be a failure later this month to raise the US debt ceiling.  The debt ceiling on the US Administration is self-imposed by legislation and is raised periodically. Debt default by the US Government could have significant negative consequences in global financial markets. Let’s hope sense prevails and this political fight ends before the US actually defaults on any obligations i.e. doesn’t repay maturing debt or interest owing on the due date.

There are always risks in investment markets but in my view it is very unlikely that this impasse will persist for too long as all politicians have too much to lose. Consequently, any further weakness in investment markets is arguably a buying opportunity for those who were already considering an investment.

The importance of taking a long term perspective and not being too distracted by short term events – wars, earthquakes, terrorist attacks, financial crises, whatever – is highlighted by the performance of share markets over the past 25 years – refer to the attached Colonial First State graph.

 Is the Australian housing market a bubble?

As I said last month, most Australians are keenly interested in what’s happening in the residential property market. In few countries do people pay so much attention to the ups and downs of the residential property market.  Recently there have been numerous stories in the media about the rise in property prices this year, particularly in Sydney & Perth, and to a lesser degree in Melbourne and elsewhere. Investors are currently much more active than home owners. Are we in a property bubble, which is normally defined as house prices being currently significantly overvalued?

Probably not. There is no doubt prices in the inner suburbs, particularly for properties costing less than $1 million, have been rising this year and in some cases selling well above reserve. Wages growth, low interest rates, investors looking for “safe” assets and continuing population growth are all contributing to demand. However, the (boring old) statistics indicate that there is currently no bubble, just strong demand that’s not matched by weak supply of new houses. This conclusion is supported by bank lending which remains at subdued levels, supporting the view that there is currently no bubble.

For some background information on housing bubbles in Australia, Wikipedia has an interesting piece:

http://en.wikipedia.org/wiki/Australian_property_bubble

Interest Rates – where to from here?

 Expect rates to stay low for some time. It is worth remembering that Australian interest rates, which are at historic lows, are only so low because the Central Banks in the struggling economies of the US, Europe and Japan have pushed their rates so low.  President Obama has nominated Janet Yellen as chairwoman of the Federal Reserve.  Assuming her appointment is confirmed by the US Senate, expect to hear a lot more of that name as she would be the first woman to chair the US Federal Reserve, one of the most important economic policy-making jobs in the world.

As Yellen is known to hold “dovish” views on monetary policy (which means she is more concerned with reducing unemployment than fighting inflation ), it seems fairly clear that there will be no substantial rise in US rates in the next year and possibly longer.  Interest rate increases seem equally unlikely in Europe given on-going concerns about low growth and high unemployment. Accordingly, it seems safe to assume our interest rates will stay around current levels for some time. Yes the Reserve Bank is concerned about any rapid rise in house prices but the Australian economy is growing more slowly – around 2.5% – than desired and unemployment is forecast to rise so a rise in our interest rates is unlikely.

At some point interest rates globally will increase by at least several percentage points to bring them back to more “normal” levels (perhaps a US Fed Funds rate of around 4% compared with 0.25% currently) but that still seems to be some way off. Similarly with the RBA cash rate which might go back to around 5% from the current 2.5% in time. In the meantime, borrowers can enjoy the opportunity to repay debt more quickly as interest costs remain low.

…. Investors need to accept lower returns

For investors, the outlook is not so positive unfortunately – expect today’s low rates to continue for some time.  As I have said before, security of capital is a paramount concern for many investors, particularly retirees. It is better to accept that we are in a world of lower returns and it can be dangerous to chase higher returns if the risk is either unknown or out of line with your financial circumstances and your ability and willingness to take risk.

 Where to for the Australian Dollar?

 In short, no-one knows. Last year most pundits were predicting it would remain well above parity with the USD, and many were predicting it would continue to rise. Six to 12 months later and the new consensus was that the AUD was over-valued and would likely fall to the low 80 cent range or possibly below, more in line with its average value since it was floated back in December 1983.

Exchange rates are frequently volatile and its worth remembering that the value of our currency depends on what is happening here but equally as important is what is happening in the rest of the world. The Australian dollar is reportedly the 5th most traded currency in the world, accounting for around 7.5% of the world’s daily FX turnover. Much of this trading is speculative so the currency can move around considerably from day to day, let alone month to month or year to year.

Exchange rates are much more difficult to forecast than interest rates, certainly in the short term, but my view is that the AUD should fall somewhat from its current level of US 94 cents over the next 6 months. I share the view that Australia struggles to be globally competitive with our exchange rate where it is so a further downward adjustment to perhaps the low 80’s is likely. The US economy is strengthening and this will eventually result in higher interest rates and make the USD relatively more attractive compared with the AUD.  This is why my preference remains for unhedged overseas investments. (Unhedged means your investment will benefit from a falling AUD but be negatively impacted if the AUD rises). However, as currency forecasts are typically wrong, this forecast may simply prove to be another example!

This newsletter is not advice and provides information only. It does not take account of your individual objectives, financial situation or needs. You should consider talking to a financial adviser before making a financial decision. 

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