Election 2016: Bad news for the banks?

Time to consider the potential casualties of Saturday's election.

Summary: An even more diverse Senate is a recipe for bigger budget deficits and a downgrade to Australia’s credit rating - with implications for bank shares.

Key take out: The election has created a degree of political uncertainty that the Australian economy and financial markets can ill-afford. At stake is Australia’s AAA credit rating.

Key beneficiaries: General investors. Category: Economy. 

The Australian people have had their say and, although we don’t yet know who will form government, we do know the Senate will be even more colourful and controversial than the one that created so many problems for the Abbott/Turnbull Government.

The situation creates a degree of political uncertainty that the Australian economy and financial markets can ill-afford. But it’s the broader implications that are more important.

At stake is Australia’s AAA credit rating, which underpins the valuation of Australian banks and, ultimately, leads to lower borrowing rates for households and businesses. It also raises the likelihood that the Reserve Bank will cut rates again.

Both major parties put together a fiscal outlook that would maintain Australia’s AAA credit. This outlook face two key problems:

  1. They are based on unrealistic forecasts for tax revenue that are much higher than can be achieved;
  2. They ignore minor parties and independents which, as we learned over the past three years, can hold up government initiatives.

Both factors will push Australia closer to a credit rating downgrade, probably within the next couple of years.

Source: Moody's 

Budget blues

Every year since the global financial crisis, the treasurer of the day has promised that tax revenue will eventually return to its pre-crisis level. The following year, without fail, those forecasts were revised down significantly.

With both major parties promising that revenue will skyrocket, this election was no different. Admittedly, superannuation reforms will broaden the tax base somewhat, as would the proposed changes to negative gearing and the capital gains tax discount from the ALP. Offsetting this, the LNP plans to push through a series of company tax cuts.

Nevertheless, it won’t be enough to replicate the revenue rich environment that allowed former treasurer Peter Costello to maintain a regular budget surplus with consummate ease.

These days, Australia faces falling commodity prices and an ageing population as "baby boomers" begin to retire. Meanwhile, credit growth has slowed. Where it has been strong it has been largely concentrated in Sydney and Melbourne.

These structural trends are often ignored but have been a leading source of political uncertainty, contributing to below trend economic growth and disappointing returns on the ASX200.

From a tax revenue standpoint, the period from 2001-2007 was the exception rather than the rule. Our major parties continue to pretend otherwise because admitting that a return to surplus is almost impossible is a sure-fire way to electoral defeat.

Senate effect

Minor parties and independents complicate the fiscal situation. Neither major party has a mandate and neither party will be able to pass key legislation without compromise. The Abbott/Turnbull Government struggled to negotiate with the existing Senate, hence the double-dissolution election. Whichever party emerges victorious from the current uncertainty, the government will face a Senate with an even greater diversity of interests.

This is a recipe for bigger budget deficits and a downgrade to Australia’s AAA credit rating. The major credit rating agencies are already sceptical about Australia’s budget outlook and further political uncertainty may force their hand.

A downgrade to Australia’s credit rating feeds directly into a decline in the price of bank shares. The major banks trade on the good reputation of the federal government, which enables low cost foreign funding. Higher funding costs are unavoidable and will be passed onto consumers in the form of higher interest rates. Other domestic shares will also take a hit, while the premium on government bonds will increase.

With a hostile Senate, savings measures will be delayed or renegotiated and key legislation and core promises will be scrapped. The major parties will pay a high price to secure the votes of the minor parties and independents. Any meaningful reform is at best compromised and potentially off the table altogether.

The credit ratings agencies won’t downgrade Australia immediately but investors should position themselves for this possibility. Portfolios will benefit by gradually reducing their exposure to domestic banks – they don’t have to be eliminated as an investment vehicle but they also shouldn’t dominate.

A good alternative is to increase exposure to overseas equities, which may suffer in the near-term due to uncertainty surrounding Brexit, but also offer upside as central banks cut interest rates and ramp-up quantitative easing. This would also hedge domestic investors against a fall in the Australian dollar.

What about interest rates?

The Reserve Bank did not mention the federal election in their monthly board statement. They kept the cash rate unchanged at 1.75 per cent on Tuesday but the market continues to price in a 52 per cent chance of a rate cut in August. The market is also pricing in a 42 per cent chance of a second rate cut by June next year.

The RBA is fighting battles on multiple fronts. A currency war is developing as everyone from the United Kingdom and the euro area to Japan and the United States seek a weaker currency. Financial and political uncertainty arising from Brexit complicates matters further. A hung parliament is a headache no one needs right now.

This all but guarantees lower interest rates in the future. This will help to offset some of these political risks, as well as the risks to our AAA credit rating. A decisive cut next month could be sufficient to settle domestic markets, particularly if the Reserve Bank maintains an easing bias. The main risk from its perspective is that they are quickly running out of ammunition.

Investors will need to balance these political risks, as well as Brexit and the possibility of a credit rating downgrade, against what the RBA can achieve via lower interest rates. Markets are being moved by broad-based macroeconomic and political factors rather than market fundamentals and company news.

Volatility is the most likely outcome across traditional asset classes such as shares and bonds; the dollar should fall further but that might be undermined by central bank activity abroad.