Autumn 2007

Not every tax break is dodgy

Swiss bank accounts, investing in ostrich farms …
some people go to great lengths to reduce their tax.
But if you’re looking for legitimate tax benefits,
prepaying the interest on your margin loan could
be a good place to start.

Markets and performance: what's been driving investment returns?

The Chinese economy continues to grow at a remarkable pace, and the US sharemarket hits an all time high. How did this impact on your investments in April?

How interest rates can impact on your investments

We all know how interest rates affect our home loan and credit card debts, but do you know how they can affect your investments?
Read how, and find out our rates forecast...

...and where are rates heading?

BT's Chief Economist, Chris Caton, gives his outlook for rates, talks Budget, and tells why we should remain alert to the US economy.

Not every tax break is dodgy

Swiss bank accounts, investing in ostrich farms … some people go to great lengths to reduce their tax. But if you’re looking for legitimate tax benefits for this financial year, prepaying the interest on your margin loan could be a good place to start.

When you borrow money to buy an asset that produces assessable income, the interest you pay is deducted from your overall taxable income and may reduce your tax. By paying next year's interest on your margin loan by 30 June this year, you may be able to claim the amount of interest you pay in advance for next year as a tax deduction for this financial year.

Case study: How prepaying interest can be a tax-effective strategy

Objective:

Damien’s objective is to create wealth so as to achieve greater financial independence sooner.

Strategy:

Damien’s investment portfolio value is $180,000 with a borrowed amount (margin loan) of $90,000. He bought his investments on 1 March and decided to prepay 12 months of interest instead of paying variable interest at the end of every month.

Outcome:

By doing this Damien was able to:

• Lock in a competitive interest rate for the upcoming 12 months protecting him from any rate rises.
• Increase his tax deduction in the current financial year, making Damien over $2,000 better off!

Why:

If Damien was to pay his interest one month at a time he would only be able to claim 4 months interest this financial year (March to June 2007), but by prepaying his interest in advance he is able to claim a full 12 months interest this financial year (March 2007 to February 2008).

Assumptions: Results are net of tax and borrowings with no change to the prepaid loan balance. Variable interest rate 9.15% pa non-compounding, prepaid interest rate 8.90% pa. Capital growth of 4.5% pa and distribution yield of 4.0% pa. Marginal tax rate including Medicare levy 41.5%. Margin loan drawn down 1 March. Portfolio is geared at 50%.

It’s worth noting that prepaying interest may provide an overall saving when a person’s taxable income in one year is higher than that expected for the following year. The potential advantage may also be reduced by any cash flow impact created by prepaying.

Things you should know about prepaying your interest

Before you decide to prepay your interest, you may want to discuss this strategy with your financial planner, to see whether it fits your own personal circumstances.  

• Prepaid interest is not refundable.
• Terms available for prepaid interest are 3, 6, 9 and 12 months

Discounts on interest rates are available

Invest to save tax or invest to make money?

It does makes sense to consider the tax implications of your investments, but one of the easiest investment traps to fall into is concentrating on saving tax and forgetting why you invested in the first place - to make more money.

To do a quick review of the potential tax benefits of margin lending, visit our education page on the BT website.

Markets and performance: what's been driving investment returns?

Stronger share markets were a major theme throughout the month of April as investors appeared to put 27 February’s market correction firmly behind them. So far this year, the global economy has proven remarkably resilient, with softer growth in the US being offset by stronger growth elsewhere, and this has been a key contributor to recent market strength generally.

The US share market hits record high

Despite a month of mostly softer economic data, the US share market continued its strong run throughout April, with the Dow Jones Industrials Index pushing past the 13,000 mark for the first time ever. Since its lows in early March, the Dow has rallied over 8%, closing April at 13,063 as ongoing merger and acquisition activity and some solid March quarter company profit results combined to drive the market higher.

^{*Source Datastream}

But perhaps the biggest news out of the US in April was the weaker than expected March quarter GDP numbers. The US economy grew at its slowest pace in four years in the first quarter of 2007 as the US housing sector in particular continued to weigh on economic growth. While the US Federal Reserve (Fed) has hinted that it’s more concerned about inflation than growth, the latest GDP figures nonetheless make for interesting reading. Why? Because if inflation was to rise too much, the Fed might be forced to raise interest rates in response, which would have the effect of slowing economic growth even more.

Stagflation

Stagflation is a term coined by economists in the 1970s used to describe an environment of slow economic growth and rising prices (inflation). This is a situation that the Fed will be working very hard to avoid, although any talk of stagflation at this point is probably a little premature. It’s likely that slower growth in the US will actually take the pressure off inflation, which would enable the Fed to start cutting interest rates later this year. Besides, inflation appears to be moderating and the Fed has already said that it expects growth to pick-up in the second half of the year.

Chinese growth still strong

Although US economic growth may have slowed, the growth outlook for the rest of the world, including China, remains strong, adding support to the view that the current global expansion still has further to run.

Since suffering its largest one-day fall in 10 years in late February, the Chinese share market had rallied nearly 40% as at 30 April 2007.

^{*Source Datastream}

The market’s rise has been underpinned by continued robust economic growth in the country, which came in at 11.4% for the year to 31 March 2007, up from 10.4% in the December quarter. Although stronger growth and rising inflation in China will no doubt see authorities raise interest rates to try and bring the country’s growth rate back to more sustainable levels, any such moves are likely to be mild.

Australia benefiting from Chinese growth

One country that has continued to benefit from strong Chinese growth is Australia. China’s appetite for resources has in part contributed to higher commodity prices in recent months and this has had a positive effect on our local resource stocks, helping to push the local bourse higher.

The resilience of the global economy contributed to positive returns for international shares and listed property trusts during the month. The BT International Fund returned 0.79% in April (after management fees), the BT European Share Fund rose 3.42%, BT’s Asian Share Fund was up 1.64%, and the BT Property Securities Fund returned 2.80%. Bond markets benefited from signs that inflationary pressures are beginning to fade, and this contributed to the performance of the BT Fixed Interest Fund, which returned 0.59% in April.

Reserve Bank of Australia leaves interest rates on hold

The Reserve Bank of Australia (RBA) decided to leave interest rates on hold at 6.25% at its early May meeting following some better than expected inflation data. Local headline inflation rose just 0.1% in the March quarter and came on the back of a 0.1% fall in the December quarter. Importantly, though, the Bank’s preferred measures of underlying inflation were again benign, so although the economy remains solid, it’s possible now that rates will stay on hold until at least after the Federal election later this year.

Statement on Monetary Policy

With the RBA’s decision on interest rates out of the way, investors turned their attention to the Bank’s Statement on Monetary Policy released a few days later. Following the recent inflation figures, the Bank lowered its 2007 inflation forecasts but appears to have retained its mild tightening bias, i.e. local interest rates are more likely to go up than down.

Australian share market makes it nine in a row

The local share market continued to perform well in April, with the S&P/ASX 300 Accumulation Index returning 3.00%. It was the market’s ninth straight month of positive returns and came on the back of positive news on interest rates, stronger commodity prices and ongoing corporate activity. BT’s Australian share funds also performed well over the month. The BT Australian Share Fund returned 2.03% in April, the BT Imputation Fund rose 2.38% and the BT Ethical Share Fund was up 2.09%.

Looking ahead

The level of market volatility that we saw throughout February and March appears to have faded somewhat, particularly if April’s market returns are anything to go by. While concerns over US growth will obviously remain a focus for investors, growth outside of the US appears to be holding up pretty well. Domestically, the economy remains on a pretty sound footing, and with interest rates seemingly on hold for the time being, there’s probably few major surprises expected in the coming month.

With global share markets having rallied strongly in the last couple of months, we could be in for another market correction in the short-term. The events of late February showed just how quickly sentiment can change, so if the market does correct, there’s the potential for it to correct quickly. However, while some sort of retracement is a possibility, the long-term outlook for global share markets remains sound. Merger and acquisition activity, particularly in Europe, where the value of deal-making has surpassed that of the US this year, will remain a key driver of market performance as more investors try to find homes for their money.

How interest rates can impact on your investments

We all know how interest rates affect our home loans or credit card debts. But what do movements in interest rates have to do with the economy? How do they influence exchange rates, the value of shares and company profits?

...and where are rates heading?

It is said that a week is a long time in politics. A month may or may not be a long time in economics. A month ago, I wrote about the possibility of a further “correction” in the share market (and the possible role played in that by a slowing US economy), about the incredibly strong currency, and about the likelihood of an interest-rate rise in Australia.

The domestic rates outlook

The outlook for the last of these (only) has changed. The Reserve Bank of Australia passed up the chance to raise the short-term cash rate in April. Its opportunity to act has since effectively been taken away by a remarkably benign CPI inflation report for the March quarter. If you’re an inflation-targeting central bank, it’s hard to raise rates when inflation is within your target zone, and apparently falling.  So investors, mortgage holders and the Prime Minister can relax. It is unlikely that interest rates will rise in Australia this side of the election.

A month ago, it seemed obvious that the expectation of higher interest rates in Australia was a major factor pushing the currency up. Now that expectation has gone, but the exchange rate is still very high. This has hurt investors with unhedged money offshore, but in my opinion the currency is more likely to fall rather than rise further, so from now on it should work for those who are invested offshore.

The US - be alert, not alarmed

Share markets have had another good month. As I type, the Dow is at an all-time high in the US, and the ASX is not far short of its recent peak. The Dow went through the 13000 barrier just 188 days after it passed 12000 for the first time. In contrast, there were 2726 days between the first time it reached 11000 and the first time it reached 12000.

It won’t hit 14000 in the next six months! We’re still waiting for the “second shoe to drop” in the United States. That economy has clearly slowed, due mainly to a full-blown recession in the housing sector, but so far the overall economy has managed to continue to eke out growth. Not that there hasn’t been a slowdown — GDP growth in the year to the first quarter slowed to just 2.1%, from 3.7% a year earlier. The economy has been kept above water by the voraciousness of the American consumer. Consumption spending has not slowed at all, increasing by 3.4% in the past year. Presumably consumer spending will hold up so long as jobs growth is good, and there is no sign of that faltering yet. But there never is until it’s too late to do anything about it.

A US recession is unlikely this year, but by no means out of the question. If it happens, share markets will suffer, both here and there. Investors should therefore be alert, but not alarmed, about the state of the US economy.

Costello answers the question 'how to spend all that money?'

May is, of course, Budget season and its déjà vu all over again. The Budget exercise this year was a challenging one. The economy, as the Reserve Bank has reminded us, is strong, and hardly in need of fiscal stimulus. But an election looms, and the temptation to buy votes, and to make sure that there’s not a lot left in the till for the Opposition to fund its promises, is very strong.

Without being too crass, the Government is looking for maximum votes for its buck, without being economically irresponsible.

Once again Treasurer Costello has faced a problem that we all wish we had. Revenue has again been flooding into the government’s coffers, led by continuing strong growth in company tax collections, as a result of the commodity price boom. Company taxes are expected to grow by 19% in 2006/07 and by a further 11% in 2007/08. The Treasurer has done his best to alleviate this problem, undertaking to shovel $3.9 billion out of the door even before the end of the current financial year, mainly in payments to seniors and low-income earners. Even with this largesse, the estimated fiscal balance for 2006/07 is expected to come to $11.9 billion, still higher than the $10.3 billion expected at the time of last year’s budget.

But the largesse doesn’t stop on 30 June. The Budget includes yet another tax cut, this time totalling $31 billion over the next four years, and there is a further $30-35 billion in extra spending over the same period. Thus the four-year effect of the Budget comes to some $67 billion (don’t forget the $3.9 billion this year), compared with the $58 billion last year, $37 billion in 2005/06 and $45 billion in 2004/05. The Murray/Darling may be drying up, but the rivers of gold are still flowing through Canberra. And still the underlying surplus totals $49 billion over the next four years, which augurs well for the Future Fund.

If you’ve read this far, you deserve to be let in on a secret economists have been keeping for years. The Budget is still a very important document from the point of view of priority setting, but its short-term implications for financial markets, and hence for investors, are rarely important these days. Economists don’t tell people this, of course, since that would drive down their value.

One last thought: the Government has presumably held something back in the Budget, so that it can finance a further vote-buying exercise closer to the election. Of course, this leaves the Opposition with the ability to fund some of its promises as well.

Chris Caton

Chief Economist