How tax hikes, carbon tariffs and inflation affect Aussie investors
Short term volatility looms as structural change in the global economy continues, according to a survey of money managers, tax specialists and analysts.
A hike in capital gains tax in the US, higher corporate taxes globally, carbon tariffs and ambitious emission reductions targets. The deluge of recent policy announcements may seem far away to Australian investors but the future arrives quickly and can transform portfolios.
Morningstar spoke to tax lawyers, portfolio managers, equity analysts, and economists to understand these developments and what they mean for the Australian investor.
Higher US capital gains taxes only a short-term bump for markets
A proposed increase in US capital gains tax could cause short-term volatility in equity markets but is unlikely to linger, says Brad Bugg, head of multi-asset strategies at Morningstar Investment Management.
The top tax rate on capital gains would rise to 39.6 per cent from 20 per cent, under a plan proposed by the Biden administration. The tax aims to help fund the administration’s US$2 trillion investments in housing, infrastructure, and climate action.
"In the longer term it will wash out but in the shorter term there could definitely be some impact on markets," says Bugg.
“In 1986, capital gains taxes went from 20 per cent to just under 30 per cent. In 2013 it went from 15 per cent to 25 per cent. In both those instances there were short-term drawdowns of about 5 per cent, but the losses quickly recovered."
Bugg is more concerned about what he sees as signs of excessive optimism.
"The thing which worries me the most is the general optimism in markets. When that becomes consensus, we typically see reasonable corrections on the back of it."
Aussie firms mostly safe from higher corporate taxes
Proposals to raise the corporate tax take globally are unlikely to impact most Australian firms, thanks to a combination of strict local tax law, and the domestic focus of many firms, according to some tax specialists.
The Biden administration is trying to reverse decades of racing to the bottom on corporate taxes by reviving stalled international negotiations. Under an OECD plan, “Pillar One” would force the world’s biggest companies to pay taxes on profits made where goods or services are sold, not where the company headquarters are located. “Pillar Two” would establish a global minimum rate for corporate tax.
“The contest now is not whether there will be a new international tax order,” says David Watkins, who heads Deloitte Australia’s Tax Insights & Policy group. “The contest is whether that new international tax order will be coordinated or uncoordinated.
“For Australian outbound companies, some of the profit targeted by Pillar 2 is already taxed under the controlled foreign company rules,” says Watkins.
“The question is: how large is the incremental tax hit under Pillar 2?”
The good news for investors is that, with 140 countries on board, higher taxes are likely to apply evenly. If a company must pay higher taxes, their competitors will too, says Watkins, thereby avoiding too much of a disruption to the global playing field.
Still, whenever there is a structural change in cost in the form of say higher taxes, investors should consider the company’s competitive position, says Morningstar director of equity research Adam Fleck.
“Firms with wide moats based on intangible assets can pass on higher costs. No moat firms in cutthroat industries could be challenged,” he says.
Australian firms tend to be quite insulated from the world, says Fleck, although there are exceptions. Building material firms such as James Hardie (ASX: JHX) or pallet maker Brambles (ASX: BXB) and healthcare companies such as CSL (ASX: CSL) or Cochlear (ASX: COH) have large foreign operations.
Carbon tariffs hinge on China
EU carbon tariffs levied on Australia’s exports are only likely to have a small impact, according to modelling by Philip Adams, Professor at Victoria University.
Carbon tariffs are import duties levied according to the amount of carbon in a product. Countries with emission-reducing regulations want to protect themselves against competitors with lax regulations. This could soon include Australia.
Carbon tariffs are part of the European Union’s “Green Deal”, a suite of policies targeting net emissions by 2050. Details will be tabled by the European parliament in June.
Adams’ modelling found the long-run impact of EU tariffs would only equate to a week’s worth of growth. Coal mining would be the main loser, with production falling 3.8 per cent.
"Effects will be negative but very small. Not because the carbon tariffs will be small but because the EU is not a big export market for Australia,” says Adams.
His paper only studied tariffs between the EU and Australia, but were tariffs extended to Australia’s major trading partners, the impact could be more severe.
"Suppose the EU put carbon tariffs on China. I suspect the impacts on Australia would be more profound than a tariff directly on Australian products,” says Adams.
"A lot of Chinese exports to the EU use Australian imports like iron ore, LNG, and coal. Any Chinese steel producers penalised by the EU would directly flow through to Australian iron ore producers, for example."
Global climate action could be an opportunity for Aussie investors
Last month the US announced a new emissions reduction target. President Biden committed to a 50 per cent reduction of 2005 levels by 2030. Japan and Canada upgraded their commitments, while the EU and UK are pushing ahead with ambitious net zero targets.
Some money managers suggest investors should look past the political announcements and partisan back-and-forth to examine how climate action will affect their investments.
One such voice is Will Baylis, lead portfolio manager for the sustainable equity strategy at Martin Currie.
"We built a shadow carbon price into our investment process for every company in our investment universe,” says Baylis.
“We have long taken the view that high emitters will face an economic cost to their valuation and future cash flows.”
"In 2021 none of these policies are law. But we need to take pre-emptive investment decisions, so we are not landed in 2023, 2024 or 2025 with a company that has lost half its value."
Aggressive policy action overseas can create opportunities for investors, says Baylis, who cites engineering and consulting company Worley (ASX: WOR) as one example.
"Worley is doing lots of work in the US about extracting carbon from the atmosphere. Woodside could also be a massive beneficiary in 10 or 15 years if it actually ends up exporting hydrogen to Japan."
Worley closed Thursday $10.93, below Morningstar’s fair value estimate of $12. Another name to watch is oil and gas producer Woodside Petroleum (ASX: WPL), which is a 5-star stock, trading at a 42 per cent discount on a fair value estimate of $40.
You can stop worrying about inflation – for now
Markets hosted a duel this year between investors warning about higher inflation and higher rates, and central banks insisting that any inflation will be temporary.
Initial results favour central banks. Headline inflation only rose 0.6 per cent in Australia in Q1, according to the ABS on Wednesday. The annual rate of 1.1 per cent for trimmed mean inflation – the RBA’s preferred measure – is the lowest on record. Elsewhere on Wednesday Federal Reserve chairman Jerome Powell used a regular press conference to put positive job growth in context.
“We’ve had one great jobs report, it’s not enough. We’re going to act on actual data, not our forecast,” Powell said.
“We’re a long way from our goals.”
Morningstar’s Bugg tends to side with central banks and doesn’t expect any unexpected inflation outbreaks.
“When the RBA says we won't see a higher cash rate till 2024, there's a good chance that's the likely outcome.
"Markets are going to be supported by these very low levels of bond yields for some time.”
The contest over higher inflation started when yields on long-dated bonds began to rise last year. Investors sold the bonds—price are inversely related to yields—on the expectation of economic recovery and higher inflation.
The US 10-year bond yield rose from 0.91 per cent on 31 December 2020 to a peak of 1.72 per cent in late March.
Inflation erodes the purchasing power of future income and long-dated bonds are especially vulnerable because the income stream stretches years into the future.
Were those expectations to materialise into rapidly rising inflation, central banks could be forced to raise interest rates, which in turn would slow down the economy and hurt companies whose valuations depend on low discount rates.
The RBA insists rates won’t rise until “at least 2024”. That’s how long it thinks is needed for lower unemployment to create the wage growth needed to lift inflation. It’s a similar story in the US and the EU.
Investors should still stay cautious about a quick change in market conditions and monitor bond yields, says Morningstar head of equity research Peter Warnes.
“Investors should be conscious and increasingly aware of the risks of overheating and the ultimate consequences of a possible more aggressive tightening,” he says.
“Keep a close eye on bond yields, particularly in the second half of the year and take some precautionary action by reducing exposure to bond proxies and high valuations supported by low discount rates.”