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ATO set sights on 27,000 funds in ongoing crackdown

While efforts by tax agents and the ATO has seen a dramatic drop in the number of non-lodgers, 27,000 registered SMSFs that have not lodged since their establishment remain on its radar.

         

 

Speaking at the CA ANZ National SMSF Conference ATO deputy commissioner James O’Halloran said the ATO identified 49,000 SMSF non lodgers at July 2018.

Since then, around 22,000 of these funds have either engaged with the ATO and lodged all overdue SMSF annual returns or decided to exit the system and wind up their fund, said Mr O’Halloran.

“No matter how large a compliance issue may be, if the SMSF and their adviser are genuine in wanting to return their SMSF to complying status, if they engage with us we will work with them to try to find a resolution,” he said.

While there has been a significant drop in the non-lodgement rate, the ATO is still monitoring around 27,000 registered SMSFs that have not lodged since their establishment, he said.

This includes some 8,900 funds that registered in the 2016/17 financial year and have not as yet lodged their 2016/17 return.

While this number is improving, we’re concerned that in some cases, this may be an indicator of illegal early release of funds, said Mr O’Halloran,

“So we will continue to look at funds that have not lodged a return since they registered where we can see that at least one of the members has rolled money out of an APRA super fund account,” he said.

 

Miranda Brownlee
21 September 2018
smsfadviser.com

 

Reverse mortgages: Short-term gain, long-term pain

Residential property has long been a major store of wealth for average Australians.

           

 

The home remains the primary assets for the majority of people and the property market – particularly in major cities – has generally been kind for those who were in the market over the past decade or so.

But with the ageing of the population, the percentage of wealth locked up in residential property ($500 billion in home equity is held by people over 65) is both a blessing and a challenge.

According to the last Intergenerational Report in 2015, the number of people in Australia aged between 65 and 84 is forecast to double by 2054 to around 7 million, while the number of people over 85 is expected to more than quadruple.

There is no disputing that owning your own home is a foundational step on the pathway to providing for a comfortable retirement. But the problem is perfectly captured for older Australians with the expression “asset rich but income poor”.

The challenge for many in the post-war, baby boomer generation, is that while the house value may have risen well beyond their expectations, you can't use it to pay for the groceries, house repairs or a car that needs replacing.

Downsizing has its advocates but comes with lifestyle challenges such as forming new friends and community contacts. So it is no surprise that there is considerable interest in developing a viable suite of products to release the equity locked up in the family home.

While the need is obvious, the solution less so, and products like reverse mortgages do not enjoy good reputations. A recent review by ASIC of reverse mortgage products acknowledged that a common view amongst retirees, and even among finance brokers and lenders, tends to be that equity release products take advantage of vulnerable elderly people.

That certainly accords with a personal experience of reverse mortgages courtesy of a family friend who, with her husband, took out a small ($50,000) reverse mortgage against the equity of their mortgage-free home.

It certainly helped provide some short-term cash and lifestyle enjoyment, but after the husband developed cancer and passed away, an early exit condition was triggered resulting in a massive bill that wiped out almost all their household savings, and left the wife wholly dependent on the age pension to live.

The ASIC review of the reverse mortgage market came after government changes in 2012 to strengthen consumer protections, including the provision of a no negative equity guarantee – that is the borrower cannot be required to repay more than the value of the secured property at the end of the loan.

The ASIC report is interesting in that it found reverse mortgages were satisfying the immediate or short-term needs of borrowers, as did the case study above, and often provided for an improved standard of living while letting people “age in place”.

Where ASIC found challenges in the market was with the long-term impacts on the borrower's asset position and, in particular, the impact of the cost of the reverse mortgage products that only became fully understood when potentially the home needed to be sold to provide a bond for entry into an aged care facility.

That was highlighted by many of the borrowers surveyed for the ASIC report who indicated that they had not seriously considered their possible future needs.

Reverse mortgages are complex and expensive products for both the borrower and the product provider, and the ASIC report does a good job at explaining the short-term benefits and the long-term risks and lifestyle implications that comes with it.

The ASIC study tested the impact on the remaining home equity by the age of 84 (the average age of entering into aged care) if interest rates on the loan rises and if property prices grew more slowly than expected.

What the ASIC modelling showed was that 63 per cent of borrowers may end up with less equity than the average upfront cost of aged care ($380,000) for one person by the time they reach 84.

The long-term risk for borrowers is that, because of the impact of compound interest, they may seriously compromise their future retirement lifestyle and ability to afford future expenses such as aged care accommodation, medical treatment and day to day living expenses.

To illustrate the costs over the long-term ASIC says the interest charges on an average loan ($118,000) came with an interest bill of $100,963 over 10 years and $180,269 over 15 years.

One of the major warnings ASIC has for borrowers is the focus on short-term objectives with “limited or no attention” being paid to their possible future needs. The review of loan files ASIC did as part of the report found “approximately 92 per cent of the loan files we reviewed did not record the possible future needs of the borrower in sufficient detail and contained no evidence that the broker or lender had discussed how a loan may affect the borrower's ability to afford future needs”.

The bottom line is that there are no silver bullets that can magically solve the income in retirement question but a clear message from the ASIC report is that you need to carefully balance both today's needs and your likely future requirements.

The ASIC Moneysmart website provides a comprehensive guide to the risks of reverse mortgages.
 

Written by Robin Bowerman
Head of Corporate Affairs at Vanguard.
24 September 2018
vanguardinvestments.com.au

 

ATO updates crypto guidance

The ATO has updated its guidelines on the tax treatment of cryptocurrencies, including issues on exchanging one cryptocurrency for another and record-keeping requirements.

         

 

In an update on the ATO website following its earlier guidance in July, the tax office has advised that if you carry on a business that involves transacting with cryptocurrency, then trading stock rules apply, rather than capital gains tax (CGT) rules.

Further, following 799 pieces of inpidual feedback and submissions, the ATO has provided additional guidance on the practical issues of exchanging one cryptocurrency for another and the record-keeping requirements.

Some of the issues raised included difficulties in keeping records due to high-volume trades or accessing data required for proper record keeping.

“As part of our research, we discovered low-cost software solutions that would be able to both record each cryptocurrency transaction (including cryptocurrency to cryptocurrency transactions) and convert the value of the proceeds into Australian dollars,” said the ATO in response.

“The software can take information directly from the exchange or a digital wallet and do the calculations, which helps alleviate the issues with recording trades and accessing data.”

According to the tax office, where you exchange one cryptocurrency for another cryptocurrency, you dispose of one CGT asset and acquire another CGT asset.

Taxpayers must compare the CGT cost base of the cryptocurrency item disposed of with the market value of the new cryptocurrency item obtained for all exchange transactions.

The ATO will continue to monitor community feedback and provide updates on new and emerging cryptocurrency risks.

 

Tax&Compliance Reporter
18 September 2018
accountantsdaily.com.au

 

What a financial adviser can add to your portfolio’s returns.

         

 

A 16 year study by Vanguard (latest report from July 2018) has found that this figure is about 3% net. 

This is over and above what might be generated by non-planner assisted investment activity.  This means that even for small investors, a financial planner will not only pay for themselves but provide the professionalism to navigate the confusion, performance and peace of mind you might not get elsewhere or if you were doing the job yourself.

A recent example:  An investor was using three stock brokers and each one thought the others were managing issues such as tax.  When a financial planner was engaged it was realised this investor had lost around $200,000 over a number of years.  This investor only has a modest portfolio.

 

Source:  Peter Graham
PlannerWeb

‘Huge’ professional risk in SG delays, big four firm warns

With single touch payroll making it easier for the ATO to identify unpaid SG, telling clients to wait for the SG amnesty could be a risky move impacting their professional obligations, warns a big four accounting firm.

         

 

With single touch payroll making it easier for the ATO to identify unpaid SG, telling clients to wait for the SG amnesty could be a risky move impacting their professional obligations, warns a big four accounting firm.

Speaking at a recent conference, PwC director of private clients Liz Westover said while there has been a lot of commentary suggesting that employers should hold off on declaring any unpaid SG obligations until the SG amnesty is passed by Parliament, there are significant risks with this.

Under the proposed SG amnesty, an employer that has an SG shortfall amount in any period from 1 July 1992 up to 31 March 2018 has the ability to claim tax deductions in respect of SG charge payments made and contributions that offset the SG charge to the extent that the charge relates to the SG shortfall. In addition, the administrative component to the SG charge will not apply.

The SG amnesty was meant to apply from 24 May but is yet to be passed as law.

Up until mid last year, Ms Westover said the ATO had a view where if an employer identified that they had made a mistake, they would take a practical compliance approach.

“They would let you quite simply catch up. They would say ‘just make the contributions to super and throw in a bit of interest to compensate for the shortfall’,” Ms Westover told delegates at the CA ANZ National SMSF conference.

“The problem was that, legally speaking, there is no wriggle room for the ATO to be able to apply that approach and so they changed their view and they started having a more hard-line approach around how SG was actually imposed.”

This means that any employer putting their hand up is going to be subject to all of the consequences, she said, including the SG charge, Part 7 penalties which can be up to 200 per cent of the amount of the SG charge and general interest charge where the SG charge or Part 7 penalties are not paid by the due date.

With the SG amnesty not yet passed as law, a lot of employers are wondering what to do, she said.

“[My view is] that I think you have an obligation to pay SG. I think you should be putting your hand up now and declaring yourself to the tax office now,” said Ms Westover.

The worst case scenario, she explained, is that the law applies as it does now and given the fact that the employer has put their hand up and gone to the ATO and admitted the mistake, the likelihood of getting those penalties remitted is high.

“If you get reported to the ATO by an employee, on the other hand, and that instigates audit proceedings, you're going to get the book thrown at you. That means all those implications plus penalties and there is no chance of the amnesty,” she said.

“[Also], if you identify a problem and you decide to wait, how does that impact your professional obligations? If you know that your client has not met their SG obligations and you are not reporting it to the ATO because you are waiting for this amnesty, then there could be a problem around your professional obligations.”

Ms Westover also warned that it’s very easy for the ATO and employees to identify unpaid super.

“This is why I think there is a huge risk in waiting at the moment. With single touch payroll coming up, where a lot of reporting is going to be made directly to the tax office, the tax office is going to be able to identify pretty quickly what's been reported to them as contributions,” she said.

“It is going to be a lot easier for the tax office and employees to start identifying when super guarantee is not being paid. If you wait to see if this amnesty goes through and in the meantime, audit activity is initiated against you as an employer, you do not get to use the amnesty and all the provisions that come with it.”

“I think there is a lot of merit and going to the tax office now and as James said it will be considered a voluntary disclosure, and the chance of being able to remit the penalties is pretty high.”

 

Miranda Brownlee
24 September 2018
smsfadviser.com

 

How financial advice helps create wealth.

An article based on a 16 year study by Vanguard Investments Pty Ltd. 

         

 

Last month we reported on a 16-year study by Vanguard Investments that found a financial adviser effectively adds around 3% to the value of a client’s portfolio over time.

The real significance of this is that you can have a finance professional take care of one of the most important jobs in your life (funding your retirement) for very little, if any, real cost.  This can even be the case for those with smaller portfolios.

However, for many people the main problem is getting started and the cost is often seen as too high or the adviser focus can seem a bit too much on their needs rather than the client. 

A major reason for this, unfortunately, is that increased regulation and monitoring has meant advisers have moved to a fee-based model and away from the commissions of yesteryear.  This is a good outcome but it has meant advisers have had to increase entry costs which, in turn, has led many potential clients to see these costs as too high.  A proverbial Catch 22.   

It is because of this sort of conundrum that firms like Vanguard Investments have undertaken long term studies.  The outcome from their work is that a WIN/WIN opportunity exists for all. 

However, this benefit isn’t just from better investing, though that will often be the case.  It’s the more holistic approach that wins the day.  Vanguard Investments identify the following areas as those that will generate this positive outcome:

  • Suitable asset allocation
  • Cost-effective implementation (expense ratios)
  • Rebalancing
  • Behavioural coaching (Vanguard Investments found this to be the most significant contributor because there are some tasks people struggle with such as budgeting and expense management.  Behavioural coaching addresses this issue).
  • Tax efficiency (An example here is where an investor with a modest portfolio lost more than $250,000 in value over a 10-12 year period because they thought the three stock brokers they used were looking after tax related issues.  They weren’t!  If the planner had been involved sooner the outcomes would have been significantly different.)
  • Total returns versus income investing.

 

Finally, the concerns many potential clients have over the cost of financial planning means they delay getting help early enough which, in turn, threatens the retirement outcomes they want to achieve. 

 

Peter Graham
PlannerWeb / AcctWeb

  

Trade tensions to choke global growth: Moody’s

The ‘synchronised global growth’ narrative appears to be over as trade tensions between the US and China look set to worsen, says Moody’s Investors Service.

           

 

Credit rating and research services firm Moody’s Investor Services has released its latest global macro outlook report, stating that there were “early indications that global growth has peaked”.

“Growth prospects for many of the G-20 economies remain solid, but there are indications that the synchronous acceleration of growth heading into 2018 is now giving way to diverging trends,” the report said.

While most advance economies remained “broadly resilient”, developing economies were experiencing some “weakening … in the face of emerging headwinds from rising US trade protectionism, tightening external liquidity conditions and elevated oil prices”. 

Moody’s outlook on the trade tensions and its impact on global growth have worsened since its last quarterly outlook update, the report pointed out.

Trade disputes between the US and the EU were also noted, but the US-China trade spat was most at risk of worsening.

“Of all the disputes surrounding trade, it is the trade relationship between the US and China that is presently most at risk of a significant deterioration in 2018.”

The impact of the tariffs will be felt more fully in 2019, according to the report – with much of the impact to “depend crucially on the resilience of sentiment”.

“Tightening of financial conditions through asset price and currency adjustment and a broader hit to business and consumer confidence are now more likely than a few months ago.”

Trade tariffs ‘manageable’ – for now

The report described the impact of the tariffs currently in place – 10 per cent on $200 billion worth of Chinese goods – as “likely [to] be manageable”, and partially offset by movements in exchange rates.

But if the proposed tariffs – 25 per cent on $200 billion worth of Chinese goods – came into effect, we would see a rise in the prices of consumer goods in the US.

“The implementation of these measures would signal a significant escalation in the trade war and could have a lasting impact on both the US’ economic and diplomatic relations with China.

“A move in this direction could be considerably damaging to global growth, not only through the global trade value chains, but also by injecting a high degree of uncertainty, dampening investment and pulling down asset prices globally,” the report said.

“In a stress scenario, a material fall in asset prices and a significant hit to confidence, recession outcomes in the US are possible.”

Greater policy uncertainty and deteriorating diplomatic relationships would cause the private sector to also feel the “knock-on effects” of the 25 per cent tariffs, bruising business and investor sentiment and creating more headwinds to “the rebalancing efforts in which the private sector has an important role”.

Moody’s has revised its 2019 GDP growth outlook for both US and China to 2.3 per cent and 6.4 per cent respectively.

Emerging markets more vulnerable to trade tensions

For developing economies – Turkey, Argentina and Brazil in particular – “external headwinds” would put pressure on these “already fragile economies”.

There were three factors affecting the global economy’s cyclical outlook, it said:  

  1. “tightening global liquidity conditions associated with the reversal of monetary policies in major advanced economies after a decade of exceptional easing;
  2. worsening economic disputes, particularly between the US and China on a range of matters including trade policy, industrial policy and investment policy; and
  3. the oil price outlook.”

 

 

 Jessica Yun
 24 August 2018
investerdaily.com.au

Examining the S in SMSF

One of the great misnomers in the Australian investment scene is that self-managed super funds are actually self-managed.

           

 

The simple reality is that there is an entire advice industry built around SMSFs – be they traditional accountants, financial advisers, lawyers or one of several SMSF administration platforms.

This makes the provision of quality advice to those Australians who have an SMSF – or those considering setting one up – absolutely critical, if the more than one million SMSF trustees are to achieve the best possible outcome when they retire.

Last month ASIC released a comprehensive report on the quality of advice and member experiences in the SMSF sector.

The 120 page report* will make uncomfortable reading for many in the industry because it calls out a high level of non-compliance with the best interests duty and, in a review of 250 client files by an independent expert, 10% of the files reviewed risked being significantly worse off as a result of the advice they received to set up an SMSF.

A healthy and vibrant SMSF sector is a vital part of our compulsory superannuation system. It provides a competitive alternative to the institutional APRA funds and gives super fund members an effective choice and alternative.

ASIC says that in the right hands “SMSFs can be very effective retirement savings vehicles. In the wrong hands, however, SMSFs can be a high-risk option”.

ASIC's focus was on funds set up in the past five years – so the research sample is skewed to relative newcomers to the sector – and while there are some strong messages for the advice industry on where it needs to lift standards, there are also some red flags that both existing SMSF trustees and those thinking about establishing an SMSF should pay attention to.

ASIC found common issues with the files reviewed centred on the disclosure of costs and risks about the set up and running of an SMSF, advisers not properly considering the client's circumstances or existing super fund and not prioritising the needs of the client.

So there is plenty for the advice industry to work on to improve outcomes for SMSF members and the overall professionalism of the advice industry.

While the reaction to the ASIC report has naturally been on the negative findings about advisers, the report provides balance by also highlighting case studies where good advice has been both given and acted on by the investor.

It also effectively holds up a mirror to trustees, or would-be trustees, with what perhaps is a challenging reality check around the personal responsibility that comes with the decision to set up an SMSF.

In some of the case studies provided by ASIC, financial literacy among trustees is clearly an issue with some trustees not aware of how their fund is performing, what it costs to operate or even if it has an investment strategy.

The bottom line is that an SMSF is not for everyone. Even someone who has good levels of financial literacy and resources may not be suited to an SMSF and ASIC cites the example of an investor with more than $2 million in super but no time or interest in running their own fund.

That level of personal self-awareness was clearly lacking among some of the SMSF trustees participating in ASIC's research. This raises the question of whether some base level of financial literacy needs to be demonstrated before the keys to an SMSF are handed over.

The stark example in the ASIC research is that 55% of the SMSFs in the research sample had more than half their money invested in one asset type. That level of portfolio concentration risk, ASIC says, means those members may face greater risk in reaching their retirement goals.

Nowhere is the issue of financial literacy more pointed in the SMSF world than on the issue of borrowing to buy property. What ASIC's online and face to face interviews showed is that for some an SMSF has become a happy marriage of convenience between those wanting to access the residential property market and using their super savings to do it.

Now Australian investors' love affair with property is beyond dispute. And the property market has generally been kind, to the point that ASIC found that the surge in prices in recent years particularly in Sydney and Melbourne markets had “created a sense of urgency driven by a fear of missing out”.

But perhaps this is a case of where love of the property market is making investors blind to risks and costs.

The fear of being locked out of the market is clearly playing into the hands of so-called “one-stop property shops”. ASIC's research showed that trustees who had used a property one-stop shop had quite different experiences to those using a financial adviser or accountant.

“After members had made a decision to set up an SMSF with a property one-stop shop they were introduced to related parties such as mortgage brokers, lawyers, insurance brokers, property management companies and property developers,” the ASIC report says.

What was surprising was not how the one-stop shops were operating but rather that the members seemed unconcerned about the potential conflicts of interest, and some even saw that as an advantage.

What is obvious from reading some of the case studies cited by ASIC was that some members didn't know if commissions or kickbacks had been paid to related parties, indeed they were vague about what the total cost of setting up the SMSF and the loan facility had been.

One Sydney case study – Luke – provided a hard-earned lesson for others to heed. He set up an SMSF to buy a property in Queensland after a cold call from an adviser and a related accountant. He found costs of buying the property were higher than he anticipated and costs of running the SMSF higher than he expected. He is now attempting to sell the Queensland townhouse for $22,000 less than he paid for it and his overall loss will be around $70,000.

In retrospect Luke admitted he should have done a lot more research.

Perhaps the only consolation for Luke is that judging by the ASIC research he sadly is not alone.

And while the financial advice industry has much to do to improve its level of professionalism, the trustees of SMSFs have to also take personal responsibility for both the decision to set up the fund, and for its investment decisions.

You certainly do not have to manage everything to do with an SMSF yourself, but if you are not prepared to spend the time understanding the costs of running an SMSF, setting an investment strategy and monitoring its performance, then you should seriously question whether an SMSF is the right retirement savings vehicle for you.

* Report 575 SMSFs: Improving the quality of advice and member experiences.

This article originally appeared in Cuffelinks on 26 July 2018
 

Written by Robin Bowerman
Head of Corporate Affairs at Vanguard.
01 August 2018
vanguardinvestments.com.au

Living expenses for retirees on the rise

The latest Association of Superannuation Funds of Australia (ASFA) statistics into retirement lifestyles has shown a jump in the cost for retirees during the June 2018 quarter, driven mainly by clothing, transport and health services.

         

 

The ASFA Retirement Standard figures for the quarter revealed couples aged around 65 had to spend $60,604 per year to enjoy a comfortable lifestyle, while a single person needed to spend $42,953 to achieve the same result. These amounts represent an increase of around 0.5 per cent compared to the previous quarter.

In addition, the standard showed achieving a modest lifestyle in retirement would require couples to spend $39,442 annually and singles $27,425, also a jump of about 0.2 per cent from the March 2018 quarter.

With regard to retirees aged 85 and over, their total budget for a comfortable lifestyle rose by 0.4 per cent and by 0.3 per cent for a modest lifestyle over the quarter.

Commenting on the result, ASFA chief executive Martin Fahy said: “The cost of retirement over the most recent quarter only increased by a relatively small amount and that is welcome news but many retirees will still find it difficult to achieve a comfortable standard of living in retirement.”

He singled out health care costs as a significant contributing factor.

“Health care costs are a significant burden for many retiree households. Health care costs in the budgets rose by over 2.2 per cent in the quarter, largely driven by the 4 per cent increase on average in private health insurance premiums,” Fahy explained.

While the overall cost of living increased over the quarter for retirees, the standard showed certain areas such as food-related expenses fell by 0.4 per cent.

The statistics also revealed the costs associated with leisure activities also dropped over the period mainly due to a 2.7 per cent reduction in the price of domestic travel.

 

 

Darin Tyson-Chan
August 23, 2018
smsmagazine.com.au

Still a long and bumpy road to travel on the way to a U.S.-China deal

Headlines about trade wars between the U.S. and other nations have been moving global financial markets this year.

         

 

In spite of talks toward free-trade agreements in other regions, trade frictions between the U.S. and China, the two largest economies in the world, have intensified recently. The increased frictions follow several rounds of cooperation, negotiation, retaliation, and escalation. So far, there has been limited progress on cooperation and negotiation. Instead, there has been another round of tit-for-tat tariffs on imports. The U.S. also has announced an additional tariff list that could take effect in the fall, if implemented. This has pushed us much closer to a trade war.

In disputes such as these, there are two final scenarios: win-win and lose-lose. Given the greater temptation not to cooperate, an ending in which both players lose is quite likely. Hence, it is understandable that the markets are highly concerned about an eventual trade war, especially since the risk of miscalculation and miscommunication between the U.S. and China is quite high, given numerous social, political, and cultural differences between the two countries.

The silver lining is that this is not a one-shot game. The U.S. and China could go for several rounds before they eventually settle into a more stable relationship, for better or worse. It is true that neither side is willing to let the other win easily and that each is still trying to test the other's limit at this moment. However, when the pain of the trade war becomes unbearable, the players may decide to back off, get back to the negotiation table, and restart. For the U.S., it may take a sharp decline in the financial markets and a significant deterioration in the labor market. For China, it could be the risk of a sharp deceleration of economic growth to below 6.3%, the pace necessary to achieve China's goal of doubling its 2010 GDP by 2020. Obviously, we are not there yet.

Higher chance of ending up with the lose-lose scenario

As the U.S. midterm elections approach, there is a decent chance of further escalation in the near term. Hence, we have revised the chance of a “trade wars” scenario from 30%–40% in May to 40%–50%. A trade war would lower growth in both the U.S. and China. The direct impact on growth in both countries would be manageable. Obviously, both are major players in the global economy; combined, they produce 38% of the world's GDP. However, their international trade, as large as it is, represents only 1.8% of total world trade and about 2% of their combined GDP. China's exports to the U.S. represent about 4% of Chinese GDP and U.S. exports to China represent about 1% of U.S. GDP.

Nonetheless, the indirect impact could be felt through the effect on the labor market and consumption, or via the effect on financial markets and business confidence.

This won't lead to a hard landing, but it does pose some downside risk to China's 6.5% growth target this year. In fact, Chinese policymakers have paused their deleveraging campaign and started to ease monetary and fiscal stimulus to cushion the potential negative impact from trade frictions. Our U.S. economists believe that in this scenario, the U.S. economy could face a modest reduction of 10–15 basis points given China's retaliation. In fact, since the second-order effects would be the more important negative driver, the U.S. administration will keep a close eye on financial market developments.

There will be a spillover effect on the rest of the world, too. From a value-added perspective, more than one-third of the goods exported from China are actually made somewhere else. This is particularly true for China's electronic and machinery exports, which have been the target products in the U.S. government's investigation into China's trade practices. For every dollar of goods that China is exporting, 20 cents comes from Asia and 7 cents from Europe. Certain Asian markets would be particularly vulnerable, such as Japan, South Korea, and Taiwan, given how integrated they are into the regional supply chain. Nonetheless, as long as the trade war is strictly limited to tariffs and protectionist measures, the global economy may not collapse into a deeper recession.

We see a 10% chance of ultimate “isolationism,” which would involve damaged diplomatic ties between China and the U.S. on multiple fronts—economic, political, and cultural. If major retaliatory measures are involved—such as a broad-based sanction against China and China's dumping U.S. Treasury bills in return—it could result in significant financial market disruption and eventually a global recession. Luckily, the chance is very low in our view since the outcome would be extremely negative for both China and the U.S., as well as for the rest of the world.

Not yet at the point of no return

Despite a higher chance of a trade war, there is still hope for eventual peace. Both countries understand that a trade war would be a lose-lose situation. As such, we continue to believe there is room for negotiation, especially when the pain becomes unbearable. We assign a 40%–50% chance to a “protectionist” scenario, with modest implementation of trade tariffs/retaliation and an ultimate negotiation on a comprehensive trade and investment agreement between China and the U.S. Even so, the path to that eventual deal is likely to be bumpy. While this scenario will have only a marginal impact on the global economy and inflation, it will translate into volatility in the market.

Trade frictions to get worse before getting better

Select U.S. tariffs likely to be used to gain leverage in future trade negotiations.

Source: Vanguard Investment Strategy Group as of July 2018

U.S. and China frictions over the long haul

Disagreements on bilateral trade represent only the first of two conflicts between China and the U.S. The other conflict is over longer-term issues and will be much more strategic and prolonged. It will focus on issues fundamental to the structure of the Chinese economy. The U.S. is pressuring China to live up to its promise to the World Trade Organization by further opening markets and pushing forward market-oriented reforms. Hence, although a comprehensive trade and investment agreement could be reached eventually, the bumpy path of negotiation on other issues will continue.

On this front, China has shown willingness to cooperate as this would ultimately benefit its long-term development through more efficient capital allocation. That in turn will eventually lead to higher productivity and growth potential. Indeed, President Xi announced at April's Boao Forum that China is planning to further open the domestic financial market, relax the foreign ownership limit in the auto and financial industries, enhance the investment environment, strengthen protection of intellectual property rights, and ensure a level playing field. However, the pace and scope of any such opening and reforms are at the core of the second conflict, especially regarding government subsidies to high-tech industries and state-owned enterprises.

What should investors do?

Along with the long and bump path of negotiation between the U.S. and China, volatility in global financial markets is likely to persist. Despite the up and downs, we advise investors, first, to maintain a diversified portfolio given the heightened uncertainties in the current environment and, second, stick to their long-term investment portfolio. That should give investors a better chance to weather the short-term volatilities and achieve long-term investment success.

 

By Qian Wang, PhD
Managing Director and Chief Economist, Asia-Pacific
14 August 2018
vanguardinvestments.com.au

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