Surprise! Another referendum.

By Eoin Fahy, Tuesday, 28th February 2012 | 0 comments

Against most expectations, the Government has announced this afternoon that a referendum will be held on the "fiscal compact" deal. At a time when many things seemed to be going well for Ireland, this throws the cat among the pigeons and raises serious risks about Ireland's ability to continue to receive bailout funds after next year. This uncertainty is likely to continue at least for a couple of months, and there is of course absolutely no guarantee that the electorate will vote Yes.


The government surprised the country, and the financial markets, by announcing this afternoon that a referendum will, after all, be held to approve (or not) the Fiscal Compact. This was not at all expected as the treaty text had been drawn up with the explicit intention of avoiding the need for a referendum, and as the government presumably wanted the referendum about as much as a turkey looks forward to Christmas! The euro weakened after the announcement, and Irish bond yields rose, though in both cases the moves were not especially large.

The timetable is not fully clear, but this will not be a quick process. As a first step, the government will have to publish the legislation to provide for the holding of the referendum. Presumably that will take a week or two, at the least. Then that bill will have to be approved by the Dail and Seanad and signed by the President. While that process can often take several weeks, it can be done quite quickly, say within a week or two, if it is seen as a very urgent priority.

After the legislation is passed, the date for the referendum will be set, which is usually at least a month after that. So if we assume that the Bill passes sometime in late March, a guesstimate for the date of the referendum would be sometime in May.

The political merits or otherwise of the Fiscal Compact are not a matter for this blog, but from an economic/investment point of view it is worth taking a look at the consequences of a No vote. The key "black and white" issue is that Ireland will not be able to borrow from the ESM (the EU bailout fund that takes over from the current bailout mechanism, the EFSF, next year) if it does not sign up to the Compact. So the current bailout funds are not at (direct) risk from a No vote, but if Ireland cannot return to the markets within the next year or so, and fund itself, it will be in very severe difficulties as it will not be able to get a second bailout.

Of course there are "greyer" consequences as well. While Ireland can continue to draw down funds from the current bailout, it will certainly lose goodwill from other EU countries [except the UK of course, which has opted out of the compact], and could hardly be expected, for example, to get concessions re the €30bn+ promissory note on which there is so much focus by government at the moment. A No vote might also make some inward investment companies, and bond investors, think twice about the wisdom of investing in a country that (again!) votes against an EU treaty, if they think that that might mean that Ireland will leave either the eurozone or the EU.

On the other hand, of course, the irony is that the Compact is supposed to give taxpayers in richer countries such as Germany some comfort that their money will not be used to support countries which cannot, or will not, get their fiscal affairs in order. But most economists agree that even if it had been in place during the boom years in Ireland, it is unlikely to have made much, if any, difference, and Ireland would not have broken any Compact rules until after the bubble burst, by which time of course the damage had already been done. Many economists also argue that the fiscal rules in the Compact are not well designed and would be quite difficult to enforce in practice.

No doubt we will all be discussing these and related issues in much greater detail in the weeks ahead, but for now, perhaps the biggest impact will be in the uncertainty that will not be resolved for, perhaps, two to three months while we await the vote.

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Kleinwort Benson Investors are pleased to announce that we are moving to a new city centre location and effective from September 15th 2014, our headquarters will be located at 

3rd Floor, 2 Harbourmaster Place, IFSC, Dublin 1, Ireland. 

After the move, the only change will be to our address, all our telephone numbers will remain the same. Please update your records and forward all correspondence after the 15th September to the above address. 

We are very excited about this move and, as always we remain committed to providing excellent client service, while continuing to focus on delivering strong performance for our clients. 

In my beginning of the year piece, I expected 2014 to be another positive year for markets. As the first half draws to a close it has indeed turned out to be a positive period, with equities up 5.6%, bonds up 4.5% and commodities up 0.8% during Q2, which took the returns for the first half of the year to 6.9%, 10.5% and 7.8% for equities bonds and commodities respectively.[i] Many of the positive tailwinds that helped markets during 2013 prevailed in the first half of this year as well, with 2013 laggard assets such as Emerging Markets, commodities and Agribusiness related equities performing admirably.

As I ponder the outlook for the second half of the year, my fundamental position has not changed and I do expect further market gains, notwithstanding an acknowledgement that with equity markets at new highs and bond yields remaining at record lows, some form of tactical setback in markets does feel overdue. The constructive outlook remains supported by some strong underlying themes:

  1. Slow return to "normalisation". The nature of this economic recovery remains similar to no other and is particularly 'sub-par' as we work through the excesses that caused the last downturn.  While not exciting from a growth perspective, from a markets perspective it leaves us with an attractive cocktail of lower-for-longer interest rates, continued low inflation, helpful central bank policies and at the same time growth that - while tepid - is leading to earnings and dividend growth that helps propel equities forward. This theme I believe has a few years left to run before the global economy gets back to its historic trend levels.
  2. Corporate usage of cash. While headline writers have obsessed on high levels of government and consumer debt, we are also focusing on the opportunity provided by record levels of cash on the balance sheets of many of the companies in which we invest. As corporate confidence improves we are increasingly seeing company management deploy this cash. Favourites to date have been to increase dividends and share buybacks (both of which are key drivers we capture in our Global Equity Strategies) as well as more judicial spending on overdue capital expenditures or hiring of new employees. A more recent phenomenon and a sign of increased confidence has been the increase in corporate takeover activity. This merger and acquisition theme will only increase in momentum from here and will be bullish for markets.
  3. Fundamentals versus liquidity! While some have argued that the bull market has been liquidity-driven rather than driven by fundamentals such as improved corporate earnings, I disagree and say it is a combination of the two. As we move towards 'normalisation', central bank liquidity will and should wane and fundamentals will become more the primary driver. I remain confident that we will see high single digit earnings growth for global equities this year, which is not inconsistent with the type of overall high single digit/low double digit equity returns that I believe it is appropriate to expect.
  4. From a sentiment perspective, despite record highs I see no evidence of exuberance or investor actions that would historically be associated with market peaks. For example, in terms of investment styles, high momentum sectors aren't persistently outperforming nor do I see any massive valuation concerns in sectors of the markets. The IPO market is still relatively subdued and finally I see little evidence of retail investors returning to equity markets to any great extent and in fact remaining generally cautious.

What will drive markets from here?

  • The continued growth of the global economy and corporate earnings
  • A continued improvement in corporate and consumer confidence
  • Investor flows should improve further as investor confidence increases and they increasingly dislike the alternatives.

What could derail markets from here?

The list is relatively short but global geopolitics is clearly a concern and something we are actively monitoring. In terms of valuations, I note that equities are no longer cheap on a standalone basis and are now at a small premium to their historic average. This is new but equally I am not concerned at this point as they remain well within historic ranges and when compared to asset classes such as bonds or cash, they still look particularly attractive.

Finally, a turn in the interest rate cycle is a potential problem. We have already seen heavy hints from the Bank of England that rate increases might come earlier than the markets expect.  As the months go by, I do expect similar comments from the more important US Federal Reserve. Rising rate worries could derail markets at some point, but I would however still believe that it will be a couple of years before we will see aggressive rate rises.

To conclude, the first half of the year has been positive and despite new highs on markets, I believe the outlook remains bright. As always there are headwinds and surprises that lie around the corner. As active managers our portfolio managers here at Kleinwort Benson Investors remain alert to opportunities as well as to threats. The environment for active stock picking remains fertile and we continue to focus on companies with strong fundamentals, attractive cash flows and a strong mindset towards shareholder return.

Noel O’Halloran, Chief Investment Officer

 

[i] Equity return quoted is the MSCI equity world index return, the bond return is the return on the ML over 5 year eurozone government bond index, and the commodity return is based on the DJUBS Commodity index, all in euro terms.

The results of the European Parliament elections have received a great deal of media – and financial market – attention.  Far-left and far-right political parties made strong gains in several countries, and those parties were in many cases in favour of their country withdrawing from the European Union and/or leaving the eurozone.  However, in other countries the results were very different, and we conclude that in reality little has changed and there is little chance of significant changes to key economic policies, or of “political gridlock” at European level.

The headlines this week have been fairly stark.  Anti-European or ‘extremist’ political parties performed exceptionally well in the European elections across the continent.  The National Front, the UK Independence Party and Syriza topped the polls in France, the UK and Greece respectively.  Voters have shown their disillusionment with Europe and their resistance to “austerity” policies.  Europe is in near-crisis with eurosceptics forming a powerful bloc in the European Parliament. And so on.

But here are some alternative headlines that you probably did NOT read this week, but which are also true:

  • Pro-European governing party in Italy makes huge gains and comfortably tops the poll.  Gets best ever result for any party in European elections.
  • Anti-European party in Germany wins just 7% of the vote
  • Hard-left Syriza party in Greece underperforms expectations, does not do enough to bring down the government.  Junior governing party outperforms expectations.
  • Centre-left and centre-right moderate bloc holds huge majority in European parliament (469 seats vs 178 for the Greens, Conservatives, Left and far-right Eurosceptics combined).
  • Governing party tops the poll in Spain. Protest party wins just 8%.
  • Far-right vote in the Netherlands well below expectations.  Takes third place with 13% of the vote.

So it's best, of course, to look at the whole story.  Yes the euroseceptic/anti-austerity/protest parties did well in some countries. But they did quite poorly in others.  In no country were the results so dramatic that the government is at risk (with the possible exception of Ireland if the Labour Party were to withdraw from government after it elects a new leader).  And the centrist, moderate bloc of parties still has a very comfortable majority in the European Parliament (which anyway has quite limited powers as most key decisions in Europe are still made by European governments, often by consensus).

In assessing the outlook for European equities and government bonds, therefore, we will continue to focus on the prospects for economic growth, for monetary policy and for corporate earnings growth, all of which are more significant in our view than the 'noise' from the European elections.Indeed it was interesting to note that despite the blizzard of news, much of it seemingly negative, the financial markets largely ignored the elections.  The European stock market rose by more than 1% on Monday, and the euro strengthened marginally.

Valuations remain reasonable for equities (though bonds are expensive, as are most developed market government bonds), there is unlikely to be a significant change for the worse in economic policies, and there is no sign of a return to the crisis days of a couple of years when some commentators expected the eurozone to fall apart.  Gridlock in the European Parliament is very unlikely, and even if it happens, the US has managed quite well for the last couple of years despite complete gridlock in Congress!

 

 

In the first quarter of 2014, investors were ‘hit’ by a barrage of macro challenges in the US, China and Eastern Europe, and investors also fretted about whether Japan and Europe were gaining the upper hand in the battle against deflationary challenges. In the US, very severe winter weather was the presumed cause of a significant decline in economic activity.  In China, the economy slowed sharply- leading to expectations of a government stimulus package – and to cap it all the crisis in Ukraine raised geopolitical tensions across Eastern Europe and beyond.

Despite these ‘hits’, global equity market performance proved to be very resilient with the world equity index rising by 1% in local currency.  Europe led the way, with the eurozone index rising 2.8%, slightly ahead of North America, which rose 2%.  Japan was the laggard, showing a decline of 7.5%, while Emerging Markets were down very slightly (all returns in local currency).  In contrast, bond markets (in Europe in particular) appeared to benefit from falling inflation and improved sentiment towards peripheral countries,  and delivered strong gains as the European over 5-year bond index rose by almost 6%.  Commodities were very strong, rising by about 7%, regaining some of their losses in previous quarters.

Hits perceived as transient

It’s very clear, therefore, that markets regarded these ‘hits’ as transient and focussed instead on improved long-term fundamentals.  That is not particularly surprising given that I believe that the current global economic recovery has at least another three years of growth before we concern ourselves about the next economic downturn. The continued slow but steady global economic recovery will prove resilient and continue to demonstrate recovery. I reiterate my strongly held conviction that real assets such as equities and other alternative asset classes are attractive for as long as  global central banks are fighting deflation and downside risks to economic growth. While in the short term such actions also help bond yields, in time recovery will prove a big negative for bonds.

In January, I expected 2014 to be another positive year, with a likely outcome of high single/low double digit returns from global equity markets. This would be consistent with expected global earnings growth for 2014. Equity markets are no longer cheap and are generally now trading at long term average valuations. Therefore, my central expectation was and remains  that returns will be consistent with earnings growth from here out rather than further expanding valuation multiples – though there remains some possibility that abundant liquidity could push valuations up still further. 

What we are watching

As we enter the second quarter there are a number of key fundamentals that we are watching:

  • A key factor will be the upcoming company earnings reporting season. While many US companies (cyclical ones in particular) will no doubt have been hit by adverse weather during the first quarter, their outlook, commentary and guidance for the remainder of 2014 will be very important to markets.
  • At a macro level it is crucial that the US economy does rebound from the weather affected first quarter. I certainly expect it to, having spent some time looking at this issue while in the US recently on a research trip.
  • A missing ingredient from this recovery has been any material sign of growth in corporate capital expenditure. We are at a stage in the economic cycle where many economists expect to see increased signs of such a pickup. This new dynamic would be a positive not just for economic growth but in particular for corporate earnings.
  • Although we have no official numbers yet for the first quarter economic growth in China, it does appear to have been particularly slow. I maintain the view that the economy will not have a hard landing and Premier Li has said several times in the last few weeks that he had means and ways to protect the economy from deterioration if necessary. A natural rebound in growth, or one helped by further stimulus measures by the government would be positive catalysts and further welcomed by markets.
  • For over 12 months now equity market performance has been polarised between strong developed market performance and struggling Emerging Market (EM) performance while EM battled with a number of headwinds. Over the remainder of 2014 I expect this trend to reverse and EM to gain positive traction again. This will have to be driven by a pick-up in both earnings and economic growth.
  • While a rising tide hasn’t to date seen any significant differentiation between US, Europe and Japan, I believe that there is a real chance that markets will challenge this more and focus on whether the latter two are truly synchronised with the US economic recovery or whether they are in fact struggling and deflationary forces are materially different for Europe and Japan than in the US. To date, markets have given them the strong benefit of the doubt but I note that the ECB for example has spent a lot of its recent press conferences discussing what tools they have at their disposal to fight deflation, if necessary.  If the economy is recovering, as the markets believe, why is inflation so exceptionally low?

Emerging Markets

It is worth expanding further on my views on Emerging Markets, as markets are very focussed on that topic.  As I stated above, I believe they will begin to converge again with Developed markets, and for those looking for a ray of hope, Emerging Markets had a significant outperformance over recent weeks. At a fundamental level while challenges remain (growth and politics) across various emerging markets, I believe we are well past the worst and that the key catalysts of economic growth and earnings growth  will help over coming quarters.

It’s important to note that investor sentiment and positioning is very poor towards EM. This is not at all unusual as historically investors either hate or love emerging markets with seemingly no in-between state! Any investor with a grain of contrarian instinct would be looking to buy EM and particularly as valuations are well below historic averages. This is also against a background where some argue that many investors are increasingly ‘in love’ with developed markets such as the US. At a fundamental level, although challenges remain, EM economies are in a much healthier state than they were ahead of the 1997 Asian crisis and I do have confidence that the Chinese will manage the rebalancing of their economy without a hard landing.

Investment markets remain as dynamic and challenging as ever. In this quick blog I have summarised some of the major drivers we will continue to focus on during the second quarter. Within markets and for your portfolios we are also managing both sector and style volatility. By style I mean whether for example value, growth, momentum or yield are performing best and we have noted more volatility in styles over recent months. Consistent with a slow but steady recovery in global economic growth we continue to believe that stock picking should remain concentrated on companies with strong balance sheets, positive earnings guidance and a strong attention to cash flow and dividend payments. The bottom line remains that I expect 2014 to be a solid if not unspectacular year of returns for investors despite the headline challenges.

Noel O’Halloran, Chief Investment Officer

Donore Harriers athlete John Travers has won the 2014 St. Patrick’s 5K Festival Road Race, which took place in Dublin on Sunday 16th March. He completed the course in a time of 00:14:07.

St.Patricks 5K winner Thumbnail0

Second place went to Colm Rooney from Clonliffe Harriers AC who finished in 00:14:23. He was followed in third place by Kevin Maunsell of Clonmel AC in a time of 00:14:43.

The women’s race was contested by two of the biggest names in Irish athletics with current star Fionnula Britton holding out against former London marathon winner Catherina McKiernan who made a rare competitive appearance for this event. Fionnula Britton completed the course in a time of 00:15:33 and Catherina McKiernan completed the course with a time of 00:15:58.

Fionnuala Britton is currently one of Ireland’s top athletes and was the gold medallist at the 2011 and 2012 European 2012 European Cross Country Championships and was the first woman to successfully defend this title. She has represented Ireland in the steeplechase at the 2008 Beijing Olympics, the 2009 World Championships in Athletics, and twice at the European Athletics Championships.

St.Patricks 5K women s winner Thumbnail0

Veteran athlete Catherina McKiernan is a double Olympian and  has won four silver medals at the World Cross Country Championship and gold at the European Cross Country Championship. She has had notable success at marathon having won at Berlin, Amsterdam and London and holds the Irish national record at the marathon distance which was set in 1998.

Third place went to Lifford AC athlete Ann-Marie McGlynn in 00:16:01. 

Organised by Metropolitan Harriers & St. Brigid’s Athletic Club, the race was a highlight of the annual St. Patrick’s Festival programme and a major element in attracting tourists and visitors to Dublin City. The record 1,700 entries were made up from dedicated athletes, families, tourists and fun runners alike.

St.Patricks 5K race start Thumbnail0
Praising the efforts of all who took part, race director Eamonn Coghlan thanked Dublin City Council and An Garda Síochána for the support which they had given to the event.
 
Sponsorship was provided by Kleinwort Benson Investors, specialist provider of niche investment strategies for pension funds, charities and corporate bodies, who have supported the event for a number of years. 

As an added attraction this year and to coincide with their forthcoming Muppets Most Wanted movie, Disney held a competition for the ‘best inspired Muppet costume’ in the race which was won by 11 year old MSB AC athlete Sarah O’Gorman from Castleknock whose prize is a private screening with 100 of her friends!

Having remained optimistic throughout 2013, I believe that 2014 will continue where 2013 left off and at this point am not advocating any changes to the “positive positioning” we have in place for discretionary client portfolios. I expect 2014 to be another positive year for global equities with bond markets once again struggling. Equity valuations are no longer cheap but equally they are very far indeed from what would be considered ‘bubble-like’.KBI078 white Thumbnail0

We are now over five years on from the worst of the global financial crisis and the global economy is moving from the post-bubble phase to a phase of ‘self-sustaining normal growth’. I expect all of the large developed economies to grow more strongly in 2014 than they did in 2013.  The improvement is likely to be strongest in Europe, with the economy returning to positive growth this year.  The picture is slightly different in Emerging Market economies, where growth has been reasonably strong for some years, but has faded somewhat in recent months.

Equity markets have of course correctly anticipated this improvement, with strong returns in 2013.  The likelihood for 2014 is that equity markets will match earnings growth (rather than exceed it), producing positive but more modest returns than 2013.  In contrast, the outlook for bond markets is negative, as central banks, and particularly the US Federal Reserve, move away from their policy of massive liquidity creation. Alternative asset classes such as commodities had a less positive 2013 but I suspect they will be more competitive in a diversified portfolio this year. I am all too aware that these optimistic views are much more consensus today than they were 12 months ago and the degree of bullishness amongst investors is increasingly high, which has historically been an uncomfortable place to be!

I have no doubt that there will be challenges to markets as the year unfolds and in this blog I will focus on the key risks – both upside and downside! – to markets this year.

The following are scenarios or risks we consider in descending order of likelihood for 2014:

 Risk 1: Economic growth turns out to be much stronger than expected:

Such an outcome would certainly be a major negative for bond markets and would exert more of a two-way pull on equity markets which could lead to a flattish out-turn for equities. We witnessed such an environment in 1994 where stronger than expected economic and earnings growth were offset by sharply rising interest rates. In this scenario much will be written about central banks being ‘behind the curve’ as bond markets create headlines of an ‘inflation scare’. 

Risk 2: Equity market valuations reach expensive levels

In this scenario, ‘easy money’ from global central banks continues to be funnelled into equity markets and other risk assets rather than into the real economy (which itself doesn’t accelerate as expected but rather continues to muddle along).  Just as in 2013, equities deliver acceptable earnings and dividend growth but are turbo-charged by a further expansion of P/E multiples into expensive territory leading to a stellar 20-30% equity year.

Risk 3: Emerging Markets materially disappoint

In this scenario the struggle of 2013 would turn into a meaningful ‘actual’ issue, such as materially slower than expected growth in the Chinese economy or an unexpectedly negative market reaction to ‘tapering’ (incidentally, I believe that to have been last year’s story). While the coincidence of a material slowdown in emerging economies occurring at the same time as developed economies are accelerating would be very rare, it would be very messy for equities and positive for developed market bonds.

Risk 4: Europe IS the new Japan

Recent nascent optimism about a genuine recovery in European economy quickly fades as the green shoots of growth wither and die. ‘Japanification’ of Europe becomes the jargon phrase of the year (replacing ‘tapering’!).  The ECB again becomes the focus of attention and the euro weakens materially. Peripheral Eurozone bond markets also become vulnerable as core defensive bond markets come back into favour.

Risk 5: A year of 2 or maybe 4 halves!

Some combination of some or all of the above could occur leading us to expect a very dynamic roller-coaster type year. We have been there before!

Summary: 2014 similar to 2013

I expect that 2014 will most likely be a similar but less spectacular year to 2013 echoing many similar trends with the strong exception that I believe Emerging Markets will perform much better in 2014. Valuations (in Developed equity markets) are no longer cheap but I remain confident that earnings and in particular dividend growth will be even more important in this year than they were in 2013.    Risks abound of course – both upside and downside – as I’ve outlined above but the bottom line is that I expect that investors will reap solid – if unspectacular – gains from equity markets this year.

 

Noel O'Halloran, Chief Investment Officer

As Ireland exits its three year troika bailout period, it is a good time to ‘take stock’ of the deficit and debt situation for the country. How big is our debt relative to history and to other countries? How much work needs to be done to get the budget to balance again? Do recent good economic data (rising employment, falling unemployment, etc) make a big difference to our fiscal situation?

Let’s start by looking at the national debt. The bad news is that of course it is at a very high level, about 124% of GDP. That’s about €45,000 of debt for every man, woman and child in the country. By way of international comparison, as the chart below shows, it’s the fourth highest in the EU, after Greece (170%), Portugal (132%) and Italy (134%). debt to gdp

The good news (though it that much to shout about) is that this year should mark the peak, and on reasonable economic forecasts the debt should be down to about 114% by the end of 2016, as this chart shows (using Department of Finance projections).

debt to gdp over time

Next, let’s look at the deficit, the gap between what the government takes in and what it spends. This year that deficit will be about 7% of GDP, or €11.5bn. That compares to a peak – excluding the money needed for bank rescues – of 11.4% in 2009. Ultimately the budget needs to balance, of course, but first the deficit needs to at least fall to 3% of GDP as that is the highest level accepted by the EU under its fiscal rules.

defict as pct gdp

So the bad news is that – at first glance - we are only about half way from the worst point (11.4%) to where we need to be (3% at max). But that perhaps understates the extent of progress, as the economy has now begun to grow. And it is economic growth, above anything, that will get the deficit down. We expect that that growth, combined with some relatively modest spending cuts and tax increases in the 2015 Budget, will drive the deficit down to below 5% next year, and to below 3% in 2015.  In fact the graphic below (from the NTMA) shows that the vast bulk of budgetary consolidation (or austerity measures, if you prefer) is already complete.  To be exact, of the 20% of GDP of budget measures that are due to be done between 2008 and 2015, 18.9% has already been done.austerity so far

So a stock-take of Ireland’s fiscal situation shows a mixed picture. The deficit has already come down substantially and the pace of decline will accelerate from here. That is vitally important as once the deficit is eliminated, or reduced to an acceptably low level, austerity measures will no longer be required.

But on the other hand the outstanding stock of national debt that has built up as a result of the huge deficits of the last few years, and the need to rescue the banks, remains very high and will only begin to decline slowly from next year. Ireland will need to continue to run very cautious fiscal policies for as long as that stock of debt – and the interest burden on it –remains at high levels.Austerity measures may be coming to an end - but Ireland is a very long way from being in a position to begin to substantially increase public spending or cut taxes.

Noel O'Halloran, CIO, spoke at the CEF Conference in New York on 6th November on the topic of the Irish economy. The presentation is called 'Celtic Comeback Continued'.  Click here to view the webcast and here to view a PDF of the presentation.

Budget 2014 was the first budget to deliver less, in austerity measures, than the amount agreed with the troika.  Indeed, it is a mark of how the balance of power has changed between Ireland and the troika that the government could reduce the size of the austerity package by €600m, and in reality there was very little that the troika could do about it. On the whole, this decision can be justified, but it's a close call as there was also a good case to be made to make quicker progress towards debt reduction.  After all, Ireland will still borrow close to €10bn this year, adding to an already-high stock of national debt.  The key issue now is whether Budget 2014 is the first step towards walking away from a sensible fiscal policy designed to get our debt under control, or simply a pragmatic recognition that the austerity package this year need not be as large as previously thought.  The jury is out!

Most public and media focus on any budget is on a few controversial measures that get the headlines, but which are often very minor in terms of the overall budgetary arithmetic, or indeed in terms of what needs to be done to get the economy moving, reduce unemployment and exit the bailout arrangements. At this early stage it seems quite likely that the main debate about the Budget in the days ahead will be about very specific issues such as the abolition of the bereavement grant or the reduction in the number of elderly medical card holders.  These are, it goes without saying, very important issues to those directly affected, and indeed important social issues, but it is sometimes unfortunate that the really important budgetary decisions - in broad economic terms - are almost overlooked in the entirely understandable reaction to particularly controversial measures which are minor in overall budgetary terms.

And this Budget does indeed merit serious consideration at a macroeconomic level:

  •  It is the first Budget where the Irish government decided to essentially overrule the troika and bring in a much smaller package of austerity measures than previously agreed. 
  • It marks the return to what economists call a "primary surplus", i.e. the budget will be in surplus when interest on the national debt is excluded. 
  • It is the first Budget in a long time that is taking place at a time when there are genuine indications that the economy is picking up somewhat, and the approaching light at the end of the tunnel may not, in fact, be the light of an oncoming train!

If Budget 2014 was Budget 2012?

Turning to the first of those broader issues above, it is interesting to think about what might have happened if, say two years ago, the Irish government had overruled the troika and reduced the amount of austerity in the budget by 20%, as it has done this year.  It seems very likely that Irish bond yields would have risen substantially, while various European policymakers would have made grave comments about the lack of commitment from Ireland to restore its finances to good order. The troika would, no doubt, have at least threatened to delay or withhold further funding, and it would have been near-impossible for Ireland to raise any money in the bond markets.

But this is late 2013, not late 2011, and the balance of power has shifted.  In reality, the government no longer needs troika funding - it has access to the financial markets instead, and also has a very large reserve of cash on hand.  And the international environment has changed as well, as the eurozone fiscal crisis seems to be steadily fading. So the government felt strong enough to essentially tell the troika that it didn't agree with the scale of austerity measures previously agreed.  Nominally, the reduced austerity measures were "agreed" with the troika, but in practice the troika had little bargaining power.

Right Decision?

Was this the right decision?  It's a very close call and there are strong arguments on both sides of the debate, but on the whole it can probably be justified. The promissory note deal reached earlier this year should result in very substantial savings in 2014 (of the order of €1bn, as an estimate), and the vastly improved sentiment towards Ireland on the international financial markets means that Irish bond yields are unlikely to react much (if at all) to the smaller than planned size of the austerity measures. At a time when the Irish economy finally appears to be turning a corner, there is a case to be made to give the economy every help possible, in fiscal terms, by reducing the size of budget cuts as much as possible.

On the other hand, of course, Ireland's national debt is very large and is still rising - we will borrow close to €10bn next year, which will in practice be permanently added to the national debt and on which interest will have to be paid for generations to come.  In addition, if 'something goes wrong' in international financial markets, Ireland may once again be cut off from raising money in the bond markets and have to rely on international lenders such as the IMF and EU once again - and refusing to comply with their targets now might turn out to be costly if Ireland is forced to ask for further emergency in the future.

Taking everything into account the smaller austerity package was probably the better option.  But it is very likely something that can only be done once, for many reasons.  Firstly, the IMF has explicitly made it clear that it expects the shortfall from this year's budget to be made up in Budget 2015, i.e. adding the €600m of austerity measures that were not implemented in this budget to the austerity measures in the next budget. Secondly, the markets are likely to ' forgive' (if that's the right word) a budgetary shortfall in one year, based on the savings from the promissory note, but they are unlikely to be as relaxed if that happens again next year - that then becomes a trend, instead of a once-off event, and markets don't like to lend money to governments who ignore budgetary agreements and targets.

Betting on better growth

The government's hope, presumably, is that the emerging signs of recovery in the Irish economy are real, and deliver respectable economic growth in 2014 and still-stronger growth in 2015 - enough to deliver stronger-than-expected tax revenues and thus lower-than-agreed austerity measures in Budget 2015.  The government may well be right - many economic indicators are lining up in the right direction. But it is a risk, without a doubt.  If growth turns out to be disappointing next year and into 2015, the government is very unlikely to be able to avoid further substantial austerity measures in the next budget - and at least in theory, they could even be significantly larger than the €2bn that has been agreed already.

Jury is still out

So the government is taking a risk with this budget, privately hoping and expecting that better growth in 2014 and especially in 2015 will remove the need for extra austerity in Budget 2015.  It will probably require a growth rate of the order of 3% in 2015 to achieve that aim - a growth rate that does seem very high by the standards of the last few years, but one which is achievable, with a "fair wind", by 2015, if the international environment remains favourable. The consensus forecast for 2014 is a little short of 2%, and if that is achieved 3% in 2015 is not out of the question.  It will be quite some time before we know whetherteh government's calculated risk pays off or not.  As we said at the outset, the jury is still out!

 

See below for a list of the principal measures in the Budget, or click here for a commentary on the overall Budget.

Overall Budgetary Position:

  • The main domestic measure of the budget deficit, the Exchequer Borrowing Requirement, will be 4.8% of GDP in 2014, down from an estimated 7.3% this year. If no austerity measures were introduced in the Budget, the deficit would have been 5.8% of GDP next year.
  • GDP is expected to grow by 0.2% this year, and 2% next year.  This is higher than the previous forecast of 1.8% (the figure endorsed by the independent Fiscal Advisory Council) due, the government says, to the measures in this budget which will increase growth next year.
  • The debt to GDP ratio will be 124% at the end of this year, but will fall to 120% by end 2014, 118.4% in 2015, and 114.6% by 2016.

Taxation:

  • The main income tax rates, band and credits are unchanged.
  • The pension  levy of 0.6% which was due to expire at the end of next yearwill first rise to 0.75% for 2014 and then fall to 0.15% from 2015 onwards.
  • Tax relief on pensions is being restricted. The standard fund threshold will be cut from €2.3m to €2m from the end of this year.  The current multiplier for converting a DB pension entitlement into an equivalent fund for the purposes of the cap is currently a flat 20 times, this is being replaced by a range of multipliers that will vary with age.
  • Changes will be made to ensure that no Irish companies can be "stateless" for tax purposes - this is a move clearly aimed to restricting the ability of companies to avoid tax both in Ireland and in other countries.  This has been a controversial issue in recent months for certain large multinational companies.
  • A "rollover" relief will be put in place for Capital Gains Tax for investors who invest proceeds of sales into new investments in certain productive businesses
  • Some investments in small companies will be exempted from the higher earners  cap on reliefs - basically giving the same tax advantages for high earners as are in place for middle income taxpayers who make this type of investment.
  • Tax relief on medical insurance is being restricted, with a cap so that the more expensive plans do not benefit from full tax relief. Tax relief will not apply on amounts greater than €1000 per adult and €500 per child.
  • Excise duty on cigarettes is up 10c
  • Excise duty on wine is up 50c per bottle
  • Excise duty on petrol and diesel is unchanged
  • Excise duty on a pint of beer or standard measure of spirits is up 10c
  • The DIRT tax rate is to rise from 33% to 41%, and the same rate will be applied to the exit tax on life insurance policies.
  • The VAT rate on tourism and hospitality related services, which was due to rise back to 15.5% from 9%, will remain at 9%.  In addition, the air travel tax will be abolished from April 2014.
  • An independent cost/benefit analysis will be carried out on the agribusiness sector to see which tax reliefs work and which don't.  Its recommendations will be considered in Budget 2015. 
  • In the construction sector, a new home renovation incentive scheme will provide a 13.5% tax credit for people carrying out work on their principal residence, for expenditure over €5000 and below €30,000.  In part, this is designed to squeeze the black economy as obviously the tax relief will only be available where a tax compliant builder is used.
  • An exemption from CGT for those who buy property and hold it for seven years is being extended to end 2014 (it was due to expire at the end of this year).
  • A new bank levy will raise €150m, levied in the same way as that levied from 2002 to 2005, i.e. essentially based on deposits. But the restriction on deferred tax assets for NAMA loses is being abolished.
  • A package of 25 measures, costing €500m in total, is designed to help business and create jobs, in particular in the SME sector will be introduced, including measures such as increasing the cash payments basis VAT threshold, a two-year tax holiday for long-term unemployed who set up a new business, and various other measures.
  • "Top slicing relief" on redundancy payments is being abolished.  This was a benefit which provided that people made redundant paid tax on the lump sum at their average rate of tax in the previous years, rather than their marginal rate.

Spending

  • Total spending cuts of €1.6bn out of total budgetary measures of €2.5bn.
  • Sick pay for employees will not apply to the first six days of absence.
  • The rate of unemployment benefit will be cut for claimants under 25
  • Other basic rates of social welfare will remain unchanged.
  • Medical card thresholds for the over 70s will be cut, reducing the number of pensioners entitled to a medical card by about 10%. On the other hand, free GP care will be introduced for all children under 5 years of age.
  • The telephone allowance for pensioners will be scrapped. 
  • The "death benefit" of €850 for next of kin to pay funeral expenses etc has been abolished.
  • Maternity benefit will be standardised at €230 per week, a slight reduction for better paid new claimants. 
  • Medical card prescription charge is up to €2.50 (from €1.50), with a monthly cap of €25.
     

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© 2014 Kleinwort Benson Investors Dublin Ltd

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