Budget moves into shock surplus

Christopher Joye

Coolabah Capital

In the AFR today I reveal that Australia's budget has shocked all analysts and credit rating agencies by moving into an official surplus for the first 11 months of the 2018 financial year---some $20 billion better than Treasurer Scott Morrison forecast in 2017---on 2 of the 3 key budget measures with potentially important implications for the AAA rating and bank funding costs (AFR subs can click here). Brief excerpt:

Media and most market participants have completely overlooked the fact that the Commonwealth budget is on track to record a shock surplus in 2018 on two of its three key measures, with major implications for the AAA rating and bank funding costs.Department of Finance quietly released the government's budget results for May, and thus the first 11 months of the 2018 financial year.

These showed that the federal government recorded a chunky $9.4 billion surplus in May on its "fiscal balance" measure, with the "underlying cash balance" and "net operating balance" metrics likewise registering surpluses of $4.9 billion and $10.4 billion, respectively.

Much more importantly, Treasurer Scott Morrison's budget is officially in surplus for the first 11 months of 2018 on both the net operating balance ($1.9 billion surplus) and the fiscal balance ($1.1 billion) benchmarks. Only the underlying cash balance remains in deficit ($10 billion).

It's helpful to put these extraordinary results – which have blindsided virtually all analysts, investors and rating agencies – in context. In Morrison's May 2017 budget, he forecast that Australia's net operating and underlying cash balances would both suffer large deficits of $20 billion and $29 billion respectively in the 2018 financial year.

For the first 11 months of 2018, Morrison is now $22 billion ahead of these estimates on the net operating balance measure and $19 billion better off on an underlying cash basis. While it's certainly conceivable that the month of June could lurch back into deficit and erode these gains, the fact remains that analysts and rating agencies excoriated Morrison for being far too optimistic in his 2017 budget. And yet he has massively outperformed these numbers by  about $20 billion in 2018 alone.

Subject to how June goes, Morrison could deliver a full-year budget surplus on two of the three key measures (he will likely have a deficit on an underlying cash basis), and is all but certain to move the budget into surplus this financial year on all benchmarks.

The only other analyst I could find that has picked up on this is CommSec's Craig James, who comments that this is the "smallest rolling annual deficit for nine years". "For the 11 months to May the operating balance is almost $2 billion in surplus – over $7 billion better than [the government] expected [only two months ago in its May budget]," James says.

The driver of Morrison's upside surprise, which this column has flagged as probable since 2017, is attributable to better than expected commodity prices, labour market conditions, and overall economic growth. "Record employment growth and company profits have boosted government revenues while at the same time the government has trimmed its spending," James explains.

This will likely compel S&P's sovereign analyst KimEng Tan to consider taking the AAA rating off its "negative outlook" and restoring it to a "stable" footing, which few thought possible 12 months ago.

S&P's Sharad Jain has already flagged that the agency is contemplating upgrading Australia's economic risk score from 3 to 2 (lower is better), which would lift the credit ratings on the major banks' hybrids from BB+ to BBB-. It would also improve the ratings on their subordinated bonds to BBB+, which all else being equal should ameliorate their funding costs. Read more here.

Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs over $8 billion with a team of 40 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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