On the couch with the Budget

The minority of Australian TV viewers that chose the Budget Address rather than tuning in to Married at First Sight were still entertained by coverage that combined poor quality acting with choreographed hugs.

Whether this is a government that has decided to leave is unclear. They seem to want to stay and give governance another chance. However, Australian voters are the other parties to this relationship, and it is doubtful whether they heard enough last night to give this marriage one more turn.

The ALP intruders presented their credentials on Thursday in the Budget Reply. Will Australians decide to stay single and engage in a series of pointless affairs with cross benches? All will be revealed in May when voters are dragged into the commitment ceremony.

The Budget is normally a serious document, but the one presented on Tuesday night might never see the light of day. The Senate, which must review and approve the expenditure and revenue proposals of the government, will not even vote on this prior to the election. It is a Budget that waits to find out if it has life, and while commentators will spend heaps of time reviewing the tax giveaways, we are not so inclined.

Rather we believe it is more pertinent for investors to delve into the tables and charts presented by Treasury to determine where Australia is right now, and where we may be heading.

For what it is worth, the Budget predicts a return to surplus in 2019/20. The underlying cash balance is predicted at 0.4% of GDP and the net operating balance is 0.6% once the Future Fund’s earnings are added in.

The Future Fund flows in and out of estimates throughout the Budget document. We will return to it later but it is interesting that the Budget claims Future Fund earnings as a credit while taxpayers continue to pay the pensions of former civil servants.

The expected receipts of the government are disclosed in the following table.

The increase from 24.2% of GDP in 2017/18 to 25.2% in 2019/20 essentially explains how the Budget is forecast to return to surplus. Hold spending and increase tax collections – it’s that simple! However, we suspect that the next chart (and forecasts) is a little ambitious with total government outlays forecast to drop to just 23.5% of GDP in 2030 from the current 25%. An ageing Australian population will be a clear headwind to this forecast.

The next chart tracks the movement of the Budget deficit from 2013 into next year’s surplus.

Looking at the forward estimates, there needs to be some clarification by Treasury why the Budget surplus does not grow as a percentage of GDP and is actually forecast to decline again in 2023. The mooted tax cuts of 2022, announced by the government, will have an impact but this is not expected to be compensated by stronger economic growth.

The categories and makeup of expenditures are shown in the following pie chart. Social security, welfare and health comprise nearly 53% of all expenditure.

But what are the “other” expenditures that make up 19.6% of expenses? The following table shows that the bulk of it goes to State Governments, which are mainly funded from the GST collections of the Commonwealth.

The above table also discloses that the interest bill of the Commonwealth government resides in other expenses and will consume about 3% of government expenditure in 2019/20. Importantly it is projected to slide lower over the next 4 years as lower interest rates and stabilised debt flow through the Budget.

As of today, the Commonwealth has issued $532 billion of debt securities representing about 28% of GDP ($2 trillion). Australian bonds trade in the open market and because interest rates have fallen, the bonds have a market value of $602 billion – that is a premium to their issue price.

The bonds on issue are itemised below and you can see that Treasury has had limited success in accessing the really “low” interest rates currently on offer. Indeed that is the problem with running massive deficits without a QE program. The open market will price bond yields higher at times when governments want to borrow to fund excessive or growing deficits. Based on offshore observations, QE programs (bond buying) can be most useful if managed by the Central Bank to manipulate interest costs down for governments.

Noteworthy is that Australia’s government debt to GDP is falling to 25% whilst many European Union Governments have debt levels of over 100% to GDP. However, excessive QE has driven European bond yields to well below those of Australia.

The beneficiaries of Australia’s elevated interest rates (compared to the poor yields offered on lower rated foreign bonds) have been international investors. Today non-residents own 56% of Commonwealth debt securities with about $270 billion owned by Australians – mainly institutions (banks and life offices) and large super funds.

As we have noted many times in the past, Australia’s total Commonwealth debt is well covered by superannuation assets. It would take just 25% of the total funds sitting inside the superannuation system ($2.7 trillion) to fully fund the Commonwealth.

Looking forward, we see bond issuance declining while Australian super assets will continue to balloon. If bonds are an intended asset class for major super funds, then there is going to be a significant shortage of them. In any case, the yields (currently 1.8% on ten-year bonds) are too low to meet the liability profile of super funds. This tells us that returns from bonds and thus super funds are set to decline in coming years.

In the Budget papers, Treasury updated its expectations for the Australian bond yield curve. It has lowered its expectations for interest rates by 0.5% across the bond yield curve from what it forecast just 4 months ago.

The poor outlook for bond returns is highlighted in the next table that discloses the asset allocation of the Future Fund’s $147 billion of assets (as at 31 December 2018). The Fund has no Australian or international bond holdings, but it was seeking out yield in debt securities and alternatives.

The Future Fund remains an important consideration for the Budget because it adds greatly to the Commonwealth’s debt. This was again disclosed in the budget papers:

Therefore despite operating for over 12 years and not paying out any pensions to the retired beneficiaries of the Commonwealth defined benefit schemes, the Future Fund is still underfunded by $75 billion. The pension shortfall is paid by the taxpayer through the Budget and there are many more civil servants, including over 50 current standing Commonwealth parliamentarians, who are future beneficiaries of the Future Fund. Thus as franking benefits are stripped from your self managed retirement fund, spare a thought for those politicians who have a secure but unfunded future.

Another significant disclosure was the impact of commodity prices on the Australian economy and thus the Budget. In the Budget, there is a current forecast that iron ore prices will fall to about $55 per tonne (current price $80), but this has been tempered by recent supply disruptions.

Thus the price of iron ore, coal and LNG exports does have a significant impact on Australian economic growth. The seemingly good news from the above is that current commodity prices are working in favour of creating a budget surplus.

The other favourable development is the low unemployment rate and the high level of employment as against retirees. These trends add to the Budget moving into surplus. If more people are employed and tax rates aren’t adjusted, then bracket creep will push the Budget revenue line higher.

The offset to employment growth for the economy has been sluggish wages growth and the failure to index tax brackets. Thus over the last year, the growth rate of household consumption has slowed despite burgeoning employment growth. The tax relief (low income tax offset) announced in the Budget (and supported by the Opposition) will give a short term lift to household income. Hopefully, this is consumed productively rather than gambled or flittered away by recipients.

Conclusions

The Budget is hardly visionary and it is structured to allow the normal budget stabilisers to play out. Thus, if Australia is not buffeted by offshore events, our natural growth profile (flowing from population growth, tourism, education and commodity export income) will continue to lift the revenue of the government.

The funding of infrastructure is not a new initiative but the focus on its importance is acknowledged. There seems much more coordination of infrastructure policy and funding between Commonwealth and State Governments.

Tax relief to low income earners and small business will be a welcome relief to discretionary retailers (such as Harvey Norman and JB HI-FI) should it translate into expenditure in 2019/20. There will likely be a surge in expenditure by SME’s on IT equipment, iPads, iPhones and other equipment that can be written off immediately in taxation returns.

The economic forecasts on which the budget is framed may be regarded as ambitious, but this will become obvious in coming months if China and the US don’t settle their trade differences. Further out, there is the implicit assumption that Australia will surpass 30 years of continuous economic growth in 2022.

As for the rest of the world, Treasury forecasts a steady growth profile for the developed nations. This is consistent with our view that growth will be moderate in coming years with a risk of only a mild downturn. Importantly for Australia, as China’s growth slows the emergence of India becomes more pronounced. Thus, a stronger alliance in trade with India must become a priority for Australia.