The real impact of the FY27 Budget may be weaker growth, not inflation

FY27 Budget snapshot

The optics of the FY27 Federal Budget look neutral for the economy. The underlying budget balance, which most economists focus on, is unchanged at 1% of gross domestic product (GDP) for the next few years, implying no new impulse to growth (as it is the change in the deficit that matters for economic growth). 

However, the fiscal deficit shrinks to 1% of GDP over the next year from 1.7% of GDP. This outcome is partly a result of the deferral of infrastructure investment due to war and capacity constraints in the economy.

The Budget mentions tax cuts for consumers - but these are backdated over the forecast horizon, and do not materially benefit households until FY29, assuming the Australian Labor Party (ALP) is re-elected.

As expected, the 50% capital gains tax (CGT) discount is being replaced with an indexation-based system. Negative gearing is also being grandfathered out, starting with new purchases from now on. Grandfathering does not change the fact that investors determine the price of housing, and so we would expect the combined effects of the tax changes to have a low single-digit negative impact on house prices. Some commentators argue that this is the equivalent effect of one rate hike from the Reserve Bank of Australia (RBA).

The Budget projects that real GDP growth is 2.25% in FY26, and 1.75% in FY27. It also projects that consumer price index (CPI) inflation peaks at 5% in FY26, and slows to 2.5% in FY27. 

Projected growth in FY26 seems optimistic, considering that partial indicators already point to a sharp slowdown in domestic demand in the March and June quarters. 

Indeed, the data do not yet have embedded in them the negative effects of tax changes and the likely full impact of recent rate hikes on the economy's credit impulse.

The silver lining is that the Budget does not add to the case for RBA rate hikes.

Investment implications

A pause in the rate hike cycle would imply that bond yields need to fall, as the money market is still pricing in more hikes. 

If bond yields fall, we would expect long-duration stocks and bond proxies in the equity market like real estate investment trusts (REITS) to benefit. 

The catch is that lower bond yields would be happening because of a slowdown in the real economy, meaning that investors need quality overlays to protect against downside earnings risks. The good news for many growth stocks and REITs is that cyclical softness/weakness does not necessarily impact their near-term earnings in material ways.

Domestic cyclical exposures and banks are likely to underperform on the growth slowdown in train and weakness in house prices. We would need to see the RBA become open to rate cuts before taking a more constructive look at these sectors.

Longer-term, CGT changes disincentivize investors chasing growth. Instead, the new regime favours income investing. The challenge will be that if the economy slows meaningfully, many high yielding stocks may not be able to sustain their distributions. With this in mind, we think that tactically the pricing in of an RBA pause could be beneficial to stocks with more resilience to the cycle, including some beaten-up growth exposures.