Abbott’s financial challenges

A Coalition victory would create spending across a wide array of businesses … but there are key global and domestic challenges.

Summary: A Coalition victory would unleash a new wave of spending across a wide array of businesses across Australia, however there are difficult structural problems that an Abbott government would need to address to tackle the country’s $30 billion deficit. There are also global economic issues to contend with emanating from China, Europe and the United States.
Key take-out: Changes to fair contract provisions will impact the likes of Woolworths and Coles, while further moves to block agreements between building unions and infrastructure developers will have negative consequences for the likes of Leighton Holdings and Lend Lease.
Key beneficiaries: General investors. Category: Economics and strategy.

This week I had to address a group of people on what happens in Australia after the election. And so today I would like to share with Eureka Report readers what I think will happen.

Obviously there are the usual caveats of uncertainty, but let’s chance our arm and set out the scene – at least as to how I think it looks at this point of time. First, the bookmakers have Tony Abbott and the Coalition as an almost unbeatable favourite and Rudd appears to be faltering.

So we must assume a Tony Abbott victory, although don’t be surprised if Clive Palmer makes a late run and takes some seats in places like Queensland.

A Coalition victory will unleash a wave of optimism, and in recent weeks we have been seeing that optimism reflected in the stockmarket. In particular, we have been seeing a great deal of short covering. There was extensive shorting of the Australian currency and our leading stocks in anticipation of adverse global events, and as those shorts were reversed it compounded buying pressure.

Then last night we saw the global side of that Abbott optimism – the tapering of quantitative easing will come in the first 100 days of his Prime Ministership. That’s why I recently urged caution to Eureka Report readers in getting too enthusiastic about the recent rises (see Global caution signs you need to heed).

Nevertheless the wave of optimism that will come with a Coalition victory will see a great deal of spending created in a wide array of businesses.

To a large extent the business community has been holding back essential capital expenditure because of a state of uncertainty. The confidence that would come with an Abbott victory will see those spending curbs unleashed.

Difficult problems

The Coalition has some quite difficult problems to sort out, and those problems will become more apparent after the initial wave of enthusiasm. On a broad level, there is a $30 billion deficit in the government coffers. This has been created, because in the last six years revenue growth has fallen from about 7.5% to 4%, and spending growth has gone up from 6% to 8%.

All the recent assumptions of balancing the books were based on very dodgy longer-term numbers from Treasury. Treasury expects spending growth to suddenly slump to between 3 and 4%; is looking to see unemployment fall from an expected 6.25% to 5%; and of course it has optimistic estimates for carbon, mining taxes, plus the abolition of the motor FBT.

Abbott is taking away those taxes and not abolishing the fringe benefits tax concessions of motor vehicles. So he has a very serious problem that must be addressed. He is going reduce spending via a marked fall in the public service. This will be achieved by stopping duplication with the states, particularly in health, the environment and education, and through the abolition of thousands of regulations which require public servants to administer. And, of course, he will almost certainly keep the current efficiency dividend that has been promised by the ALP. That will cause a great deal of weeping and protests, and will adversely affect parts the economy, particularly in Canberra. Property prices in Canberra are likely to be reduced.

His plan to create jobs comes not through changing industrial relations legislation but rather by instilling a whole new culture into the public service, particularly the tax department, that will encourage independent contracting and the creation of new businesses.

In addition, even during the election campaign, he has groups working feverishly so that they can reduce the cost of building infrastructure, which is another major employment-creating area. This will affect Leighton and Lend Lease (see below).

Fair contracts provisions

He is going to extend the fair contracts provisions that exist to protect consumers into small and medium business. This will require large companies to dramatically change the agreements they have with smaller suppliers and customers.

Those dealing with a large number of smaller customers (like Woolworths, Coles, and the suppliers to small retailers) will find preparing “fair” agreements very disruptive. This will not be apparent in the first 100 days but keep your ear to the ground, and be wary of companies that announce they have problems.

The public service cuts and the new contracts will also mean that the Abbott honeymoon will not last a long time. But the moves are necessary if we are to restore some balance to what is taking place in Canberra.

I don’t believe either party will be able to fund some of the very big promises that have been put through in this election. Without major cost reduction and employment encouragement, either party will have to find ways to defer some of the Gonski education reforms and disability provisions (I’m not suggesting that I want these things to happen, but I don’t think the money is going to be there without action). Of course, the money will be there if China surges ahead and in the last few weeks we have seen a sudden turnaround in the sentiment for China.

China demand

Kevin Rudd has been forecasting the end of the minerals boom, and yet we are seeing iron ore prices rise sharply. Is this sustainable? Forecasting China is always difficult, but let me have a try. The new leadership in China has as a major priority, over time, to adjust the Chinese economy so that there is much greater consumer demand and less need for exports and infrastructure expenditure.

But in the last few months they saw how dangerous this could be, because as China cut back on infrastructure and property expenditure the economy started to slip back quite sharply. Accordingly, in recent months there has been a big swing towards pumping money into infrastructure and property. This may not be maintained, because China has deep problems in its financial and social structures that do need addressing. But what that tells us is that the Chinese economy is not simply going to disappear.

There will be strong demand for our minerals, albeit that the growth will be reduced and there will be sectors like coal where there is oversupply. Gas could also be in that oversupply category, although if the current turmoil in the Middle East persists it will help Australia. What that means is that the attraction of new projects will be far less and, of course, in the case of energy – coal and gas – we have the effect of the US expansion of energy supplies to cope with. (Also see Justin Braitling’s article today, Exploding shale).

So my view is that we are not facing a minerals catastrophe, but a much tighter market – be wary of pushing stocks too high. And I recognise that the current good figures out of China are causing the market to send out a different signal, albeit that those signals are being boosted by short covering.

European crisis

When it comes to Europe, I think that at some time during the first year of the Abbott government there will be another crisis. European bank shares have improved and it is a wonderful opportunity to recapitalise. That is happening, but not enough. So I am staying with my original predictions on Europe.

The US recovery

And you know I am bullish about the US. Bond prices are rising there because the market now expects quantitative easing to be phased out in the next six months. But the US economy is doing pretty well overall, with a rise in house prices plus the extra energy and low-cost US labour that is giving America momentum.

So that should cause the US dollar to rise and the Australian dollar to fall, and that will boost inflation pressures. Within a year of the Abbott government gaining office he will be very worried about what is happening to house prices in the inner cities of Sydney, and to a lesser extent Melbourne and Brisbane. The low interest rates are really kindling the demand and the banks are being very tardy in backing new developers, so the supply is being restricted. In the outer suburbs where supply is easier to generate, we will not see quite the same momentum, although it will gradually flow through. But that rise in inner city dwellings is going to make the Reserve Bank look pretty hard at what happens and how far it should cut rates.

Infrastructure changes

Finally infrastructure, and Leighton and Lend Lease.

They generate a large amount of their profits via agreements with unions, which makes it hard for new subcontractors to enter the industry – it makes it very profitable but boosts the costs of major infrastructure by about 20%.

We have seen action in Victoria, NSW and Queensland to block the union-big company cartel style agreements, and Abbott will duplicate that action.

In Victoria it is starting to bite. Lend lease has been banned from government contracts and the government is now splitting jobs so smaller building groups can tender in areas that were once confined to the majors.

I was stunned that this week’s Leighton report did not mention that the group faced major changes in the way it manages. Both companies have lots of work in the pipeline but given the management change they face I would be very wary.

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