Budgeting for better times ahead

The budget has been well covered by the mass media, and so I intend to only give you a brief passing view of it. More important to my mind was the Reserve Bank’s quarterly update that reviewed the March quarter and updated a range of economic charts, which allows investors to look at reallity. In contrast, the federal budget does seem to have quite a lot of predictions that seem unreal.

First to the budget, and I note that there is clearly no problem with government receipts. The government obviously overestimated the collection of mining and carbon taxes, but receipts from other places grew substantially. The following table shows that in the three years from 2011 to 2014 tax receipts have and are expected to lift by $56 billion, or 16%. In the meantime, outlays have grown more slowly from a base swelled by the government’s reaction to the threat of the GFC.

In reviewing the budget papers, I noticed that 20 years ago the Australian government notched an $18 billion deficit. The Keating government budget was literally belted by the economic downturn of 1992, which included a property market collapse and the near collapse of Westpac Bank. The $18 billion deficit was on a receipts base of $102 billion. It represented a deficit of over 4% of GDP. However, it was an expansionary deficit that helped stabilise the economy after its massive economic shock.

Ten years later and 10 years prior to now, the Howard government produced a surplus of $8 billion. The intriguing figure from below is that tax receipts represented over 25% of GDP. It suggests to me that we are currently not overtaxed, but rather the burden of tax is not fairly distributed. A government can certainly produce a surplus by increasing taxes and maintaining expenditure as a percentage of GDP. The simplest way to do that would be to increase the GST and lower income taxes similar to that undertaken in New Zealand.

Overall, I felt the budget contributed little to lift the confidence in Australia’s future. There continues to be no roadmap that identifies both the enormous opportunity and growth potential of Australia. We remain a unique economy positioned well between the developed world and the burgeoning developing world. Unfortunately the severe lack of understanding of Australia’s opportunity was starkly presented in the budget – by its silence.

RBA charts – painting a realistic view

I have grabbed only a few charts from the RBA. These charts support my contention that Australia continues to have a solid outlook, but there are substantial challenges ahead.

The first few charts that I have highlighted are specifically focussed on China. The last 10 years have produced extraordinary growth that has averaged 8% per annum. The Chinese economy is now 60% of the size of the US economy. However, per capita, GDP is just 20% of that of the US. Those commentators that predict a rapid decline in the growth of China are suggesting that economic history will be created. Why would the most dynamically growing industrial economy in the world, supported by a fixed currency regime, stop growing? Why would that economy stall at such a low rate of per capita GDP? There is no historic precedent for those claims. China is emerging, and indeed it has probably learnt more from the disastrous financial mangement of US and European economies than the commentators who question its growth.

China’s growth is real and so long-term investors need to have a sensible investment exposure to those companies engaged in that growth. To my eye, BHP stands perfectly in that position. Commentators may question the short-term outlook but the longer term is very clear. BHP will be growing throughout the next decade.

As for Australia, the following charts paint an interesting picture of Australia’s financial wellbeing. From a household perspective, our net wealth has still not recovered to pre-GFC levels. Our household gross wealth is estimated at $7.5 trillion. Household debt approximates $1.5 trillion, and so net household wealth is about $6 trillion. A cursory look at this chart suggests that household net wealth as a percentage of household income is at the same level of 10 years ago. Standing back, I would suggest that wealth has grown substantially for the older baby boomer generation. Yet, on the flip side, debt has grown substantially for the younger generation.

The above chart shows that younger households piled on debt in the years up to 2005. Now, some eight years later, that debt has produced very little in wealth gains. The arguments promulgated by many that debt is a clever strategy to make wealth needs to be tempered. It works in special situations but it often does not.

The realisation of this has obviously dawned on young households, whilst the older generation is increasing its long-term savings. The savings ratio fell into negative territory in 2001 to 2003. It remained around zero up to the GFC. Now it sits around 10%, and given the the sobre presentation in the budget, this will not change anytime soon.

So this leads me to the two charts that reflect on our banking and financial system. Since the GFC and the end of the debt binge, credit growth has slowed to near-historic low levels. This will continue to be quite confronting to our banks, who are struggling to grow their assets. Recent profit increases have been quite impressive in this low-growth period. However, with so much debt residing in the household sector, it is hard to see the low-growth cycle ending anytime soon.

I remain a holder of the bank shares, but the recent rally and the low-growth outlook needs to be acknowledged.

The better news is the stabilisation of the funding profile of the banks since the GFC. As household saving has increased, then so has the retail funding base of our banks. There is now less (but still significant) wholesale funding exposure to offshore markets. In the meantime, equity and therefore capital ratios have improved dramatically. Australian banks are not bullet proof but they are much better funded than they were in 2007.

Finally, all investors should remain cognisant of developments in the US. It was the epicentre of the world debt binge in 2002 to 2007, and so its economic decline was most pronounced. There are clear but tentative signs of a recovery. However, as the charts show, it fell a long way from its peak and the recovery will not take it back to those prior levels.

In conclusion, all the charts above show that the financial markets and economies continue to move through a restructure, work-out and recovery. China stands above all of that and remains the clear growth engine of the world. Therefore, from a growth portfolio perspective, I am about to undertake a review of its structure in the light of the substantial price rises and the sell-down in resources. Intuitively, that does not make sense, and the banking of some profits – an increased allocation to cash and to deep-value stocks – may soon be appropriate.

John Abernethy is the chief investment officer at Clime Investment Management.

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Clime Growth Portfolio

Return since June 30, 2012: 37.35%

Returns since Inception (April 19, 2012): 27.71%

Average Yield: 5.52%

Start Value: $111,580.24

Current Value: $153,256.80

Dividends accrued since 31 December 2012: $3,842.64