PORTFOLIO POINT: The 2012 budget is not 'contractionary’ and is unlikely to upset a trend towards lower interest rates.
The good news for investors is that this budget isn’t the contractionary horror story we were led to believe it might be. But the budget is actually supportive, in a broader macroeconomic sense, of a switch out of cash and into equities over the medium term.
Now to understand this point of view, we need to consider the discussion surrounding the stimulatory impact, or otherwise, of the budget. There has been a lot of it over the years and the common perception, perpetuated by tough-talking politicians and some economists, is that the 'austerity’ undertaken by the government would weigh on the growth outlook. This is partly the reason why, according to this view, the RBA would need to cut rates.
Indeed, it’s true to say that under some well-accepted measures, the budget appears to be contractionary. The way this is measured is by looking at changes in the fiscal balance (on an accruals basis, not a cash basis, given cash accounting is more susceptible to deceptive accounting practices) and in the economics fraternity, this is indeed a well-respected way of analysing budgetary impacts on the economy.
If you do this, and I’m sure you’ll see it quoted often over coming days, the fiscal contraction in 2012-13 is around three percentage points. Or in other words, the contraction in public spending will take off 3% from growth over that year. With notional growth of only 2.2% in 2010-11 and about the same (2.5%) expected this year, that’s the stuff of recession, and you can see why there was the worry.
But the measure is not without its criticisms and as always, it’s only part of the story. Indeed it can be quite misleading.
For a start, tonight’s budget shows that expenses aren’t actually being cut (on an accruals basis). And this is a crucial point: Following the GFC, government spending surged by 16%-17% in one year, on both a cash and accruals basis. Since then, however, expenses have not been cut at all; they’ve actually increased by around 5% per annum on top of that. There has been no fiscal contraction – I wouldn’t even call it a fiscal consolidation and this budget doesn’t change that momentum in any fashion. Over the forecast horizon, growth in expenses is certainly expected to slow – to 3.7% on average over the next four years – but by no means detract from growth. Expenses are not declining and this, in any event, is not how the government intends to reach its surplus next year.
So it makes sense that if government is going to increase spending in the coming years, this will surely add to economic growth. How then, may you ask, does the budget get back into surplus? Well that’s largely due to an expected surge in revenue growth in 2012-13 – almost 12% or some $40 billion, which compares to an average of about $20 billion in the three years preceding the GFC – notwithstanding downward revisions to revenue estimates in this budget to the tune of $19 billion in the four years to 2014-15. That surge in revenue comes down largely to an expected lift in economic growth, buttressed by a $10 billion lift in tax revenues due to resource rent taxes ($6 billion) and the carbon tax ($4 billion).
The question as to how safe those revenue assumptions are probably isn’t all that important, and certainly big questions can be raised about the contribution to revenue that both resource taxes and also the carbon tax will make. But as to the proportion of increased revenue that is due to an expected uplift in growth? I think those assumptions are safe and to be honest, there may even be some upside. This again is supportive of that switch out of cash and into equities.
Consider the backdrop more broadly and recall that the RBA has cut rates by 100 basis points so far this cycle – the commercial banks have not passed on the full cuts, but rates are nonetheless lower. That 100bp rate cut occurred despite domestic demand growth being at its strongest in four years in 2011. At a basic level then, if you had strong demand already and monetary policy is more stimulatory, growth prospects must be better over the period ahead, especially now that we know the budget isn’t contractionary.
This is why I don’t actually have a problem with Treasury’s growth forecasts as outlined in the budget.
Growth is expected at 3% in 2011-12 and then 3.25% in 2012-13. Domestic demand growth, however (excluding next exports and inventories) is forecast to be much stronger at 6% this financial year and then 5% next. Of course, much of that is due to a surge in business investment (expected to be 18% and 12% respectively in 2011-12 and 2012-13) and specifically resource-related investment. We know this story. To be precise, where I think there is some upside to the government’s forecasts is in the consumer space. Consumer spending, at trend through much of the last year, is expected to remain at or below trend over the next two to three years (3-3.25%). Considering the stimulatory policy environment and the expected pick-up in global growth, I’m not as cautious on the outlook for consumer spending.
I think my optimistic view is a reasonable view to have when you consider the constraints to household spending that we’ve witnessed over recent years. Growth in household spending has, as the Treasury notes, been around trend over the last year or so, despite an unprecedented run of natural disasters, fears of renewed financial crisis and, of course, grave concerns over global growth.
I suspect that as some of these fears abate, consumption growth will lift as households become less cautious. That’s especially the case given Treasury’s employment outlook. The unemployment rate is forecast to effectively peak at 5.5% next year and employment growth accelerate to 1.25% next year, from 0.5% this year. Again, and for the same reasons as to why there is upside to household spending, there is probably decent upside to the government’s employment forecasts. This week’s strong lift in retail sales would lend support to that notion.
The other thing I should note is that in terms of the interest rate outlook, today’s budget doesn’t really add to the case for the RBA to cut rates. That said, it’s likely we’ll get those cuts anyway. Certainly markets are predicting that and recent rhetoric from the RBA board gives no reason to doubt it.
So we are left with an economy where domestic demand is running above trend, interest rates are 100bp lower regardless and now we have a budget which rather than weighing on growth as widely expected, is still acting to support it, albeit by a smaller magnitude than what we saw during the GFC. The bottom line, and considering only domestic factors for a moment, is that there is little standing in the way of economic growth.