Looking beyond the noise at this year's Budget

Pendal

May 2024

WHEN you've watched enough federal Budgets (this was my 35th in markets), you start to see familiar patterns across commentaries.

Every vested interest or ideological bent comes out bleating about the Budget being irresponsible or reckless, that there's too much spending or not enough major reform.

What worries me more is when people view the government as no more than a large corporation and when they speak of the budget like a profit and loss statement.

Looking through the noise and self-interest is what really matters for bond markets in the year ahead.

I have narrowed it down to three impacts.

Inflation

There are a number of direct measures that reduce inflation, one of which is electricity subsidies.

Every household gets $300 off their electricity bill, by way of quarterly $75 payments directly off the bill. Businesses receive $325.

The average household bill is $2,000 a year, so that's 15% off.

Electricity is 2.4% of the CPI basket, so this equates to 0.36% off inflation in direct impact. The government is quoting 0.5% overall impact.

Queensland has already announced a $1,000 subsidy while Western Australia has announced a $400 subsidy, again not means tested.

It will be interesting to see what upcoming state budgets keep rolling existing subsidies (no impact to inflation), let them roll off (inflationary) or, like Queensland, increase them (deflationary).

If we assume modest subsidies coming up from other states, then the electricity impact on lower CPI could be 0.8% or even higher.

Other measures in rental assistance and cheaper medicines are slightly deflationary.

Overall, federal Treasury is forecasting inflation of 2.75% in 2024/25, which is below the current Reserve Bank (RBA) forecast of 3.2%.

We expect an upcoming downward revision of the RBA forecast of 3.8% CPI for 2024, which looked too high anyway. This could also see its 2024/25 forecast moderated lower, though still near 3%.

Tax cuts and spending

Against the direct impact of the Budget on lower inflation, markets ask the question of whether the extra money in people's pockets may cause higher inflation if and when it is spent.

There is around $20 billion of new spending measures (the Stage 3 tax cuts have been locked in since 2019) in this Budget, with the majority in the next two years.

The Budget will return to deficit, with a forecast of $28.3 billion for 2024/25 and $42.8 billion in 2025/26.

While still low by international standards, the main question is whether or not deficits are appropriate at this point of the cycle.
It must also be noted that it also is based on the usual conservative commodity price forecasts.

For example, an iron ore price of US$60 is assumed, despite a current price nearer US$110 and a five-year average of US$120.

This opens up potential upside surprises as we have seen in the past few years.

This has really excited Budget hawks and has some calling for higher rates as all this money is supposedly spent, stoking inflation.

The question I would ask is whether or not this money is being injected into an economy at full capacity.

On this, my view is that we are sufficiently past the pandemic that supply chains can handle the modest rise in consumer spending without stoking inflation.

Consumers will be spending more in the year ahead. Tax cuts, subsidies and lower inflation should finally see some growth in real incomes - however, this is from a base of real incomes having for the past few years.

Bond issuance

We will see an update on the 2024/25 program from the AOFM shortly.

Given high refinancing (two benchmark maturities totalling $83 billion) the borrowing task is expected to be around $90 billion, as the RBA has borrowed much more than needed this year.

It is important to remember that when determining yields, bond demand and supply dynamics are largely outweighed by economics.

As a bond manager, I only view supply and demand as a short-term impact around supply events.

Ignore the booming debt rhetoric from some commentators and self-styled bond vigilantes - Australian debt will remain AAA for at least the medium term, and with the RBA moving to an "ample liquidity" framework, demand for bonds will remain robust.

So, what does this mean for bonds?

Well, the market always votes straight away, and has already made a half-hearted attempt to run with the higher spending higher inflation narrative.

However, as the dust settles (to quote the cliché), yields are "sharply unchanged".

I think the RBA will see the Budget for what it is - a mixed bag of measures that will leave it hopeful of further inflation relief but wary of whether the 2%-3% band can be achieved and then sustained.

I would also make the observation that the "Future Made in Australia" spending is an overdue response to the global game-changing US Inflation Reduction Act.

By comparison, our government's measures are modest for now, but can be expected to increase in the future.

We are in a very different world to the last decade and governments must respond.

For now, a more detailed breakdown of the domestic economy is below.

Author: Tim Hext, Pendal portfolio manager and head of government bond strategies

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