Hefty Budget surplus steadies economy in volatile times

An important feature underlying this year’s Federal Budget for investors was the highly uncertain global and domestic economic backdrops.

Lower projected growth and higher levels of inflation have suggested that heightened market volatility is likely to be sustained.

The key message to investors is that diversification has never before been more important. Portfolios with many sources of return will be best placed to negotiate the uncertain waters.

The facts and figures

The Government is forecasting a combination of below trend growth and higher inflation over the next year. A projected fiscal surplus of $22 billion emphasises the strength of the Government’s finances.

That strength is allowing the Government to contribute to the Reserve Bank’s objective of slowing demand while assisting working families (with tax cuts and more specific targeting of family benefits), honouring election commitments and having enough to fund future health, education and building projects.

Australian growth is expected to slow to 2.75 per cent in 2008-09 from 3.5 per cent in 2007-08 (see Graph 1).

The good news is that an expected 16 per cent rise in Australia’s terms of trade in the coming fiscal year due to soaring commodity prices is expected to cushion the economy from the effects of a slowdown in the US, Japan and Europe.

The bad news associated with rising commodity prices is that inflation, which increased by 4.2 per cent over the year to March 2008, is forecast to rise by 3.5 per cent in 2008-09 (see Graph 2).

This rise is expected to be temporary, although there are risks to this outlook. Budget projections assume inflation will fall back to the middle of the 2-3 per cent band targeted by the Reserve Bank of Australia (RBA) in 2009-10.

The unemployment rate reached a 33-year low of 4 per cent in February 2008. The Government expects a weaker labour market to contain wages growth.

However, pockets of labour market tightness, particularly in resource related areas, are expected to persist. The unemployment rate is forecast to rise to 4.75 per cent by June 2009.

Business investment is forecasting that investment will remain firm in 2008-09 given the economy is working at close to full capacity.

However, higher interest rates, tighter credit conditions and uncertainty in global markets are expected to have more of a dampening effect as the year progresses.

The Budget measures are unlikely to have an immediate impact on the Australian dollar, which continues to be supported by strong terms of trade and attractive yields in interest rate markets.

In a world of increased uncertainty, international investors should gain comfort from Australia’s large Commonwealth fiscal surpluses. It will use these surpluses to establish three funds that will support long-term infrastructure investments in education, health, transport and communications. These investments will enhance the economy’s growth potential over the medium to long-term.

Monetary policy and cash rates targeting inflation

In its Quarterly Statement of Monetary Policy in May, the RBA stated that domestic demand will need to slow significantly if inflation is to track back towards its target range of 2-3 per cent. There are signs this is starting to occur, and Budget measures that contain growth in government spending will contribute to this process, albeit moderately.

Following recent turmoil in credit markets, which diverted the attention of Australia’s central bank to ensuring the free flow of liquidity in the economy, the RBA’s focus is once again squarely focused on the fight against inflation.

Expectations for a further boost to incomes from the strong rise in the terms of trade and slow progress in moderating inflation suggest the RBA is likely to maintain its current tighter monetary policy for an extended period.

Mixed messages for fixed interest markets

The economic outlook contains mixed messages for the domestic fixed interest market. To a large extent, these markets have already priced in the economic outlook, which was in line with the market consensus. The prospect of higher inflation in the short-term and the maintenance of tighter monetary policy settings (higher short-term interest rates) should underpin short-term bond rates.

Long-term rates are subject to a broader set of factors, and are more influenced by inflationary expectations and developments in global capital markets. The outlook for longer-dated bonds remains more uncertain and the near-term impact of the Budget should be minimal.

The recent sharp widening in credit spreads across all investment grades as a consequence of the re-pricing of risk in financial markets appears to be offering some potentially interesting investment opportunities, particularly for shorter dated securities.

Spreads on most fixed interest securities are now well above historic averages. In this environment, advisers should think about the opportunities that might once again become available in credit markets. While conditions are still uncertain, the emphasis should be on maintaining quality.

Good long-term prospects for shares

Typically, the performance of shares has been more constrained when inflation is rising. Currently, however, shares seem better placed to withstand increases in inflation, provided it is not extreme.

Corporate margins should be able to withstand the risk of inflation, provided wages growth remains manageable. The more serious challenge to margins is if the slowdown in demand and activity growth is more severe than anticipated.

The economic outlook underpinning the Budget presents different challenges for various sectors of the Australian share market.

With the RBA focused on slowing domestic demand, interest rate sensitive sectors more heavily exposed to the domestic economy seem more likely to be adversely affected.

At the other extreme, materials and energy company earnings appear to be strongly underpinned by high commodity prices and may provide something akin to an inflation hedge. Companies delivering sustainable, more predictable earnings streams may also be better positioned in the current climate.

The planned transfer of the bulk of the 2007-08 and 2008-09 Budget surpluses to three new funds will boost Australia’s long-term infrastructure needs in the transport, communications, education and health sectors.

The Government initially expects to allocate $41 billion to these funds and make contributions from future surpluses. These initiatives should provide longer-term support to industries in the building and construction, communications and engineering sectors, servicing these sectors or providing expertise in managing infrastructure projects.

A combination of capacity constraints, slowing demand, rising inflation and a restrictive monetary policy presents a more challenging business environment.

Share markets are likely to experience volatility in the year ahead as fiscal and monetary policies work towards a more sustainable, non-inflationary growth path.

Following the sharp price declines experienced in the first quarter of 2008, valuations are reasonable and appear to be making some allowance for an extra degree of downside earnings risk beyond that currently forecast by the market.

David Roberts is the head of investment strategy at ipac Securities.