Themes For April

Global equity markets once again posted positive returns for the month, with the Australian market improving 1.8% with strength in both the real estate and gold sectors offset by weakness in the materials sector. Other major markets also posted reasonable returns with the US market up 1.3 percent while Europe fared better up 3.6% percent. China was the exception declining by 5% on concerns about the growth trajectory of their economy which served to depress commodity prices, especially iron ore which fell by 8.5% for the month.

Central banks continued their path of tightening monetary policy with both the Australian Reserve Bank and the US Federal Reserve increasing interest rates by 0.25% early in May. It is quite likely however that they will now pause in their tightening schedule to assess the impact of past interest rate increases which only take effect after a lag of up to 12 months. Bond markets were reasonably subdued with both Australian and US 10-year bonds improving 5 basis points to converge at around 3.4%. The US dollar was somewhat weaker against major currencies however $A was steady against the greenback finishing at just over US 66 cents.

Australian Federal Budget

 The second federal budget of the current Labour government delivered an eye-catching surplus of $4.2 billion for the current financial year, largely on the back of revenue windfalls from historically high commodity prices boosting company taxes as well as wages inflation contributing to higher income tax receipts from bracket creep. This will now ensure the stage 3 tax cuts legislated by the previous government are now almost certain to be delivered next year.

Investors should always take budget forecasts by the grain of salt evidenced by the fact that as recently as October last year, the current year budget was forecast to be a deficit of $36 billion only see a $40.2 billion turnaround in just eight months! The return to surplus was driven by cyclical factors rather than government policy so structurally the budget will remain in deficit for the foreseeable future driven by spending as a % of GDP at well above pre-COVID levels.

Given the regressive impact of high inflation, it is understandable the government would assist lower income earners with a range of cost-of-living assistance measures totalling some $15 billion (over 4 years) however the $12 billion in stimulus ear-marked for next year will work contrary to the Reserve Bank initiatives to dampen inflation. Unfortunately, the budget surplus will be short lived as new spending programs will return the budget to a $13.9 billion deficit next year before ballooning to $35.1 billion the following year. To some degree, the budget was a lost opportunity to bank the benefits of an unexpected cyclical surplus which will be transitory given the expectation of slower growth next year as tighter monetary policy begins to bite. Although the lack of fiscal austerity was disappointing, the budget was not irresponsible and will not have a great impact on the market’s direction.

Can the US really default on its debt?

 Like a movie that we’ve seen many times before, the US is once again facing a political standoff over raising the debt ceiling to fund the government’s spending obligations. The impasse has arisen because of the divided nature of the US government, with the Republican Party assuming control of the House of Representatives in November last year, while the Democrats control both the Senate and the White House. While the spectre of the US government defaulting on its debt obligations sounds dramatic, and indeed would be a seismic event for financial markets, it is highly unlikely to occur.

Under the US Constitution, the House of Representatives holds the “power of the purse” meaning that it must approve all tax and spending bills including the aggregate amount the government can borrow which then must be consented by the Senate and signed by the President. While the President has broad ranging powers and can veto any bill passed by Congress, he (or she) does not have the unilateral power to approve government spending or borrowing. Given the large and persistent government deficits over several decades in the US, including the extraordinary level of government spending during the pandemic, the US government’s debt has ballooned up to the $31.4 trillion limit last approved in November 2021. This has resulted in a familiar political stare-down with both sides of politics standing their ground to extract concessions from the other side.

The Republicans for their part are quite legitimately trying to curb the rampant growth in government spending which ignited global inflation in 2021 and which is likely to see a federal deficit more than $1.5 trillion in the current fiscal year. The Republican House has already passed a Bill that increases the debt ceiling by $1.5 trillion in return for spending levels to be returned to 2022 levels. The Democrats position is that additional borrowing is required to implement spending that has been already approved by the previous Congress and are unwilling to make cuts to the $7 trillion of spending proposed in their recent budget.

 

While the spectre of a US government debt default is always dramatic political theatre, it is highly unlikely if not impossible to occur. Firstly, the government’s obligation is to pay coupon interest payments on existing debt as well as repaying maturing securities, most of which can be refinanced within existing debt limits. The US treasury collects roughly $400 billion of revenue per month of which only $33 billion is directed towards servicing net debt interest payments. If push comes to shove and the debt limit is not increased, the Federal Treasury can prioritise government revenue towards debt servicing ahead of other spending obligations as well as not implementing new spending initiated by the Congress.

There is indeed a strong argument that there is in fact the Constitutional obligation of the Treasury secretary to honour the “full faith and credit” of the US government. While this would be very disruptive as it would involve shutting down large sections of the public service, curtailing entitlement programs and even cutting military funding, it is preferable to the government defaulting on its debt. The practical reality is this is merely an academic argument as the issue will (as always) be resolved despite both sides playing a game of chicken before an 11th hour compromise agreement is reached. With the US entering a general election year in 2024, neither side would want to wear the blame of being responsible for the economic fallout from the impasse. In the lead up to this issue being resolved, there is likely to be some nervousness in financial markets however this will wash though once an agreement is reached.

Strategy and Outlook

 The focus of economic policy remains on the imperative to reduce inflation to more acceptable levels. Following a year of interest rate increases by central banks around the world, it is reasonable now to expect that there will be a pause to assess the effect of rate rises to date. It is reasonable to assume we are past the peak of inflation, and that it will further reduce from current levels, however it is too early to say that there will be no further interest rate increases.

The uncertainty concerning just how much the global economy will slow and to what degree corporate profits will be impacted remains the key question that markets are currently grappling with. Equity returns so far this year have been impressive and are factoring in an optimistic scenario for both interest rates and inflation. The expectation of interest rate cuts later this year, which is reflected in the interest rate futures market, is unrealistic and would only occur due to a severe recession which is both unlikely and undesirable. We are optimistic that as we move through the course of calendar 2023, the outlook for equity markets will improve particularly once corporate earnings begin to be positively revised which is a reliable indicator of future share price returns.