Answers to the questions on every investor’s minds

In the wake of the Federal Budget, a number of common questions keep coming up.

In a recent article, Diana Mousina, Economist – Investment Strategy & Dynamic Markets at AMP, gave her views on the issues currently occupying the attention of many Australians.

Can the Commonwealth afford this level of debt?

2020 was supposed to be the year that the Federal Budget sprang back into a strong surplus, but the need for massive fiscal stimulus amid an uncertain future has pushed the prospect of a balanced budget out until around 2032 at the earliest.

DebtHowever, net public debt in Australia is still exceptionally low by world standards, at well under 40% of GDP for this financial year, although officially expectations are that it will rise to 43.8% of GDP by 2023-24.

In our estimation that figure could end up slightly higher, at somewhere north of 60%, but even in such a scenario we will be well placed compared to our global counterparts.

The logic for running such a large deficit at this point of time to support the economic recovery is well founded.

Interest rates are at record lows and expected to remain that way for some time, and as credit ratings are measured in relation to other borrowers, the Federal Government’s AAA rating appears to be safe.

These factors give Australia a long horizon to retire this debt, meaning that even low levels of inflation will erode the balance before we return to surplus.

This is in large part how Australia escaped our last public debt of this magnitude, which was accumulated in the Second World War, and there’s currently little reason to be concerned that we won’t be able to manage the same feat this time.

How is the Australian dollar faring?

The Australian dollar enjoyed a strong run over past few months, as the US dollar weakened on the back of a strengthening global growth environment and lower volatility in US share markets.

Our currency is often seen as a proxy for commodity markets, and high prices for a number of commodities, especially iron ore, are also supporting the Australian dollar at the moment.

Our stimulus efforts are probably adding to the upside as well – the Reserve Bank of Australia (RBA) is arguably running a less aggressive program of monetary easing at the moment than the US Federal Reserve, and our ongoing fiscal stimulus is at the high end of comparable countries.

All things considered, we think that the Australian dollar is currently priced at around fair value, considering terms of trade and the inflation rate, but further downside risks for the US dollar gives our own currency room the opportunity to strengthen further over coming months.

Do we expect negative cash rates?

The RBA seems adamant that we won’t have negative cash rates, and the Budget doesn’t appear to have introduced any new dynamic that will affect this stance.

It could be argued if the cash rate is cut further, from 0.25% to 0.1%, parts of the yield curve will move into negative territory and produce interest rates below zero in some markets, but the RBA will presumably seek to avoid this if at all possible.

Are US-China trade tensions still a risk?

This is absolutely a wait-and see, largely due to the upcoming US election next month and a potential change in administration should the Democrats capture the presidency.

29081526_lThere is no doubt that Biden’s track record on free trade is stronger than Trump’s, however sensitivities in the electorate and within the Democratic Party may prevent an immediate move away from the protectionist policies of the past four years.

A Biden presidency would certainly mark a renewed commitment on the part of the US to a rules-based international order, including greater engagement with international institutions, such as the World Trade Organisation.

A new administration would also presumably adopt a more conciliatory approach to traditional US allies and trading partners, and potentially open the door for a US return to the Trans-Pacific Partnership.

On the other hand, a re-elected and newly vindicated Trump could escalate his trade war with China further with the introduction of “made in America” tax credits and additional tariffs on goods from China and elsewhere.

Are we worried about inflation?

We’ve become used to low inflation over the past decade, partly due to low global growth in the wake of the 2008-09 financial crisis.

InflationBut the rapid expansion in money supply has many nervous about the potential to spur on inflationary pressure, especially given that central banks have expanded the money supply through asset purchases, which appears to have led to some level of asset price inflation in certain markets.

It’s important to remember that monetary expansion doesn’t always lead to higher inflation, particularly if a central bank keeps a deft hand on interest rates, and that asset price inflation doesn’t necessarily translate to consumer price inflation.

At the moment the prevailing dynamic in most economies is excess capacity, and as long as that continues inflation will be held down.

The key moment will come when the private sector does recover (which could be years away, considering the long-term effects for industries, such as tourism), at which point the government will need to pull back on fiscal stimulus to avoid overheating the economy.

 

Source:  AMP Econosights – Author: Diana Mousina Economist – Investment Strategy & Dynamic Markets

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