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Everybody has heard the saying, “If you seek peace, prepare for war.” That was said by a guy called Vergetius who lived in 390 AD. There was someone else more recently, his name was Winston Spence Churchill. He said, “it is important to understand that the United States is essentially a naval power”. He made this comment in the first volume of his history of the Second World War. If we consider the current military situation, particularly the risks in the Pacific, a good starting point is a speech by Admiral John Aquilino US Commander of the Indo Pacific Fleet to the US Senate in March 2024.

Admiral Aquilino said that the most dangerous national security challenges are evolving faster than the current government processes can address them. Each of the three major state threats— the People's Republic of China, Russia, and the Democratic People's Republic of Korea—are taking unprecedented actions to challenge international norms and advance authoritarianism. These regimes are becoming increasingly interconnected, as evidenced by Xi Jinping and Vladimir Putin's "no limits" friendship and Kim Jong Un’s materiel support of Putin’s illegal invasion of Ukraine. Despite this, China is the only country with the capability, capacity, and intent to fundamentally alter the international order, even amidst its slowing economic growth.''

Aquilino continued "China continues its aggressive military buildup, modernisation, and coercive grey-zone operations. All signs point to the People's Liberation Army following President Xi’s directive to be ready to invade Taiwan by 2027. The recent actions taken by China also indicate their preparedness to meet Xi’s timeline for the unification of Taiwan with mainland China by force if directed."

One of the results of this growing military capability is the rapid pace at which China is building ships, surpassing the US in this area. This has led to the introduction of a bipartisan bill in the US Senate called the “Ships for America Act,” which was introduced to the Senate on December 19, 2024.

The Act outlines that strategic sealift, made up of government and commercial vessels, is a critical capacity for executing the United States' maritime defence strategy during both peacetime and wartime. On March 4, just a few days ago, US President Donald Trump said in a speech to the US Congress, among many other things, he said" We will create a new Office of Ship Building in the White House and offer special tax incentives to bring this in industry home to America “. In his first term, Trump attempted to rebuild US manufacturing of steel and aluminium to support military construction, imposing a 10% tariff on these materials.

This move led to a significant increase in domestic production of steel and aluminium. However, during the Biden administration, waivers were issued, allowing the US to import steel and aluminium. This led to a decline in domestic production. In response, Trump has now proposed a 20% tariff on these metals in a bid to revitalise the shipbuilding industry. So, the point of that is to rebuild the US ship building industry so the US can defend our parts of the Pacific as well as other parts of the Pacific as well.

Looking ahead, there is a narrative circulating due to the falling stock market that the US economy is heading into recession. However, the evidence does not support this claim. Last year, the US economy grew by 2.9%, and while growth is expected to slow, this is due to the Federal Reserve raising interest rates to curb inflation. As inflation begins to decline, the Fed will likely reduce rates again, leading to a projected growth rate of 2.3% this year and 2% next year.

In contrast, the Euro area grew at just 0.7% last year, but it is expected to grow at a faster pace—around 1.1% this year and 1.4% next year, maybe even faster. This growth will be driven by a significant increase in domestic manufacturing in Europe. One important outcome is now that German interest rates are rising relative to US rates, particularly at the longer end of the yield curve. This has contributed to the strengthening of the Euro and a corresponding decline in the US dollar.

We expect further downside pressure on the US dollar. As the dollar weakens over the coming year, commodity prices are likely to rise. Our model of Australian export prices for commodities is based on two key factors: variations in the US budget deficit and the level of international liquidity used to finance global trade. This liquidity is measured by Total International Reserves, updated quarterly by the International Monetary Fund (IMF).

In recent years, the growth rate of international reserves has been the lowest since the early 1980s, leading to a slump in commodity prices. However, International Reserve growth rate is now accelerating again, and as reserves increase, commodity prices are expected to recover. This will result in a gradual rise in commodity prices, lifting them above the levels seen in 2015, 2016, or 2017.

Looking at the rate of change in international reserves, we can see that the recent low growth observed in 2022 is now rebounding. This acceleration is already back to its median growth rate of around 7% and will eventually reach the historical average of 9.7%. This will help support the recovery of commodity prices in global markets.

Regarding the US economy, our model, which tracks a broad index of economic activity called the Chicago Fed National Activity Index, has been highly reliable over the past 30 years. The Federal Reserve’s goal was to slow economic growth to allow inflation to fall, and it has been successful in doing so. With solid, sustainable growth of around 2% expected in the US economy, the reports of the demise of the US economy appear to be exaggerated.

However, the US government faces a significant challenge with the rising level of national debt. Unfortunately, the US debt-to-GDP ratio has risen to a point where the cost of rolling over its debt now exceeds military spending. this poses a danger to the country’s long-term security.

The great thing about gold is that it holds its value over long periods of time. Right now, it’s higher than our model suggests. However, what usually happens when it reaches this kind of level is that it builds a top for a long period. Silver is cheap right now because it always follows gold.

When it comes to currencies, the U.S. budget deficit, plays a significant role. Similarly, the budget deficit in the Eurozone is another factor that influences currencies. Additionally, short-term interest rates are important, but it’s really the long-term interest rates—such as ten-year bond yields—that matter most.

On 28th February, our model suggested that the Euro should be trading significantly higher than it was at $1.04, and it did exactly what the model predicted. Since then, the Euro has lifted dramatically. Based on the latest run of the model, the Euro is expected to rise further to around $1.20 within the next three months.

This suggests that the U.S. dollar is beginning to fall, which sets the stage for a rally in commodity prices.

When it comes to the Australian dollar, our commodity price model suggests it should be a bit higher, although interest rates and inflation targeting are more relevant to the U.S. Federal Reserve's (Fed) policy.

The Fed has room to cut rates, whereas the Reserve Bank of Australia (RBA) does not.

There has been speculation around China holding all U.S. Treasury bonds and potentially destabilising the U.S. Treasury market by selling them off. However, since 2013, China has aggressively sold down the U.S. bonds it held. Back in 2013, China was the biggest holder of U.S. Treasury bonds, but now Japan is the largest holder, followed by the U.K. The question then arises: why would the U.K. hold U.S. Treasuries? The U.K. has the largest international banking sector in the world, and its banking system generates most of the international value and export services for the U.K. economy.

It’s not that the U.K. government is holding these bonds, but rather the U.K. banking system is holding them on behalf of a range of international investors. After the U.K., countries like Japan and smaller ones, such as Luxembourg and Canada, hold U.S. Treasury bonds. Canada, for example, holds these bonds due to its banks' interactions with the U.S. banking system. The Cayman Islands also hold a significant number of U.S. Treasury bonds, with their large industry and manufacturing sectors. So, the notion that China holds all the U.S. bonds and can destabilise the market is no longer true. In fact, China sold off many of those bonds years ago.

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I'm currently preparing my quarterly updates, which includes revising my outlook for the U.S, the Euro Area, China, India, and Australia, focusing on both GDP and inflation. When discussing inflation here, I am referring to the headline measure of CPI inflation.

Looking at the outlook for growth, it’s quite benign, and the same goes for inflation.

GDP Growth:

In 2024, the U.S. economy grew by 2.8%, but we anticipate it will slow down to about 2.3% in 2025. The Federal Reserve tightened monetary policy for an extended period to slow the economy to a level that wouldn't be inflationary. So, for this year, U.S. growth is projected at 2.3%, with expectations for 2% growth next year.

The model we use for U.S. GDP, is based on the Chicago Fed National Activity Index This shows significant fluctuations in growth projections. The pandemic shutdown drove growth much lower than the model predicted. As the economy recovered, there were large swings above the model's projections, particularly in 2021 when actual growth was much higher than expected, followed by a downturn in 2022. In 2024, growth was then higher than anticipated but is now aligning more closely with our model, which projects US growth at around 1.9% to 2.0%.

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Turning to the Euro area, this has experienced a significant slump, with output in some countries even negative in prior years. However, growth picked up to 0.7% in 2024, and we're forecasting 1.1% for this year, with a slight increase to 1.4% next year. The key difference between Euro area growth and U.S. growth lies in population growth, which is about 1% faster in the U.S. than in the Euro Area. Much of the Euro Area’s growth is driven by productivity.

Officially China's growth was expected to be 5% last year. Amazingly , due to some unexpected lifts in output, it did ultimately reach 5%. Some believe that the actual growth rate was lower . This year, I expect growth to be around 4.5%, with a slight dip to 4.1% next year. For the second-largest economy in the world, a growth rate of 4.5% is still quite strong.

India continues to outpace other economies, with a growth rate of 6.3% last year. We forecast it will grow by 6.9% this year and next year as well.

Meanwhile, Australia has seen some interesting developments. Historically, Australia's economy follows the U.S. cycle, but this time, Australia is leading the U.S. cycle due to increased domestic demand driven by government spending. Growth in Australia was 1.1% last year, and we expect 2.4% this year, with growth stabilizing around 2.3% in the following years.

Inflation:

Now, focusing on inflation, we are primarily looking at Headline CPI inflation, which in the U.S. is projected to reach 2.5% over time. The Federal Reserve's target, however, is based on the Personal Consumption Expenditures (PCE) deflator, which is currently around 2.5% and should gradually decline to 2%. In the U.S., CPI inflation was 3% last year, projected to be 2.9% this year, and 3% again next year, before finally reaching the target of 2.5% by 2027.

In the Euro Area, inflation was 2.4% last year, with a slight decline to 2.1% this year. The Euro Area is targeting a CPI inflation rate of 2%, and we expect it to reach 1.9% by the end of 2025.

For China, inflation was much lower than expected last year, coming in at just 0.2%, compared to a target of 2%. It almost slipped into negative territory in the second half of the year. This year, Chinese inflation is expected to be between 0.6% and 1%, with a slight increase to 1.1% next year. The key issue in China is the lack of domestic consumption, which is necessary to drive economic growth.

India, which targets 4% inflation, saw 4.8% inflation last year. This year, inflation is expected to moderate to 4.3%, with a slight increase to 4.4% next year. India’s focus remains on growth rather than strict inflation control.

Australia’s inflation has been interesting due to government intervention. Last year, headline CPI came in at exactly 2.4%, but core inflation was much higher. This result was achieved through subsidies, particularly for electricity prices. If such subsidies continue into 2025, inflation will likely remain stable. However, without such support, inflation could rise to around 3.7% by 2025, potentially reaching 2.8% by 2026.

Overall, the outlook is one of moderate growth and moderate inflation across the major economies. Recession risks seem minimal, and the global economy is poised for steady, if unspectacular, progress in the coming years.

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What I'm looking at today is how the major campaign announcements we've seen in recent weeks, and those expected in future weeks, will affect the Australian budget deficit.

I think when the political history of this current period is written, significant emphasis will be placed on the long-term friendship between Prime Minister Anthony Albanese and the former Premier of Victoria, Daniel Andrews. This is a close friendship, which might even be referred to as a "bromance".

Andrews was a grand master politician. At the state level, he understood how his party worked and how to control it, knowing what to give different parts of it to ensure they stayed in line. He also understood how the budget cycle worked. Very significantly, he knew how to campaign, how to be a master of the campaign, and how to manage big project announcements, which in his case were always debt-financed. He was skilled at making announcements in such a way that they took the oxygen out of his opponent's campaign. Still, as I say, these projects were always deficit-financed. As a result, we saw Victorian debt levels rise relative to other Australian states.

Deficit spending was first analysed in the 1930s by Maynard Keynes. At that time, the major issue was deflation, meaning price levels were falling. As a result, real wages were rising, and people were being thrown out of employment. Maynard Keynes argued that running deficits would lift the price level, which would reduce real wages and push workers back into employment. This lead to a situation where employment rose, but living standards fell.

Just so, this current period of deficit spending, particularly in the US and to a lesser extent here in Australia, has driven down living standards and generated much of today's political sentiment.

The problem in Australia is that this debt will be paid down by younger generations who will pay a higher proportion of their income in taxes. As I mentioned earlier, further deficit spending will only worsen this problem of living standards; it will not make it better. The current government under Albanese is heading in this direction, with an increasing deficit and levels of debt.

A couple of months ago, Treasury released the Mid-Year Economic and Fiscal Outlook (MYEFO), which showed how future budget deficits and debt levels are moving compared to last year's budget.

According to the MYEFO, the deficit for the year ahead (2025-26) was expected to be $42.8 billion. However, that deficit rose by $4.1 billion to $46.9 billion. For the year after that (2026-27), the deficit was projected to be $26.7 billion but, according to MYEFO, increased by $11.7 billion to $38.4 billion. In 2027-28, the projected deficit of $24.3 billion from last year’s budget was project to rise to $31.7 billion. So, the deficit problem is worsening, and as expected, that means the debt problem is also getting worse.

In last year’s budget, the level of gross debt was expected to be $1.007 trillion for 2025-26. But in MYEFO, that expanded by $21 billion to $1.028 trillion. By 2026-27, the debt level is expected to expand by $36 billion, and the following year, by $49 billion. This shows that the situation is getting worse, not better.

Looking ahead to the election, given that Albanese has learned much from Daniel Andrews, we can expect to see the announcement of big projects. We've already seen the expansion of Medicare announced, and we're sure to get more before the budget is finalised.

The problem is that this situation of expanding deficits, which was a particular specialty of Daniel Andrews and is now a speciality of Anthony Albanese, will make the issue of living standards worse, not better. Let's see what further data we can get on this when the budget is released on 25 March.

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