Margin Lending

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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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Yesterday, the Reserve Bank of Australia (RBA) board met and reduced the Australian cash rate by 25 basis points to 4.1%. At the same time, they released the Quarterly Statement of Monetary Policy, which provides a broad range of outlooks for various variables affecting the Australian economy. The release of this report, on a quarterly basis alongside the RBA meeting, serves a similar function to the Summary of Economic Projections released by the Federal Reserve.

The RBA’s initial message was that even with the reduction in monetary policy, the outlook remains restrictive. However, according to our own model, A Cash Rate of 4.1% is not restrictive, but modestly expansive. Our model is based on 35 years of data.

The Quarterly Statement indicated that the outlook for the Australian economy is for considerable expansion. After last year’s GDP growth of only 1.1%, which economists consider a soft landing, growth is projected to pick up, with a forecast of 2% for the year to June 2025. This is followed by 2.4% for the year to December 2025 Growth continues between 2.3% and 2.5% over the following years. Even in 2027, growth is expected to remain above 2%. This represents a promising future for the Australian economy. Interestingly, business investment is not expected to be the main driver of this growth. Business investment growth for the year to December was zero and is expected to remain at zero for the year to June, only growing by 1.4% by the end of 2025. It seems that growth will accelerate only after the economy picks up speed. Household consumption is also forecast to increase slightly from 0.7% last year to 2.6% this year.

The primary factor driving the anticipated growth is Public Demand, largely funded by "other people’s money". Public Demand (Government Spending) grew by 4.9% in the year to December 2024 and is expected to grow by 5.3% or more for the year to June 2025, with projections of 4.3% for December 2025 and 4% for 2026. This growth in public demand, largely financed through public borrowing, includes Federal and State Government spending, particularly on infrastructure projects. While this expansion will stimulate demand, it will be paid for later by taxpayers.

The unemployment rate, currently at 4%, is expected to rise slightly to 4.2% mid-year, where it is anticipated to remain. The RBA has indicated that this increase in unemployment will help reduce inflation, although not to the target of 2.5%. Inflation is projected to fall from a trimmed mean of 3.2% for the year to December 2024, to 2.7% by June 2025. However, inflation is expected to stabilise at this level, not reaching the 2.5% target.

This raises an interesting question: why does the RBA believe that inflation can fall to the lower end of the 2-3% range without unemployment reaching 4.6-4.7%, as suggested by historical data? We believe that the significant import boom in Australia, with imports rising by 6.2% for the year to December 2024, has played a role. Import growth is expected to slow in the coming years. We think that but year's surge in imported manufactured goods at low prices has created an illusion of sustainable low inflation at the same time as relatively low unemployment.

Our analysis suggests that such low inflation is unsustainable unless unemployment rises to 4.6% or higher. This issue may resurface in the coming quarters as the true challenges of reducing inflation are revealed. However, for now, we can say that the Australian economy appears to have bottomed out. We’ve had our soft landing with 1.1% growth in December 2024, and growth is now accelerating, even if it is being driven by public spending. By the end of 2025, growth is expected to reach 2.4%, and the economy is set to maintain above 2% growth for the next several years. This represents a strong recovery, and the Australian economy appears poised for a period of better performance in the coming years.

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The start of an easing cycle is upon us, but the path forward remains unclear, much like the post-pandemic economy. The debate now shifts from when the cycle commences to where the terminal rate for this cycle might land. Nonetheless, the first interest rate cut since November 2020 marks a definitive turning point for market sentiment and its impact on risk assets.

Rationale for the Cut

The RBA's decision for a 25bps cut reflects a view that inflation is sustainably moving back towards the Bank's 2-3% range. Three consecutive declines in quarterly core CPI from 4.0% to 3.2% in the December quarter afford some space for monetary easing.

In the February statement, the Board also highlighted some weakness in the demand side of the economy, with consumer and business sentiment subdued. Noting that "there has also been continued subdued growth in private demand and wage pressures have eased".

The Board was careful to point out that upside risk remains, suggesting that the labour market may be tighter than previously thought. So, while today’s policy decision recognises the progress on inflation, the Board remains cautious on prospects for further policy easing.

While Australia's economic stability presents minimal recession risk, the RBA must balance stimulus against potential overheating concerns from ongoing fiscal spending, as our economist Michael Knox points out in his recent piece.

What is priced in

Before today's announcement, futures implied a further 50bps interest rate cut, taking this cycle's terminal rate to 3.6% by December 2025. The RBA's forecast assumes three further cuts by June 2026 and a terminal rate of 3.4%. Given the uncertainties around the path of inflation, we think the RBA’s comments will unlikely alter the market outlook for interest rates.

Updated Economic Forecasts (Feb 2025)

Michael Knox is more cautious and believes there is limited scope for further rate cuts until unemployment rises from 4% to around 4.6%. The situation is complicated by fiscal policy. The Labor government has been expanding employment in sectors like the NDIS and other areas of the public service. This fiscal stimulus is preventing unemployment from rising to the level needed for inflation to fall. As a result, unemployment remains stuck at around 4%, and inflation remains too high for the RBA to cut rates further.

ASX performance following the first RBA rate cut (1996 – 2021)

The impact on investor sentiment is clear - historically, the ASX 200 has risen by an average of 4% in prior cycles since 1996 when the RBA proactively cut interest rates, excluding the periods of the Global Financial Crisis and the COVID-19 pandemic. As per prior cycles, we think this marks a definitive turning point for sentiment and is likely to support the positive underlying momentum in the equity market.

However, at a sector level, performance is mixed - Industrials, Healthcare, and Utilities generally outperform the ASX 200 in the three months following the first cut, while Financials, REITs, and Energy tend to lag.

Market implications

The multiples being paid by the market, particularly for interest rate-sensitive sectors, are high (ASX Industrials c22x vs the 10-year average of 19x), suggesting that some level of interest rate easing is already factored into prices. The prospect of two further rate cuts will help sentiment but is unlikely to create a step change in earnings forecasts. Every cycle is unique, so positioning is key for us, especially around industries and stocks that are best placed to benefit from this easing cycle.

Banks

A lift in front book volumes and more-buoyant mortgage demand needs stronger anticipation of lower product rates than a modest start to easing would bring at this stage. We still struggle to find value across the major banks (CBA – no major upside surprise supporting the price).

Consumption

Assuming a terminal rate of 3.60%, this equates to a savings of ~$300 a month for the average $666k loan size  (ABS housing finance). This is expected to provide a modest boost to household consumption but the full impact is unlikely to be felt until 2H FY26. We prefer consumer linked stocks tied to lower-valued products (UNI, LOV) over housing-linked exposures at this point in the cycle.

Best ideas

Universal Store, Lovisa, Webjet Group

Property/Housing

As borrowing capacity improves, the housing market could see increased activity in lower-priced segments, alleviating some affordability issues that persist and offset inflation that is still evident in the cost of building. Banks are likely to actively promote fixed-rate mortgages ahead of potential further cuts.

Best ideas

James Hardie, Qualitas, Maas group

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