In light of the federal government’s recent announcement of its delayed May budget, we would like to share our thoughts and the implications for financial markets for the remainder of 2020 and into 2021.
The left-hand chart below reflects the absolute size of the budget deficit that we’ve seen since the budget was handed down. That deficit sits at slightly above 5% of GDP – close to $220 billion in dollar terms. This is the largest deficit that we’ve seen since the Second World War, and is certainly more significant than what it was through the 2008 Global Financial Crisis. While yes, this sum is significant and large, in our view it is entirely appropriate given the current economic backdrop faced by Australia and the rest of the world.
Meanwhile, the right-hand chart highlights the reaction of bond markets the budget being handed down on October 6. It’s clear that bond yields have fallen. In our view, this is reflective of financial markets’ understanding that fiscal spending is required – alongside activity from central banks around the world – to get economic activity moving and people returning to the workforce.
With this in mind, we believe that this move in bond yields is entirely appropriate. Typically, we might expect bond yields with that size of deficit to sell off, prompting yields to move higher. We think that financial markets have been very sensible in the way that they’ve considered the need for additional fiscal spend.
The chart below demonstrates where Australia sits, relative to the rest of the world.
When considering the size of the deficit, it may appear that Australia doesn’t compare favourably. However, when comparing the level of deficits – net debt to GDP of Australia – to that of other market economies, it sits at the low end at about 40%. This does afford the federal government the opportunity to increase that level of debt further, if necessary, over the next couple of years.
It’s also important to note that Australia has been able to maintain its AAA credit rating. This is particularly important in the context of being able to go to markets, as well as the funding rate that the Australian Government can receive on any additional borrowing. From that perspective, credit rating agencies have been comfortable in the way the government has been able to land with the deficit at this point in time.
We don’t believe that the government can continue to grow the deficit – and ultimately, it does need to be addressed. But certainly, as we look over the next couple of years, we think it’s entirely appropriate that the government does run a deficit, with plans to rein it in as the outlook starts to improve.
Finally, there’s the impact of the central banks, which have also continued to be very active in this space. The chart below features both the RBA and US Federal Reserve, and the significant expansion that we’ve seen in their balance sheets over the course of 2020.
When considering the fiscal spend demonstrated in the budget, the ongoing work that we’re seeing in that space, and what we’re seeing in central banks – expansion of balance sheets, reduction of cash rates – we continue to expect that this will be generally positive for financial market performance through the back end of this year and into 2021.
Of course, there is no doubt that the post-COVID landscape will bring very different economic and investment market environments. We continue to believe that there are significant opportunities, and that the budget that we’ve just seen handed down does provide for those opportunities to be reflected in financial market performance.
More broadly, we continue to remain overweight equities relative to bonds in our portfolios. But we continue to believe that bonds have an important role to play, particularly during the periods of higher equity market volatility that are most likely going to continue throughout the year and into 2021.
As always, if you have any queries about your portfolio, please feel free to reach out to your advisor.
Piers Bolger is Chief Investment Officer at Viridian Advisory
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