Tim Hext: what the state budgets mean for investors

Portfolio manager Timothy Hext from Pendal's Bond, Income and Defensive Strategies team.

Here’s our weekly Bond, Income and Defensive Strategies wrap from Pendal portfolio manager Tim Hext (pictured).

WHILE the NSW victory in the NRL State of Origin was impressive last weekend, another important interstate contest is now underway — the state budget updates.

We’ve had two states come in with their 2021-22 budgets in the past week — NSW and South Australia.

State budgets do matter to investment managers. But before we look at what they mean, it’s important to remind ourselves on one crucial and massive difference between the states and the federal government: the states do not have a printing press.

They cannot simply print money to meet a repayment. They must first earn or borrow money before spending it.

The federal government (thru the Reserve Bank) can simply create money with a keystroke. The only reason they tax is to drain money they have spent from the system, with the aim of limiting inflation.

This creates very different dynamics when building a budget for a state versus the federal government. 

States should aim to run balanced operating budgets through the cycle. Like all of us they must “live within their means”. 

For the federal government the notion of a balanced budget is irrelevant. The only question they should ask is: does the budget help produce full employment without inflation being too high? If this means creating and spending more money than is drained through taxes (a budget deficit), then so be it.

Pendal named 2020 Fund Manager of the Year in Zenith Awards.

The budget position is merely an accounting result of attempting to strengthen the economy — or if inflation is too high, slow it down.

Therefore the federal government is to be applauded for finally catching on that they need to keep spending despite an improving economy — as they did in the recent budget. We are not yet at full employment and we do not have an inflation problem, so why would you stop?

The states in Australia are primarily public service providers – health, education, police and so forth. No income or company taxes and no (or few) welfare payments.

These services are less dependent on economic cycles, so the tax and spending base of states should also be less dependent on economic cycles. That’s one of the reasons taxes such as stamp duty and payroll are inefficient, while a land tax and GST are preferable. (Good luck with the politics though.)

Recent operating budgets are improving, but borrowing is going higher in NSW

That brings us to the state budgets.

The improving economy is seeing operating budgets improve. South Australia should win the race back to a balanced budget in 2022-23 (if we exclude Western Australia). NSW and Queensland are forecasting balanced budgets in 2024-25. Victoria will be the laggard, forecasting deficits over a four-year forecasting period.

Following recent elections Tasmania will come out in August and Western Australia in September. In Perth they are probably too busy counting all the cash to hurry with a budget that is already well into surplus and moving higher.  

For bond investors the operating position is only part of the equation.

Rating agencies put a high importance on it because it shows the sustainability of debt. But it is infrastructure spending — in General Government and State Owned Corporations — that largely drives funding tasks.

On this account all states are still going hard. NSW alone is spending $27 billion this year and around $108 billion over four years. This should see public sector investment continue to grow at 5% a year, helping drive overall GDP growth.

The NSW funding task announced last week actually moved higher despite an improved operating position. It seems they are now borrowing to put money into the NSW Generations Fund (NGF), rather than merely using asset sales.

Given ratings agencies allow them to use the NGF to offset gross debt for their metrics, it seems like a free kick. Borrow at 2% and invest in riskier assets assuming a 6-7% return.

Like the federal government’s Future Fund this is essentially a credit arbitrage which should work through the cycle. However the federal government used the one-off windfall of Telstra and budget surpluses to seed the Future Fund, rather than current borrowings. If this pays off it is ultimately good for NSW. But it does increase the state’s exposure to the economic cycle and asset prices.

Wages are making a comeback

The other important change from the NSW budget is the reinstatement of the 2.5% wage increase.

This has been in place from almost day one of the LNP Government in 2011, but was put back to 1.5% last year. The NSW government is Australia’s biggest employer with more than 400,000 workers. Even the federal government has removed its 2% wage cap, now linking it to private sector outcomes.

This all leads us to think the RBA wage forecasts of 1.75% this year and 2.25% medium term are far too low —particularly as unemployment falls to 4%. We expect 2.5% wage growth this year and above 3% by 2023.

Risk reward remains underweight semis

Our portfolios are generally underweight semi (state) governments with a bias to holding West Australian and Tasmanian bonds.

Despite ratings pressures we never worry about getting repaid due to the federal government’s implicit support.

However two positive forces behind outperformance of semi governments in the last year – RBA Quantitative Easing and Bank Balance sheet Liquid Asset purchases – are likely to taper in the year ahead.

These factors, together with high borrowing tasks, mean the cost of borrowing relative to the federal government should move higher.

We expect semi-government spreads around 15 to 20 basis points higher in the medium term.

About Tim Hext

Tim Hext is a portfolio manager with Pendal’s Bond, Income and Defensive Strategies (BIDS) team.

Led by Vimal Gor, Pendal’s BIDS boutique is one of the most experienced and well-regarded fixed income teams in Australia. In 2020 the team won the Australian Fixed Interest category in the Zenith awards.

The team oversees $22 billion invested across income, composite, pure alpha, global and Australian government strategies with the goal of building Australia’s most defensive line of funds.

Find out more about Pendal’s fixed interest strategies here

Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.

Contact a Pendal key account manager here

Related Articles