The downgrades to the economic outlook and change in approach to commodity price forecasting have been some of the big talking points of the budget update yesterday from federal treasurer Scott Morrison.
Goldman Sachs believes this could prove part of a smart political strategy, with the conservative assumptions carrying a lot of potential for outperformance over the next six months.
It leaves “a great deal of scope for a meaningful upgrade to forecast revenues in the lead up to the May Budget,” the investment bank says.
With unusual volatility characterising commodity market movements through 2016, Treasury dropped its usual approach of using an average price for iron ore and coal, instead plumping for a projected “step-down” in prices in 2017, where the price reverts to $US55 in the second half of next year.
As we pointed out yesterday, the impact on the budget is the forgoing of billions of dollars in projected revenue. But by next May, when Morrison will unveil his second budget, should the iron ore price retain a good chunk of its gains (with the spot price currently around 85% up for the calendar year), there could be significant improvements to the budget bottom line.
The potential improvement is not just confined to the influence of commodity prices. Tim Toohey and the Australian economics team at Goldman Sachs believe there are other areas that leave room for positive surprises.
For example, the Goldman team says, Treasury appears to have dropped a previous assumption that a rise in commodity prices would result in a $4.8 billion increase in company taxes over two years.
Here’s an excerpt from a note to clients yesterday (their emphasis):
In our view, there is nothing particularly alarming in today’s update – with no further blow-out in government expenditure, some success in legislating previously promised savings (A$22bn), a lower forecast peak in net debt (as a % of GDP), and a very conservative assessment as to how a much higher terms of trade might be expected to flow through to corporate tax revenues.
It is this latter factor in particular where we believe the Government’s approach has been extremely conservative – leaving a great deal of scope for a meaningful
upgrade to forecast revenues in the lead up to the May Budget. Note, for example:
– Firstly, that following upgrades to the outlook for commodity prices, today’s update features a +12.75ppt upgrade to Treasury’s terms of trade forecast for FY17 (now +14%), which is only partially unwound in FY18 (-3.75%). Even so, company tax receipts have been revised -A$1.1bn lower than at PEFO – despite sensitivity analysis by Treasury at the time that a permanent +10% rise in non-rural commodity prices would add no less than A$4.8bn to company taxes over a two year period.
– Secondly, in contrast to Treasury’s forecast increases in the corporate tax take in FY17 (+8.1%) and FY18 (+14.4%), BBG consensus forecasts for the ASX300 firms at a micro level are currently for much larger increases in tax paid, especially over FY17 (+24.7% and +8.1% respectively over FY17 and FY18).
– Thirdly, at a macro level, Treasury’s mix of economic forecast changes also speaks to stronger (not weaker) corporate profits. Specifically, while wages – a key input cost for companies – have been revised lower, both private final demand, the terms of trade and nominal income growth (in net terms) have all been revised higher over FY17 and FY18.
In turn, from the perspective of the corporate tax take, the implications from today’s changes are that either: i) losses carried-forward will prevent a significant increase in mining profits from translating to higher taxes, and/or that ii) profits in the nonmining economy will be especially weak. In our view, the impact from these forces look to be significantly overstated – as does the implied downside to the personal income tax take (given that wages growth was revised only -25bp lower in each of FY17 and FY18).
So there are a couple of things to watch: non-mining sector profits, and the tax treatment of losses when the miners report next year.
Of course the other area to watch is how the economic data tracks against the Treasury forecasts. Slightly stronger wages and GDP data than predicted (remember, Treasury cut its GDP growth forecast to just 2% yesterday) would also help improve the deficit trajectory.
Goldman adds: “From a political strategy point of view, doing enough to maintain the AAA rating in the near term positions the Government well to present a much more upbeat set of numbers in the far more detailed annual Budget Report in May 2017 – and particularly if our Commodity team’s bullish outlook for bulk commodity prices plays out.”
Goldman is projecting an average iron ore price of $US65, some 18% higher than the eventual level forecast by Treasury.
Underlining the problems Fortescue Metals Group chief executive Nev Power tells The Australian today: “Whatever you forecast is going to be wrong” on the iron ore price. But, he adds: “$US55 a tonne would reflect the average price typically for the last 12 to 18 months, so I can see why they would have done that.”
This is a sign of how difficult it has become to read the market activity around bulk commodities. And that’s before you get to the more intricate process for forecasting GDP, inflation, and the profitability of companies.
With this latest update, at least according to Goldman, Scott Morrison has issued a document that errs very much on the side of caution.
At the very least, lowballing the forecasts manages, as much as is reasonable, the risk of having to announce yet another another round of write-downs.
But there is a clear better-case scenario, in which the treasurer is telling a much better story about the national economy and the state of the budget 12 months from now.