Here's what to watch in today's critical federal budget update from Scott Morrison

Prime minister Malcolm Turnbull and treasurer Scott Morrison. Photo: Stefan Postles/ Getty Images.

The past six months for Australia’s economy – the period since the federal election in which the Coalition was returned with a wafer thin majority in the House of Representatives – have been characterised by some mixed signals.

On one hand, there has been a very strong increase in the market prices for some of Australia’s major exports, especially iron ore and various coal products.

Here’s the iron ore chart:

On the other, the election resulted in a fractious Senate that makes policy reform difficult (underlined by Rod Culleton’s decision to quit One Nation and now sit as an independent), and we have seen a relative weakening of the jobs market, and continuing weakness in wages growth.

Here’s the wage price index chart:

This wages weakness is budget poison: it dampens income tax receipts, with the absence of pay rises stopping people progressing into higher tax brackets, and also acts as a drag on household consumption because people aren’t getting ahead with their earnings. And household consumption is by far the biggest component of Australia’s economic activity.

Also the economy just hit a pothole in its astonishing 25-year run without a technical recession, posting its one of its rare negative quarters of GDP growth earlier this month.

There has been a lot of talk about the potential loss of Australia’s AAA rating as a result of the Mid-Year Economic and Fiscal Outlook, coming today from Treasurer Scott Morrison.

A loss of the rating would be triggered by a continued deterioration in the budget bottom line (and up to $100 billion in revenue write-downs are being discussed) along with a failure to outline a credible strategy for returning to surplus over time.

This makes the forecasts from Treasury for a whole range of important data points – future economic growth, wages inflation, job creation, commodity prices – all important, especially the political environment having become so volatile that statements of intent on policy (“we plan to save billions”) being meaningless until they hit the Senate.

Tim Toohey, chief economist at Goldman Sachs in Australia, wrote in a note to clients:

In the nearer term, larger-than-forecast deficits will likely owe to slower-than-forecast growth in wages and nominal GDP. Further ahead, we would be surprised if the balance does not return to a surplus in the out-years of the forecast period with the numbers on that horizon very sensitive to Treasury’s assumptions on prices for Australia’s iron ore (Budget assumption: $US55/tonne), metallurgical coal (Budget assumption: $US91/tonne) and thermal coal (Budget assumption: $US52/tonne) – all of which seem likely to be revised higher given current spot prices (iron ore: $US91.5/tonne; metallurgical coal: ~$US260/tonne; thermal coal: ~$US83/tonne).

At this point, however, it is impossible to know just how much Treasury will raise its outlook for commodity prices and longer-run forecasts of nominal GDP. If Treasury were to shift towards our relatively bullish stance on commodity prices for 2017 (GS forecasts 2017 prices to average: iron ore: $US65/tonne; metallurgical coal:
$US340/tonne; thermal coal: $US61/tonne), the impact of higher mining tax revenues on Australia’s public finances would be nothing short of transformational – delivering material surpluses by 2020. At this stage, however, we expect Treasury to adopt a cautious approach, with only modest price upgrades sufficient to prevent a downgrade to Australia’s AAA credit rating – but no more.

Morrison, too, has repeatedly said that the government was being conservative in its forecasts on commodity prices. The trap for Morrison, of course, is that over-optimistic forecasts would potentially lead to even further downgrades in future.

Morrison will likely use today’s figures to try and appeal to the Labor opposition and the Senate crossbench to act in the national interest and work with the government on passing budget savings. Goldman believes he may not need it, for now at least:

… given that S&P has not acted to this point, that some “savings” measures have been legislated and – most importantly – that Australia is now potentially facing another significant positive income shock from higher commodity prices, we lean towards S&P maintaining its current stance for now (i.e., a AAA rating with a negative outlook).

We’ll be watching in particular for an update to this chart which shows the string of budget disappointments Australians have been watching over recent years.

Business Insider will have full coverage of the budget update when it’s out at 12pm AEDT.

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