Reviewing a year of renewed risk and reading the runes for 2019
In late November 2018, KangaNews hosted its annual roundtable discussion for Australian fixed-income strategists. At the end of a turbulent year for markets and geopolitics, the discussion was unusually wide-ranging – taking in factors as diverse as the long-term status of the US dollar as global reserve currency, the duration of the Australian housing-market decline and the credit-supply outlook.
RISK FACTOR REVIEW
Davison We’ll start the discussion by looking back at some of the themes from the 2017 roundtable. A year ago one of the most notable recurring themes was the fact that inflation was seen as the missing link in the global growth story. Fast forward to November 2018 and inflation remains sluggish. What is going on?
What we missed was how deep the scars from the financial crisis were and how much spare capacity the global economy had created. It is recovering and growth rates are picking up, but it is taking a lot longer than anyone expected.
It’s also important to remember that it wasn’t long ago that we were talking about heightened deflation risk in some places, such as Europe. There is more confidence now that these risks have eased. Growth has slowed a bit, but capacity measures and wages are starting to come through.
For the first time, we are trying to have an Australian recovery without the credit cycle overlaying it. This means we are seeing what an economic cycle without credit involved looks like.
The answer is that it is very slow. Credit was a key part of the self-reinforcing recovery. Once people start feeling more optimistic, they are meant to borrow money, invest and create jobs – which then makes other people feel optimistic. This accelerant isn’t in the economy anymore, and we are learning what the business cycle is like without it.
There should at least be confidence that we are in a growth cycle. It is creating jobs and supercharging profits, but it is not coming at the pace we would have seen previously.
The parallel back to the markets is that every time employee-cost indices have gone up, indicating that inflation and wages are slightly higher, bond markets have become scared. The biggest moves this year have been when inflation has reared its head. The biggest sell-offs have been in the US rates market, which is the vanguard for cash-rate hiking and inflation around the world.
Davison Europe was another risk factor that came up a lot in our 2017 roundtable. The things that seemed problematic at the time haven’t blown up but also don’t seem to have gone away. How do strategists view European risk right now?
It is likely that there will continue to be flare ups but the project will continue to work. Risk has declined, but there are two potential things to keep an eye on. The first is when Mario Draghi is replaced as president of the ECB in October 2019. So much of what has been possible there has been because of Draghi’s “whatever it takes” speech.
We are going to find out if this approach makes sense when the big buyer is no longer there to perpetuate the crowding in to credit. European markets could face a very different backdrop and, at the same time, a new ECB president.
Australia's future state of credit supply
Australia’s banking royal commission and the sluggish state of corporate capex seem likely to shape the future of domestic credit at retail and institutional level. Neither factor points to a major supply uptick.
WHETTON What the Reserve Bank of Australia, the council of financial regulators and the Australian Prudential Regulation Authority say about financial stability is not going to change on a dime. I cannot see the RBA endorsing a policy about competition to provide credit at the expense of stability.
The pendulum hasn’t swung too far the other way yet but the atmospherics are not good in the housing market and one of the reasons is the availability of credit. There was too much for a while. At the moment I don’t think we have too little but we probably can’t afford to tighten much further.
The balance in the regulatory system is right. The banks are more stable than they were and are now able to weather a downturn thanks to the capital requirements that are largely in place. The regulator has been very effective in this. It is important not to introduce too many new things that may bring unintended consequences.
Atmospherics are not good in the housing market and one of the reasons is the availability of credit. There was too much for a while. At the moment I don’t think we have too little but we probably can’t afford to tighten much further.
Davison One thing that everyone seemed to predict when we met in 2017 was market behaviour becoming characterised by periods of calm interspersed with bouts of volatility. How closely has the reality matched what was predicted?
I don’t think it is because there is some sort of magic central-bank put in the background. I think it is simply that the ability to take and warehouse risk is not what it previously was.
In this context, one important message is that borrowers should be willing to make hay while the sun shines, exploiting calm periods where spreads are tight and markets are able to absorb issuance.
That’s what happened in New Zealand: positioning moved against the backdrop of some surprise data. As a general rule, though, volatility does seem to be more about technical factors and positioning rather than anything underlying.
We saw this in the stock-bond correlation at various points in 2018. Often we would have expected more of a second-round bid for US Treasuries, but the Fed has been resolute on a number of occasions.
DEMAND FOR AUSTRALIAN DOLLARS
Davison How resilient has demand for Australian dollar bonds been in 2018, in an environment of rates reversion and rising US dollar yield?
In this way, the stability of the Reserve Bank of Australia (RBA) policy outlook has been very supportive. If you look at Japanese demand over the last six months, while hedging costs have significantly increased for funding Australian dollar bonds we can see there is a positive net inflow compared with the likes of Canada – which is advanced in a tightening cycle and has a flatter curve. This is important, notwithstanding the ructions we have seen in funding and FX forwards.
These investors are now being paid on the Australian dollars before they even start with bond yields. They can afford to take 40-60 basis points less than US Treasuries and still end up ahead because they have the FX carry coming through. Relative headline yield therefore hasn’t been as much of an issue as it might have been.
Davison Is what you are saying that the type of demand for Australian dollar bonds has changed but net demand has remained stable?
The global yield structure is higher, so while these investors can still consider Australia to be part of their portfolio the inflows that supported it in recent years have eased. It is still an important component but there are competing assets.
This is also helped by the stable RBA outlook. Offshore investors can buy with a reasonable amount of confidence that they won’t lose too much on the currency. The Australian dollar-yen was in the high ¥70s recently and long-term this is not a bad entry point. If the Australian curve is steep and yield is attractive enough there will be demand.
I also wanted to touch on credit demand. This has been an unusual year for Australian credit supply. Corporate Australia is not borrowing much because there isn’t much capex and at the same time there have been a lot of asset sales. Corporate Australia is flush with cash and there were also a lot of unique factors which made 2017 look like a big supply year, in particular some large Kangaroo deals. In fact, the 2018 run rate is probably close to normal.
Next step for Australian capital
The Australian Prudential Regulation Authority (APRA) made its first official pronouncement on a potential Australian equivalent of total loss-absorbing capacity (TLAC) rules in November 2018. Local market participants are still assessing the potential consequences.
WHETTON They will do that much less in senior funding. Senior pricing will come in and tier-two will go a bit wider. This is whether the banks do 10-year non-call five years in Australian dollars or bullets in the US supplemented by euro issuance.
If anything, there may be more of a bid to the cross-currency basis in that environment because there is a larger amount of issuance to be done. Investors in senior debt will have a larger buffer under them, which is good. It is not as good on the equity side, perhaps.
GOODMAN We are talking about big numbers and the issuance will come at the expense of senior. It remains to be seen whether the domestic investor base wants or has capacity for this much subordinated debt.
I think the Australian proposal is appealing for offshore investors. Having an asset class they are already comfortable with and have done their credit work on – rather than a new, untested regime – is probably a good thing.
Davison We have finally seen the long-expected bond-market yield reversion in the last 12 months. However, the equity market has had a tough time in the second half of the year. Should we not have seen a bond market rally?
To my view, the bond market has it right. The Federal Open Markets Committee (FOMC) is still hiking and it is not going to turn around because there has been some success. If we were having this discussion 10-15 years ago, the view would be that economic conditions are improving, unemployment is low and there is a hint of inflation – in other words, there are good things happening so we need to raise rates.
GEOPOLITICS AND ECONOMIES
Davison The supercharging force arguably could be the unfunded stimulus the US has put into its growing economy over 2018, in the form of an estimated US$1.5 trillion tax cut. Should markets be more worried about the consequences of the tax cut than they appear to be?
It is bizarre, and there should be worry about the path of the US. Not just the political path but the brazen late-cycle, unfunded and somewhat pointless tax cuts.
The political machinations that are happening now – from the South China Sea to the Port of Darwin to One Belt, One Road – are all part of it. But November 2016 will be seen as the trigger, similar to when sterling lost reserve status.
If there is no cooperation within NATO, there is no pushback. Whenever president Trump’s term ends, lots of people are going to realise they should have been watching what was happening in other parts of the world over this period.
When Deng Xiaoping was in power in China the official policy was to “hide your strength and bide your time”. About six months ago this policy was retracted and China has been taking a much more muscular stance ever since – to which no-one is reacting.
Davison The fiscal and monetary armouries that were emptied in the wake of the financial crisis have not really been restocked in the succeeding decade. Should we be worried about governments’ capacity to respond given the general assumption that we are getting close to the end of this cycle?
Previous FOMC cycles were 12-16 months. We are currently at 33 months since the first rate hike in the US; 57 months if you count tapering as the start of the hiking cycle. That is five years this cycle has been going for.
There is still arguably scope for varying amounts of policy intervention in the instance of a downturn in different parts of the world. In Australia, rates never got to extremes so there is arguably more room to cut if needed. The US has done 2 per cent of hikes so it has room as well.
The other point worth making is that the financial system is now better placed to deal with a downturn because of regulation implemented in the last 10 years. Banks have increased capital and lengthened funding profiles. Other responses, like central-bank swap lines, have been set up to deal with liquidity pressures.
I am talking about things like electronic money and “time-bomb money” – money which has to be spent within 12 months or it becomes invalid. These sound fanciful but, as Alex Stanley said, they are no more fanciful than if we sat here 10 years ago and said there would be negative rates or that central-bank balance sheets would go to US$15 trillion.
I think we may move to fiscal rather than monetary dominance in the coming decade. We have experienced an extraordinary decade for monetary policy, and perhaps the balance of power might start leaning towards politicians using more fiscal policy – whether it is expansionary or contractionary.
Davison Speaking of changing norms, could we also be at a point where the conventional way of talking about the health of public finances is abandoned completely? In different circumstances there would surely be more commentary about the wisdom or otherwise of the US running a substantial deficit at this point in the cycle, yet this issue just doesn’t seem to be on the agenda in most places.
This reality deficit is a concern over the medium-to-long term. It will probably not bite in the next 5-10 years but it definitely will in 15-20 years. It could take longer – but it will come back and bite eventually.
US debt as a percentage of GDP is actually no worse than many countries in Europe, even if the US continues down the path the president has put it on.
The demise of interbank offered rates globally looks set to be the latest major upheaval international capital markets will have to confront. Australian borrowers need to start preparing for a major shift in the years ahead.
STANLEY The end of LIBOR might seem a long time away right now, but with the amount of work that needs to be done I think market participants will have to start preparing sooner rather than later.
BROWN We are less convinced that BBSW will survive, even though the banks have said they want it to. The main reason is that there will be the secured overnight financing rate (SOFR), sterling overnight index average and other rates offshore which, for cross-currency basis swaps, need to be set against an Australian equivalent.
As soon as this Australian equivalent is created it could be used for anything. I suspect there would be strong pressure from offshore over time to use a risk-free rate. It’s hard to imagine a big US-based issuer like World Bank, which will be using a risk-free rate everywhere else in the world, wanting to issue against BBSW in Australian dollars.
The end of LIBOR might seem a long time away right now, but with the amount of work that needs to be done I think market participants will have to start preparing sooner rather than later.
Davison The housing-market correction in Australia so far seems to be the orderly downturn more or less everyone in the market wanted. But has the downward trajectory now persisted for long enough – with no sign yet of the bottom being reached – that it might be time to start thinking about revising views on whether what we are experiencing can still be called a healthy correction?
At a macro level, the Australian dwelling investment cycle peaked near the level of some previous cycles as a percentage of GDP. It was nothing like what was seen ahead of some of the offshore housing corrections a decade ago, where there were excess supply issues. The Australian population has also continued to grow strongly so supply, demand and unemployment are all positive stories.
It would be great if prices bottomed out in the next six months at around 10 per cent below peak. But once the fall gets to around 12-15 per cent it starts touching homeowners’ loan-to-value ratios (LVRs), which can cause some nervousness.
So far, you will still have some equity in your house unless you bought at 95 per cent LVR. Once the market gets towards a 15 per cent fall, factoring in transaction costs, there is nothing left even if you started with 80 per cent LVR. This would start to alter behaviour and I think we would begin to see the negative wealth effect coming though. At present I think most people who bought recently should still be comfortable.
The jobs market is very strong if we believe the figures. But house prices are falling – something is going on here. Meanwhile, political changes that may come next year around negative gearing, investors, immigration and foreign-buyer restrictions could conspire to push the housing market further into negative territory.
Two things give me confidence. First is that transaction volume is still very low. It was quite low on the way up and has been low on the way down as well. It is possible that people weren’t realising the wealth on the way up – they weren’t cashing out. If the jobs market remains strong there shouldn’t be many forced sellers, even with a change of policy.
The second is sentiment data. Our sentiment survey found that people think affordability has improved and it may be a good time to buy. Sentiment has improved, and this has been most marked in New South Wales (NSW).
Davison How serious a factor is underemployment when it comes to housing affordibility and loan serviceability?
The jobs market certainly provides this type of confidence in the US. Actually, we can now say with reasonable confidence that wages have bottomed around the world. They are rising faster in some countries than others, but either way it could spur some inflation down the track. It also can feed into confidence if there is some comfort that income won’t go backwards.
Davison Which of the potential political inputs into the housing market is of most cause for concern?
The policy could be formulated to allow for long enough that property investors would be able to get their last ‘bite’ of negative gearing. The rules around grandfathering will be very important.
Ultimately, though, they will sell and the secondary market is not tax-favoured. A rational investor should never pay more if the next buyer won’t get the same value. When people start investing based mainly on tax outcomes you can get a problem of oversupply.
Risk factors for 2019
In a world of renewed volatility with political risk at a heightened level in Australia and abroad, it is no surprise that strategists find it easy to highlight a raft of potential future risk factors for markets.
GOODMAN I think the main overstated risk is China falling off a cliff. Through 2017 and 2018 there has been a fear of China’s growth stalling. It is slowing, but we are comfortable that this is an overstated risk to the world economy and to Australia’s economy. The main risk globally, I think, is quantitative tightening (QT) and what it means for liquidity. The US$15 trillion which has been inserted into the global economy in the last decade peaked in March 2018. It is slowly coming off, but I think we are still playing in that experiment.
Domestically, with an upcoming federal election there is uncertainty around corporate regulation. This clearly makes for an uncertain environment for investment.
It is very difficult to test the regulatory system for funding when QE is being run at the same time. But we have changed the rules on funding, and we are now starting to test them. The outcome of these tests is a risk.
Davison Presumably if there is any expectation of property investment being pulled forward ahead of a change to negative-gearing rules it would have to rest on an assumption that finance will be available for this investment rush?
Davison Could it be said that the Perth market is a plausible base case for the Australian housing trajectory overall? Prices in Perth seem to have bottomed but are now drifting along flat-to-down rather than rebounding.
Specifically, there was a big run up then changes to foreign investment and macroprudential rules. These changes are now done. There are still some changes to come with the interest-only loans that are rolling over in the next 2-3 years. The lowest base case I see is a couple of years with close to zero growth then a more prolonged period at 2-3 per cent.
It is difficult to see how there could be inflation in the general economy, wages trending up, strong employment and a functioning credit system – it isn’t providing as much as it used to but it is still functioning – and non-rising house prices.
Davison It has been interesting to observe the gradual capitulation of Australian rate-hike expectations. Are the risk factors now such that the next move is as likely to be down as it is up?
Relative to what we have seen, there is a degree of slowing in the high-frequency indicators for global growth. But this is coming from an above-trend, strong level. I’m not concerned about short-term risks that would lead to the RBA cutting rates. This does not mean there aren’t challenges to the idea of it hiking next year, but I can’t yet see the case for a cut.
I agree with Alex Stanley that the barriers to a rate cut are huge. [RBA governor] Philip Lowe’s speech where he said financial stability is the goal will be referred to again and again.
This could trigger a rate cut, but it requires some big assumptions. First is that a US recession starts at that point and second is that it is particularly nasty. Neither of these are self-evidently true. In fact the last couple of unemployment prints have been very good.
Business and consumer confidence remain relatively high and the federal government is moving towards surplus. If it needs to have a bit more in the tin to spend it can do so, as can the states, so there can be stimulus if necessary.
Exports are going well in bulk commodities, services, education and tourism. Even with the proposed immigration cut, population growth presents a strong backdrop for consumption. All of this conspires to make a high hurdle for a rate cut.
But it is also not easy to see a rate hike. It is easier, purely because it is what the RBA is saying. But we have just extended our expectation for the RBA hike into 2020 given the weakness in housing. I think waiting as long as 2021 is a bit of a stretch. But the near-term risk of a hike is not there, and I think the market has priced this accurately.
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