Australia Market Commentary
The Australian bond market (as measured by the Bloomberg AusBond Composite 0+ Yr Index) was up 0.28% over the month. The yield curve steepened as the spread between long-term and short-term bond yields widened. 3-year government bond yields ended the month down 11 basis points (bps) to 1.28% while 10-year government bond yields were up 1 bp to 1.79%. Short-term bank bill rates ended the month lower. The 1-month rate was down 20bps to 1.60%, the 3-month rate was down 21 bps to 1.56% while the 6-month rate was down 22 bps to 1.62%. The Australian dollar remained unchanged to close the month at USD 0.71. The cash rate remained unchanged in April at 1.50%. The Reserve Bank of Australia (RBA) has shifted to a more dovish tone, noting that if inflation did not move any higher and unemployment trended up, a decrease in the cash rate would likely be appropriate.
The latest domestic economic data releases were mixed in April. The Commonwealth Budget was delivered early in the month, largely delivering on expectations, with a return to surplus forecast in 2019-2020 of AUD 7.1 billion. The inflation result was lower than expected, with the Q1 headline CPI flat for the quarter. Employment growth rose a larger than expected 26,000 positions in March, but the unemployment rate ticked up to 5.0%. The NAB Business Conditions index rebounded 3 points to +7 in March, while Business Confidence fell a further 2 points to zero. Residential building approvals for February rose a larger than expected 19.1%, with higher density approvals spiking 62%. Year-on-year approvals remain negative at -12.5%. National CoreLogic dwelling prices continued their fall, with April down 0.5%. This sees the year-on-year decline at -7.2%, the lowest since February 2009. Retail sales were up 0.8% in February, the largest monthly gain in over a year.
Australia Market Outlook
Global growth has desynchronised with one of the lead indicators for economic growth, the Purchasing Managers Index, showing contraction in over 40% of countries across the globe. We remain cautious about the global trade environment and shifting central bank policy settings. The US Federal Reserve has turned more dovish, appearing to drop their bias to hiking rates. Meanwhile, the US instigated trade still lingers.
While the Australian economy has completed 26 years of uninterrupted expansion, there are some risks on the horizon. Over the past six months the consumer has struggled despite a strong business and employment outlook. Corporate profits are robust and business confidence remains positive, however historically low retail sales and poor consumer confidence driven by very low wages growth moderates the outlook for growth. Furthermore, the weaker housing market is starting to bite with falling house prices, lower building approvals and lower mortgage approvals filtering through to the broader economy.
We expect the RBA will cut rates in 2019, as the decline in house prices will slowly feed through to the real economy. Given weaker GDP growth and the soft inflation backdrop the RBA has little justification to move cash rates higher in the near term. The RBA has changed its tone, with a speech from Governor Lowe in February indicating that the probabilities of either a rate cut or hike appeared evenly balanced. Market participants are also starting to come around to this view, with some pushing back their expectations for rate hikes, while others are calling for cuts this year.
Sentiment for credit in April was positive with substantial spread contractions across both physical and synthetic markets. Australian physical spreads were about 6 basis points (bps) tighter, especially for shorter maturity issues. Investment grade synthetic indices all rallied with the Australian iTraxx 9.5 bps tighter and, in offshore markets, the US CDX 5.5 bps and European iTraxx 7 bps tighter.
Woolworths announced the intention to close 30 BIG W stores over the next three years and also to close two distribution centres at the end of their leases. The actual stores to be closed are as yet undisclosed .The closures result in about AUD 370m of costs or charges. These plans have implications for A-REITs with exposure to the retailer already exposed to diminishing floor space demand from Myer, David Jones and Target. Debt issuers potentially impacted include Scentre (19 stores), Vicinity (17 stores), GPT (10 stores), Stockland (11 stores) and SCA Property (9 stores). Closures are slated for FY21 and FY22, providing some time to respond. Woolworths also confirmed that it has now completed the sale of its petrol business. These transactions are not expected to have rating implications for Woolworths.
Also in the A-REIT sector, quarterly updates from both Stockland and Mirvac highlighted issues in their residential divisions, although still manageable at this stage within current ratings. Stockland did note a moderate increase in cancellation rates. Stockland’s Retail Town Centres remain another focus point with weak conditions continuing but their Logistics division performed positively and the Retirement Living division broadly neutral. Dexus’s March quarter update was solid benefiting from strong office and industrial property market conditions in Sydney and Melbourne. Dexus and Dexus Wholesale Property Fund (DWPF) earlier in the month settled the purchase of 50% of MLC Centre with DWPF confirming it had attracted AUD 340m of its AUD 400m targeted equity raising to help fund the purchase. Vicinity Centres results were reasonable but consistent with a challenging retail market. The main focus is on whether Vicinity can achieve its targeted divestments. GPT Group’s March quarter update showed the negatives of the retail sector outweighing the positive performance of the office and logistics sectors.
Rio Tinto, BHP, Woodside and Fortescue all signalled disruption from Cyclone with Rio declaring a force majeure. Rio Tinto also announced a further USD 302m commitment to progress its Resolution Copper project. In all cases, it should not have ratings impact since the three companies have sufficient financial head room at current ratings. The ACCC has reportedly delayed its decision on Origin Energy’s proposed sale of its Ironbark project to the APLNG JV. Overall, Origin reported a solid quarterly operational (and revenue) performance. AGL Energy reaffirmed the FY19 guidance provided at its February interim profit announcement.
Crown Resorts had an exciting 24 hours with a takeover proposal from US based Wynn Resorts described as being at a “preliminary stage." Wynns said it viewed Crown’s disclosure as “premature” and promptly terminated all discussions with Crown. Incitec Pivot flagged that dry weather in Eastern Australia caused in a 1H FY19 EBIT reduction of approximately AUD 20m compared to the pcp with a further reduction of AUD 60m from a February Queensland rail outage. The total full financial year impact is now estimated to be around the lower end (AUD 100m) of the range previously announced. Transurban reported a reasonably positive 2.3% increase in Average Daily Traffic, with growth across all its markets and all its assets apart from two which are impacted by upgrade works.
National Australia Bank announced it will incur additional charges of AUD 525m after tax in connection with increased provisions for its customer-related remediation program bringing total provisions for customer-related remediation to AUD 1,102m. Westpac also provided an update on accounting provisions for remediation with 1H 2019 cash earnings being reduced by AUD 357m.
Bank of Queensland reported first half results in line with consensus which had been revised downwards after a February trading update. S&P flagged the results as below its expectations but expressed reasonable comfort with the bank and held its rating stable.
S&P published a commentary (“Australian Government Support For Banks: Will There Be More Twists In The Tale?”) which suggests a more nuanced approach to the major banks than before that could mean that even with a tighter resolution process, it could continue to assess the Australian government as remaining highly supportive of the banks thereby reducing the risk of downgrade – but the devil will be in the detail of APRA’s determination. The RBA was reasonably upbeat in its semi-annual Financial Stability Review about the housing market: noting banks’ significantly improved housing lending standards and that the incidence of negative equity remains low with house prices having to fall significantly from current levels for negative equity to become widespread.
Offshore, reporting for the quarter was mixed. US financials were in general positive with JPMorgan, Wells Fargo, Bank of America and Morgan Stanley beating expectations but Goldman Sachs’ and Citigroup disappointed. In Europe, Deutsche Bank beat estimates but through cost savings not top line growth. Over the month, Deutsche Bank also abandoned merger discussions with Commerzbank. UK banks Barclays and Royal Bank of Scotland had weakish results while Credit Suisse had a positive first quarter result. In the non-financials, Ford had a strong result while Apple had another decline in quarterly profit and revenue with iPhone revenue down 17%. Glencore confirmed it is under investigation by the US Commodity Futures Trading Commission for potential corrupt practices.
In credit rating news, S&P placed Swedbank's AA- long term and A-1+ short term ratings on CreditWatch negative after regulatory investigations into alleged money laundering (linked with the Danske Bank case) and disclosure of insider information. Later, Moody’s affirmed Swedbank’s Aa2 ratings, but revised the outlook to negative while Fitch placed its AA- on CreditWatch (negative). S&P revised its outlook on Wells Fargo’s ‘A-’ credit rating to negative from stable, following the announcement that CEO and President Timothy Sloan will immediately retire. S&P upgraded its ratings on BNP Paribas based on the rapid build-up of bail-in-able debt. BNP’s senior non-preferred, subordinated and hybrid ratings were, however, all left unchanged. Moody's upgraded Origin Energy to Baa2/stable, one notch higher than S&P’s BBB- rating. Moody’s revised its outlook on QBE’s ‘A3’ Issuer and ‘A1’ Insurance Financial Strength ratings from negative to stable reflecting stronger operating performance.
Easter and Anzac Day holidays limited issuance over the second half of the month, but the first half saw about AUD 3 billion of supply with nearly half from six non-financials (BWP Trust, Volkswagen, Edith Cowan University, Woolworths, Downer and Shopping Centres Australasia) and the other half from three financials Bank of China, Bank of Queensland and Suncorp. RMBS supply came from four issuers: AFG, Pepper, Sapphire and La Trobe. The AFG and Pepper deals were prime securitisations and the others non-conforming. None of these issuers is an ADI (approved deposit-taking institution); ADI issuers have been noticeably quiet with only Westpac accessing the market this year and AMP the only ADI issuer currently in the pipeline.
Recent months have seen a substantial tightening in credit spreads. At current levels, there is the risk of widening in an environment where global or economic uncertainty continues to apply pressure: however, underweighting credit at current spreads for any sustained period of time has remained an expensive position.
Supply has begun to increase domestically after a slow start this year in terms of number of issuers. Domestic non-financial supply is often less abundant and is always uncertain given many Australian investment-grade issuers tend to be lowly geared and so require less debt. In addition, the bank loan market remains attractive for shorter maturities and offshore markets offer competitive pricing for sizable long-term debt issues. Many issuers have also taken advantage of low rates to refinance many of their maturities and the short-term corporate pipeline is thin.
Given the possibility of further weakness of spreads, caution needs to be applied especially when investing in lower-rated credits. Despite the differing performance in terms of ratings, high-yield spreads offshore appear reasonably tight and are vulnerable to widening; as such, the extent of compensation for taking exposure to lower-rated credit is less compelling.
Domestic and offshore financials tend to be the most common issuers in the Australian market and can offer value. However, for offshore issuers, caution must be applied due to the complexity of the variations in treatment of TLAC (total loss-absorbing capital). Accordingly the domestic major banks offer a simpler value proposition due to their liquidity and some of the smaller local approved deposit institutions (ADIs) provide a solid spread with conservative management. On the non-financial side, the lack of supply has resulted in many deals being expensive but stable sectors such as the utilities and quality REITS remain more attractive sectors. Securitised product remains another area of value given solid spreads and in many cases superior credit quality.