Australian Market Commentary
The Australian bond market (as measured by the Bloomberg AusBond Composite 0+ Yr Index) returned -0.49% over the month. The yield curve steepened as 3-year government bond yields ended the month up 7 basis points (bps) to 0.81% while 10-year government bond yields were up 12 bps to 1.17%. Short-term bank bill rates ended the month mixed. The 1-month rate was down 9 bps to 0.92%, the 3-month rate was down 2 bps to 0.93% while the 6-month rate was also down 2 bps to 1.03%. The Australian dollar (AUD) was slightly stronger, closing the month at USD 0.69.
The Reserve Bank of Australia (RBA) cut the cash rate by 0.25% to a new record low of 0.75% at the 1 October meeting. The RBA reiterated that they would ease monetary policy further if needed "to support sustainable growth in the economy, full employment and the achievement of the inflation target over time".
Domestic economic data releases were mixed in October. Employment increased by 14,700 positions in September, which was broadly in line with expectations. The unemployment rate edged back down to 5.2%. Retail sales missed expectations slightly, recording a 0.4% gain in August. The NAB Business Conditions index rose by 1 point to +2 in September while Business Confidence fell to 0 from +1. Both readings remain below their long run average. National CoreLogic dwelling prices continued to rise, increasing 1.2% in October, the fourth consecutive month of gains. On the inflation front, the CPI rose 0.5% during the third quarter, while the annual rate was 1.7%. Both were in-line with consensus.
Australian Market Outlook
Global growth has moderated, largely due to the impact of the ongoing US-China trade war which has reduced international trade. Global industrial production has stagnated and US economic data remains soft. A pause in US-China trade tensions during October was welcomed by markets, however it is still unclear if an agreement will be reached. We remain cautious about the global trade environment but remain hopeful regarding the overall growth outlook given the US Federal Reserve's recent rate cuts and the dovish view of other major central banks which should help support global growth. Furthermore, no-deal Brexit risks have eased, with a UK election set for 12 December and the European Union granting the UK a ‘flextension’ to 31 January 2020.
Domestically, the Australian economy is growing below-trend, with sustained low income growth impacting household consumption. Despite strong employment growth, unemployment has hovered at 5.2% in recent months as labour force participation has increased to a record level. Economic growth is expected to increase only gradually, supported by the record low level of interest rates, recent tax cuts and stabilisation in the housing market.
The delivery of three 0.25% rate cuts in quick succession has seen the RBA take action to support employment growth and reduce the spare capacity in the labour market. We were somewhat surprised to see the RBA continue with its third cut of 0.25% in October, as we thought that the RBA would wait to see if the prior two cuts where flowing through the economy. In spite of this we think that the RBA is warranted in providing additional support to the Australian economy amidst concerns that global trade is slowing. We now expect rates to remain on hold until mid-2020.
Despite the ongoing US-China trade war, Brexit and the likely impeachment proceedings against US President Donald Trump, October maintained the calm of September with domestic physical spreads stable while synthetic spreads tightened. The US CDX tightened 4.5 bps, the European iTraxx 3.5bps and the Australian iTraxx closed 6.5 bps.
In a busy month for financials, APRA released a draft of APS111 which outlines the capital treatment for Australian approved deposit institutions (ADIs). The most noticeable consequence is an increased capital charge for the holdings of NZ subsidiaries, with ANZ impacted the most due to its higher exposure to the NZ market.
Both ANZ and National Australia Bank announced remediation charges that would severely impact performance, with the rating agencies signalling no change to the rating on the back of these payments. The Australian Commonwealth Director of Public Prosecution has launched criminal proceedings against Commonwealth Bank's subsidiary, CommInsure, alleging 87 contraventions of anti-hawking laws. Australian Treasurer Josh Frydenberg asked the Australian Competition and Consumer Commission (ACCC) to undertake an inquiry into the pricing of residential mortgages.
Standard and Poors (S&P) updated its Banking Industry Country Risk Assessment (BICRA) for Australia, upgrading the Economic Risk score to 3 (from 4), which raises the BICRA group to 3. The stand-alone credit profile (SACP) of major banks, ING and Australian Unity, were upgraded as a result. This followed through to an upgrade of subordinated debt of the major banks.
Bank of Queensland reported a disappointing result with cash earnings down 14% on the prior corresponding period (pcp) Suncorp sold its Australian and New Zealand smash repair business ‘Capital S.M.A.R.T. Group’ at a historic EBITDA multiple of 20x. Suncorp retains a 10% interest and expects to realise an after-tax profit on the sale in the range of AUD 275-295 million. AMP announced a restructure merging of AMP Bank and its wealth management businesses, into a new business, ‘AMP Australia’.
In the property sector, Office REITs remain strong, although some concern is raised by WeWork's struggle to survive in terms of existing exposures and future demand. On the other hand, the possibility of a recapitalised Retail Food Group may improve counterparty risk for various retail REITs. REIT reporting was reasonably positive with Dexus, Stockland and Mirvac releasing strong results. Vicinity, however, reported flat results with the outperforming Chadstone and DFOs being offset by weakness in much of the remaining properties.
Woolworth's released its 1Q20 sales report, with revenues up 7.1% from pcp with all segments seeing growth. The one negative is a substantial remediation for underpayment of 5,700 staff over an extended period estimated at a cost AUD 200-300 million. Coles released 1Q20 sales results showing first quarter revenues up 1.8%.
In other news, Qantas provided a 1Q20 update with group revenue increasing 1.8% to AUD 4.56 billion, with an improvement in the international market more than offsetting weakness in the domestic. Aurizon released its September quarterly above rail volumes, with total above rail volumes increasing 1% to 64.4Mt. AGL displayed a focus on convergence of data and energy through a small proposed acquisition of regional telco Southern Phone Company Ltd. Transurban released its 1Q20 update, recording a 1.8% increase in average daily traffic. The AER has released its draft 2020-25 regulatory determination for SA Power Networks (of which ETSA Utilities Finance is the issuing subsidiary), with the draft decision allowing revenues over the period which are 6.4% lower than for the 2015-20 period – an appeal is expected. The Australian Commission for Law Enforcement Integrity's (ACLEI) public hearing into Crown Resorts was delayed. In a busy day for the regulator, the ACCC has also opened an enquiry into the prices that the National Broadband (NBN) Network charges NBN providers such as Telstra and Optus. The Australian is reporting that US PE Firm Lone Star Funds is weighing a potential AUD 6.0 billion acquisition of Boral, with the PE firm's interest coming at a time when the company's share price is trading near five year lows.
Resource companies (BHP, Rio Tinto, Fortescue Mining Group, Woodside and Santos) were upbeat in their quarterly production reports. Santos announced the proposed acquisition of ConocoPhillips’ Northern Australian asset with no anticipated rating impact.
Offshore, JP Morgan, Bank of America, Citigroup and Morgan Stanley all beat expectations, albeit with net interest margins contracting , while Goldman Sachs's profit result missed estimates largely due to public market investments in Uber, Avantor and Tradewe. Wells Fargo is looking to better times under new management but is still struggling with large litigation related charges.
Across the Atlantic, results were mixed: Deutsche is on target for its transformation; Santander reported net income down 75% due to a EUR1.69 charge to goodwill but underlying results closer to the norm; Credit Suisse reported good results; UBS recording a sharp decline in 3Q earnings, but was marginally ahead of expectations. Swedbank reported a 16% decline in 3Q net income compared to the pcp; it expects Swedish and Estonian money-laundering investigations to wind up in 1Q20 but US investigations to drag on. In the UK, Barclays and Standard Chartered reported strong underlying results while RBS continues to struggle with losses.
For US issuers in the Australian market, Caterpillar recorded 3Q19 sales of USD 12.76 billion, down 6% on pcp through lower sales volumes; McDonalds (equity -5%) missed estimates for the first time in two years; and GE results were better than expected but more is needed. PACCAR (4.6%) produced strong results and a positive 2020 outlook.
In ratings news, Ford Motor Co was downgraded to BBB- from BBB by S&P and Rabobank had its outlook revised to negative from stable by Fitch. CNH Industrial Capital Australia Pty Ltd was assigned a BBB rating by S&P. Caltex was assigned Baa1 (Stable) by Moody's as compared with S&P's BBB+ (Positive). Mitsubishi UFJ Financial Group Inc had its outlook revised to negative from stable by Fitch. Nissan Motor Co Ltd had its A- rating placed on CreditWatch Negative by S&P and its subsidiary, Nissan Financial Services Australia Pty. Ltd, was also placed on CreditWatch Negative.
Domestic supply picked up in October with just over AUD 5.68 billion issued with non-financial issuance dominating at AUD 3.15 billion across six issues: three domestic (Dexus, United Energy Distribution, Origin Energy and Coles) and two offshore (Korean Southern Power and Verizon). Securitised markets had a record month, with AUD 6.4 billion of new issuance: four RMBS (Pepper, Resimac, La Trobe and a Firstmac private placement); two auto ABS issues (Silver Arrow from Mercedes and Driver Trust from Volkswagen); and two small-ticket CMBS (Liberty and Think Tank). Pepper also refinanced two issues of just over AUD 400 million in total. In mortgage performance reporting, S&P released SPIN data (Mortgage Arrears) for August 2019 with improved levels of delinquencies across the board.
This year has seen a substantial tightening in credit spreads. At current levels, in an environment where political or economic uncertainty continues to apply pressure, the risk of widening is increasing; however, underweighting credit at current spreads for any sustained period of time remains an expensive position. The weighting can be more focused, however, on shorter dated credit which is less sensitive to spread widening.
Supply has been strong this year in terms of number of issuers —although still biased towards financials. 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 already 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 or longer-dated credits. 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 they can offer value. However, for offshore issuers, caution must be applied due to the complexity of the variations in treatment of capital requirements with varying rules on TLAC (total loss-absorbing capacity). Accordingly, domestic major banks offer a simpler value proposition due to their liquidity while some of the smaller local 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 products remain another area of value given solid spreads and in many cases superior credit quality.