Global outlook
The year 2008 was characterised by unprecedented involvement in financial markets by governments. Given the extent of their action this year, their involvement in insuring markets are able to function will increase in time and scale in 2009.
As fiscal stimulus packages and rate cuts work through the system some element of confidence should be restored. Demand for commodities may rebound as state sponsored infrastructure projects get underway, but it may not be as early as 2009.
Credit markets will remain challenged until the US housing market recovers, the US consumer starts spending again and market volatility is reduced. More importantly, the banks have to face up to their losses, both in their books and in their mentality, before a true recovery can begin.
Offshore primary markets will be dominated by government guaranteed bank issuance, with a flood of supply anticipated as banks refinance debt. The key dynamic will be the interaction of GGBs and sovereign debt as governments ramp up their borrowing programmes to fund deficits.
The pros and cons of various sovereign guarantees will become clearer and the French system will emerge as a clear winner. By issuing bonds from a single entity the French government is able to issue larger volumes (and liquidity for investors) at tighter spread. The same outcome, which is to provide banks with access to funds, is achieved at a lower cost. The Government is also better able to coordinate the process and phase it out when banks are able to raise their own debt, and banks have scope to raise funds independently through the existing un-guaranteed market.
While other steps taken in 2008 were implemented to reduce systemic risk, there will be some adverse consequences, Do government balance sheets have sufficient capacity to underwrite bank losses and guaranteeing bank debt? Are governments able to assume an increasing role in overseeing financial systems? Will they find the middle ground between over-regulation impeding private sector growth and under-regulation encouraging excessive risk taking? The strain placed on governments to guarantee banks and the effects its creation has had on semi-governments and agencies means that for the time being, there will be no such thing as risk free security.
Significant supply from true corporates looking to refinance is also expected to keep the cost of debt wider. The market will remain closed for many, forcing them to raise funds through either equity issues or reduced dividends. This is fundamentally positive for investment grade credits. Refinancing however will prove too onerous for many debt laden high yield issuers and we will see more defaults.
In the banking sector, hasty mergers have now created institutions that are too big too fail, and as time passes they may be tempted to take on more risks. If governments are to ensure their bailout is effective and long standing, they will have to carefully manage the behaviours of banks to ensure they are acting in the long term interests of all stakeholders, including ‘passive’ tax payers.
‘Mega banks’ credit policies will also decrease the efficiency of capital allocation. Regional lenders have historically proven to be far more effective in determining credit worthiness but larger banks will systemise credit processes potentially limiting access to capital for worthy borrowers.
The dark horse is geopolitics. China’s economic downturn is causing increasing social unrest. India and Pakistan remains a hotspot, fluctuating oil prices is resulting in meddling and Russia continues its brinkmanship towards the West. While threats are not immediate, rising tensions could impede global capital flows. A more likely outcome will be trade tariffs as governments seek to protect key industries and source access to vital inputs.
Domestic outlook
Credit markets will remain volatile and illiquid. Cash markets will continue to suffer as the pool of ‘investable’ fixed income has been substantially reduced by redemptions and rebalancing into equities.
Real money investors will continue to exhibit caution, favouring cash and more liquid assets to avoid distress selling. 'Cash Plus’ funds faced heavy redemptions and we do not expect them to return as buyers in the near future. The flight to safety will manifest itself in an increase in deposits rather than a reallocation from equities to fixed income.
Whilst corporate bonds have and probably never will offer such attractive risk adjusted returns, only a handful of funds will be in a position to capitalise on wide spreads. This will keep the cost of borrowing high and prohibitive, forcing those in need of funding to turn to equity markets.
Credit is yielding equity like returns and one solution to the current misallocation of deployable capital in credit markets is to entice equity funds to examine the opportunities in credit markets. The returns are as attractive, and investors are being rewarded for holding the assets.
Bank balance sheet investors will remain the most active investors, underpinning demand for repo-eligible securities. These investors are likely to drive primary markets supply. Their participation in credit markets however resembles nothing more than an elaborate paper shuffle as banks swap paper that allows them access to RBA cash. Internal securitisations too, which has transformed billions of dollars of mortgage loans into securities that are in a format palatable for the RBA have no true economic rationale. Until such time that external funds enter the system, credit markets here will remain challenged.
Ironically the fate of regional banks lies in the hands of bank balance sheets. If the premium regionals can afford to pay to issue guaranteed (and un-guaranteed) bonds is attractive enough for bank balance sheet and real money investors, they will be able to be able to access capital markets. If not, we may see some consolidation. Early signs are encouraging as Suncorp and Macquarie were able to issue guaranteed debt, albeit at high spreads. The danger is that their desperation for funding at any price, will push up the cost of funds for the major banks.
The key to the survival of smaller regionals is deposits and with most of their holdings being less than A$1m, they can offer free insurance to their customers. Old fashioned banking and servicing customers may ensure they survive by funding through deposits, shored up by the government guarantee.
The major banks will experience some losses in their corporate and mortgage portfolios, and face higher cost of funds, but will be compensated through decreased competition. Capital raisings are likely as the Tier I bar is raised, benefiting credit investors at the hands of shareholders.
The advent of the Government guarantee will create ‘the new semi’. Australian debt markets have made room for semi Government bonds ie a quasi government risk with a yield pick up. The issuance of bank debt with a government guarantee will create a new curve sitting above its more liquid semi cousin. Unfortunately semi governments are now in effect subsidising the banks as their funding costs have spiked at a time when they need to up their fund raising, due to the competition from the guaranteed sector. Unless modifications to the wholesale guarantee are made (adaptation of the French issuance model could be one) banks will capture funding from semi governments. Political factors may impede aid to the semi governments as the Federal government may not want to be perceived to jumping to the aid of Labor states.
So what is the future of credit markets in Australia? Not very bright given pressures on both supply and demand. The true corporate bond market has hardly existed since well before the credit crunch, lack of liquidity in the RMBS market is keeping investors hesistant, and wide secondary spreads are pricing primary bonds out of the market. Structured credit had only received support from middle market investors, who have been badly burnt and both insto and retail investors have found out that hybrids are equity dressed up as debt. Added to that are the losses, redemptions and reweightings that have impaired our bond funds. It might be some time before our credit markets have regenerated, and are once again vibrant and thriving.
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