AAA rating rock-solid

Christopher Joye

Coolabah Capital

I write in the AFR this weekend that Standard & Poor’s has confirmed that Australia’s AAA rating is rock-solid despite downgrading both NSW and Victoria from AAA to AA+ and AA respectively. Excerpt enclosed:

This was an important new message because there had been feverish speculation in markets that the move to deprive our two largest states of their prized AAA monikers presaged a similar sovereign downgrade.

S&P still has Australia on a “negative outlook”, which means there is a 1-in-3 chance it could push the nation down to the AA band in the next couple of years. Our central case has, however, been that Australia will retain its AAA rating. We expected the Victorian downgrade, but were surprised by the decision apropos NSW, which we believe S&P will be eventually forced to reverse.

NSW and Victoria both claimed the Reserve Bank of Australia was ultimately responsible for encouraging them to sacrifice their ratings in the name of supporting jobs, wages and growth, which is accurate.

The Victorian downgrade reflected structurally larger deficits and substantially higher debt, which increasingly appear to be permanent. In contrast, the NSW notching was attributed to temporary deficits propagating an elevated stock of debt.

There are nonetheless real problems with S&P’s logic. First, we are projecting large upside surprises to the federal and state budgets, which will significantly outperform their extremely conservative assumptions. These positive revenue shocks reflect an ebullient housing market, robust employment growth, and booming commodity prices. This will in turn drive better than expected stamp duty and payroll tax revenues, royalties, GST payments, and commonwealth tax receipts.

In our proprietary real-time tracking of the NSW budget, we are already seeing it running materially ahead of the state’s dour projections. Similar insights apply to the Commonwealth’s GST receipts.

Second, S&P has failed to acknowledge that its forecast 10 per cent drop in national house prices has failed to materialise, and that the bounce-back since September is miles better than it anticipated. It has also underestimated the economic benefits of eradicating COVID-19 in Australia, which is enabling the states to open-up aggressively and liberate latent growth.

Finally, it has confused the temporary blow-out in the NSW deficits, which it should be looking-through, with structural problems. On the balance of probabilities, NSW will return to surplus much earlier than the state and S&P projects.

At the sovereign level, it might be ostensibly surprising that the best-performing AAA rated nation in the world during the pandemic, Australia, is also the only AAA rated nation S&P has put on "negative outlook". Other AAA rated countries that have had, and continue to have, huge problems in managing COVID-19, including Switzerland, Sweden, Germany, Canada, Denmark, the Netherlands, and Norway, bizarrely remain on a "stable" outlook.

The truth is that S&P has always had an itchy trigger finger when it comes to the wonder down-under, putting it on negative outlook in 2016 when the consensus was convinced the AAA rating was lost. (We consistently forecast that Australia would retain its rating.)

S&P’s pessimism proved profoundly misplaced as the government smashed expectations on all fronts. Contrary to S&P’s predictions, the federal budget was balanced, the current account deficit roared into surplus, and commodity prices remained much higher than it assumed. After an inordinate delay, S&P reluctantly removed the “negative outlook” and returned Australia's AAA rating to its rightful "stable" position.

If we are so bullish on the outlook, this begs the question: is there much more for the RBA to do? As deputy governor Guy Debelle has explained, it is important not to be head-faked by the tautologically positive data following the biggest shock since the great depression. The truth is we have a long way to go to recoup the employment and income losses from the pandemic. And house prices are still lower than they were at the start of 2017.

The governor, Phil Lowe, has made it clear that Martin Place is focussed on doing everything it can to get the jobless rate down to the “4 point something” level that is consistent with full employment, and which will exhaust the large amounts of labour market slack that make it impossible to generate decent wages growth.

“You need wages growth to increase from its incredibly low 1.4 per cent pace to over 4 per cent to get consumer price inflation sustainably back into the RBA’s target band,” says Kieran Davies, a former forecaster at the Commonwealth Treasury who now works alongside me. Even assuming Australia’s recovery is pitch-perfect and does not suffer from any further interruptions, Davies estimates that this process will take “at least a couple of years”.

History teaches us that the one constant is volatility. And the ride ahead is, therefore, likely to be turbulent and could materially elongate the resumption of normality. The sharp deterioration in relations with our most important trading partner is but one example of the manifold downside risks.

While the RBA has exhausted its conventional short-term cash rate tool, it has vast amounts of untapped ammunition in the form of its direct lending and asset purchase programs. By buying 5 to 10 year federal and state government bonds, the RBA has been actively arresting the increase in long-term interest rates that serve as the benchmark for pricing all assets.

This reduces the relative appeal of owning Australian dollar assets, such as government bonds, which has helped attenuate the otherwise aggressive appreciation in our exchange rate. Were it not for the RBA’s commitment to a substantial asset purchase program, the Aussie dollar would be much closer to US80 cents. And long-term interest rates would be a lot higher. My own view is that the Aussie dollar is going to march its way back towards parity with the US dollar in the absence of additional RBA interventions.

Governor Lowe has made it clear that an essential input into the sizing of the RBA’s asset purchases will be what other central banks are doing overseas. On Thursday the ECB announced that it was increasing its asset purchase program by €500 billion to €1.85 trillion. The ECB and central banks in Canada, Japan, New Zealand and the US and UK have all committed to buying government bonds worth between 15 per cent and 25 per cent of their GDP. In comparison, the RBA has announced a smaller program worth 9 per cent of GDP, although it has signalled that it will be calibrating its size in the months ahead.

Beyond throwing sand in the wheels of the Aussie dollar’s climb and trying to rein-in the rise in long-term interest rates as global growth improves, the RBA has also played an important part in reducing debt servicing costs for state governments that account for almost half of the total public stimulus that is bolstering the economy at present.

During the week, NSW Treasury Corporation (TCorp) issued a 2032 bond, explicitly citing the RBA’s influence in keeping a lid on the interest rates taxpayers pay. “The involvement of the RBA, changes to bank holdings of high-quality liquid assets and APRA’s update to [a regulatory standard] meant rating downgrades have less effect than they may have done in the past,” Fiona Trigona, head of funding, told KangaNews.

While Trigona highlighted that foreign investor participation hit a record high of 32 per cent, this is awkward news for the RBA which is trying to actively dissuade overseas participants from buying Aussie dollar assets and bidding-up our exchange rate.

The problem is that NSW taxpayers are still paying investors a yield of 1.48 per cent on this AA+ rated bond. This is the best return in the world right now for a AA or AAA rated government bond in outright terms, or hedged into US dollars, Euros or Yen, which is why offshore investors have been gobbling these assets up. It is ironically a much higher interest rate than what these investors can get on even lower-rated government bonds.

The dilemma for the RBA is that our businesses are being put at a comparative disadvantage by foreign central banks aggressively expanding their balance-sheets to depreciate their currencies relative to the Aussie dollar. And so the RBA is reluctantly doing what it can to keep pace and ensure we are no worse off.

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Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs $7 billion with a team of 33 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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