The downgrade Australia needs to have

This year marked the 30th Anniversary of Paul Keating’s famous “banana republic” statement. To celebrate, Standard and Poor‘s lowered our credit rating outlook to “negative” from “stable”. Given what happened in the election last Saturday, the challenges we still face in transitioning away from the mining boom, and the size of our current account deficit, an outright downgrade may not be too far off. Under ordinary circumstances, a downgrade to Australia’s credit rating outlook (let alone an outright downgrade to the rating) would put downward pressure on the Australian dollar and upward pressure on our sovereign bond yield. The yield on semi-government and corporate bonds, priced as a spread over government, would also be higher. Keep reading for our take on the Australian economy and what a credit rating downgrade could mean.
UBS Asset Management

UBS Asset Management

Certainly, back in 1986, the last time we were downgraded, our current account deficit was running at 5.9%, the Australian dollar was on the downhill road to 60 US cents, and our 10-year bond yield was tracking very close to 14%. Today, our current account deficit is 5.1%, the Australia dollar is sitting at 75 US cents, and the 10-year bond yield is sitting at close to record lows of 1.9%. 

We are operating in circumstances far from ordinary

The decision by S&P needs to be considered in a relative setting. The UK referendum result confirms we are now in a lower for longer environment for much, much longer. Investors know they have central bank support. Interest rates will be cut (or rate hikes delayed), and quantitative easing will be expanded and/or extended at the first sign of trouble.

This means investors will continue to seek blindly yield from wherever they can get it. When you have the backing of the central bank, the risk premium built into asset prices to cover sovereign risk is much thinner. Look at the UK. Just last week it lost its AAA rating and bond yields there are currently 0.76%, down from 1.1% before the downgrade. Incidentally, the UK current account deficit, the highest in the G20, is higher than Australia’s by the thinnest of margins (5.2%). 

Moreover, increasingly a large part of the bond universe is being closed off to certain types of investors (such as European insurers and defined benefit pension plans) with the rise in negative yielding sovereign bonds. There is now $8.7 trillion worth of sovereign bonds with a negative yield. 

In this context, Australia still looks like an attractive place to invest. You only have to look at what happened to the Australian dollar post the Brexit result – it immediately fell 2.5 US cents but has since rallied back almost 2 US cents. The Australia dollar gave a quick jolt down to the news from S&P this week only to quickly recover. Bond yields barely moved.

Implications for investors

  1. Australia remains an attractive place to invest, particularly for those investors constrained from investing in negative yielding bonds. In this regard, the T-IN-A rule applies – There Is No Alternative.
  2. The pool of AAA rate sovereigns is rapidly shrinking making AA the new AAA. 
  3. Perversely, this may be the downgrade Australia needed to have to wake the politicians from their economic slumber. Freed from the constraints of needing to maintain the coveted rating, a downgrade may allow Canberra to focus on longer-term challenges such as much need.

No time for complacency

The main difference between Australia’s current account deficit today and the one we experienced in 1986 is the investment environment we were operating in. Back then it was a competitive struggle to attract foreign investment to fund the deficit. Today, 60% of the Australian bond market is owned by foreign investors. This is no excuse for complacency, however. Foreign investors can be fickle.

Written by Tracey McNaughton, Executive Director & Head of Investment Strategy, UBS Asset Management. 

Original article was taken from UBS website:  (VIEW LINK) 

UBS Asset Management
UBS Asset Management
UBS Asset Management

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