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AUSTRALIAN CREDIT IS A SHELTER

03/06/2013

Having reached new highs on main developed markets this year, investors should now consider diversification at least to protect realized performance. In this context, we draw attention to the Australian credit market.

It is always smart to have a defensive play, even if one’s general sentiment is bullish. Australia remains a member of an increasingly elitist group of global AAA credits in a QE-driven world which has become somewhat complacent about fundamentals. Australia’s net debt to GDP remains at a very comfortable 11% (well below all G10 countries with the exception of Sweden). Its economy may no longer be benefiting from the global commodities boom, leading growth to slow, the RBA to cut rates, and the AUD to lose ground, but the medium-term outlook remains sound. And with rates either likely to move down or remains steady, the current economic backdrop lends a strong argument for credit markets.

Looking ahead, the growth outlook is modest but not dire. Growth is likely to slow to below 3%, but hardly move into recession. We expect a shift to modest fiscal tightening after the September 2013 election, in fact, as the government aims to bring the economy back to fiscal balance, which should decrease the need for monetary tightening, pushing the rate hike cycle off beyond 2014. Recent AUD weakness has prompted concerns that the AUD has further to fall, particularly if rates are cut again. For those worried about this risk, an FX hedge could be used. Yet, we do not see such imminent weakness, which also reflected a period of less attractive relative rate differentials. Furthermore, another rate cut would lend upside potential to credit.

The Australian fixed income market is expanding quickly. Although the global bond market is twice the size of the global equity market, it is only two thirds of the equity market in Australia. Yet, this is up from one third just 10 years ago. The fixed income market is made of six main ranges of issuers (in % of outstanding AUD bonds): 1) Australian Commonwealth Govt, 23% 2) Australian State Govt, 19% 3) domestic corporations, 4% 4) Financials, 20% 5) Kangaroo bonds – i.e., foreign issuers, 10% and 6) Structured credit, 24%.

 

As we very much favor the spread element of fixed income instruments, we focus on credit (i.e., Financials and Corporates). Even if Corporates are slightly re-leveraging, credit quality remains very good on average. And we believe that even if the resource investment boom (driven by LNG) is about to peak, a production boom is set to take over: LNG and iron ore may be the leads. So if, admittedly, the mining sector tends to struggle, several other industries could be played (e.g., retail or contracts/engineering).

Away from Corporates, we like the banking sector. Large banks’ fundamentals are sound, with high asset quality, good liquidity and solid capital levels. 2013 results could be record high again for the Big 4 (NAB, Westpac, ANZ and CBA). As a reminder, ratings agencies recently reaffirmed the strength of the system, whereas they downgraded another AAA-rated banking system (i.e., Canada). Above all, a key element is that deposit growth exceeds credit growth, leading to the banking industry funding needs declining.

We believe demand for Australian bonds remains solid, driven by relative value across developed markets. Spreads should tighten by the end of the year. A 120bps to OAS spread target on the BofA ML index is not out of reach (vs. 138bps on May 23, 2013). Therefore, we are very constructive on this diversification play. Credit spreads should tighten, especially when it comes to banks.

 

OUR VIEWS

- Prefer the banking industry for technical reasons (lower supply)

- Look at Kangaroo bonds too (foreign corporates issuing in AUD).

Global Strategist Societe Generale Private Banking
Global Head of Fixed Income Société Générale Private Banking