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Weekly Highlights

Markets had a poor start to last week but a late change on Friday in the US will give investors hope for this week. Banks led the domestic equity market lower (-1.24%) and the possibility of a Royal Commission did not help alleviate the concerns for the sector. Bond and credit indices were stronger as the Treasury bond curve tightened slightly (-0.05%) across the curve. Investor sentiment remains mixed with equity market turnover well below average and the ASX200 volatility index has been creeping up since its low on 22 March 2016.

 

Over the past few months, credit markets have reversed a reasonable amount of the negative trajectory seen in late 2015 primarily thanks to the European Central Bank and its purchase power for European corporate bonds. Although this is not a long term answer to the problem it is likely (at least in the short term) but a floor under credit spreads in Europe which in turn will have a knock on effect in Australia. The long term effects are that at some point down the road something major needs to be forgiven. At the moment approximately $7 trillion dollars of the world bonds are trading with a negative yield to maturity and hence investors are guaranteed to lose capital if they hold them to maturity. We now have a situation where Japanese government bonds have gone to negative yields and German bonds are threatening to do the same.

 

Newsflow was strong and in some cases provided real insight into the second half of 2016.

 

The Basel Committee on Banking Supervision’s (BCBS) leverage ratio proposal (part of the suite of regulatory actions taken following the Global Financial Crisis (GFC)) was revised last week. The BCBS have yet to decide on how to implement this for Global Systemically Important Banks (G-SIBs). From an Australian perspective, APRA is expected to set the initial framework during 2016 and then consult industry participants during 2017 with implementation in 2018. Should BCBS decide on a leverage ratio of 4%, or higher, APRA would be obliged to implement a higher ratio as our four major banks are a net importer of capital. Although no Australian bank is considered to be a G-SIB, the four major banks are considered to be Domestically Systemically Important Banks (D-SIB) and APRA are like to impose a further 0.5% to 1% add on to any BCBS agreed leverage ratio (i.e. if the BCBS eventually settles on a 4% ratio, the Australian major banks are likely to be set a 5% ratio by APRA assuming a 1% D-SIB add on). All four major Australian Banks are compliant with a 4% (3% + 1%) leverage ratio but would have to raise additional capital for a 5% (4% + 1%) leverage ratio. The four major Australian banks will likely be compliant by 2018 through greater equity accretion and may not need to perform additional rights issues, however, dividend payout ratios may be lowered slightly if retained earnings and dividend reinvestments plans are insufficient. The banks may also decide to increase the Tier 1 capital category by issuing further Additional Tier 1 hybrid securities, which may see trading margins widen further from current levels if demand does not keep up with supply.

 

Bank of Queensland (BOQ) reported a statutory net profit after tax of $171 million, up 11% on the prior corresponding period (pcp) and cash earnings up 7% on the pcp at $179 million. (see updated reports here). BOQ reported a common equity tier 1 ratio (CET1) of 8.80%, slightly down (-0.11%) over the half. While BOQ generated 0.7% of internal capital, this was almost fully eroded by the dividend payout (0.35%) and Risk Weighted Assets (RWA) growth (0.32%). BOQ also surprised the market by increasing their mortgage lending rated for both owner-occupiers (0.12%) and investors (0.25%) despite the RBA maintaining the cash rate at 2.0% last week for the 10th meeting in a row. While the result was not taken well by equity investors, from a debt investor’s point of view BOQ have improved their credit profile over the past few years by maintaining relatively high capital ratios and making selective acquisitions which have helped their profitability. Our broad thesis is that BOQ has performed well given the uneven regulatory landscape and deteriorating economic conditions in Queensland. We expect this improvement will continue in 2016 as the Financial System Inquiry recommendations are being implemented resulting in narrowing residential mortgage pricing differentials between the major and regional banks.

 

Macquarie (MQG) provided a brief market update with no changes to its outlook for full year earnings (2016). The result from operating segments will be up on 2015 but the 2nd half result will be lower than the 1st half (transaction timing). Continued capital market weakness during the 2nd half will see lower performance fees and transaction fees from asset management and capital markets segments respectively. MQG provided an update on their term funding activity year to date, with $20.9 billion raised across a broad mix of instruments (senior unsecured (34%), private placement (16%), securitisation (20%), covered (4%) and sub debt (5%)).

 

Last week Crown Resorts held a conference call for investors to try and alleviate some concerns regarding its debt and hybrid securities. The call had almost no influence on our investment thesis (click here to see more) primarily because the risk to the capital structure (and in turn the securities behind the capital structure) is completely out of the hand of the Crown board. They have refused to speculate on any action by Consolidated Press (CPH) stating “What CPH does is what CPH does. We (CPH) have very little visibility”. Operationally the domestic business continues on with reasonable success but Macau continues to be weak (March revenue figures confirmed this theme) and capital expenditure requirements remain elevated (Sydney) hence the requirement for partial sell downs in joint ventures (keeping funding as non-recourse project finance). The key risk remains speculation around corporate activity and this will not disappear anytime soon.

 

Also last week the newsflow about the future of Arrium (formerly known as OneSteel) took hold and many truths came out. In an interesting course of events the board of Arrium decided “that it has, unfortunately, been left with no option other than to place the relevant companies into voluntary administration to protect the interests of stakeholders”. This means the banks who were funding the company (strangely on an unsecured basis) didn’t like Blackstone’s proposal to recapitalise the group (because they would effectively lose money) and so the board acted to appoint their own administrator before the banks could appoint their own. It is not clear how this will all play out but what is clear is that it won’t be the last Australian company to be at the mercy of creditors with Atlas Iron announcing last week a creditors’ scheme meeting on 22 April 2016.

 

First quarter reporting season starts tonight in the US with the main interest coming from JPMorgan (Wednesday), Wells Fargo and Bank of America (Thursday).

 

Click below for Interactive Charts

Chart 1: Bloomberg AUSBond Composite Index (Monthly)

Chart 2: Bonds vs Equities 2014/15/16 (Monthly)

 

Interest Rates

 

Last week the RBA maintained its stance by leaving rates on hold at 2.0%. Minutes will be released next week but the decision makers are effectively watching the data (especially employment) with the same rhetoric. Low inflation provides scope for easing and a high currency “complicates the adjustment under way in the economy”. Last week minutes of the last US Federal Reserve meeting showed investors that policymakers have debated whether or not they would hike rates in April but a number of them argued headwinds to growth would “probably persist….and they “should be cautious about raising rates”. This reiterates the holding pattern in the US even though the labour market remains resilient. The problem is the developed economies are battling to be leaders in service industries but this is unduly influenced by currencies.

 

In February 2015, the 10-year bond yield hit an all-time low of 2.27% before lifting to highs near 3.15% on 11 June 2015. In early November 2015 there was a progressive increase in yield from ~2.60% to a high of 2.99%. Since mid-December the flight to quality meant the 10-year yield gave back the changes in Q4 2015 and on 1 March 2016 hit a 6 month low of 2.35%. In the past few months we have seen a short term bounce back up but the yield is now consolidating back down around 2.40%. The 3-year bond has followed a similar pattern and broke out of its recent yield range (1.90 – 2.10%) in November / December 2015 reaching a high of 2.18% on 7 December 2015. It retraced back to a short term low of 1.70% but since then it has wildly jumped up and down and currently sits around 1.82%. On 8 April 2016, the ASX 30 Day Interbank Cash Rate Futures April 2016 contract was trading at 98.095 indicating a 42% expectation of an interest rate decrease to 1.75% at the next RBA Board meeting (up significantly from 7% the week prior).