Weekly Highlights

The US Election last week caused markets to gyrate dramatically primarily because most investors were not prepared and / or hedged for a Trump victory. As a result, bond prices tumbled and equities soared. In fact, the Dow Jones Industrial Average managed its biggest weekly gain in nearly five years.

But the real question is why? And what does it mean to Australian investors? Clearly this is an anti-establishment and globalization vote but Trump’s policies (or promises) are arguably positive for a number of US sectors as they could benefit from increased government spending, decreased regulation and a pickup in inflation (this is what is driving bond yields). As an example, Trump promised $USD550 billion in infrastructure spending while in office and this has caused a surge in industrial metals like copper (up 11% in a week) and coal. Clearly this benefits Australia as a net exporter of commodities but protectionist policies could endure, so it is difficult to get a clear view.

But what happened to the bond market? Ultimately all of these policies revolve around the US going into more debt (more deficits) but the big driver of the change in yields is the spike in inflation expectations. Long term inflation expectations (as measured by 5-Year, 5-Year Forward Inflation Expectation Rate click here) was already in an upward trend but a potential increase in fiscal spending has given this trend some fuel. In fact, renewed inflation expectations have reversed all of this year’s declines to take it back to where it started (~2.00%). This has caused the US 10-Year Bond Yield to rise from ~1.80 to 2.15% in a week and as always this had a direct knock on effect to the Australian 10-Year Bond Yield which rose from ~2.30 to 2.60%. This is bad news for passive investors in fixed income who hug the indices (i.e. Bloomberg AusBond or Global Aggregate). It is difficult to see long term inflation expectations rising above its 10Y average (~2.30%) but this doesn’t rule out another further steepening in the yield curve if and when the Federal Reserve decides to raise rates again (see interest rates section).

Domestically, the chairman (Wayne Byres) of the Australian Prudential Regulation Authority (APRA) gave a speech at ‘The Regulators’ event (hosted by the Financial Services Associate of Australia, i.e. FINSIA) last Friday. The setting ‘unquestionably strong’ capital standards across the sector as recommended by the Financial Services Inquiry in 2015 will be the primary objective throughout 2017 but Byres noted progression by the Basel Committee on Banking Supervision (BCBS) on transitioning Basel 3 into Basel 4 is required as a prerequisite. As a result, 2017 is likely to be a year of consultation with any potential reforms being implemented afterwards.

Importantly, the regulator has stated that it will not be adopting all of the BCBS standards which means less stringent capital requirements for Australian banks. Having said this, Byres also noted that capital accumulation should remain the underlying strategy, as requirements are not going down, as evidenced by the major banks returning to capital markets during late 2015 to raise equity in preparation for APRA’s new residential mortgage risk weights (came into effect on 1st July 2016).

Overall, the final regulatory reforms will incorporate a range of factors such as rating agency assumptions and stress tests but the top quartile among international peers (as also recommended by the Financial Services Inquiry) is being described by APRA as a guidepost rather than an absolute target.

In hybrid markets, the AFR reported today that IAG plans to launch a ~ $300 million Additional Tier 1 Hybrid issue as early as the 15th of November 2016. They are suggesting an optional call date in 2023 and mandatory conversion 2 years thereafter.  The margin is expected to be within 4.65% to 4.85% p.a. over the bank bill swap rate. The proposed securities would likely be aimed at replacing the $377 million IAG CPS (IAGPC) due to be called in May 2017.

Click below for Charts

Chart 1: Bloomberg AUSBond Composite Index (Monthly)

Chart 2: Bonds vs Equities 2015/2016 (Monthly)

Chart 3: Term Deposit Review – October