In cricket, one of the trickiest playing surfaces to bat on is a wet and sticky pitch because it results in unpredictable bounce. The current global macro conditions are reminiscent of a sticky wicket, with markets subjected to uncertainty at every macro data point. Yet, the outlook might start getting clearer as slowing inflation and banking induced risk-off has provided hopes of a central bank pivot.
Over the last quarter, the dominant theme of inflation and central bank hawkishness was temporarily interrupted by the banking crisis highlighted by the collapse of Silicon Valley Bank (SVB) and the forced merger of Credit Suisse and UBS.
The collapse of SVB rejuvenated fears of another economic downturn similar to the Global Financial Crisis (GFC) of 2008. We believe the fears are overblown as SVB’s failure were a result of several company specific factors. True, monetary tightening has raised pressures on banks’ investment books but, during the GFC, risk mismanagement was more systematic. There were lower risk capital standards and an industry-wide investment in assets with poor risk controls. The banking industry now has strong balance sheets and adheres to higher liquidity standards today, particularly at the larger banks. Additionally, unlike during the GFC, this time round regulators were more proactive. Within days of the crisis, Federal Deposit Insurance Corporation (FDIC) and the US Government guaranteed all deposits of SVB (over and above the insured amount).
In Australia, the health of the banking sector is robust. We expect the banking sector to be one of the few outperformers in earnings growth in 2023. In comparison to US banks, the regulatory standards in Australia are far more stringent. Minimum Liquidity Standards are applied on all banks regardless of their size. Additionally, there is an explicit capital charge for interest rate risk. Moreover, loans make up for most of the assets for Australian banks compared to investments in US banks. Hence, there is a less chance of an Asset-Liability Mismatch, which was the case for SVB.
Although we believe the banking crisis is contained, the perception of the crisis will lead to tighter credit markets, which in-turn will slowdown borrowing and spending. This is where we see a silver lining from the crisis. Before the banking crisis, monetary tightening was met with inflation that was falling slowly and strong labour markets. The crisis and subsequent credit tightening has accelerated the central banks’ objective of economic rebalance. The tighter credit standards will slowdown economic growth and inflation which has now increased expectations of a central bank pivot.
For the RBA, a pivot may already be on the horizon. GDP growth has eased, and we have lowered our 2023 forecast due to weakening household consumption. The latest retail spending number was subdued. The February inflation number came in at 6.8%, lower than expectations of 7.2%. Additionally, the labour market is likely to face headwinds from increased immigration. A lot still depends on the economic data going forward starting with the CPI and retail numbers in April and May. Additionally, we will be watching the labour market’s performance over the next few months.
While we anticipate an economic downturn, we do not expect a recession. The broader economy is robust. In addition, any slowdown will lead to monetary easing, which in turn will pave the path for economic growth. Moreover, the Australian economy’s pinch hitter – exports – is always in play. We believe exports could again offset the lower growth forecasts. One of the key reasons that Australian economy has been recession-proof since 1992 (excluding the COVID led downturn) has been growth from exports. The key reasons for our expectation of further export growth are an increase in demand for rare earth metals and agreement on Indo-Pacific trade deals.
With the outlook for equity markets quite challenging, fixed income has been gaining more attention. Fixed income yields are high relative to recent history, but one should be wary of lower credit quality exposure given the market uncertainty. In the event of a downturn, a long duration strategy would be favorable as policy rates are cut but we believe that central banks will remain more hawkish than dovish in the near-term to ensure inflation falls towards target. Given this tricky environment we are anticipating, we favour high quality credit over duration.
Credit risk can be of many subtypes – High Yield, Investment Grade Corporate, Residential MBS (RMBS), Hybrids, and Floating Rate Notes. High Yield, Hybrids, and RMBS are exposed to their own idiosyncratic risks. High Yield is exposed to more default risk as the economy goes through a possible downturn this year. RMBS remain vulnerable to higher cash rates as a large set of Australian borrowers rollover from fixed to variable mortgage rates in 2023. Hybrids are relatively less liquid compared to other credit offerings and the recent write down of Credit Suisse’s hybrid securities highlighted the higher risk profile these instruments carry by being ranked lower in the capital structure.
Credit risk alpha is generally a function of economic growth. We expect subdued growth in 2023 but we also expect certain sectors to deliver positive earnings growth. One of the growths sectors for the year is the banking sector which continues to deliver solid financial performance as they benefit from benefit from expanding net interest margin in 2023.
A way to gain favorable exposure to this sector is bank-issued Floating Rates Notes (FRNs). Banking FRNs offer coupons pegged to the cash rate plus a margin. This ability to reset the coupon on a quarterly basis allows FRNs to offset interest rate risk. Additionally, FRNs offer yield comparable to fixed rate credit peers. The yield per unit of volatility is five times that of other fixed income segments. Figure 1 highlights characteristics of fixed income instruments in the market.