May 4, 2015

Australian Markets Weekly: AAA downgrade quite unlikely; negative outlook possible

Ahead of next week’s Commonwealth Budget, there has been speculation on whether Australia’s AAA sovereign credit rating is at risk. There are several aspects to consider here. First the likelihood and second the implications.

  • The likelihood of Australia’s AAA credit rating being downgraded anytime soon is quite low. Australia’s net debt position remains modest and the economy retains economic, monetary, and fiscal flexibility
  • That said, the deterioration in the fiscal position in recent years has been fairly substantial – outside of the two World Wars and the depression, it’s the second largest deterioration since Federation.  This does at least raise the possibility that a ratings agency could send a lower level “negative watch” warning
  • The directional risks for markets from such an event are fairly obvious – A$ and shares lower and perhaps bond yields higher.  But we’d be wary of overstating the size of the moves which are likely to be fairly modest.

Ahead of next week’s Commonwealth Budget, there has been speculation on whether Australia’s AAA sovereign credit rating is at risk.  There are several aspects to consider here. First the likelihood and second the implications.

Likelihood of a downgrade?  Quite unlikely but a negative watch more possible

Next week’s Budget is expected to confirm Commonwealth’s fiscal position is under both cyclical and structural pressure.  Weaker revenues on the back of the lower terms of trade and a cyclically-soft economy are the main near-term factors, but it is also well known that Australia (like other advanced countries) has a longer-term structural fiscal problem driven primarily by an ageing population. Over the next few decades, government revenue will need to increase and/or expenditures be curbed. There’s no news here.

Last year’s Commonwealth Budget made an attempt to start on the path of medium-term repair but of course much of that reform never passed through the parliament. In fact both sides of politics talk about finding this credible/quality path back to surplus – good news from a ratings perspective. The bad news from a ratings perspective is that they can’t agree on what this path should be. The political stalemate in the US was a significant aspect of the US’s credit rating downgrade.

The good news for Australia is the fiscal starting point remains quite good in an absolute sense and even better from a relative perspective – i.e. when compared to other rich countries.

Chart 1 gives a very long perspective on the Commonwealth’s debt position, from Federation in 1901 to a forecast out to 2055 from the Government’s latest Intergenerational Report (IGR) put out in March – the IGR projects the Governments fiscal position based on currently legislated policy.

These projections suggest that net debt will peak a bit over 14% of GDP in the next few years before 1) falling modestly out to 2025 and then 2) rising sharply to reach 57% of GDP by 2055. The latter forecast mainly reflects increased spending on health and pensions as a result of the ageing population.

By way of comparison, the net debt position of the US is currently 85%.

The other relevant metric is that the ratings agency Standard and Poor’s said a year ago that “we could also lower the ratings if significantly weaker than expected budget performance leads to net general government debt rising above 30% of GDP.”   There is little risk of this in the foreseeable future without a further significant downturn in the Australian economy.

So given Australia retains economic and monetary flexibility, and that the Commonwealth’s net debt is likely to remain well below 30% over the next decade or more, we reckon the Government still has fiscal room left before they would trigger a downgrade.

It seems they are going to use some of this wiggle room, with newspaper reports suggesting next week’s Budget is likely to have larger 2014/15 and 2015/16 deficits, as well as a slower path back to surplus.  Coming back from NY in recent weeks (where he chatted to the key ratings agencies) Treasurer Hockey implied that the ratings agencies wanted to see a “quality” trajectory back to surplus in order for Australia to retain the AAA rating.  Encouragingly, the Prime Minister and Treasurer have talked in recent days about finding a “credible” and “quality” path back to surplus.

The significant recent deterioration makes a Negative outlook possible

While we doubt there is any immediate threat to the AAA rating we are not sanguine either.  While the overall fiscal position still looks healthy, the recent deterioration has been sharp.  In fact, outside of the two world wars and the depression this has been almost equal to the previous sharpest fiscal deterioration in the early to mid-1990s – see chart below.  Then Australia’s credit rating was AA according to S&P.

So a lower level “negative outlook” warning is at least possible.  Negative outlook would be saying the fiscal path for now is on a downward trend but there is no obligation for the ratings agency to downgrade or even review the AAA rating.

Should the Government be able to pass legislation to put the Budget on a medium term path towards surplus (and ironically a negative watch may help get some political traction) then an actual downgrade could still easily be averted.

All the ratings agencies typically come out with an updated assessment of the Budget immediately after the Budget, so we’ll know a lot more about their current thinking on May 13.

Implications of Australia losing its AAA rating

A negative watch would surely cause some short-term volatility – downward movements in the $A, shares, and perhaps an up-tick in bond yields.  But as this is not a downgrade we expect the impact would be modest and unlikely to persist.

An actual downgrade would have wider ramifications. There would be implications for the level of Australian Government bond yields as well as other $A bond and swap yields. There would likely also be implications for other highly rated entities in Australia, like the AAA Semi Governments and the Banks.

But again we’d be careful about overstating the impact.

For example, many factors drive bond yields.  The key ones are the outlook for inflation, growth and the RBA’s cash rate.  The credit rating, and risk of default, is another factor – in reality the difference in credit risk between AAA and AA+ is very tiny.   When the United States lost its AAA rating bond yields actually fell on the day, as the poor state of economy and an expectation the Fed would need to cut the funds rate further over-powered the credit rating downgrade.  The other aspect is that by the time the US was downgraded most had got used to the idea – so it was already “in the price.”

If you can do an “all other things equal” analysis, and try and isolate the credit rating impact, some economic literature reckons a one-notch downgrade is worth about 12 basis points on bond yields.

The potential flow-on to the ratings of the banks and State Governments if the Commonwealth was to lose the AAA could be more important.  The major banks enjoy a two-notch rating uplift due to the ‘High Likelihood’ of Sovereign Support. And semi-government credit ratings are capped by the sovereign rating. So we should acknowledge there is a downstream risk but for now there seems little point in speculating about an event that we still think is quite unlikely.


While Australia’s fiscal position has deteriorated in recent years we reckon the ratings agencies will continue to judge it worthy of a AAA rating, particularly if next week’s Commonwealth Budget shows a credible/quality path back to surplus. That said, the scale of the fiscal deterioration in recent years has been substantial and does at least raise the possibility that a ratings agency could send a lower level “negative watch” warning.  The directional risks for markets from such an event are fairly obvious – A$ and shares lower and perhaps bond yields higher.  But we’d be wary of over-stating the size of the moves which are likely to be fairly modest.

This week

There will be intense focus this week on tomorrow’s RBA Board meeting outcome on Tuesday and whether the RBA will cut the cash rate to 2.00%.  If Peter Martin’s article from last week’s Fairfax press in right, then the RBA Board will consider a recommendation to cut.  But the question is whether the Board (including very senior members of the RBA staff will accede). While recognising the risk of a move, NAB would argue that the Bank should again hold fire, given emerging more favourable economic trends (including today’s job ads and building approvals).

Whether they cut or not, the 2.30pm Media Release will require some refinement.  For the global economy, there are opposing forces: the RBA is set to recognise the softness in the US economy in recent months (though may be inclined to discount it as possibly temporary), while for China also acknowledging there has likely been some further softness but with some policy steps taken to support growth.  Europe’s economic growth looks to have stabilised, notwithstanding the continued uncertainties over Greece.

We will, of course, be interested to see what qualitative references the Bank makes to any forecast revisions for the Australian economy, including for growth and inflation, the detail of which will be included in Friday’s Statement on Monetary Policy.  We do not expect any material change to its inflation outlook and we would expect some modest upgrade in the description of the Australian economy’s performance in recent months, even if the outlook remains somewhat fragile.

Finally, we’ll be looking to see the description of the Bank’s forward guidance.  If the Bank cuts, it’s likely they will not shift back fully to their previous outlook for “a period of stability in interest rates”.  But neither will they wish to dissuade the market that yet more easing might yet be required, in time.  This will require something of a balancing act to leave markets with the impression that they would be prepared to ease, but only if required.

Before the RBA Board meeting is the release of the weekly ANZ-Roy Morgan Consumer Confidence and then the March International Goods and Services Trade report.  The trade deficit is expected to shrink to $A-1.0bn from $A-1.256bn, benefiting from a 4% fall in already published merchandise imports, a counter to the fall in commodity price receipts.

Wednesday sees the HIA Home Sales report for March first up, followed by the March retail sales report, the Statistician also publishing Q1 retail volumes that forms 31.7% of household consumption and 17.5% of GDP.  We expect a second quarter of 1.5% growth in retail volumes, a sign that consumer spending over the past six months is showing signs of making a more material contribution to Australia’s growth transition to the non-resource economy.  Ahead of the ABS Retail Trade data, NAB’s Online Retail Sales index for March is being released on Tuesday, while the NAB Business Survey, configured on a sample of ASX 300 companies is set for release on Thursday.

As for the most sensitive market data, the crescendo is Thursday’s labour force report.  After positive employment surprises, we are alert to the statistical probability/likelihood of some payback in this report.  NAB’s forecast is for a flat outcome, the market expecting meagre growth of 3.0K and also an unemployment rate of 6.2%, up from 6.1%.  The real surprise would be a higher than expected outcome or even a steady 6.1% unemployment rate (or lower).  Also on the calendar are the AiG PSI Services (Tuesday) and PCI Construction (Thursday) indexes for April.

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