March 20, 2018

Debt market outlook suggests old school may finally be back in vogue

NAB’s general manager, capital markets and advisory, Jacqui Fox, and head of debt syndicate, Mark Abrahams, highlight the key themes for Australian credit in 2018 and why they point to a positive fundamental story despite the resurgence in equity market volatility early this year.

2018 could be the year when market drivers go back to the old school.

The equity-market correction we saw at the start of February, and the bond-yield spark that lit the fire, had the type of cause we would have regarded as conventional a decade or more ago: concern that the Federal Reserve (Fed) might have to move quickly to prevent an inflation outbreak. Markets are familiar with this type of response and they broadly know how to deal with it, so it’s tempting to suggest the equity-market response is a bit of a red herring for credit.

The underlying story that matters to the credit market is that fundamentals are strong and the world is experiencing synchronised growth for the first time in years. This is a great scenario for credit markets, if you can look past episodes of short-term volatility. Even the volatility represents a positive development. We needed good fundamentals for monetary conditions to normalise, but the normalisation was always likely to spur volatility events.

On the subject of normalisation, market watchers should pay more attention to central banks than politicians in 2018. The Fed isn’t likely to get too far behind the curve. It is watching data like a hawk and will do what’s necessary not to let the economy overheat. The European Central Bank (ECB) has been more cautious about stymieing growth but it has also signalled its intentions to start the process of reversing quantitative easing.

In Australia, something to watch closely is the Australian-US rate differential for 10-year bonds. Historically, Australian dollar volatility has allowed the rate differential to stay around the 0.4-0.8 per cent range above US 10-year Treasuries. The differential now – minus 0.1 per cent – is rare.  Australian 10-year rates are trading below parity with the US on a sustained basis for the first time in decades.

While this could be a threat to the aggregate bid, that demand will continue to exceed supply of Australian dollar assets. There is still an enormous amount of liquidity out there and many of the global investors that have come into the Australian market are too big to reverse course overnight. The institutional and non-institutional funds-management pools in Australia continue to grow substantially.

On the supply side, there are reasons to think credit issuance might take a step back in 2018. The major Australian banks are expected to have less aggregate bond funding requirement as they have concluded the regulatory process while credit growth has slowed. They could however maintain domestic issuance and cut back offshore.

But the bottom line is that Australia has reached a new level of sophistication and critical mass in its credit market. The investor base, especially local institutional investors, have progressed in size and investment approach to the extent that corporate borrowers are now much more inclined to tap the debt capital market for their funding. We are starting to get closer to the position that the US market has enjoyed for many years, where the debt market (both in public format across a range of markets and private format, including Reg D) can now more readily meet the funding needs of corporate Australia.