As 2016 draws to a close, two sources of potential instability overshadow financial markets: the rise of US protectionism under the presidency of Donald Trump, and the spread of populism through pending plebiscites in Europe.
Australia is exposed given its trade dependence on China, the US and the EU. However, what is bad for economies might be good for bonds.
As we look ahead to next year, here are five reasons for investors to consider the safety of Australia’s liquid, high-quality debt market.
1. Reflation rethink on risk
Financial markets have been pricing in US reflation in the belief that Donald Trump will cut taxes and spend on infrastructure.
If he follows through we could see a huge reversal in asset allocation, ending the “lower-for-longer” narrative that prolonged a multi-year rally in credit spreads.
Australia would not escape the bond sell-off. But we believe the recent spike in US yields should be viewed differently to 2013 (“taper tantrum”) and 2015 (“bund tantrum”).
Those surges were premised on a pullback in central bank accommodation, not a supply-side shock to growth. If government yields keep rising, we expect global (including Australian) credit spreads to tighten.
Given that investors would then be getting less yield enhancement from the credit risk they are taking, the appeal of Australian government bonds should grow.
2. Hedging Trump volatility
Among his more bellicose electioneering statements, Donald Trump threatened to label China a currency manipulator and impose 45 per cent tariffs on Chinese imports.
This would have a negative impact on global growth and productivity, given that China would likely respond with protectionist policies of its own.
Such a scenario would hurt the growth prospects of both nations, which as Australia’s largest and third-largest trading partners would augur badly for businesses on these shores.
The likelihood the Australian government and/or central bank would launch fiscal expansion and loosen monetary policy would rise as the nation’s growth prospects darkened. Australian bond yields would fall as equity markets suffered – amid rising volatility, the case for investing in Australian government bonds would strengthen.
3. Shelter from China uncertainty
The surge in commodity prices buoyed by China’s seasonal industrial upswing could come unstuck as Beijing seeks to curb an overheated property sector.
Any slowdown in property and infrastructure investment would hurt Australia in trade terms and could spark a flight to safety, but a more imminent risk is that Beijing can’t contain capital outflows.
These started last year after authorities widened the renminbi’s (RMB) trading band so it could be included in the International Monetary Fund’s Special Drawing Rights currency basket.
China has already imposed capital controls to prevent large offshore transfers, but this has only slowed the trend, not halted it. Facing a strengthening dollar and hawkish Federal Reserve, we can expect the RMB to depreciate further, driving outflows.
That raises the prospect of drastic government intervention, such as a one-off devaluation or freeze on repatriation of foreign investments. This could prompt a flight to safety, and to Australian government bonds.
4. Undermining commodities impact
We don’t see Donald Trump’s agenda to spend on infrastructure as a catalyst for a surge in commodity prices – it’s China’s efforts to stimulate its economy via infrastructure investment, as well as supply cuts to key commodities, that lie behind the rally in coking coal and metals, such as iron ore.
Bulk commodities are already trading well above marginal cost, and China has begun curbing supply cuts to coal production as prices have risen faster than anticipated.
Trump’s support for increased oil and gas drilling on US federal land may stymie co-ordinated production cuts from OPEC as new supply and competition emerges, but it is premature to suggest recent commodity price movements will cause S&P to shy away from cutting Australia’s AAA sovereign rating.
Even if the AAA rating is lost, we would not see that as a major deterrent of foreign interest in Australian government bonds – relative yield remains the key attraction.
5. Property cool-down lends support
Years of strong growth and low interest rates have fanned a belief that Australia’s property market is a bubble about to burst, but this fails to take regional differences into account.
While east-coast prices have soared, Perth is seeing sharp declines underpinned by weakness in the mining sector. Meanwhile, there are concerns about apartment over-supply in Brisbane and Melbourne.
Overall the rise in house prices has affected affordability, while banks have pulled back on lending. So we expect price growth to slow and the Reserve Bank of Australia (RBA) to leave rates unchanged for some time.
Lowering rates could fuel demand for housing at a high point in the cycle and risk inflating a bubble. A stable cash rate supports investment in bonds and raises the relative appeal of Australian government bonds globally.
Nick Bishop is the head of Australian fixed income at Aberdeen Asset Management.
