Australia’s AAA Credit Rating at Risk

The best thing I can say about the sell-off in markets right now is that it robs market cheerleaders, and brokers looking for a bit of Christmas commission, the chance the blurt out ‘Santa Claus rally’. Sorry folks, Santa ain’t coming to town this year.

Well, at least not today. With US markets down bigtime on Friday — the S&P 500 lost 1.6% — Australian stocks are set for another big fall today. Futures show a loss of 63 points on the ASX 200 and the market is down 67 points in early trade.

Who would’ve thought the end of the Federal Reserve’s QE experiment would’ve caused such carnage at the outer rim of the financial system? Commodity producers (especially emerging markets) are feeling the pinch. As capital flows back into the core of the financial system (US capital markets), it’s leaving these periphery nations in tatters.

As a result, you’re seeing falling currencies and upward pressure on interest rates. I’ll explain how this works in a moment, because it’s an important point for Australia to take into account, or at least it will be in 2015 and beyond.

But first, I’ll give you a quick rundown of what markets are worried about.

The biggest concern right now is the oil price collapse. This should be good for markets — or at least it should be good for Western consumer markets — but that’s not the way it’s playing out.

The long oil boom led to a lot of borrowing, both in the corporate debt market and through the banking system. This borrowing looked safe and secure at US$100 per barrel prices. At sub-$60, some of it now looks very risky. If prices stay down at these levels, you’ll start to see defaults and restructuring.

This won’t be big enough to cause any systemic problems, but it could hit investor (or speculator) confidence, which in turn affects market liquidity more broadly, which is probably what is happening now.

The other issue is Europe. Greece is again freaking markets out. The concern this time is that a potential general election might result in a win for the populist Syriza party, threatening Greece’s austerity drive and their position in the Eurozone.

The concerns are probably overblown, but it’s adding some nervousness to the markets. On top of this, you’ve got an uncertain political environment in Italy too. 2015 looks like another tough year for the Eurozone.

Not making it any easier for the region is the ongoing slowdown in China. Granted, the slowdown is so far an orderly one. But it will continue to have an impact on the Eurozone, as trade between the two regions is huge.

Obviously, you’ll see a greater impact of the China slowdown here at home. It’s already blown up the iron ore price. Now, Treasurer Joe Hockey tells us it’s blowing the budget too. Today will see the release of the mid-year budget update that will show a continued deterioration in government finances. The government now expects China to grow at a slower than expected 7% per annum and for long term iron ore prices to stabilise around US$60 per tonne. That’s far more realistic than earlier projections, although they’ll be surprised to see China’s growth grind lower in the years ahead.

And while US$60/tonne for iron ore might seem conservative, prices always go further than you expect on the downside (as they do on the upside) and so you’ll probably see a brief period where iron ore gets close to $50/tonne.

Hockey’s trying to put a positive spin on things by saying the budget is acting as a shock-absorber, telling the Financial Review:

“If we don’t use the budget as a shock absorber for this extraordinary fall in the terms of trade, then Australians will lose jobs and we will lose our prosperity”

That’s all well and good, but shock-absorbers should work both ways. That is, they should work to absorb the positive shock of the booming terms of trade too. That means running surpluses in the good years…to give you cover to run deficits when things aren’t so good, like now.

But we didn’t do that. Instead, Australia produced deficits during the biggest terms of trade boom in history. Now we’re under pressure to get deficits under control during one of the biggest terms of trades busts in history (if not the biggest).

The reason we need to do that is to retain credibility in the eyes of foreign lenders. Which brings me back to my earlier point…

In many emerging markets, you’re seeing foreign capital flee on weaker commodity prices. That means falling export revenues, which in turn put pressure on these governments’ fiscal policy. If foreign lenders don’t view these governments as credible (that is, give them credit), they’ll sell out, pushing the currency lower.

The fall in the currency, if extreme enough, threatens to bring about inflation, so in many cases, interest rates need to rise to protect the currency and entice foreign capital back in. Such a response obviously constrains the flow of credit and leads to a sharp economic slowdown…if not outright contraction.

With the Aussie dollar down sharply over the past few months, is this something we need to worry about?

Not yet. Foreigners still see the government as a credible borrower. Total debt is low and we retain one of the world’s few AAA credit ratings. It’s this credit rating that implicitly backs the banks (who collectively borrow much more from foreign creditors than the government does) and makes it easy for them to borrow at low rates.

But if the government doesn’t have some sort of sustainable medium term plan to get the budget in order, then we’re at risk of losing that AAA rating. David Murray said as much last week when releasing the ‘Financial System Inquiry’. If that happens, the resulting adjustment in the cost of credit would put Australia into recession. (A ratings downgrade pushes up the cost of credit, regardless of what the Reserve Bank of Australia does to interest rates).

This isn’t a risk for tomorrow or even next year. But it’s a looming risk at a time where Australia must deal with a structural change to the budget. That is, the revenues we’ve grown accustomed to through years of booming commodity prices are no longer. Yet the spending promises remain.

That means the government will have to make some tough choices to structurally change the budget, like modifying negative gearing and reducing other tax and super perks for the relatively well-off.

But will it happen quick enough? Probably not. The government wants to raise these issues in an upcoming tax ‘white paper’. But that is not due until the end of 2015. After debate and discussion, and an election that must take place before January 2017, you’re not likely to see structural reform implemented (if at all) until well into 2017.

If in the meantime another global crisis hits our shores (and as I keep saying, there’s a good chance of that happening) and Australia doesn’t have a plan to deal with it, our credibility in the eyes of foreign creditors will come into question. Last time the plan was China. We got lucky.

To ensure we retain our AAA rating, the government will need to move much quicker than they currently think is appropriate. But in the absence of either party having a genuine leader who grasps the issues and risks to our economy, don’t bet on this happening.

Greg Canavan+
For Markets and Money

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Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:


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