Tyndall Investment Management (Tyndall AM), a Nikko AM company, has formalised its team management and strategic functions to provide further depth and breadth to its fixed income capabilities.

The move follows the success of new hire, Mr James Alexander, who was appointed in June 2013 to manage the fixed income team. His appointment has enabled Mr Roger Bridges, to continue to focus his strength and expertise in macro economic and strategic investment research for Tyndall’s Australian Fixed Income funds and insurance asset management solutions.

Mr Alexander will become head of fixed income and Mr Bridges will become head of fixed income strategy.

Managing Director, Mike Davis, says since the appointment of Mr Alexander the roles of the two fixed income team leaders have evolved as expected, and the new titles are a formalisation of the existing team management and strategic functions.

“The investment team has been reporting to James since his appointment when he was given the responsibility for the team, process, products and performance,” Mr Davis says.

“There will be no fundamental change in the Tyndall AM fixed income investment process, philosophy or strategy, and the fixed income team will continue to focus daily on managing downside risk and maintaining low volatility for clients.

“Roger has been with Tyndall for 15 years, and has a wealth of experience in fixed income strategy with a strong focus on insurance investment strategies. He has become increasingly focused on strategic investment at a macro level, and working with our global investment team to bring greater recognition of our broader investment views and capabilities to prospective and current clients.

“This team structure allows Roger to further enhance his macro focus, while the day to day running of the fixed income team and its product diversification strategies will continue under James’ leadership.”

Global CIO, Mr Yu-Ming Wang, said the move is in line with the recent announcement of a management structure that is being introduced globally, that allows local market needs to be met with products based on the highest global standards.

“The formalisation of function titles recognises the success of Mr Alexander’s appointment, and acknowledges Mr Bridges’ expertise and experience in macro assessment, and contribution as part of the Nikko AM’s Global Investment Committee,” Mr Wang says.

Both Mr Alexander and Mr Bridges will report to Mr Wang for investments and Mr Davis for local management issues.

The fixed income team is continually working to improve and refine its investment process and offerings to both the insurance markets as well as local and regional institutional and retail investors, Mr Davis says.

“The Tyndall fixed income team put in a very strong performance in 2013 and these changes will help ensure the strong long term performance record of the team continues. We strongly believe that the focus on fixed income and associated product will grow with both demographic trends and outcomes based investing preferences,” he concludes.

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“Super-Abenomics” on the horizon: Nikko AM

Nikko AM uses the expression ‘Super-Abenomics’ to describe our expectation that Japan will exceed its own targets, as well as consensus expectations, for its new economic plans and reforms. 

Of course, not every improvement desired in Japan will occur, and those who are looking for wide-open immigration, headline corporate tax cuts, or aggressive labour reform are likely to be disappointed. However, in our view:

• The amount of monetary stimulus in the first arrow has exceeded expectations;
• Due to the Olympics, the fiscal stimulus will be larger than targeted; and
• Economic and regulatory reforms of the third arrow will exceed consensus expectations, with the Trans-Pacific Partnership (TPP) negotiations (and the associated farm tariff reduction and other reforms) being the most closely watched imminent item.

We believe that Japan is already ‘different this time’ and change will continue accelerating as Prime Minister Abe has more power than any other Prime Minister in the last few decades and resistance to his strong ‘all-in’ beliefs is dissipating from other factions. For instance, even though previous Prime Minister Koizumi was popular with the people, he had strong resistance from his political rivals and the bureaucracy and despite some successes, his long reign did not achieve much reform. Conversely, Abenomics is not just one man’s belief, but a shift in the view of the large majority of the citizenry. In our view, it is durable and also supported by major global geopolitical re-alignments.

The Abenomics Wealth Effect

One area that is not highlighted enough is the role of the wealth effect. Inflating asset prices, while keeping interest rates down, has been the hallmark of the US economic recovery (and a trend for past three decades, along with higher leverage ratios).  The wealth effect is hardly covered in most economics text books, mostly because equity and housing prices are so difficult to predict and because they are reflexive with the economy (higher risk asset prices equal a better economy and vice versa). While simplistic (and dangerous, if carried too far), the underlying logic is similar to our knowledge that consumer and business confidence is key to economic growth.

When asset prices are rising, as they are in the US with nearly USD 4.5 trillion (27% of GDP) of household net worth being created in H1 2013, consumer confidence clearly rises, as does the economy via consumption, residential capex, etc. This leads to higher income taxes and higher business capex. Coupled with tax hikes and the US sequester, this has cut the US fiscal deficit by almost half in the past two years.

Japan is well advanced in this process too, with more than Yen 71 trillion (USD 720 billion) of household financial net worth (excluding real estate) created in the 12 months to June 2013, totalling Yen 1.2 quadrillion of net financial assets. Many analysts will likely be surprised to see that it is at a record high. The data including all household net assets is frustratingly lagging (only 2011 full year data is available), but total net assets are nearly twice the size of financial net worth.

Total household net assets have been nearly flat since 1993. Indeed, assuming that real estate was the vast portion of the non-financial net assets, this would imply that since 1997, its Yen 1.4 quadrillion level has declined to Yen 1.0 quadrillion. This is a 28% decline in non-financial net assets since 1997, with the Yen 0.4 quadrillion increase in net financial assets mostly offsetting it.

2012 likely showed a moderate rebound in net assets, but in 2013, with land prices rising along with equity prices, one can expect that the wealth effect has started to play a key role and will have an even stronger positive effect on Japan’s economy and tax revenue in future.

 Tyndall AM – part of the Nikko Asset Management group (Nikko AM , a leading independent asset manager in Asia – has access to on-the-ground insights and research from the global Nikko AM offices. This paper has been compiled from interviews and papers developed by the Nikko AM investment experts.

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This document was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (“Tyndall AM”). The information contained in this document is of a general nature only and does not constitute personal advice. It is for the use of researchers, licensed financial advisers and their authorised representatives. It does not take into account the objectives, financial situation or needs of any individual. Tyndall AM is a owned by Nikko Asset Management Co. Limited.

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FY2013 results flat as expected.

Brad Potter, Portfolio Manager and Senior Analyst, Tyndall AM provides his key take-outs from the August company reporting season.

Weak consumer demand, a slowdown in China and a high Australian dollar are just a few issues challenging Australian businesses. To maintain or improve their profit margins companies have needed to cut costs, reduce capital expenditure and improving efficiencies. Is it working?

Benign reporting season – no great surprises

Overall, the company reporting season was benign with earnings coming in close to market expectations.  Around 56% of companies beat expectations. Earnings overall in FY2013 were flat, but up 7% when excluding resource companies, which have fallen substantially because of the decline in commodity prices over the year.

FY2014 earnings forecasts have been lowered as expected in the current environment. Prior to reporting season the expectation was 8% to 10% earnings per share (EPS) growth in FY2014. Those expectations have now been reduced by about 1% or 2% (this is likely to be revised as analysts fine tune their numbers).

Many of the rallies during reporting season were based on ‘no further bad news’ or that the news wasn’t as bad as priced in going into the result – rather than good results. Stocks such as Qantas, Arrium, Origin Energy and UGL were typical of these stocks which had acceptable to probably slightly down results, but were not as bad as what the market was expecting.

Top line growth continues to be weak

The key takeaways from reporting season were very similar to last reporting season. Top line revenue growth continues to be poor. This was expected. Companies suggested things were not getting any worse, which is a positive.

When there is no top line growth companies cut costs. Cost outs were again a major thematic this reporting season across the market. Companies as diverse as BHP, Rio Tinto, AMP, Boral, Coca-Cola Amatil, Fairfax, Toll, Downer and all the banks have cost out and efficiency drives in place in a bid to keep margins flat or improving.

In the case of resources companies, such as Rio and BHP, their large cost-out programs are only just beginning. They’ve slashed their exploration programs, which has saved them between $500 million to $1 billion per annum.  Miners have seen substantial cost inflation over the last decade during this mining boom and they need to pare that back substantially because commodity prices have arguably peaked. They need to cut costs as there are a number of mines in a range of commodities that are now looking unprofitable. This is likely to be an ongoing theme, which provides a poor backdrop for the mining services industry.

Dividends still the flavour of the month

Dividends surprised on the upside again, like they did last reporting season. Payout ratios continued to rise, which reflects a combination of investor appetite for yield in a low interest rate environment, strong company balance sheets, a lack of investment opportunities and/or risk appetite to invest their money. In this environment, the easiest thing for companies to do is pay back excess capital as dividends, especially when they’re being rewarded for it. Therefore dividends again outstripped EPS growth quite substantially this reporting period.

Company outlook statements were guarded

Company outlook statements were quite guarded or non-existent. That’s understandable given the problematic economic environment, exacerbated by the uncertainty of the September Federal election.

Post the Federal election consumer and business confidence, currently at very low levels, should rebound. Companies are not investing at the moment because of this low confidence.  This was clearly illustrated by the low levels of capital expenditure (outside of mining projects that are already in construction) that we saw during the reporting season.

Profit downgrades were quite modest and many CEOs suggested that business conditions haven’t deteriorated further. This reflected a combination of interest rate cuts finally starting to have an impact and the recent decline in the Australian dollar.  Although, that hasn’t had a full impact yet given that the Australian dollar only tumbled in May.

All the banks stated that provisioning levels, while very low, they couldn’t see any issues currently.  That was quite positive, given that investors worry about that on an ongoing basis.

Housing was a strong theme during reporting season. Lend Lease commented that their residential property sales in July were two times higher than March levels and they also had increasing apartment commitments.  Stockland made similar comments about residential land sales, with the run rate in the second half of the financial year the best since 2010. The positive signs have continued with long queues for residential land sales on weekends. The first release of the Barangaroo apartments in Sydney was sold out in three hours and they were all $1 million plus apartments.

James Hardie commented that they’re seeing rising building activity in Australia and New Zealand, which was interesting given we saw more comments from other building materials companies. The company was very positive on the US environment with profit margins over the 20% level, and they’re suggesting that housing is continuing to pick up in the US.

Iluka also made the point that they sold more zircon in the first half of 2013 than they did in the entire 2012, so they are starting to see green shoots in the zircon market. I expect, given the recent positive news out of Europe (one of the biggest consumers of zircon), that may continue. They also commented that the titanium dioxide market, which tends to be primarily used in painting, is turning.

Seven West Media suggested that advertising spending appears to have stabilised. This is a grey area at the moment due to the election period because there is extra advertising spending by the political parties.  A lot of companies peel back their spending during the election period and start after the election. They are now suggesting they’re seeing good interest for commitments post the election, so that’s quite positive.

Companies that provided negative comments included Toll, which suggested activity levels had yet to show any signs of improvement. Fletcher Building also pointed out ongoing weakness in Australia, but commented that New Zealand was going full steam ahead.  At Wesfarmers, Target was quite disappointing, with no signs of improvement, which the market disliked. Echo commented that the weak consumer environment was driving soft conditions on the main gaming floor. Tabcorp made similar comments about the weak consumer environment.

Boral disclosed that activity in Australia remains broadly flat in FY2014, so similar to Toll.  BlueScope had a solid result but their outlook statement suggested that the first half of this year would be flat on the last half, but over the year would be up, thus indicating the second half would be strong. The market was initially disappointed with that, and the stock was punished severely on the day and subsequent days. It has however subsequently recovered. This was a classic example of where market expectations for the stock were very high and when the company didn’t meet those expectations, the stock was sold off heavily.

Mining boom is over

The reporting season didn’t provide any further clarity on the mining boom. My views pre the reporting season haven’t changed. The mining boom is effectively over in the sense that we’re close to the peak of capex.  Commodity prices have also peaked so if that’s the definition of a mining boom then it is finished.  I don’t expect commodity prices to fall in a hole though. I expect them to remain at reasonably elevated levels for the next few years at least, given demand from China is still reasonably strong and so I expect mining companies to do quite well in certain commodities. Rio & BHP for example are making great margins in iron ore.  On the flip side of that, coal companies are really struggling because coal prices have fallen substantially. A number of coal mines have shut down because margins are just not good enough, and there are a number of them really struggling given the low margins.

Gold is another commodity whereby a number of mines have become marginal, even at current prices, just because cost inflation has been so great. Reserve decreases are the likely next shoe to fall.

Highlights for the Tyndall share portfolios?

In our flagship fund, the Tyndall Australian Share Wholesale Portfolio, Twenty-First Century Fox, our largest overweight, was a highlight. They had an in line but quite messy result given the recent split from their publishing assets. Two days later however they had a strategy day where, for the first time, they laid out quite detailed information on their strategy and all their new revenue streams. The market upgraded substantially on that view.  The market, particularly in the USA, has been reluctant to price in these new earnings streams.  The share buyback continues at a meaningful pace and there’s an expectation that once this buyback finishes they’ll start another one.  The stock was up about 5% over the month.

Downer, which is our only exposure to mining services (albeit it’s not entirely mining services as it represents only about 30% of the business), had a solid result, slightly ahead of guidance, which is very credible given the negative sentiment in the sector due to the peaking in mining capex. The company’s mining segment was down but that was offset by other divisions.  It’s been hurt over the last six months because of the ongoing downgrades from other mining services companies, despite the fact that Downer has continually maintained their guidance, which they delivered.  The dividend was ahead of expectations and their cash flow was very strong.  The cost-out program has doubled to $500 million given that they achieved $250 million two years ahead of forecast.  The stock rallied substantially to be up nearly 15% during the month.

Qantas had a strange result in the sense that it was one of those stocks that rallied on the fact the news wasn’t as bad as what the market was factoring in.  Transformational initiatives delivered $428 million to EBIT during the year. They started up the small buyback, it’s continuing and the stock rallied 11% over the month.

Sims Metal’s result was also close to what the market was expecting. All divisions had good results, other than the European division which has been problematic over the last year or so due to governance issues. Operating cash flow was strong. No guidance was given, but Sims is leveraged to the US economy and in particular the housing market and scrapping of automobiles as people trade up cars and white goods as the economy improves. So the stock actually responded very favourably; again I think it was a relief rally with the expectations that it was going to be ugly. The stock was up about 11% for the month as well.

Portfolio positioning

Banks have run hard over the past 12 months or so. We’re underweight banks because we believe they’re expensive despite the attraction for yield.  We have selective exposures in domestic cyclicals, tilted towards housing and residential as we think that’s a reasonable area given the interest rate cuts and hopefully we’re seeing some green shoots at the moment so that’s quite positive.  We also have reasonable exposure to the USA, both from a growing US economy perspective and also a falling Australian dollar.

Conclusion

It was a by and large a non-eventful reporting season, due mainly to many companies confessing or reducing earnings guidance prior. Companies are adapting to the structural changes occurring in the Australian economy as evidenced by the various cost cutting and efficiency programs in place. These initiatives are having a positive impact on company bottom lines, but we now need to see a recovery in top line growth. Lower cash rates, a weaker Australian dollar and resolution of the Federal election, together with signs of stabilisation in the Chinese economy should assist this.

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Disclaimer: This document was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (“TIML”). The information contained in this document is of a general nature only and does not constitute personal advice. It is for the use of researchers, licensed financial advisers and their authorised representatives. It does not take into account the objectives, financial situation or needs of any individual. The Tyndall Australian Share Wholesale Portfolio ARSN 090 089 562 is issued by Tyndall Asset Management Limited ABN 34 002 542 038 AFSL No: 229664 (“TAML”).  Investors should consult a financial adviser and the information contained in the current Product Disclosure Statement available at www.tyndall.com.au before deciding to invest.  TIML and TAML are wholly-owned subsidiaries of Nikko Asset Management Co., Ltd.

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Tyndall AM launched the fund in May this year to the retail market, although the strategy underpinning it has a 15-year track record and was originally developed by Tyndall for institutional investor mandates.   It is managed by Tyndall AM portfolio managers Jason Kim and Tim Johnston.

In its report, Zenith said “[It] believes the Tyndall Australian Equities team is well resourced and highly experienced.

“Tyndall’s team structure and work process is both well organised and clearly defined, with stock and sector responsibilities allocated across analysts (approximately 15 to 20 stocks per analyst) to ensure solid peer review of companies and a ready basis for comparison with other stocks in other sectors.

“The Tyndall team is well incentivised through equity participation and for the most part have worked together for many years. The peer review process ensures that a collegiate environment is fostered and is one of the core strengths of the Tyndall process.”

Zenith added that: “Overall, we consider Nikko AM’s global network to be an advantage for Tyndall in which to gain additional regional and global insights to complement their existing capabilities.”

Matt Russell, head of marketing and sales at Tyndall AM, said the strong rating from Zenith is a positive endorsement of the skills and track record of the Tyndall equities team, in particular Mr Kim and Mr Johnston.

“We are already seeing a high level of interest in the fund after just a couple of months in the retail market, and this is testament to the quality of the team behind the fund and the long-standing success of their investment approach and strategy,” Mr Russell said.

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The fund’s aim is to provide long-term capital growth and income by investing in a concentrated selection of shares listed on the S&P/ASX 200 Accumulation Index.

As at 30 June 2013, the fund returned 29.5% over the previous 12 months (before fees), outperforming the index by 6.2%. Since inception in May 2010 it has returned 11.2% p.a. (before fees) versus 8.3% p.a for the index**.

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Mr Robert Woodford has joined the business in a combined role of fixed income investment specialist and institutional account manager and Mr Sebastian Mullins has been appointed portfolio manager in Tyndall’s implemented management team.  

In addition, Tyndall has created a new position of investment writer within each of the Australian equities and fixed income investment management teams, appointing Ms Janelle McKimm and Ms Jessica Burnstone respectively to these positions. 

Mr Woodford is responsible for managing Tyndall’s relationship with key institutional clients for the fixed income business, as well as assisting in developing and implementing fixed income strategies for institutional clients. 

Prior to joining Tyndall, Mr Woodford was co-founder and executive director of Columbus Capital Ltd, and has also worked as a senior investment specialist with AMP Capital Investors Fixed Income and Currency and with Westpac Institutional Bank as an associate director in the debt capital markets division, as well as spending time in London with Bankers Trust PLC and ING Barings. He holds a masters degree in applied finance from Macquarie University’s Centre of Applied Finance and a bachelor of business studies degree in accounting and finance from Massey University in New Zealand, and is a member of the Australian Institute of Company Directors.

Mr Mullins is responsible for managing the business’s multi-manager global equities strategy and its diversified funds range. He was previously with Challenger Limited, working primarily in performance, risk analytics and security valuation.  He is currently studying for a masters degree in applied finance at Macquarie University and has an honours degree in mathematics and computer science. 

The two investment writing roles are part of the marketing capability but sit within the investments teams and will develop specific investment communications about each asset class, primarily for external audiences such as institutional investors and advisers.  This will include the creation of additional market commentaries, reviews and research papers. 

Ms McKimm previously worked at Tyndall in a similar role for both asset classes and will now become part of the Australian equities team.  She has over 20 years’ financial services experience, including senior marketing and investment communication roles with organisations such as Perpetual Investments, BT Investment Management, AMP Capital Investors, Sydney Futures Exchange and Westpac Investment Management. 

Ms Burnstone joins Tyndall from Standard & Poor’s Fund Services in Sydney and will work within the fixed income team.  She has also worked for S&P Rating Services’ structured finance department in London and holds a masters of arts in English with first class honours from the University of Cambridge. 

Mr Craig Hobart, managing director of Tyndall, said that the new appointments are part of the strengthening of Tyndall as an independent fund manager in Australia, reflecting Nikko AM’s commitment to reinforcing the operation and establishing a solid local presence. 

“We have now largely developed the elements required to make us an independent asset management firm and we are well positioned to achieve our expansion goals whilst continuing to maintain our highly rated investment approaches and portfolio management style. 

“We have already benefited from additional investment and business insights from our relationship with Nikko AM and their support is proving invaluable. 

“We are also finding it useful to have access to other investment managers within the Nikko AM group which acts as an additional resource with a two-way flow of information,” Mr Hobart said.

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Click to open the White Paper on Domestic Covered Bonds

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The suggestion to introduce domestic Covered Bonds was contained in the Federal Government’s proposals for a “Competitive and Sustainable Banking System”.

The Federal Government then released an Exposure Draft on Covered Bonds legislation in March 2011.

Comments on the draft are due by 22 April 2011 before the Bill in its final form is tabled in Parliament.

Introducing Covered Bonds form part of a strategy to: create an additional AAA-rated funding source; lower bank funding costs; create competition in the bank lending market; and address the issue of the liquid assets requirement in Basel III.

A Covered Bond is a security issued by a bank with assets (usually mortgages, but sometimes other loans) assigned to provide security for the debt. Typically the size of the asset pool (or ‘cover pool’) is larger than the bond issue.

As the Tyndall paper, co-authored by John Sorrell, head of credit at Tyndall Investments, and senior credit analyst Ileria Chan, explains, unlike a residential mortgage-backed security (RMBS), Covered Bond cashflows are funded by the financial institution and not by the cashflows of the pool of assets.
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Thus a Covered Bond has regular payments and no prepayment, so that it resembles a traditional bond issue.
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Dr Sorrell says that it is possible we could see domestic Covered Bonds traded before the end of 2011.
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“They offer investors further high-quality credit investments but investors must remember that they are still bank debt and not a direct substitute for government-guaranteed bank debt.

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“Indeed, despite the government’s intention, while the introduction of Covered Bonds in Australia is a strong positive for the major banks, they may weaken, rather than enhance, competition in the banking sector and could further widen the funding access gap between the major and the second tier banks.
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“Covered Bonds may also cause consequences for senior debt holders and bank depositors leading to potential conflicts and regulatory risk,” he said.
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The Tyndall paper notes that the size of the Australian Covered Bond market will be constrained by investors’ existing senior debt exposures, so for most Australian portfolios, offshore issues of Covered Bonds available domestically will probably still be of more interest.
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Nevertheless, Dr Sorrell said that the Tyndall fixed interest team will itself consider Covered Bonds as a potential sector for investment, depending upon pricing and liquidity, and adding Covered Bonds to the total fund exposure to each issuer.
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The Tyndall White Paper points out that Australia is one of the last developed countries to introduce Covered Bonds, and considers why they are now being introduced, who will buy them, and what the risks are.
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Co-author Ileria Chan says that unless controlled, Covered Bonds could lead to conflict and regulatory risk for senior debt and depositors.

“They do have some attractive risk features – perhaps the most important for investors is the dual recourse to the bank and to the collateral, while senior bank investors can only claim on the bank and RMBS investors can only claim on the collateral. This is an important risk enhancement but comes at a price in yield to investors.
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“Also, as the assets used to provide the cover must be assigned unambiguously to the Covered Bond issue it does result in a reduction to the amount of assets available to other unsecured lenders, including depositors.
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“In addition, risks are not completely removed since the assets are correlated with the issuer and are long-dated illiquid assets,” Ms Chan said.
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Dr Sorrell added that being able to issue Covered Bonds does provide an attractive alternative funding option in a bank’s funding mix – but perhaps not as attractive as might at first appear and they may impact on lower-rated entities’ ability to compete.

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“In Europe Covered Bonds form a deep and mature market. The European experience showed that they were one of the first asset classes to recover and provide liquidity during the credit crisis.
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“Canadian investors have preferred senior debt to Covered Bonds for their banks and Canadian banks have issued their Covered Bonds outside their borders.
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“Australian banks may, likewise, find more acceptance for their Covered Bond issues offshore than they will domestically, as they could cannibalise their Australian dollar senior debt programs,” he says.
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Ms Chan believes that overall they have a place for investors, but the risks need to be understood and priced appropriately.
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“Covered Bonds are well suited to the needs of investors who can only invest in AAA-rated securities (i.e. sovereign funds) or have a minimum allocation to AAA-rated assets. They potentially also offer an alternative to supras or government guaranteed debt.
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“For investors who are able to invest in senior bank paper and have comfort with the issuer’s name, Covered Bonds may be less appealing since they can use up limits on exposures to these names with lower yielding investments,” she said.

Click to open a full copy of the report

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The appointment follows the promotion last year of Mr Andrew Julius, who previously held the position, to Tyndall’s head of retail.

Mr Russell has over 13 years financial services experience in both Australia and the UK, most recently with Vanguard Investments as business development manager.

He started his career in England as a financial adviser with Loring Walls Financial Services, and worked as an equities investments specialist with Charles Schwab Stockbrokers before moving into business development roles with Jupiter Unit Trust Managers and MLC Investments in the UK.

Mr Russell holds an honours degree in economics and business studies from the University of Lincolnshire and Humberside.

Mr Julius said that Mr Russell’s appointment contributes to the depth and range of experience in the team.

“Aaron’s well-established relationships with a number of dealer groups, and his broad experience in the financial services industry, will be key to further developing our retail business.

“In particular, Aaron’s knowledge of markets will enable him to help advisers develop suitable portfolio and asset allocation strategies in a changing economic and regulatory environment,” Mr Julius said.

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• Ireland has gone from financial market darling to a challenging credit in the space of three years. With a similar concentrated banking system that has a high exposure to the property market, could Australia become another Ireland?
• The rapid rating decline of Ireland has various lessons for investors: not to rely on ratings; and that state support for banks is not necessarily a panacea.
• Sovereign guarantees to banks may defend them to an extent but ultimately it may only transfer the risk from the banking system to the sovereign.
• While Ireland’s problems could be partly mirrored in Australia, various factors should mitigate some of the causes that were central in Ireland.
• Ireland should provide a salutary lesson to Australian investors that relying upon the status quo is unwise.
• Australia did weather the financial crisis effectively due to a variety of factors, but if these factors reverse, Australia’s safe haven status could be dented.

Introduction

Ireland has rapidly deteriorated from financial market darling to a challenging credit needing a bail-out. The extent of the turnaround is such that the factors that caused this need to be considered in regards to other economies. In particular, could this happen in Australia? The Australian economy is considerably more robust and diversified than Ireland’s but the systemic exposure to banking has noticeable parallels, suggesting that complacency about Australia’s economic strength may need to be challenged.

Of the European states that have so far experienced severe challenges and much public consideration, Ireland stands out to Australians because of a greater similarity in banking systems, with both having a small set of major banks which are very focused on the domestic market. It is therefore informative to compare the situations of the two nations and more particularly the banking systems.

To do this, we first examine the events in Ireland and then compare them with Australia so as to determine if there are lessons for Australian investors.

The Irish situation

Ireland has been in the headlines in the last few months for all the wrong reasons. A bail-out by the European Union (EU) and International Monetary Fund (IMF) is now in progress and the creditworthiness of the state is continually deteriorating. Four years ago, it all seemed so different: prior to the GFC, Ireland was a shining star, attracting financial institutions around the world to the new financial hub of Dublin. Low taxation, a knowledge-based culture and a convenient location made Ireland a hive of activity.

What went wrong?

Ireland was badly affected by the financial crisis of 2007 and 2008. Many of the institutions operating there contracted in size and often the Irish operations were scaled back or closed. The Irish economy had transitioned from being primarily an agricultural exporter to being a ’knowledge centre’ but unfortunately this ’knowledge’ was often centred on more innovative products such as Structured Investment Vehicles (SIVs) which were the most vulnerable to the liquidity squeeze caused by the global financial crisis (GFC).

To meet the rapid growth up to 2006, Irish property was in strong demand from genuine and speculative buyers, causing house prices to more than double between 2000 and 2006 (as shown in chart 1). Commercial property was squeezed and developers borrowed heavily to meet the increased demand.

When growth stopped, the banks were left with large books of commercial and residential real estate and extensive loans to developers. Since 2006, house prices have fallen nearly 40%. Commercial property has been performing even worse with Investment Property Databank Ltd. estimating a 60% slump in the values of shops, offices and warehouses in the three years to September 2010.

The Irish banking system

Four main banks operate in the Republic of Ireland: Bank of Ireland, Allied Irish bank, Anglo Irish bank and the Ulster Bank. Ulster Bank is a subsidiary of Royal Bank of Scotland (RBS). On the night of 29-30 September 2008, two weeks after the collapse of Lehman Brothers, the Irish Government issued a guarantee of Allied Irish, Anglo Irish Bank, Bank of Ireland and three building societies. To address European Commission concerns, the guarantee was extended on 9 October 2008 to Ulster Bank and five other institutions which had non-Irish sponsors.
In January 2009, the Irish government nationalised Anglo Irish Bank. At the time of writing, it appears quite likely that Bank of Ireland and Allied Irish will also be nationalised.

Recent developments in Ireland

The population of the Republic of Ireland is about 4.5 million people. Unemployment has risen from a low of 4.4% in November 2006 to the current level of 13.6% (as shown in chart 2). With limited prospects of improvement, the size of the bank debt problem has, despite political resistance, forced the EU and IMF to intervene. Effectively an €€85 billion package has been established of which between €€35 and €€50 billion will be used to prop up the banks with the remainder to support the Irish state.

Ratings downgrades

Since the crisis started, the ratings of Ireland have deteriorated rapidly. For over seven years up to March 2009, Ireland was a solid triple-A rated state with ratings as good, or in some cases, better than Australia’s1. Now Moody’s and Fitch have lowered the sovereign into the triple-B rating grade and at A (Negative Watch), S&P is expected to follow shortly.

Bank ratings have been even more adversely impacted. The Irish banks are all rated in the triple-B range or below and subordinated bank debt has now been downgraded into the weaker end of sub-investment grade if not to default.

An Australian perspective

Effect on investments

For Australian investors, Ireland seems a long way away and direct exposure to Irish entities is likely to be limited for most.

The contagion effect to other challenged European sovereigns may possibly increase the significance of Ireland’s problems for investors, and portfolios need to be monitored to control the extent of impact.

Loss of faith in governments and banks

Perhaps the most significant contagion effect is a loss of faith in the creditworthiness of major banks – even when strongly supported by the government. Although the Irish government has indicated that senior bank paper is ‘money good’, some commentators are questioning whether it is possible to achieve this. Certainly, any hope that Tier 2 paper is very resilient has been dimmed, if not extinguished, by the action of Irish authorities on their banks’ subordinated debt as well as by ECB legislation that is intent on clarifying and ensuring the loss protection purpose of all subordinated debt.

The rapid rating decline of Ireland has various lessons for investors. The first of which (if not already learnt) is not to rely on ratings. The next lesson is that state support for banks is not necessarily a panacea. It might appear that the Irish state has been weakened by the explicit guarantees that it gave for the banks, but probably the more pertinent point is that these guarantees were forced upon the Irish government, since without them the collapse of the banking system may well have been much earlier.
Australia was fast to follow Ireland into guaranteeing bank debt. This action was not a casual decision and emphasises the systemic importance of the banks within Australia. The subsequent events in Ireland highlight that sovereign guarantees do not eliminate the risk but instead transfer it from the banking system to the sovereign.

Could it happen here?

This raises the more intriguing question for Australians: could it happen here especially with a similar concentration of key banks, all of which have high exposure to the property market? It should, however, be noted that the four major banks are serving a country with about five times the population of Ireland.

Australia has had a relatively gentle GFC compared with the US and Europe and the banking system has remained largely unscathed especially when considering the major banks. The cost of funds has increased for all banks, but the competitive landscape has eased with many of the smaller competitors being squeezed out. The reduction in competition has allowed the major banks to protect their margins, especially in the mortgage and small and medium enterprise (SME) markets.

This protection of margins has helped maintain the credit quality of the major banks but it has created political problems, as borrowers see their interest rates being increased by more than the official Reserve Bank of Australia rate rises.

The four major banks have increased their balance sheets over the last few years substantially as competing lenders have gone by the wayside – although the growth has not reached the level predicted in early 2009.

Australian banks have always had a heavy property focus and in the early 1990s some banks nearly collapsed due to their exposures. Since the advent of the GFC, the banks have been steadily managing down the more challenging commercial property exposures and this sector should not impact Australian banks to nearly the same extent as the Irish banks, but residential mortgages remain a key exposure. Although Australian house prices increased slightly slower than Ireland’s before the financial crisis, they have continued to increase and convincing arguments can be made that prices are in a bubble. (Chart 3 emphasises the extent to which the Australian housing market has continued to perform.) Possibly, the biggest risk is if unemployment in Australia rises significantly as it did in the Republic of Ireland.

However, unlike Irish banks, Australian banks have had a broader range of assets with much of corporate Australia traditionally relying on bank loans as their main, and often only borrowing avenue. With the banks’ increased borrowing costs and investment money beginning to build up both domestically and offshore, corporate bond markets are now competing with relatively attractive borrowing rates and issuers are being lured away from the banks.

Caution may be needed if the banks’ exposure to stronger Australian corporates continues to be eroded and the banks’ balance sheets become overwhelmingly focused on just SMEs and mortgages. That being said, there is a long way to go before we reach that situation.
Beyond the banking sector, other factors definitely distinguish the two countries. Unlike Ireland, Australia has its own currency which enables it to use more levers in controlling economic issues. However, the fact that Ireland shares the euro places a strong incentive upon other euro participants to find a solution and hence is not a complete negative.

Finally, the situations of Australia and Ireland are very different: Ireland is an agricultural producer that reinvented itself as a ’knowledge centre’. In Australia, although agriculture is a main export earner, commodities are a dominant earner and with the relative geographic advantage, in terms of proximity to Asia, Australia has been fortunate in continuing to find buyers of its exports, and while trying to become more of a focus in the financial world, it has not relied upon this.

For Ireland, the exposure was to a downturn in demand for ’innovation’ but Australia is much more exposed to a downturn in demand for agriculture and commodities. This important variation means that the causes of any Australian crisis will most likely be quite different from those of the Irish crisis. However, the similarity of banking systems suggests that the banks, as a transmission mechanism for a crisis, may be similar even if the stronger nature of the Australian banks results in the end effects being less dire.

Conclusion

Australia is not Ireland and, as the discussion above suggests, while Ireland’s problems could be partly mirrored in Australia, various factors should mitigate some of the causes that were central in Ireland. However, with the corporate market attracting strong credit names away from their traditional bank markets, the banking system is moving towards the Irish in its concentration on property and this trend should be monitored.

More importantly, however, than any similarities of the two countries, Ireland should provide a salutary lesson to Australian investors that relying upon the status quo is unwise. Australia did weather the financial crisis most effectively due to a variety of factors. But if these factors reverse (e.g. the Chinese market for commodities reduces) then Australia’s safe haven status could be dented. In such a case, the banks and their dominant position in Australia would become a core focus and they may be more vulnerable than currently thought.

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