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Asian local bonds have outshone global peers over the past five years

From 2018 through 2022, financial markets around the world had to endure a prolonged trade war between the US and China, a global COVID-19 pandemic, rising inflation, elevated oil prices and widespread geopolitical upheavals—namely the Russian invasion of Ukraine.

Another key stress factor global markets had to withstand since early 2022 was the aggressive monetary tightening by the US Federal Reserve (Fed) and other major central banks, many of which have implemented a series of interest rate hikes to quell decades-high inflation.

Still, Asian local bonds (also known as Asian local currency bonds, as they are denominated in the currencies of their home countries) have shown great resilience under such trying times. As a group, these regional bonds have outperformed their global peers by a big margin over the past five years (see Chart 1).

Local government bonds of India and Indonesia, for instance, turned in impressive gains of more than 43% and 40%, respectively, in local currency terms through 2018-2022, whereas those of Malaysia, the Philippines, China and Thailand all marked decent returns ranging from 9% to 21%. Conversely, most government bonds of the US, Europe and Latin America generated losses in local currency terms over the corresponding five-year period.

Backed by strong fundamentals and high-quality yields (as most Asian local currency government bonds have investment grade credit ratings) coupled with lower foreign ownership (compared to five years ago) and the potential appreciation of local currencies versus the greenback, Asian local bonds currently look attractive as a fixed income asset class.

In our view, regional local bonds will continue to perform well for the rest of 2023 and beyond as inflation rates in the region trend lower and Asian central banks refrain from further interest rate hikes. Moreover, we believe that the Fed, which recently hiked rates by 25 basis points (bps) at its Federal Open Market Committee (FOMC) meeting on 22 March, is near the end of its rate hike cycle. At the moment, given the ongoing global banking crisis, the market is pricing in less than a 50% chance of the Fed hiking rates at its next FOMC meeting in May.

In addition, there are other supportive factors that are expected to increase the appeal of Asian local bonds, namely the post-pandemic narrowing of Asia's budget deficits, which will lead to lower issuance of local currency bonds, and the possible inclusion of these regional bonds in established global fixed income indices.

Chart 1: Asian local bonds outshine global peers

Source: Markit iBoxx, JP Morgan, Bloomberg

For individual countries, we use Markit iBoxxGlobal Government Bond Indices as proxies except India, which uses iBoxxAsia India Government Index. For emerging markets composite indices, we use JPM GBI-EM Index and its sub-indices. For Global developed markets, we use JPM Global Bond Index (GBI) as proxy. *China bond index's inception was February 2019 and it has less than five years of track record.

Budget deficits of Asian countries set to narrow

As Asian fixed income investors, we are especially watchful of the fiscal stance of countries within in the region. During the COVID-19 pandemic, notably in 2020 and 2021, almost all Asian countries experienced increases in their fiscal deficits as they were implementing expansionary fiscal stimulus to support their respective economies during periods of lockdowns and social restrictions, which had a negative effect on business and economic activities.

With the region's economies reopening amid a return to normalcy following the pandemic, various countries in Asia are now adhering to stricter fiscal discipline and have started to trim their fiscal deficits, which are forecasted to narrow this year (see Chart 2).

Chart 2: Asia's budget deficits are likely to narrow going forward

Source: MOF India, Moody's, official sources, Bloomberg, January 2023

Note: India's data comes from MOF India and Philippine's budget deficit forecast is from Fitch.

A case in point is Indonesia, which has managed to narrow its fiscal deficit substantially, from -4.6% of GDP in 2021 to -2.4% in 2022. Moreover, for 2023 the Indonesian government has set a budget deficit target of 2.85% of GDP, below its statutory limit of 3%.

But what implications will a reduction in the fiscal deficits of Asian economies have on regional local bonds? To start with, we expect lower fiscal deficits to ease the financing pressure faced by Asian governments and, as such, lead to a lower issuance of local currency bonds. A cutback in net issuance or supply of Asian local bonds is generally supportive of bond prices. We expect the net local currency government bond supply of most Asian countries to be lower in 2023, as compared to 2022 (see Chart 3), creating less downside price pressure for regional local bonds over the next few quarters.

Chart 3: Net issuance of Asia local currency bonds projected to be lower in 2023

Source: ANZ, January2023

Ample room for inflows into regional bonds

Since March 2022, when the Fed started to embark on an aggressive tightening of monetary policy with a series of outsized rate hikes to tame rising inflation, we have seen an outflow of funds from Asia, with the move exacerbated by the strengthening of the US dollar.

However, in our view the aggressive rate hike cycle by the US central bank may not persist, given the ongoing banking crisis in the US and Europe. In addition, we believe that the Fed is now nearing the end of its tightening cycle as red-hot inflation in the US cools. Indeed, US annual inflation, as measured by the headline consumer price index (CPI), has been coming down since June 2022. For instance, the latest US annual inflation rate slowed for an eighth consecutive month to 6% in February 2023, the lowest since September 2021.

Likewise, the magnitude of the Fed's interest rate increases has gradually shrunk since mid-2022, from a series of 75 bps hikes in June, July, September and November to 25-bps hikes in February and March 2023. At the moment, the Fed has to intricately balance the taming of inflation with its effort to avert a full-scale turmoil in the banking system.

In the coming months, a possible pause in the Fed's tightening cycle amid a slowdown by the world's largest economy may help to stabilise the global rates market, resulting in an improvement in risk appetite. This could potentially prompt foreign funds to return to Asia as the greenback weakens. We believe that such developments will support Asian currencies and regional bonds. As at the end of 2022, foreign investors' positioning in Asian local bonds (see Chart 4) was light relative to previous years. But once the environment turns more conducive for regional bonds, we expect inflows to Asia to resume.

Another factor that could spur more inflows of foreign funds into regional bonds in the near future is the possible inclusion of some Asian government bonds in established global fixed income indices. South Korea is seeking the inclusion of its government bonds to the FTSE World Government Bond Index (WGBI); similarly, India is pursuing the inclusion of its government bonds in the Bloomberg Barclays Global Aggregate Index and the JPMorgan Government Bond Index-Emerging Markets Global Diversified Index.

Chart 4: Foreign holdings in Asian local currency government bonds remain low

Source: ANZ, January2023

Regional central banks seen halting rate hikes as inflation in Asia eases

Russia's invasion of Ukraine in February 2022 and the subsequent sanctions against Moscow by many developed countries have led to a diminished supply of major food staples, such as wheat and vegetable oils. As a result, Asia's inflation, which is largely driven by the volatile food component, rose steeply in the first three quarters of 2022. Although global food prices remain elevated amid the ongoing war in Ukraine, price pressure has eased of late, especially in the fourth quarter of 2022, as new supply chains were established.

All in all, the pressure in the global supply chain is easing (see Chart 5). We see easing pressure leading to a decline in global inflation, especially in US CPI, as suggested by a recent research paper by economists from the Federal Reserve Bank of New York (New York Fed), which projects annual US CPI normalising to 3.8% within 12 months. Global supply factors are measured by the New York Fed's Global Supply Chain Pressure Index (GSCPI), which uses various global price indicators, including the producer price index and the CPI of the US and the EU. The New York Fed's academic projection of a substantial easing of US CPI in 2023 to below 4%, which is a level consistent with a soft-landing scenario, is based on the assumption that the GSCPI normalises to its historical average over 12 months.

Chart 5: Global supply chain pressure is easing

Source: Bloomberg, January 2023

At the same time, the cost-push pressure (namely the food price component) that drove Asian inflation is coming down and softening Asia's inflation outlook (see Chart 6). As inflation in the region ebbs (as evidenced in the February CPI of countries such as South Korea, Thailand, China, India, Singapore and the Philippines), Asian central banks are likely to slow the pace of monetary policy tightening. As of March 2023, several regional central banks, such as those of South Korea, Indonesia and Malaysia, have already suspended rate hikes as inflation in their countries has eased.

Chart 6: Price pressure that drove inflation in Asia is easing

Source: Morgan Stanley, January 2023

Note: Asia includes China, Hong Kong, India, Indonesia, South Korea, Malaysia, Philippines, Taiwan, Australia and Japan. Singapore and Thailand are excluded due to a lack of data.

Moreover, the purchasing managers' indexes of many Asian countries are falling in line with the global trend, whereas Asia's exports, which are still largely dependent on demand from the US and the EU, have also started to come off as growth in developed countries slows. That said, a potential recovery of exports to China may offset the slowdown. But given the overall weaker growth outlook, we expect most of Asia's central banks to pause hiking rates. In our view, Asian central banks—cognisant of the slower economic growth outlook—are likely to be less hawkish in their monetary policy stance and will be more inclined to keep interest rates accommodative, all of which should bode well for regional bonds.

Asia's FX reserves remain adequate; regional currencies look cheap

Asian foreign currency (FX) reserves have decreased over the past few months. They remain adequate, however, and are in accordance with the International Monetary Fund (IMF) rule of thumb from of having at least three months of imports being covered by FX reserves (see Chart 7). This underscores the sound fundamentals of Asian economies.

Chart 7: Asia's FX reserves remain adequate

Source: Bloomberg, IMF, January 2023

In addition, Asian currencies, as measured by the real effective exchange rate (REER), currently look cheap relative to their historical long-term averages. As regional currencies weakened against the US dollar (USD) in 2021 and 2022, the USD-Asia REER had recently exceeded two standard deviations from its long-term averages, making Asian currencies cheap from a long-term perspective (see Chart 8). In our view, the environment surrounding regional currencies is improving. As mentioned, we think that dollar strength will start to fade as the Fed may be nearing the end its tightening cycle, and Asian currencies will have ample room to appreciate versus the greenback. In terms of regional currencies, we favour the Thai baht, which is seen benefiting from increased tourism inflows and current account improvement. We also like the renminbi. China's reopening and the imminent recovery in the world's second largest economy are likely to spur the renminbi to appreciate against the greenback, in our view.

Chart 8: Asian currencies look cheap versus their long-term averages

Source: Citibank, Bloomberg, January 2023

Positive on the local bonds of Indonesia, India and South Korea

Within the region, we are most positive on the local currency bonds of Indonesia, India and South Korea. We expect Indonesian bonds to perform well on the back of strong foreign inflows—both portfolio fund flows and foreign direct investments (FDIs)—into the country. Indonesia is attracting considerable foreign investments on the back of its thriving electric vehicle supply chain ecosystem, which entails mining and the processing of metals all the way to the manufacturing of cathodes and battery cells. Strong FDIs into Indonesia are expected to support its economy and currency, as well as boost the appeal of its local currency government bonds, which also look attractive on a real yield (nominal yields minus core CPI) basis (see Chart 9).

Chart 9: Asian local currency bonds offer attractive real yields

Source: Bloomberg, January 2023

Local currency Indian bonds also look attractive from a real yield perspective and offer a good carry. Furthermore, we expect Indian bonds to receive a fillip when the Reserve Bank of India (RBI) ends its rate hike cycle in the near future. The RBI raised its benchmark repo rate by 25 bps to 6.5% in February. Like many other Asian central banks, the RBI is waiting for inflation to make a sustained decline before it stops hiking rates and revert to a more accommodative stance as the Indian economy slows.

Likewise, we expect South Korea's local currency bonds to perform well. The Bank of Korea (BOK) was one of the first central banks in the world to hike interest rates to address soaring inflation; it embarked on its tightening cycle back in August 2021 and raised benchmark interest rates seven consecutive times. In February 2023, however, the BOK paused its rate hike cycle by keeping benchmark rate steady at 3.5%. We think that South Korea could be the first country in Asia to cut interest rates. The possibility of steady or declining rates coupled with the potential inclusion in the FTSE WGBI in the future will be supportive of South Korean local currency government bonds, in our view.

Summary on why Asian local bonds may outperform

On the whole, we expect Asian local bonds, which have outperformed their global peers over the past several years, to thrive in the remaining quarters of 2023 and beyond, supported by a conducive global environment of lower inflation, lower growth and steady interest rates.

At the same time, slower but still positive growth in Asian economies and a pause in regional central banks' policy rate adjustments will benefit the Asian local bond market, in our view. We believe that Asian central banks are nearing the end of their rate hike cycles as inflation eases and growth prospects weaken. The prospect of stable or even falling interest rates in Asia bodes well for regional bonds.

Strong fundamentals, high-quality yields and low foreign ownership (and hence more room for fund flows recovery) are other factors that are supportive of Asian local bonds, which are also seen doing well as regional currencies strengthen versus the greenback.

Within the region, we favour Indonesian local bonds, which could benefit from strong inflows (both FDI and foreign portfolio fund flows) and fiscal consolidation. Indian bonds continue to offer good carry as the RBI looks to end their rate hike cycle, while South Korean bonds are also favoured to outperform on rate cut expectations over the longer term and their potential inclusion into bond indices.

There are risks that could alter our positive views on Asian local bonds, such as a resurgence in inflation, a big flare-up in global geopolitics and full-blown turmoil in the global banking sector, which undoubtedly will lead to widespread risk aversion in global financial markets. Those risks, while possible, are not likely to transpire in our base case scenarios, which by and large look conducive for Asian local bonds.

Author: Edward Ng, Senior Portfolio Manager

Important disclaimer information
Please note that much of the content which appears on this page is intended for the use of professional investors only.

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China's population declined last year, the first annual contraction since 1961, amid a Covid-induced sharp decrease in new births and long-term structural factors. China has followed a similar trajectory to many developing countries as having an aging population is a common demographic problem in developed countries, where birthrates have steadily declined with higher levels of income, healthcare and education. Countries such as Japan and Germany have had decades to adjust as their populations have aged gradually. China, on the other hand, has begun the aging process at an earlier stage of development and at a more accelerated pace than most countries have experienced. In 2022, official statistics revealed a decline in China's population with a fall of 850,000 from the previous year. However, for a country of more than 1.4 billion people, the difference is relatively small but shows the general trend.

The central government has acknowledged the looming demographic problem with a policy package to boost births in August 2022, pledging to improve public services such as healthcare and childcare as well as to offer priorities on public housing to bigger families. Local governments have since followed suit, rolling out home purchase subsidies or allowances for families with multiple children. Despite China's population decline often presented as a crisis, we see a number of opportunities as we continue to believe China's economic growth will be driven by labour quality rather than labour quantity. We expect China's GDP to potentially grow around 5.5% to 6% in the medium term, within which service sectors should become more prominent.

Source: CEIC, Jefferies as at 31 January 2023. The information shown above is for illustrative purposes.

Given the forecasted population contraction, many are concerned that the demographic crisis will turn into strong growth headwinds. In our view, the shrinking population may influence total demand, but the negative impact may not be as large or damaging as the headlines suggest. We examine the economic impact of this demographic trend on China's manufacturing and consumption.

Source: NBS, United Nations, Citi Research, as at 31 January 2023. The information shown above is for illustrative purposes.

Manufacturing will see little impact
It might be intuitive to conclude that China may lose its edge in some labour-intensive sectors due to higher labour costs caused by a decline in the working-age population. We argue differently, on the basis that China's growth miracles in the past 30 years were not solely driven by an expansion of its labour force. The working-age population grew 1.4% annually between 1980 and 2019 in the country, while its GDP grew 9.4% annually. Productivity gain is evidently more important in economic growth and will continue to be China's key growth driver.

Source: CNBS/H, United Nations, Haver, as at 31 January 2023. Past performance is not a guide to future results. The information shown above is for illustrative purposes.

Most developed countries actively increase immigration to mitigate population collapse. However, this is less applicable in China: from 1990 to 2020, China has seen total immigration of merely 1 million. This lack of immigration is due to both language barriers and the country's restrictive immigration policy. While we do not expect this to reverse in the foreseeable future, we do think that raising the retirement age could enable more workers to stay in the labour force for longer. China currently has the lowest retirement age among the OECD countries. China requires most men to retire at 60, white-collar women at 55 and blue-collar women at 50. That is well below the retirement age of 65 in Singapore, 67 in Germany, and 70 in Japan. The Chinese government has pledged to gradually increase the retirement age by 2025. We believe this could offset some of the impacts from the declining labor force.

Source: United Nations, as at 31 January 2023. The information shown above is for illustrative purposes.

Labour aside, productivity gain should continue to be the key contributing factor for growth. China's manufacturing sector has seen a strong productivity improvement in the past three decades. Since joining the World Trade Organisation (WTO), China has established massive production scale and expanded into several diverse industries. The economies of scale and comparatively integrated industrial chain have created impeccable production efficiency and cost effectiveness, which offers a significant advantage to other nations in comparison. Looking at the labour-intensive textile industry as an example, in addition to mass production, China's cost advantage in the textile industry stems from the fact that China leads the upstream production of polyester. China has about 80% of the world's polyester production capacity, which provides unparalleled cost advantages to local fabric manufacturers and subsequently the garment producers. China, therefore, has remained a production powerhouse in apparel, which might seem to be among the easiest to shift to lower-cost countries. However, China remains at the forefront of FDI inflows into neighbouring regions such as Vietnam as China aims to move up the value chain and give priority to projects which could generate high value products and operate using cutting edge technologies.

Source: National Bureau of Statistics, as at 31 January 2023. The information shown above is for illustrative purposes.  Past performance is not a guide to future results.

Going forward, we expect China's productivity to gradually improve. Its productivity gain could come from rising investment in human capital, further urbanisation and technology-driven efficiency improvement.
From the human capital perspective, China continues to gain human capital on the back of better education. 7% of Chinese individuals born in the 1960s were able to attend college. The figure became 23% in the 1980s and has reached over 50% for millennials. There is still room for China to increase its stock of human capital.

Source: United Nations, National Bureau of Statistics as at 31 January 2023. The information shown above is for illustrative purposes.  

Urban migration has been a major source of cheap labor in China. As people move from villages to cities, productivity tends to increase significantly due to the productivity differentials between agriculture and industry. Additionally, there is a change in consumption spending growth as consumers look to increase spending on property and durable goods, such as cars and appliances. China's urbanisation rate rose from 36% in 2000 to 65% in 2021, which remains low compared to developed countries such as Japan (92%) and the United States (83%). While facing higher costs, China's improved labour productivity should allow it to compete with quality in the next wave of industrial prosperity.

Source: National Bureau of Statistics as at 31 January 2023. The information shown above is for illustrative purposes.  

Source: CEIC. The information shown above is for illustrative purposes. Forecasts and estimates are based upon subjective assumptions.

Finally, new technology, such as automation and artificial intelligence, could reduce the demand for labour and extend the working lives of the labour force in general while maintaining output growth. China has been the world's largest industrial robot market since 2013. With the aid of government policy to push towards automation across industries, we expect China to keep leading in robot adoption and production in the next decade. More importantly, similar to Korea, China is making great strides in high-tech industries in which it still accounts for a relatively small share of global markets, such as renewables, machines, tools and pharmaceuticals.

As a result of these factors, we believe China's productivity improvement will continue to outweigh the lack of population growth when it comes to manufacturing. We, therefore, see the impact from labour on growth to be minimal.

Unlike manufacturing, consumption should see structural changes
China's aging population is expected to stay elevated after reaching a peak in 2050, based on UN estimates. This irreversible trend is set to structurally change the country's consumption demands due to the older consumer having real spending power and different tendencies. Healthcare, consumer services and insurance will be significant in the future. In order to fulfil demand from a silver economy, we expect China to invest in areas such as healthcare management, serviced community, vocational education, wealth management schemes etc. China is still at a nascent stage in most of these areas. As a result, the service sector should continue to grow as a portion of GDP. In 2022, the service sector accounted for 53% of China's GDP, up from 44% in 2010 and 40% in 2000. The share could rise further in the coming years.

Source: National Bureau of Statistics, CICC, as at 31 January 2023. Past performance is not a guide to future results. The information shown above is for illustrative purposes.  

Conversely, businesses in areas such as child-care and higher education will face a smaller market cohort should the number of newborns fail to stabilise. These sectors are at a natural disadvantage. We think that population and demographic changes will bring both rising and receding prospects to China's general consumption. We are selectively constructive in the service sector, where both the policy and market set-up are much more favourable.

While the demographic shift is often presented as a crisis for China, we see immense opportunities in these challenges. We think that China's economic growth will be driven by labour quality rather than labour quantity, which will partly offset the impact of a declining population. We expect China's GDP to grow around 5.5% to 6% in the medium term, within which service sectors should become more prominent. Against this backdrop, we are well positioned for opportunities in these growth areas: new technologies, smart manufacturing, healthcare, insurance, and consumer services.

Episode 4- Artificial Intelligence and Big Tech - What does this mean for responsible investors? Charlotte O' Meara is joined by Mary Manning and Jessica Cairns, Alphinity Investment Management.

Alphinity Investment Management have incorporated artificial Intelligence (AI) into their ESG integration process for a number of years, developing their own responsible investment framework for AI. With the rise of AI technologies such as Chat GPT, AI is now receiving a lot of publicity, but what does that mean for responsible investing? This episode provides an overview of AI and how considerations of AI can be factored into the ESG integration process.

This information is for advisers & wholesale investors only.

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Funds continue to flow into equities despite recent volatility and recession fears, with Barclays noting fund flows lag performance. Performance is highly correlated with money supply, notes GLJ Research, and central bank liquidity may actually have been increasing lately according to Citi Research. The "Buy the Dip" mantra helps, as Bloomberg charts this strategy's recent success. Despite equity markets holding up, capital raising remains suppressed relative to dealogic's 2020 and 2021 figures. WSJ highlighted aerospace and defence technology as an area where there does appear to be strong capital flows. US banks, however, have seen deposit outflows, as charted here by Reuters. Margins have blown out on ASX-listed debt and hybrids, as per Bell Potter charts, which are largely issued by banks and financials. Bond market volatility is at historically high levels as seen from Bespoke and FT charts. Back in equities, the concentration of major indices stands out and Equitable Investors has pulled together top ten stats. The S&P 500 would have been down in March without "big tech", eToro highlights.

Property Values as at 31st of March 2023

The property market continues to show signs of recovery, with CoreLogic's National Home Value Index posting the first month-on-month increase since April 2022, with values up 0.60% for the month of March.

This monthly growth was driven by strong results in Sydney, with values increasing 1.40% for the month. This figure has been impacted heavily by housing values in the most expensive quarter of Sydney's market up 2.00% and unit values also up 1.40%. Results across Melbourne, Perth and Brisbane were also positive, with the capital cities recording growth of 0.60%, 0.50% and 0.10% respectively. Adelaide (-0.10%), Darwin (-0.40%), Canberra (-0.50%) and Tasmania (-0.90%) however all recorded reductions in value.

Clearance Rates & Auctions 20^th - 26^th of February 2023

The week before Easter brought the busiest auction week of 2023 thus far, with 2,685 properties going to auction, up 16.60% on the previous week, however still 16.30% below that of last year (3,209). Melbourne led the way with 1,188 auctions taking place, followed closely by Sydney with 1,019. Brisbane, Adelaide and Canberra which all saw significantly fewer auctions, with 177, 161 and 121 respectively.

In addition to strong auction volumes, clearance rates have continued to improve, with Sydney, Adelaide and Melbourne all receiving above 70.00% clearance rates with 73.3% (63.8% last year), 71.6% (79.1% last year) and 71.2% (67% last year) respectively, contributing to a 70.7% weighted average, up from 66.8% last year. Brisbane also recorded a clearance rate of 64.2% (65.9% last year), however results across Canberra and Perth were well down on last years values, with 55.6% (73.3% last year) and 54.5% (64.7% last year) respectively.

With the RBA opting to leave the cash rate unchanged in their April meeting after 10 consecutive increases, some relief is now given to existing mortgage holders, whilst also providing some comfort for those looking to enter the market. In line with previous forecasts, we believe buyer demand is likely to continue to increase throughout the year and into 2024.

Median Dwelling Values as at 31^st of March 2023Source: CoreLogic, Report, Article

Quick Insights

Australia faces huge housing shortfall as new home sales slump

A dramatic slump in new home sales will exacerbate the national rental and affordability crisis and put further pressure on the ability of new housing supply to meet future demand, the Urban Development Institute has warned in its latest State of the Land report. According to the benchmark report, over the 2022 calendar year, greenfield lot sales almost halved and settled apartment sales fell to their lowest level since the global financial crisis as buyer demand plummeted, all due to higher interest rates, surging construction work, and fears about builder failures.

Source: Australian Financial Review

Walk-in buyer interrupts auction, takes house sight unseen

A four-bedroom house with a pool located in Floreat, Western Australia, sold at auction for $1.7 million. There were a lot of interested parties - 10 registered bidders but only three were active bidders. Right at the tail end of bidding, as things were starting to simmer down, someone walked in and asked if they could quickly register. She'd never seen the home. She walked straight into the backyard and said "I like this house." and within minutes she purchased the property.

Source: Australian Financial Review

Infrastructure Victoria urges Andrews to scrap stamp duty

Stamp duty should be scrapped and replaced with a broad-based land tax according to Infrastructure Victoria In a landmark report it also warned that transport and amenities are struggling to keep pace with suburban sprawl and density needs to increase in existing suburbs. The report calls for the government to fast-track planning approval for more high-quality, three or four-bedroom townhouses and better standards for family-friendly low-rise apartments, to reverse the trend of families continuing to move to bigger blocks in newly created outer suburbs.

Source: Australian Financial Review

Author: Filippo Sciacca, Director - Investor Relations, Asset Management and Compliance

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Tim Toohey, Head of Macro and Strategy, looks at the the key factors behind the collapse of Silicon Valley Bank (SVB) ($209bn of assets) and Signature Bank ($110bn in assets), and notes that there is one thing we know for certain amid a banking crisis: the cost of credit will rise and the availability of credit will fall sharply. Tim details the likely implications for Australia and concludes that despite the coming headwinds, Australian banks will remain resilient.

Jay Powell declared to the US House Financial Service Committee on 9 March 2023 that there was no evidence that suggests the US Fed has overtightened policy. Instead he declared that "the ultimate level of interest rates is likely to be higher than previously anticipated. Within 24 hours the 2nd largest retail bank failure had commenced.

Collectively the collapse of Silicon Valley Bank (SVB) ($209bn of assets) and Signature Bank ($110bn in assets) exceeds the biggest bank collapse in 2008 (Washington Mutual, $307bn). We are rapidly closing in on the 2008 collective peak of $374bn. Should First Republic Bank, whose share price has fallen 90% from mid-February 2023, also fail then a further $213bn of assets can be added to the total.

Despite the size of these collapses, it is important not to confuse the collapse of several regional US banks as a harbinger of the next Global Financial Crisis (GFC). It was the excessive leverage, excessive risk taking and poor regulation of the investment banks that led to the GFC, not a collapse of regional and retail banks.

The US does have a long history of bank crises. Most of these crises were a function of excessive speculation in real estate and financial markets and occasionally the cause could be traced to a collapse in commodity markets:

• The 1819 banking crisis was an example of a commodity price led banking collapse, whereby a peace settlement between England and France saw US commodity prices fall sharply and commercial bank failures.
• The 1873 banking crisis can famously be traced to Railroad speculation.
• The 1907 panic stemmed from just two speculators who failed attempt to control the copper market.
• The Great Depression (1929-1939) had many causes, but it was made drastically worse by the decision to hike interest rates after the stock market bubble had burst, contributing to 9,000 bank failures though the 1930s.

It is the savings and loans (S&L) failures of the 1980s and early 1990s that have the most similarity to today's failures. Simply put, long-dated housing loans written at low interest rates rapidly become uneconomic if funding is short dated and interest rates are rising sharply. The small and fractured natured of most US retail and commercial banks means there is no ability to turn to the equity market to raise capital which makes for fertile ground for bank runs.

What has marked the failure of SVB and Signature was that instead of lending recklessly for the purposes of commodity, equity market, or housing market speculation that had brought down banks in the past, it was large falls in the value of 'long duration' crypto and tech start-up assets that proved the source of the failure. The railway bonds and Florida swamp land that had brought down banks decades earlier had merely been replaced by some equally dubiously long duration tech assets.

The other relatively interesting aspect about SVB was that it seemingly forgot to do what banks normally do. Instead of making loans to purchase homes and to finance business expansions, it seems to have feasted on cheap money and start-up capital for tech entrepreneurs and purchased Mortgage-Backed Securities and Treasuries at relatively low yields and financed venture capital investments at expensive multiples. As the Fed jacked up rates, tech values fell, investors became nervous and deposits declined slowly. And then they moved very quickly.

Being forced to liquidate MBS and Treasury securities at a large loss merely helped expedite the decline. Social media did the rest. Indeed, SVB is likely to be the first bank run played out almost exclusively in digital space.

To be clear, this is not likely to be reflective of the average bank in the US banking system. It is not evidence of a systemic threat to the system. And importantly, depositor insurance and the preparedness of the US Treasury to provide selective guarantees for bank deposits for non-systemically important banks does make these type of banking collapses less economically painful. Nevertheless, the failures are incredibly important events for financial markets.

Chart 1: US Retail and Commercial Bank Leverage & 'Greed'

To gain an insight on the vulnerability of other regional US banks, the above Chart 1 provides a broad measure of bank leverage plotted against how fast banks have attempted to expand their balance sheets. The banks that have failed or are under immediate stress are highlighted in red.

What should be clear is that although the commonality of lending to tech and crypto assets may have been the source of the initial phase of the crisis, it is unlikely that the names with higher leverage and just as rapid balance sheet growth will all prove to have sufficient loan quality and the asset and liability mismatches that have created bank stresses in the past.

The unique feature of the current crisis is the speed at which deposits have been shifted from the smaller regional banks to the large US banks. Electronic transfers make a bank run far more immediate, and social media has been an amplifier of fear and contagion. The other unique feature of this crisis is that the proximity to the GFC has seen major banks and policy makers act far quicker and aggressively than in the GFC.

For instance, short term loans made by the Fed to the major banks in exchange for cash has surged well past the peak of 2008, a time where banks were afraid of the stigma of being seen tapping the Fed's emergency liquidity facilities. No such stigma this time around!

Meanwhile, commitments from policy makers that they stand ready to do whatever is necessary to support the banking system have come much faster than during 2008, which was marked with successive failures to secure the legislature authority to make emergency funding available.

In short, it is unlikely that the US banking crisis is complete and a raft of consolidation of regional banks is feasible, but it is also unlikely to be marked by the same level of confusion, inaction and liquidity shortfalls that prevailed in 2008.

Of course, the banking crisis becomes more global in nature if it spreads to the 'globally systemic' banks. In the Chart 2 below, the same analysis is repeated for international listed banks. The gleeful adoption of Quantitative Easing (QE) which fuelled the surge in global money supply and bank lending has helped create plenty of other potential sources of contagion.

Chart 2: Global Banking System Leverage & 'Greed'

Some familiar 2008 players are back again - i.e. Lloyds, Barclays and Credit Agricole - it is the emergence of a new batch of banks ranging from Japan, the Nordics, Canada and the Middle East that could be new sources of contagion. Nevertheless, few of these banks have attempted the same sort of balance sheet growth as the US banks that have already failed.

For a central bank task with controlling inflation and economic stability, these failures and the build-up of excessive leverage are embarrassing. But they are no accident: central banks are at least partly complicit. Why?

• Firstly, by taking interest rates to the zero bound, excessive risk taking across the financial system was guaranteed. Indeed, central bankers globally hung out the welcome mat to risk takers in the hope of reviving aggregate demand. The watering down of regulation for smaller US banks also meant the banking regulators, of which the Fed is one, collectively took their eye off the ball.
• Secondly, by providing long forward guidance that interest rates would remain low for a long period of time, they have distorted the cost of capital which funnelled capital into 'long-dated' exposures in general, and tech and crypto in particular.
• Thirdly, printing an unprecedented supply of money via quantitative easing merely added petrol to the long duration speculative fire.
• Fourthly, by failing to identify the inflation threat early and by adopting backward looking policy settings even once inflation was trending higher, central banks kept too much liquidity in the system for too long and helped create the biggest rise in global inflation since the late 1980s. Be wary of central bankers trying to shift the blame of excess inflation to being a function of excess fiscal stimulus and supply constraints - excess credit provision was a central plank in generating excess inflation.
• Finally, with their reputations sullied, central banks have attempted to overcompensate for past inaction. In a desperate attempt to have history record that it was central bank action via aggressively hiking rates that slayed high inflation, central banks collectively increased interest rates more rapidly than any prior period whilst simultaneously rapidly shrinking their balance sheets (refer Chart 3).

Chart 3: Central Bank Asset Growth and Global Money Supply'

The recent rapid movement in interest rates has been sufficient to unveil some spectacular asset and liability mismatches in some US regional banks and has cast doubts on whether other banks are also sitting on large unrealised losses.

Suffice to say, 'good' policy is typically marked by hiking early and in large increments at the start of the cycle and then slowing and spreading out the hikes towards the end of the cycle as incoming information is accessed for signs of a turning point. That is not what central banks have done this cycle. They did the exact opposite.

Given central banks know they are already in the restrictive zone for monetary policy, given economic growth is well below trend, given inflation peaked months ago and given long dated inflation expectations are falling, then continuing to hike at this point of the economic cycle risks breaking more than just a few US retail and commercial banks. It continues to risk recession.

In this respect, there is one thing we know for certain amid a banking crisis: it is that the cost of credit will rise and the availability of credit will fall sharply. The next several surveys from the US Fed's Loan Officers Survey will show a marked tightening in the availability of credit, and this has always been a rather accurate precursor to US recession (refer Chart 4). So much for the "no-landing" optimists of January and February.

Chart 4: Central Bank Asset Growth and Global Money Supply'

To be clear, after its latest 25bps hike, we believe the Fed and the RBA have now completed this hiking cycle.

It had been our position since mid-2022 that the economic data would not allow the Fed nor the RBA to persist with their stated interest rate intentions into mid-2023. The fractures in the banking system are by themselves sufficient to guarantee a pause in the hiking cycle, but the reality is the data is telling the central banks that the monetary tightening task is complete even if the central banks have yet to fully acknowledge it.

In the case of the Australian banks, most would agree that they have some natural advantages. Capital ratios are higher - and that is a good thing - but by itself this is not a necessary or sufficient reason to avoid contagion. The real security of the big four Australian banks is fivefold:

1. The Australian banks have transformed to be primarily home loan lenders

The days of the banks taking on large single loan exposures to big corporates or taking proprietary risk positions on the balance sheet are long gone. Australia's banks are boring by international banking standards, and in times of crisis that is a good thing. In the context of our chart on leverage and asset growth, the Australian banks are in the zone shown by the oval shape. The leverage is only slightly higher than it has been over the past five years and balance sheet growth has been between 11% to 29% since 2019. That's significantly below the offshore banks that experienced difficulties so far.

2. Australia's banks are homogenous

To create a genuine bank run, a link with poor asset quality, poor risk controls and poor governance typically becomes the catalyst for a crisis. While Australian banks are not perfect, they do manage asset and liability risk religiously and in the post-Royal Commission period governance has been given a higher priority.

But more importantly, the banks are all pretty much the same. Smaller banks were absorbed into the big banks around the GFC, and the lack of competition and underlying profitability of the back book of mortgages makes it difficult to propose a sufficient shock to the system that would see depositors flee any of the major banks.
The big four make similar rates of return, offer investors similar dividend yields on the equity and similar yields on the debt instruments, hold similar levels of provisions and show similar levels of arrears. Naturally if there was something like a 35% fall in house prices and a double digit rise in the unemployment rate then the Australian banks are vulnerable, however, that is far from the base case.

3. The banks co invest in each other

One of the underappreciated aspects of the Australian banks is that they hold large amounts of each other's paper on balance sheet. This creates an additional level of security to the oligopoly. In some ways it is a form of insurance whereby any stresses in the paper of one of the majors is diluted by the ability of the remaining banks to ensure sufficient liquidity and functioning of bank paper.

4. Government backing is clearer in Australia

There is a difference between depositors having a formal government guarantee (that exists in Australia) and industry-provided depositor insurance (that exists in the US). In Australia, depositors are protected by a government guarantee up to $250,000 for each deposit holder at each bank, building society or credit union. There is very little risk to the vast majority of household deposit holders given the mean level of deposits at Australian financial institutions inclusive of offset accounts is $82,000.

5. Australian banks have stable funding sources

Bank funding is overwhelming sourced from deposits. Almost two-thirds of all bank funding needs are currently met from deposits, up from 52% in 2011.

Whilst it is common to think of deposits as merely household deposits, the deposits by corporate Australia, Government, Superannuation funds and other financial institutions holding deposits in banks easily exceed the level of deposits held by households. In other words, to destabilise the deposit base of Australian banks it would take more than fear amongst households.

Moreover, the share of bank funding reliant on offshore issuance has declined in recent years, in part due to the cheap access to the government's term funding facility (TFF). Should stresses in international funding markets again become acute, we have the blueprint of the 2008-15 Australian Government Guarantee Scheme where the Government's AAA rating was lent to the banks to issue bonds. Australia is one of only nine countries to be rated AAA by all three major credit rating agencies, and the scheme proved highly successful in mitigating offshore funding difficulties during 2008 and 2009.

In addition the Australian banks retain easy access to equity markets to maintain equity buffers. Equity remains less than 10% of bank funding requirements, however, in times of crisis the combination of offering discounted equity placements with fully franked dividends tends to find very ready recipients from both retail and institutional investors.

It is worth noting that the big four banks currently offer yields of between 6.1% and 9.0% before franking benefits. Typically, US regional banks offer dividend yields of less than 2%. The combination of large, sticky deposits and ready access to capital markets with attractive yields for Australian banks provides a stark contrast to smaller US banks who are subject to deposit flight and poor access to alternative funding sources.

Although Tier 1 bonds will likely remain under some pressure whilst overseas concerns are highest, we see this as more of an opportunity to selectively buy some securities at opportunistic prices.

While we expect the Australian banks will underperform the broader equity market as credit growth slows, funding costs rise and P/E ratios de-rate on global concerns, we are not fearful of anything that approximates a banking run amongst the major banks.