Banks, debt, stress and anxiety
We’ve recently seen an unwind of much of the market anxiety that had arisen through the prior quarter as European sovereign debt concerns peaked and then abated. Enthusiasm for this unwind was prompted by the release of the bank stress test results undertaken by the Committee of European Bank Supervisors, a hitherto innocuous agency of 25 people based in London, which found that only 7 of 91 banks in 20 European countries needed to raise capital, and even then only 3.5 billion Euros was required. For context, this is approximately double the capital of Bendigo Bank, which is why we were not surprised that the results were met with widespread cynicism.
Our cynicism stems from the episode in the US a little more than 12 months earlier, when our UK based credit team described the US stress tests as “distinctly unstressful”. In fact, what has struck us recently is that the pattern of economic and political response (including language) to the sovereign debt crisis, and ensuing market performance, bore remarkable resemblance to that witnessed through the GFC almost 18 months earlier.
That pattern sees an underlying shared problem, being too much debt, prompting the subsequent pattern of reaction. The first step in the reaction is investor panic, with material fall in asset prices. This is soon followed by a spike in the Gold price, as a “diversifier of risk” into “hard assets”. The third step is the Government (US Government or European Union) announce the instigation of “quantitative easing” and a “stress test” process, the findings of which are then criticised as being benign. Nonetheless, in each case gold has eased; and immediately assets which had been hit the hardest through the prior sequence of steps one through four recover most aggressively. Indeed, Greece was the best performing global equity market through July!
What did this mean for the Australian equity market? It meant that, firstly, gold stocks underperformed through July after having had a stellar prior quarter. It also meant that Westpac was the best performing bank in July after having been hit hardest through the prior quarter on concerns that global liquidity rules for banks would tighten as part of the Basel 3 reforms, and that these changes would come into effect as soon as 2013. In the spirit of regulators shying from the opportunity for structural reform, that date has now been deferred to 2018. Finally, it meant that stocks hit hardest by bad news through the prior quarter, such as Downer EDI, rallied hardest as the market turned.
Perhaps more importantly, what does it mean for our assessment of risks attaching to investing in the Australian equity market? In the US, unsustainably high levels of debt started in the financial system, but has been progressively socialised. In any event, debt to GDP remains at stubborn and high levels. Across Europe, the public sector started with a higher relative debt load, and hence public austerity programs have been announced alongside bank stress tests as part of the remedy. These programs have featured pay cuts and aggressive reductions in headcount for the public sector, across all of Greece, Spain and the UK. Obviously Tony and Julia missed that edition of “Responsible Government Monthly” as they campaign for the affections of an Australian public which, in the main, has remained insulated from the travails that have beset our northern hemisphere cousins. As we have highlighted several times before we are cognisant of Australia’s total debt to GDP being at higher levels than that of the US, and take little solace in that debt having been (ultimately) largely applied to increasing house prices, even though the current popular wisdom is that the risk of loss for a lender to this asset class is as low as any major asset class in the world. That has indeed been the historical experience, which only heightens our wariness of the most likely path in the future. Nonetheless, right now a fall, or even stagnation, of Australian housing prices and the subsequent impacts upon lenders and retailers and other consumer discretionary purveyors in Australia is not commonly perceived as a risk to our equity market, to the extent that we feel it should be. It may not be a base case, but neither is it a risk that should be ignored. The steps for rectification of a financial crisis that we detail above don’t comfort us in an Australian context, given our starting debt to GDP level. The case that our government is issuing our banking system an implicit guarantee is a hard one to refute. Finally, the shilly-shallying around, preventing meaningful structural change in either the US or Europe as a result of these episodes through the past 18 months only increases our caution.
Whilst the matching of the playbook of the past several months to the period around the GFC has helped us make some sense of the market in recent months, our longer term observations that making sense of the current global picture is, to say the least, challenging, remains. The major themes affecting the Australian markets of too much debt, albeit concentrated in the financial and household sectors, aging demographics, and commodity prices continuing to trade at levels well above what we consider long term sustainable prices, all remain on foot.
As we have seen through the past 18 months markets are thirsty for what they perceive to be good news, and will rally when it is received. Equally, it would be imprudent for us to ignore what we see as the ongoing risks detailed above, which only become amplified the longer they remain unaddressed. It is this balancing act that will continue to dictate our assessment of not just future likely returns, but also risks, in our portfolios.
Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this article. They do not necessarily reflect the opinions of Schroder Investment Management Australia Limited, ABN 22 000 443 274, AFS Licence 226473 ("Schroders") or any member of the Schroders Group and are subject to change without notice. In preparing this document, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was otherwise reviewed by us. Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this article. Except insofar as liability under any statute cannot be excluded, Schroders and its directors, employees, consultants or any company in the Schroders Group do not accept any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this article or for any resulting loss or damage (whether direct, indirect, consequential or otherwise) suffered by the recipient of this article or any other person. This document does not contain, and should not be relied on as containing any investment, accounting, legal or tax advice. Schroders may record and monitor telephone calls for security, training and compliance purposes.