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Italian bond market in ruins as "hurricanes" bear down on the US

Peter Warnes  |  01 Jun 2018Text size  Decrease  Increase  |  
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Never underestimate what the Greeks and Italians can do to world financial markets. Last week Italy had 53 UNESCO world heritage sites, more than any other country. Another one was added this week – the Italian bond market ruins! The incredible jump in Italian sovereign yields is a stark reminder of the carnage illiquidity can create. What level of complacency, no stupidity, is on display when investors price an Italian sovereign bond, of any maturity, at a negative yield?

There have been positive aspects of the synchronisation of global economic growth over the past couple of years and equities markets have responded accordingly. Improving growth, accommodative monetary policy and benign inflation have underpinned investor sentiment. But in more recent times some bearish signs have emerged for global financial markets to digest.

Tax reform in the US has provided a sugar hit to corporate earnings and has increased household disposable income. But there are increasing concerns around the sharply growing US deficit required to fund the Trump administration’s fiscal stimulus plans and the implications of the meaningful increase in bond supply. The bond market remains on edge, evidenced by the continued rise in short-term rates.

Rarely have I seen so many experienced commentators predicting very troubled times ahead for the US bond market. Franklin Templeton’s Michael Hasenstab warns of “hurricanes”. The well-respected John Mauldin previews a “train crash”.

In Australia, Treasury secretary John Fraser joined Reserve Bank governor Philip Lowe and ratings agency Moody’s in warning of the possible negative implications the royal commission could have on Australia’s economic growth. Lending practices and the availability of credit are likely to be affected by the findings of the Hayne royal commission, at least in the near term. In the worst-case scenario, a credit squeeze could result as banks stiffen credit policies making it more difficult for home buyers and businesses to borrow.

Tails winds provided by east coast residential construction over the past few years are abating. April building approvals fell 5% from March and are up 1.9% year-on-year. Private sector houses edged up 0.1% while volatile apartments fell 11.5%. The value of total building approvals fell 4.2%, with residential down 4.3% and non-residential 4% lower. Offsetting slowing residential activity, infrastructure remains robust and while non-residential construction is peaking, it remains at an elevated level.

Australia’s iron ore export volumes are peaking as Chinese demand has been satisfied by meaningful expansions over the past few years. These expansions have resulted in Australia’s share of Chinese iron ore imports surging from 43% in 2010 to 62%. Increased supply from Brazil is likely to put some pressure on export growth. A slowing in the rate of growth in Chinese fixed asset investment will tend to cap steel output and have some impact on iron ore demand. In recent months iron ore prices have drifted from US$75 to just below US$65 per tonne. Offsetting iron ore’s contribution to net exports is the strong growth in LNG exports.

Generally, Reserve Bank speak is non-alarmist and very considered. But governor Lowe’s recent speech to the Australia-China Relations Institute on Australia’s deepening economic relationship with China: Opportunities and Risks produced a headline “Alarm over China debt bomb” the following day. Clearly China’s debt levels are of growing concern and a good reason China will not be so supportive of future US bond sales, as it was 10 years ago post-GFC. Lowe believes among the largest economic risks Australia faces is something going amiss in China, where perhaps the biggest danger to the Chinese economy lies in the financial sector and the big run-up in debt over the past decade. He is not a lone voice crying in the wilderness.

Incredibly, the International Monetary Fund (IMF) believes a sharp contraction in the Chinese economy would only have a modest impact on Australia unless it turned into widespread financial crisis. Its modelling suggested our other trading partners in Asia and the US would fill most of void left by a collapse in exports, assisted by a lower A$. China is Australia’s largest trading partner accounting for about 33% of our exports, more than the combined exports to Japan, the European Union and South Korea and 20% of our imports, just shy of the European Union. China imports 62% of our iron ore exports alone. I can’t see any going to the US. I don’t share the IMF’s confidence.

Research of the Week

This week on page 3 of the newsletter, Johannes Faul takes an early peek into the Coles demerger and the likely fair value estimate of the standalone supermarket operator. The separation will allow a slimmed down Wesfarmers (ASX: WES) greater optionality, but Bunnings will be the workhorse and allow investors to get greater exposure to one of Australia’s premier retail franchises.

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Peter Warnes is Morningstar's head of equities research. Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar.

 


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© 2018 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written content of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.

is Morningstar's head of equities research.

Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar.

© 2020 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782. The article is current as at date of publication.

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