Global Rating Outlooks Most Positive Since Crisis, But…

The prospect of rating upgrades outnumbering downgrades this year and next is higher than at any time since the financial crisis, Fitch Ratings says in its latest global Credit Outlook report. But credit quality may start to weaken beyond this as ultra-supportive monetary policy is phased out and rising interest rates start to affect funding costs and asset quality.

“The rating outlook trend is the most upbeat in a decade, with positive outlooks outnumbering negatives. But the net bias is only just over 1% and occurs as the world is about to hit peak growth in the current cycle. The continued tightening of monetary policy, together with significant policy and political uncertainty, is likely to pose increasing challenges to ratings,” said Monica Insoll, Managing Director, in Fitch’s Credit Market Research team.

Global rating outlooks continue to improve. The average net outlook balance across all sectors globally turned positive for the first time since the financial crisis, at 1.1% as at 30 November 2017, up from -7.9% at the start of the year.

The trend is evident across sovereigns, corporates and financial institutions, with prospects brightening for developed and emerging markets alike. The outlook for structured finance has the most pronounced positive bias, at net 9%. Other sectors are largely experiencing rating stability, although there are pockets of rating pressure in some regions and certain subsectors.

The key drivers of the expected widespread improvement in credit quality are economic growth, still largely supportive monetary and fiscal policies, and more stable commodity prices. Fitch expects global growth to edge up to 3.3% in 2018, boosted by increased investment. However, beyond 2018 growth is likely to moderate, while monetary policy conditions will tighten.

The two main macro risks to ratings are the unwinding of quantitative easing and policy and political uncertainty, including from a heavy election cycle in emerging markets this year.

The QE unwind is likely to put pressure on sovereigns as government debt is high in many countries. Banks could be exposed to asset-quality problems following the long period of cheap credit, with high property prices in some countries at risk of deflating as the interest rate cycle turns. In the eurozone, banks will also need to rely more on market funding rather than the ECB.

In the corporate sector, emerging-markets issuer could be challenged by the reversal of capital flows but those in developed markets are likely to cope quite well. However, certain sub-sectors face rating pressure for idiosyncratic reasons, including traditional retail in the US and Europe, and utilities in the UK.

Geographic areas with negative rating outlook bias include the Middle East, Africa, China and Latin America, where several countries will hold elections this year and outcomes are uncertain.

The more positive outlook for rating activity in the short term should be seen against the backdrop of downward rating migration in several sectors in recent years. This trend has been most pronounced for sovereigns and financial institutions, with the share of ‘AAA’ to ‘A’ ratings in the latter hitting a low of 37% on 30 November 2017, having fallen steadily from 54% at end-2007.

Our six-monthly credit outlook report provides an overview of Fitch’s outlooks across all rated sectors and regions, identifying the main macro factors that will drive credit trends over the next 12-24 months. It focuses on outlook outliers – negative and positive – as the vast majority of ratings are typically stable. The data in today’s report is as of 30 November 2017.

Australia’s Budget Update Reinforces Improving Outlook

From Fitch Ratings.

Australia’s Mid-Year Economic and Fiscal Outlook (MYEFO) released on 18 December highlights a modest improvement in the fiscal outlook, largely reflecting a boost in tax collections, including from higher corporate profits in the mining sector. Fitch Ratings expects the gross public debt ratio to peak in 2018 and the fiscal balance to be brought into a surplus by 2021, which is consistent with our ‘AAA’/Stable sovereign rating on Australia. Nevertheless, the rise in public debt over the last decade has eroded the sovereign’s buffer against economic shocks.

The government’s MYEFO forecasts an underlying cash deficit of 1.3% of GDP in the fiscal year ending June 2018 (FY18), slightly smaller than the 1.6% projected in the May 2017 budget. Moreover, the cumulative deficit through FY22 is now forecast to be AUD9.3 billion lower than in May, with AUD5.8 billion of that improvement expected to come in FY18.

Fitch still expects the deficit to shrink at a slower pace than forecast in the MYEFO, largely owing to our less upbeat forecasts for real GDP growth and commodity prices. The economy should be supported by buoyant employment growth, the fading drag from mining investment and improved non-mining investment prospects. However, weak wage growth will weigh on household consumption, while slowing growth in China is likely to constrain commodity price rises and Australia’s export growth.

The government has revised down its growth forecast for FY18 to 2.50%, from 2.75%, but still expects a rebound to 3.00% in FY19 and for growth to remain at that rate until FY22. That compares with our growth expectations of 2.4% in 2017 and 2.7%-2.8% in the following years.

Australia’s economy and fiscal performance are vulnerable to negative global economic developments, particularly a sharper-than-Fitch-expects slowdown in China or drop in commodity prices. Risks might also stem from a faster-than-expected rise in US interest rates, which could lift borrowing costs and pressure domestic liquidity conditions, given the banking system’s reliance on international wholesale funding. High household debt levels could make the economy especially sensitive to rising rates.

The sovereign’s buffer against economic shocks has diminished over the last decade, as debt ratios have increased. General government gross debt was less than 10% of GDP in 2007, but it is likely to peak next year at close to the median public debt-to-GDP ratio for ‘AAA’ sovereigns of 42%. That said, the flexible exchange rate and credible monetary policy framework should help cushion the economy against external volatility.

Misconduct Inquiry Adds to Challenges at Australian Banks

From Fitch Ratings.

The Royal Commission into alleged misconduct in Australia’s financial sector announced on 30 November 2017 adds to the challenges for the system, says Fitch Ratings. It could potentially weaken the reputation of the system or individual entities, and exert further pressure on profitability, even if it does not identify broad or significant failings.

We continue to believe the system is well regulated and that the major banks are among the strongest that we rate globally. However, momentum for an inquiry has increased following a number of conduct issues across wealth management, life insurance and banking that have been identified in recent years. These incidents appear to be isolated, and we have not changed our view that the risk-management frameworks and policies of Australian banks are fundamentally sound. Any commission findings to the contrary are likely to result in Fitch reviewing ratings of affected banks.

Public perception of Australian banking has been weakened by the debate leading up to this inquiry, and may be further undermined by the Royal Commission, regardless of whether it exposes significant shortcomings. The reputation of the system is particularly important as the Australian banking sector is heavily reliant on foreign investors for funding. Any loss of trust may lead to higher wholesale funding costs, which in turn could intensify competition for deposits and push up funding costs for the entire system.

Profitability would be pressured by a rise in funding costs, while interest rates and fees on banks’ products would also be most likely to come under additional scrutiny. We already expect profitability to be squeezed in 2018, with margins likely to narrow as a result of low local interest rates, competition for assets and deposits, and upward pressure on funding costs from rising global interest rates. Slower asset growth and a rise in loan-impairment charges could also drag on profits.

Banks may seek to offset any sustained impact on profit by taking on additional risk, although we would expect the regulator to ensure this is adequately managed, meaning any increase in risk appetite should be limited.

The major banks have a strong competitive advantage in the Australian market, and there is a danger that the commission ultimately leads to some erosion of this position at smaller Australian banks and other competitors, such that the banks’ ability to set prices is weakened. The commission may also move the focus of bank management away from the day-to-day running of the bank, which could give an advantage to competitors.

The inquiry is to submit its final report within 12 months of its establishment, with an interim report to be provided by September 2018.

Chinese Homebuilder Outlook Stable, but Market to Cool

China’s housing market is likely to continue to cool in 2018, with sales growth set to slow across most of the country and house prices likely to stay relatively flat, says Fitch Ratings.

However, the authorities have considerable policy flexibility to support housing demand, which limits the risk of a market downturn. We therefore maintain a stable sector outlook for Chinese homebuilders.

The Chinese government has imposed tougher rules on home purchases and minimum loan deposits in higher-tier cities since October 2016 to dampen speculation. We do not expect further tightening in 2018, except perhaps in some lower-tier cities in strong economic regions that could see price increases. Most of the existing restrictions are likely to remain in place, but policies could be adjusted to encourage homeownership for first-time homebuyers or to attract skilled labour migration in some cities where house prices have stabilised.

The curbs have had a clear impact on the market, reining in house price inflation, tempering home sales growth and encouraging destocking. We expect them to limit any gains in house prices in 2018. Contracted sales growth is likely to slow for most homebuilders, and we forecast that overall housing sales will decelerate to 5%, from 10.9% yoy on a trailing 12-months contracted sales at end-October 2017. The destocking cycle could, however, begin to reverse, as some companies now only have land bank reserves for two to three years of development.

A major house price correction is unlikely, given that the authorities directly control many aspects of the housing and mortgage markets. Moreover, the restrictions in higher-tier cities, which have seen the strongest price gains in recent years, have led to considerable pent-up demand that could be released if policy is relaxed.

Homebuilders’ EBITDA margins could begin to narrow in 2018 and 2019 as homebuilders start to work through their higher-cost inventory in a market where prices are under pressure from government controls. Leverage is likely to remain relatively stable over the next two years, with net debt/adjusted inventory averaging 40%-43% among Fitch-rated homebuilders. Cash flow generation is also likely to remain strong.

We maintain a stable sector outlook on commercial property. Mall traffic in higher-tier cities is suffering from strong saturation and competition from e-commerce, with only mature malls in prime locations performing well. We believe these first-tier city malls will achieve low single-digit yoy rental growth in 2018, similar to 2017. However, malls of established operators in less-saturated lower-tier cities are seeing strong traffic growth.

Grade A office space in most first-tier cities is likely to remain broadly stable, and we expect the vacancy rate to stay below 15%. However, office assets in Guangzhou and Shenzen, as well as in lower-tier cities, have higher vacancy rates and could be affected by an increase in supply in 2018.

Australian 3Q17 Mortgage Arrears See Seasonal Falls

Australia’s RBMS mortgage arrears fell to 1.02% in 3Q17, a 15bp decrease from the previous quarter; consistent with the nine-year long seasonal trend where 30+ days arrears have eased in the third quarter. Fitch Ratings believes the curing of third-quarter arrears was helped by borrowers using tax return receipts to make repayments.

The 30+ days arrears were 4bp lower than in 3Q16, reflecting Australia’s improved economic environment and lower standard variable interest rates for owner-occupied lending. Unemployment improved by 10bp and real wage growth, although low, was positive. Underemployment has continued to improve, reflecting an increase in available work for underemployed workers.

Prepayment rates remained low during 2017, with the conditional prepayment rate (CPR) staying below 20% for three consecutive quarters; the longest period this rate has remained below 20% since 2011. The CPR increased slightly qoq to 19.6%, from 19.1%, while the Dinkum RMBS Index borrower payment rate increased to 21.6% qoq, from 21.2%.

The gap between investor lending and owner-occupied rates has widened, as authorised deposit-taking institutions respond to regulatory investment and interest-only limits on new loan origination. Historically, investors paid a 25bp-30bp premium over owner-occupied loans, but this widened to 60bp in September 2017.

Losses experienced after the sale of collateral property remained extremely low, with lenders’ mortgage insurance payments and excess spread sufficient to cover principal shortfalls in all transactions during the quarter.

Fitch’s Dinkum RMBS Index tracks arrears and the performance of mortgages underlying Australian residential mortgage-backed securities.

Australia’s Major Banks Face Earnings Pressure in FY18

Fitch Ratings expects Australia’s four major banks to face earnings pressure from higher impairment charges and lower revenue growth in their 2018 financial year, with cost control to remain an important focus. This follows the banks’ solid results for the 2017 financial year, supported by robust net interest margins and strong asset quality.

Australia and New Zealand Banking Group Limited (AA-/Stable), Commonwealth Bank of Australia (AA-/Stable), National Australia Bank Limited (AA-/Stable) and Westpac Banking Corporation (AA-/Stable) reported total statutory net profit after tax of AUD29.6 billion in FYE17 (up 30.3% compared with FYE16, which included National Australia Bank’s one-off losses on the sale and demerger of subsidiaries, or 6.4% higher based on cash net profit after tax).

Net interest margins held up well during the year despite strong competition for both retail deposits and loans. The major banks benefitted from asset repricing in the second half of the year largely in response to the Australian Prudential Regulation Authority’s (APRA) announced additional macro-prudential limits on mortgages in March 2017 (for more details, see Fitch: Further Regulatory Tightening Possible in Australia, dated 31 March 2017). Volume growth held up reasonably well during the year, which supported revenue growth, although this is likely to slow through the next financial year.

All four major banks reported lower impairment charges and a reduction in impaired assets (apart from a small uptick for Commonwealth Bank of Australia) relative to recent years, which also supported operating profits. Fitch expects the current impairment levels to be close to the peak of the asset quality cycle, with impairments likely to increase in FY18. Mortgage arrears have increased modestly from low bases in most markets – Western Australia has had more noticeable deterioration – and we expect this trend to continue in FY18 due in part to continued low wage growth and an increase in interest rates for some types of mortgages. However, interest rates in general are likely to remain low and we do not think unemployment will increase so any increase in mortgage arrears is likely to be modest and manageable.

The banks highlighted an ongoing focus on cost management, efficiency improvements, and investment, including in their IT systems and digital distribution, and regulatory changes in their FY17 results announcements. National Australia Bank especially flagged a significant increase in digital investment of AUD1.5 billion over three years to enhance its technology and customer experience. Rising investments and a focus on cost reduction to improve profitability will be a challenge for the major banks in the coming years. The banks are likely to face pressure on their profitability in the short term, although in the longer term these measures should improve efficiency. Conduct related charges may also have a negative impact on future costs.

Common equity Tier 1 (CET1) ratios are broadly at the regulator’s definition of “unquestionably strong” levels well ahead of the 2020 deadline. The CET1 ratios of National Australia Bank and Commonwealth Bank of Australia lag the other two major banks, but Fitch expects both to get to the minimum levels through internal capital generation, and, in the case of Commonwealth Bank of Australia, the sale of its life insurance business. Fitch is awaiting further clarification from APRA on how the “unquestionably strong” capital levels will be implemented, with the regulator likely to provide details by the end of this calendar year.

US Tax Plan Will Be Revenue Negative, Result in Higher Deficits

United States: Outlook for Public Finances Worsens says Fitch Ratings who expects a version of the tax cuts presented in the Tax Cuts and Jobs Act to pass the US Congress.

Such reform would deliver a modest and temporary spur to growth, already reflected in growth forecasts of 2.5% for 2018. However, it will lead to wider fiscal deficits and add significantly to US government debt. As such, Fitch has revised up its medium-term debt forecast.

US federal debt was 77% of GDP for this fiscal year. Fitch believes the tax package will be revenue negative, even under generous assumptions about its growth impact. Under a realistic scenario of tax cuts and macro conditions, the federal deficit will reach 4% of GDP by next year, and the US debt/GDP ratio would rise to 120% of GDP by 2027.

The Republican tax plan delivers a tax cut on corporations, seeking to lower the corporate tax rate to 20% from 35%, and removing many exemptions, while eliminating some tax breaks affecting corporate and personal filers. It would leave the overall personal tax burden somewhat lower, although the effects would differ depending on circumstances.

Tax cuts may lead to a short-lived boost to output, but Fitch believes that they will not pay for themselves or lead to a permanently higher growth rate. The cost of capital is already low and corporate profits are elevated. In addition, the effective tax rate paid by large corporations is well below the existing statutory rate. From a macroeconomic perspective, adding to demand at this point in the economic cycle could add to inflationary pressures and lead to additional monetary policy tightening.

Fitch expects US economic growth to peak at 2.5% in 2018 before falling back to 2.2% in 2019. The US will enter the next downturn with a general government “structural deficit” (subtracting the impact of the economic cycle) larger than any other ‘AAA’ sovereign, leaving the US more exposed to a downturn than other similarly rated sovereigns.

The US is the most indebted ‘AAA’ country and it is running the loosest fiscal stance. Long-term debt dynamics are also more negative than those of peers, with health and social security spending commitments set to rise over the next decade. In Fitch’s view, these weaknesses are outweighed by financing flexibility and the US dollar’s reserve currency status, underpinning its ‘AAA’/Stable rating. The main short-term risk to the rating would be a failure to raise the debt ceiling by 1Q18, when the Treasury’s scope for extraordinary measures is expected to be exhausted. The debt ceiling is currently suspended until early December.

China, QE and Housing Key Australian Investor Concerns

A China downturn has moved back into the top spot of Australian credit markets risks over the next 12 months, according to Fitch Ratings‘ 4Q17 fixed-income investor survey, with 42% of respondents ranking a hard landing as a high risk, up from 25% in 2Q17. China replaces a domestic housing market downturn as the top risk, which has dropped to third, while the prospect of quantitative easing (QE) withdrawal has moved into second place.

More investors (43%) expect fundamental credit conditions to deteriorate for financials, rather than improve (16%). Property market exposure is still considered the main threat to bank asset quality, although risks were broadly considered to be rising. Most investors also expect bank lending conditions to tighten over the next year.

However, investors are decidedly more upbeat about the economic outlook. More than 80% believe unemployment will not rise above 6% over the next two years and 37% expect house prices to rise over the next three years, up from 23% in our 2Q17 survey. Consistent with this improving outlook, not one investor anticipates interest rates being cut over the next 12 months.

Our 4Q17 survey shows a continued rise in investors expecting cash to be used for capex by Australian corporates; 67% see this as a significant or moderate use of cash, up from 45% in 2Q17 and 33% in 4Q16. However, shareholder oriented activities remain as the most likely use of cash, consistent with the finding of all eight surveys undertaken over the previous four years.

Australian fixed-income investors believe debt issuance is likely to increase over the next 12 months, and structured finance remains the favoured asset class, with 67% expecting issuance to increase, up from 58% in our 2Q17 survey.

A new question introduced in our 4Q17 survey asked investors about the effect of environmental, social and governance risks on their investments. A 60% majority expect an increased financial impact.

The 4Q17 survey was undertaken in partnership with KangaNews – a specialist publishing house that provides commentary on fixed-income markets in Australia and New Zealand. Findings represent the views of managers of more than AUD500 billion of fixed-income assets, accounting for over three-quarters of Australia’s domestic real-money market.

Fitch’s 4Q17 fixed-income investor survey was conducted between 28 August and 11 September 2017. This survey is unique in the Australian context, reflecting the partners’ strong ties with the local investor community.

Australian 2Q17 Mortgage Arrears Remain Stable

Australia’s mortgage arrears remained stable in 2Q17, with a 4bp decrease to 1.17% from the previous quarter, reflecting Fitch Ratings‘ expected seasonal recovery from Christmas and holiday spending.

The 30+ days arrears were 3bp higher from 2Q16, despite Australia’s improved economic environment and lower standard variable interest rates for owner occupied lending.

Unemployment improved by 20bp and real wage growth was low, but positive. Underemployment also improved by 20bp, reflecting a proportional increase of full-time employment during the quarter.

Repayment rates have decreased as borrowers recover from Christmas and holiday spending. The Dinkum RMBS Index borrower payment rate fell to 21.2% at end-2Q17, from 21.9% in the previous quarter. The conditional prepayment rate also dropped qoq to 19.1%, from 19.8%.

Losses experienced after the sale of collateral property remained extremely low, with lenders’ mortgage insurance payments and/or excess spread sufficient to cover principal shortfalls in all transactions during the quarter.

Fitch’s Dinkum RMBS Index tracks arrears and performance of mortgages underlying Australian residential mortgage-backed securities.

U.S. Home Prices Climb to Pre-Crisis Levels

Home prices in the United States have now climbed to levels last seen a decade ago, though unlike 10 years prior, much of the country’s growth is now sustainable, according to Fitch Ratings in its latest quarterly U.S. RMBS sustainable home price report.

Home prices grew at nearly a 5% annualized rate last quarter and are 36% higher nationally since reaching their low in 2012. As a result they are now slightly above peak levels reached in 2006 – 2007. The difference this time around compared to a decade ago rests with several other notable factors aside from the much talked about low mortgage rates and falling unemployment.

“The U.S. population has increased by more than 30 million people and personal income per capita has increased by more than 30% since 2006,” said Managing Director Grant Bailey. “Both the significantly higher population and income levels provide much greater support for the price levels today.”

That said, growth remains somewhat disjointed in some regions of the US. “Prices in major metro areas of Texas are now more than 50% higher than they were in 2006, while prices in New York, Philadelphia and Washington DC are still 4% – 10% below 2006 levels,” said Bailey. “Elsewhere, home prices in major cities throughout Florida remain more than 15% below 2006 levels.”

The overheated home price pockets remain largely in the Western United States (Texas, Portland, Phoenix and Las Vegas), which Fitch lists at more than 10% overvalued.