Corporate Strategy Weekly Radar Update

Week ending Friday 23 November 2012 (the inverted Aus Govt Bond yield curve) Highlights and Insights Financial Services The IMF has recommended (1) systemically important institutions carry higher capital and (2) greater Central Bank involvement in conducting stress testing, as part of a review of the stability of Australias financial system. Global bodies including G20 and the Financial Stability Board are also drawing up a framework for Domestic Systemically Important Banks (DSIBs) to apply in 2016. o This follows the list of Global Systemically Important Financial Institutions (GSIFIs) (the famous 'Too Big To Fail) that will need to hold extra capital of between 1% and 2.5% of risk weightedassets. Australias banks had not been included on this 'global' list. o Australias major banks have Tier 1 capital ratios of ~8%, well ahead of the 6% Basel III minimum requirement due from Jan 2013 (which will lift to 8% by 2016). However, both ANZ and Westpac warned against adopting the recommendation, arguing it would compromise their ability to compete with foreign banks, and highlighted liquidity as more crucial to bank stability. The IMF has also urged for tighter rules on shadow banking financial companies offering bank-like services, but who are exempt from the Banking Act and from the same level of regulatory oversight as traditional banks. The IMF also plans to reclassify the AUD as a reserve currency, causing fears it will keep pushing it up (fears played down by the RBA: no material change expected from existing situation). o The potential regulatory crackdown follows the $650M collapse of Banksia Securities, a debenture issuer who also offered at call deposits. The Financial Stability Board found that shadow banking grew by $US41T between 2002 and 2011. o Finance Minister Bill Shorten this week requested help from APRA to help regulate the $4.5B unlisted debenture industry and asked ASIC for a roadmap to resolve regulatory gaps. Banks have reportedly tightened their lending standards over the last 6 months due to concerns about the economic outlook and prospects for the housing market. A USB survey of Australian bank CFOs indicated tougher underwriting criteria are being applied to both home and SME borrowers (particularly in industries such as travel and retail). o The results are, if not surprising, at least counter intuitive given previous comments from APRA that Banks were loosening those lending standards to boost a credit growth that remains at historically low levels (4% over the last year) and a demand that is expected to remain relatively weak (~5% growth). On the Equity front, analyst Merrill Lynch put a SELL recommendation on IAG despite solid earnings momentum, and retained a BUY on SUN. The move was considered a relative call with SUN favoured because of trading at a discount to fair value and the potential for further capital returns. o Merrill Lynch acknowledges IAGs solid earnings momentum given benign catastrophe backdrop (13% upgrade to FY13 forecasts), however consider there is already premium in the share price to reflect this. Shares are priced at the top end of historical relative pricing bands. (57% TSR calendar YTD). o A review by UBS highlighted favourable fundamentals for domestic GI in 1H13 including stronger investments markets and benign weather conditions. Ratings were unchanged. On the CSR front, QBE introduced targets for gender diversity as a key component of performance for its most senior executives. o Several companies, including SUN, have introduced targets on gender diversity at senior levels, however implementation remains challenging: women comprise ~ 15% of boards on the S&P ASX 200 and <10% of senior management in corporate Australia. Other industries Online shopping aggregator website Click Frenzy launched and crashed within minutes due to an unexpectedly high volume of site visitors. The website was part of a 24-hour online super sale (online version of Boxing Day Sales) that aggregated discounted deals from ~200 retailers including Myer, Dick Smith, Dan Murphys and Camera House. o Traffic to the online shopping site was 3x what was expected (~2.5M total site visitors and 1.5M unique visitors) and is proof of the continued growth in online retail sales. The ironic twist is that the website meltdown highlighted a worrying misunderstanding of the demand was a lost opportunity; Oz retailers really have a way to go to get online right. A consortium is rumoured to be agitating for a strategy change at Qantas which would involve the sales of Qantas Frequent Flyer and a partial float of Jetstar to return capital to shareholders and a more aggressive push to Asia. The Group reportedly has the support of 20% of the Qantas register and is thought likely to be considering buying a stake that would allow it to push for an alternative strategy. o Qantas shares have fallen 26% over the past 12 months, compared with a 2% rise in the broader benchmark index. Any material change in strategy or an inconsistent investment where a third party secures a stake of more than 20% has the potential to put the Qantas-Emirates proposed alliance (currently before the ACCC) at risk. o This 'alternative' strategy would also be value destructive for Qantas given the health of FF and Jestar with the group. Macro Economy, Politics and Regulation The ongoing 'war of words' between those predicting Australia's slowdown and their opposites continued with Michael Chaney (NAB, Woodside Petroleum) arguing Australia is likely to fall off a growth cliff largely due to a failure to increase productivity: he claims economic growth is likely to slow to <2.5% after 2015 due to burdens of business, state and federal regulatory overlaps and the IR system. o His comments were echoed by RBA governor Glenn Stevens who warned of the potential vulnerability of the Australian economy as it transitions from the mining investment boom to other forms of growth. He called for policies to fix Australias poor productivity growth to offset lower terms of trade and decline in capital investment when the mining boom ends in the next few years. Movember RBA meeting minutes released, noting weak leading indicators of labour demand (suggesting modest employment growth), more moderate economic growth and continued concerns about high AUD, concerns however offset by tentative signs of a housing recovery (Also see Appendix) o Reaffirming that further easing may be appropriate in the period ahead and added to expectations of a rate cut in Dec. Eurozone: European Finance Ministers could not reach an agreement on details of the release of the next tranche of bailout aid (31b) for Greece. The funds, which are required to keep servicing Greek debt and to avoid bankruptcy, remain frozen until an agreement can be reached. o This follows the EUs decision to soften and push back Greeces debt-reduction target to 133% of GDP by 2 years to 2022, against IMF's target for a reduction to 120% of GDP by 2020, from a projected peak of 190% in 2014: quite contrary to the assumed recent softening of heart against austerity at the IMF. Talks to continue next week to reach an agreement.

Snapshots of the week: "Just Yield it"... what's behind the inverted Australian Government Bond yield curve? What is a 'normal' Yield Curve for Government Bonds - (the 'benchmark' for risk-free bonds)? The peculiar shape of Australias yield Typically, short-term interest rates are lower than longcurve, dubbed the Nike swoosh by term rates, so the yield curve slopes upwards, reflecting A textbook normal yield curve traders after the shoe logo higher yields for longer-term investments. This is referred to as a normal yield curve. A positive sloping curve suggests that as economic growth takes hold, interest rates will rise to curb inflation. When the spread between short-term and long-term Maturity interest rates narrows, the yield curve begins to flatten. A A textbook inverted yield curve flat yield curve is often seen during the transition from a normal yield curve to an inverted one. Historically, an inverted yield curve has been viewed as an indicator of a pending economic recession. When shortMaturity term interest rates exceed long-term rates, market sentiment suggests that the long-term outlook is poor and that the yields offered by long-term fixed income will continue to fall. Why is it seen as a problem? One of the persisting 'market laws' (empirical belief as opposed to 'mathematically' proven) is that an inverted yield curve is a precursor to a recession. It happened in the US pre-Great Recession, and economist Arturo Estrella, writing for the Federal Reserve Bank of New York in 1996, credited the curve with effectively predicting every recession since 1950, with the exception of "one false signal" in 1967. So some commentators are saying the fact that we have an inverted yield curve now in Australia (the Nike Swoosh) signals a dire economic future for the country: o "As long-term bond rates remain below the cash rate set by the RBA partly because of strong foreign demand for local bonds the swoosh of the curve predicts that the economy will get worse before it gets better." (AFR 22 nov 2012) An explanation is that traders are convinced that the economy is weakening and that more rate cuts are coming so they take longer interest rate instruments below the cash rate. It is due to the cost of carry*: the treasury desk of a bank will usually be charging the traders the cash rate as its cost of funds, but for the trader to buy a bond at a yield 2.6% (65bps below the cash rate of 3.25%) s/he has to believe that economic weakening will be sufficiently fast and deep that the capital return on the bond will outweigh the loss on the yield! So for this reason, a negative slope is thought to be suggesting that the RBA is going to have to cut rates substantially and that the chances of a recession are high in the next year or so. * Costs incurred as a result of an investment position: they can include financial costs, such as interest costs on bonds, interest expenses on margin accounts and interest on loans used to purchase a security, and economic costs, such as the opportunity costs associated with taking a position However this viewpoint has recently been called into question... Indeed, in a world of riskier sovereign debt (countries are being downgraded one after the other), Australia stands out as quality. Add the scarcity of Australian bonds relative to demand from offshore, and there could be a disconnect between what the curve is saying about the future path of our economy and the actual really economy. The fact is that foreign investors are purchasing securities backed by Australian Govt debt. When this occurs, many argue that it is the laws of supply and demand, rather than impending economic doom and gloom, which enable lenders to attract buyers without having to pay higher interest rates. The Australian sovereign bond curve is being pushed artificially lower by those supply/demand dynamics not entirely unrelated to our economic performance but probably more related to its relative strength than its weakness, this school of thoughts argues. Consequences and actions: To restore the curve to a more positive shape which would signal to investors the economy will improve the RBA could further cut interest rates. Particularly if it weakens demand for the Australian dollar. However, such action runs the risk of creating overly cheap debt, re-igniting speculative bubbles and reducing the income of savers. This is one of the key reasons the RBA has been reluctant to slash rates. The RBA cut 150 basis points [this year] and normally you think the yield curve would steepen up. declared UBS strategist Matthew Johnson. He says the curve hasnt done so because foreign buying of Australian bonds continues to suppress long-term rates: The more demand there is for duration [longer- term bonds], the flatter the curve should be. The other reasoning is that perhaps the RBA isnt really being stimulatory [enough], so therefore the curve isnt steep." Impact on Consumers: In addition to its impact on investors, an inverted yield curve also has an impact on consumers. For example, homebuyers financing their properties with variable-rate mortgages have interest-rate schedules that are periodically updated based on short-term interest rates. When short-term rates are higher than long-term rates, payments on variable-rate mortgages tend to rise. When this occurs, fixed-rate loans may be more attractive than variable-rate loans. Consumers' lines of credit are affected in a similar manner. In both cases, consumers must dedicate a larger portion of their incomes toward servicing existing debt. This reduces expendable income and has a negative effect on the economy as a whole. Impact on Fixed-Income Investors: A yield curve inversion also has a non negligible impact on fixed-income investors. In normal circumstances, long-term investments have higher yields; because investors are risking their money for longer periods of time, they are rewarded with higher payouts. An inverted curve eliminates the risk premium for long-term investments, allowing to get better returns with short-term investments. Impact on Equity Investors: When the yield curve becomes inverted, it can have a negative impact on profit margins for companies that borrow cash at short-term rates and lend at long-term rates, such as banks. Likewise, hedge funds can be forced to take on increased risk in order to achieve their desired level of returns. For instance, anecdotally, it is a bad bet on Russian interest rates is largely credited for the famous demise of hedge fund Long-Term Capital Management in 1998. The Bottom Line So those who argue the 'supply and demand' viewpoint have a more positive outlook: for them instead of a recession call, the curve indicates that the RBA might cut again probably 80 basis points over the next 12 months because the low point is only one year out before rates start to rise again. This suggests that the market still believes monetary policy is and will be effective in Australia. And to finish on very light hearted note, while doing this research I also found that for some commentators this is not a Nike Swoosh at all, but... a banana - and they mean it! (screen capture). After Westpac's infamous banana smoothie from 2009, who would have thought this fruit had such prominent place in the world of Australian finance...

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