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Long-time readers of this column have been hearing about the drum beats of war between China and the US for the best part of a decade. Back in May 2020, Coolabah Capital gave a detailed private seminar to hundreds of our wholesale clients assessing these risks and advised that the probability of major power conflict in the Indo-Pacific had lifted to as high as 50 per cent.
While none of our geopolitical advisers had quite such a pessimistic perspective (they tended to be in the still-elevated, circa 25 per cent camp), most are now handicapping war as a toss-of-a-coin prospect. In fact, one of our most accurate foreign policy advisers said Thursday that the conflict probabilities have lifted above 50 per cent. A “tell” in this regard is the combatants probing the contours of the cyber-security battlespace much more aggressively than before.
With facilities like Pine Gap essential to the Western war-fighting machine, Australia is in the cross hairs.
The prospects for war are actually higher in the next five years than the period thereafter because of how successfully China has closed the military capability gap with the US. Every day President Xi Jinping delays, his potential adversaries in a battle over Taiwan (which would undoubtedly include the US, Japan, Australia and the UK) are investing enormous effort to prepare for war and once again expand the capability gap. Sadly, the wider Australian community has yet to come to grips with these morbid contingencies.
Perhaps the first time non-readers of this column would have heard the drum beats of war was when the Home Affairs secretary, Mike Pezzullo, sensibly sounded them during the week. Presumably with the blessing of government, he warned that “as free nations again hear the beating drums and watch worryingly the militarisation of issues that we had, until recent years, thought unlikely to be catalysts for war … let us continue to search unceasingly for the chance for peace while bracing again, yet again, for the curse of war”.
This followed a similar warning from Defence Minister Peter Dutton, who cautioned that the spectre of major powers battling over Taiwan “should not be discounted”.
At around the same time, the federal government has subordinated defence’s glacial procurement processes in favour of urgent capability decisions, including, among others, the ability to manufacture missiles locally and upgrading Australia’s military bases to ensure they are operationally ready for the advent of war.
Expect much more news in this vein as our government radically ramps up its otherwise anaemic defence spending.
Anyone telling you not to worry about the risk of war frankly does not know what they are talking about. The one thing we can do to reduce the chances of conflict erupting is by massively increasing the costs of our largest trading partner crossing the Rubicon.
Experts agree that in any conflict over Taiwan, China will consider targeting strategic military assets located in Australia with its long-range land and submarine-launched ballistic missiles. Facilities like Pine Gap are, for instance, essential to the Western war-fighting machine. The homeland is, therefore, absolutely in the cross hairs.
At dinner last night I asked some friends how well their portfolios and businesses were prepared for the outbreak of war. There were laughs and smiles – they assumed I was joking. They had never seriously considered it.
Along similar lines, in May last year I asked the CEO of one of Australia’s largest resources companies whether his team had evaluated a downside scenario whereby the federal government banned his business from selling critical war-fighting inputs, such as iron ore, natural gas, and coal, to China in the event a conflict erupted. The CEO responded that neither he nor his team had ever contemplated this idea.
We’ve been thinking through and forward-planning for these risks for years and have a clear vision of precisely what we would do. I would encourage everyone to do the same. You cannot simply rely on the assumption that war will not happen: ask yourself the question, what are the personal and financial costs that you will wear if you are wrong?
Bond tsunamiAnother significant event risk that we have been actively positioning for is a tsunami of senior bond issuance from Australia’s banks as they seek to gradually repay the $180 billion they will have eventually borrowed under the Reserve Bank of Australia’s three-year term funding facility (TFF).
In contrast to the consensus, we forecast that this wave of supply would start hitting before June 30 when the TFF expires. In March I asked two major bank treasurers at The Australian Financial Review Banking Summit what their expectations were for senior bank bond issuance, and both guided towards the second half of the year.
The day I posed this question, ANZ broke the drought with a one-year senior deal in Aussie dollars, which was followed by a five-year issue by Macquarie Group in the UK. And this week we had Bank of Queensland launch the first five-year senior bank issue in Aussie dollars in a very long time. (Banks have not needed to borrow from debt markets, given they had so much cheap funding available via the TFF.)
Earlier this year our analysts built detailed financial models that allowed us to forecast the quantum of senior bank bond issuance that will be required as a function of two crucial variables: balance-sheet growth and changes in deposit funding.
The enormous surge in deposits that flooded into the banking system in 2020 reduced the need for banks to issue wholesale bonds. Assuming, however, that this starts to slow down while balance sheets expand more rapidly on the back of the housing boom and a recovery in business lending, it is easy to arrive at the conclusion that the major banks alone will have to issue more than $150 billion of senior debt over the next few years.
This supply shock should result in the cost of five-year debt normalising from its historically low level around 45 basis points, which has not been seen since 2007, back to the 70 basis point area that represented the low-watermark for these spreads in the post-crisis period.
There are complex nuances that influence this analysis. First, the banks will not likely issue much, if any, three-year paper because they need to extend their liabilities beyond the three-year repayment date of the TFF to avoid concentrated refinancing cliffs. This is why we are predicting longer tenor issuance with a focus on five-year deals in Australia and 10-year deals in US dollars and euros.
Second, the banks will have to shift more of their funding offshore given they will be restricted from being the biggest buyers of their own bonds in Aussie dollars as the Australian Prudential Regulation Authority winds-back the committed liquidity facility (CLF).
When Australia had few government bonds on issue, the RBA and APRA created the CLF as a substitute. But with massive coronavirus-induced issuance, now underscored by the federal government’s military procurement needs, there is no real need for the CLF.
This eliminates what has historically been the single-biggest buyer base for senior-ranking Aussie bank bonds: the banks themselves.
A related development over the week was Standard & Poor’s banking analysts making a raft of changes to their credit rating assessments. S&P has upgraded the “negative” economic risk trend for Australia to “stable” (as we had suggested) while also upgrading the banking sector’s industry risk score from “stable” to “positive”, which was a welcome surprise.
S&P advises that there is now a one-in-three possibility that it will lift Australia’s Banking Industry Country Risk Assessment (BICRA) score to put our financial system alongside Canada, Singapore and Switzerland in safety terms. Bizarrely, S&P reckons that a now non-democratic Hong Kong is the safest banking jurisdiction in the world, which is exhibit A in farcical rating agency decisions.
If S&P does belatedly decide to normalise Australia’s BICRA score to being equal with Singapore and Canada, it would trigger a chain reaction in ratings. The major banks’ Tier 2 bonds would jump from BBB+ to A-. Their hybrids would likewise lift a notch from BBB- to BBB. While the major banks’ senior bond ratings would not change, all regional banks would benefit from rating upgrades to their senior, subordinated and hybrid ratings.
A final word on this week’s inflation data. It was obviously very weak, shocking the market, and underscored how much heavy lifting the RBA has to do to get employment and wages growth running at a level that can sustain consumer price inflation within its target band. It was therefore unsurprising to see Toronto-Dominion Bank raise its forecast for the RBA’s third round of quantitative easing from $50 billion to $100 billion, joining Westpac and ourselves, among others.
If any of the above analysis is news, you should consider getting superior advice.
