Earlier this week, Moody’s downgraded the big four Australian banks’ ratings to Aa3 from Aa2 commenting that ‘elevated risks within the household sector heighten the sensitivity of Australian banks' credit profiles to an adverse shock, notwithstanding improvements in their capital and liquidity in recent years. While Moody's does not anticipate a sharp housing downturn as a core scenario, the tail risk represented by increased household sector indebtedness becomes a material consideration in the context of the very high ratings assigned to Australian banks.’
For Moody’s ‘significant house price appreciation’, combined with a very high level of household debt, (188.7% household debt to disposable income at the end of 2016), and low nominal income growth has increased the risks associated with the sector. Moody’s take the view that ‘capital adequacy is likely to strengthen further’ but that ‘the resilience of household balance sheets and, consequently, bank portfolios to a serious economic downturn has not been tested at these levels of private sector indebtedness.’
Interestingly, last month S&P left the four major banks’ ratings unchanged helped by a very high likelihood of sovereign support but adjusted down the ratings of some smaller banks. However, S&P left the majors’ rating outlook as negative: if S&P were to adjust down the sovereign rating or their expectations of sovereign support then the banks’ ratings could be adjusted down to reflect this too. But the rating move by Moody’s is only bringing their bank ratings on the big four in line with the equivalent ratings from S&P or Fitch at AA- so the lower rating should be factored into market pricing to a large extent already. Estimates suggest a 1 notch downgrade for the banks from AA- by S&P could impact the banks’ long term funding costs by ~10 basis points.
Moody’s still rates the sovereign at AAA (stable). S&P also rates Australia AAA but with a negative outlook: they acknowledge the sovereign’s risks from high external indebtedness, its vulnerability to commodity export demands, risks to the fiscal consolidation plan and increased risks from the rapid growth of credit and house prices. A strong fiscal position is important to offset the weak external position and to act as a buffer if the housing market were to enter a sharp downturn, although they note that their base case at this stage is for a softer landing.
Australia is excluded from our investable universe as our estimates show its net foreign liabilities are greater than our cut-off of 50% of GDP, the threshold that IMF research indicates is associated with increasing risk of external crises, making it ‘an avoid’ from an investment point of view. While it is true that the period of re-leveraging and accommodative monetary policy has supported many weaker debtor nations; the move by central banks, particularly the Fed, to start to reduce stimulus and deleveraging means we prefer to be positioned in higher rated creditor nations at this stage of the cycle.