insto - Australian financial markets

At the halfway point of 2009, Citi's chief economist, Josh Williamson, gazes into his crystal ball to give Bernard Kellerman a few predictions for the rest of the year.

The timing of the RBA's next increase has been a topic of some speculation, now that it looks like we’re entering a more “normal” cycle. What is your outlook for the rest of the year?

What we’re seeing is a massive and wide-ranging policy stimulus, which is much more decisive than what we saw in the early stages of the Great Depression. That’s actually underpinning recovery, and there are early signs that the worst, economically speaking, is behind most economies.

Globally we’ve actually edged up our economic forecast in many countries in recent months and actually expect a return to positive growth for the US, one quarter earlier than we had expected - that’s the September quarter rather than the December quarter.

We’ve also brought the timing of our forecast positive growth in the Euro area forward to the December quarter and expect positive growth in Japan for the remainder of 2009.

In terms of what’s more important from a strategy perspective, in terms of trading partners, is our Chinese economists have raised their forecast for Chinese progress for 2009-10, we’re looking at a growth of between 8 and 8.5 per cent in both years and that’s certainly above what we had before so that’s significantly positive for commodity demands in Australia and overall Australia’s economic prospects.

So, which way will the inflation line move, and how steeply?

In terms of Australia, we changed our view on interest rates, and that followed moderate upgrades to our economic forecast for Australia. The positives for the policy stimulus is underpinning of business and consumer confidence has improved, certainly business confidence has improved to neutral levels, consumer confidence is back in positive territory and we’re seeing a recovery in housing so, looking ahead we think that the outlook for commodities and infrastructure is also improving now.

The last published RBA forecast for the economy was GDP to contract by 1 per cent to the end of December '09. It now seems like GDP is going to grow slightly through this year and that the RBA is probably going to have to upgrade its forecast in its next quarterly statement of monetary policy in August.

You also mentioned earlier about the need for fixed income product to play a bigger part in super funds. How underweight do you think funds are?

When we’re talking about fixed income, we’re really talking about the suite of Commonwealth bonds and semigovernment bonds, high grade supra and high grade corporate debt, particularly looking at domestic paper.

One of the things is that we’ve seen over this current economic cycle, indeed this current period of economic and global financial market downturn is that Australian nominal real pension funds really have been put in the worst positions out of the OECD countries, or certainly in the bottom part of the range, over January to October 2008, and that’s OECD data I’m quoting here.

Part of that performance is to do with the allocation of fixed income to overall pension funds. Our direct fixed income asset allocation is probably the lowest, or one of the lowest, in the OECD. Compare that to countries like Germany with a 60 per cent allocation to fixed income.

Now, some of that is obviously due to the fact that we have generally been an equities-centric culture when it comes to investing and the fact that we do have a defined contribution scheme that is heavily weighted toward equities, but there is an opportunity, given what we’ve seen for a re-assessment at an aggregate level about the appropriateness of allocations across portfolios, particularly given that we have an aging population. There needs to be more of a life-cycle approach to portfolio management.

We have people retiring who want a regular income stream, and the fixed income investment can actually provide that through its coupon payments. Of course this is going to a require a shift in the mindsets of portfolio managers, but even a 5 or 10 per cent improvement in allocations in fixed income portfolios would go a very long way to adding to demand for fixed income investors, helping the secondary market and helping what has been a lack of corporate bond market, certainly in Australia in recent times.

There was a view that, especially with government guarantees, state and federal issues would crowd out corporates. This hasn't happened with the banks, as far as can be seen. Is it actually a factor to be concerned over?

Citi holds the view that there is solid national and international demand for sovereign Australian bond products. At the AOFM’s bi-weekly tenders, the bid to cover ratio on Commonwealth bonds has averaged a very healthy 3.5 times, not the sign of a bond market that’s in distress.

If you look at the forward estimates for 2014 where the stock of issuance is forecast to be around triple the size it is now, net debt to GDP is forecast to be about 14 per cent and that’s way below the US at 82 per cent and the Euro average of 72 per cent and even if you include the semi-government and authorities in that analysis the Australian ratio still remains much lower than what we’re seeing in most, if not all OECD nations.

Given the fact that we’ve got our economic outlook looking better than it did in our budget time back in May, the overall Commonwealth deficit could actually be smaller than all our forward estimates. Now if that’s actually the case then net debt is actually going to be smaller, as will the Commonwealth's borrowing requirement.

So the outlook there in terms of investors and demand is generally good for both Commonwealth and semigovernment sectors. In terms of the issue of crowding out, firstly the point to make is that banks have finished the majority of their funding for 2009 and are well on the way for their funding requirements for 2010. In a more general sense with the corporate bond market, because of the weak activity environment in 2009, certainly today, in our expectation that although we do look for an improvement, this part of the market is going to remain relatively weak.

So, for the remainder of 2009, that does minimize the chance of a crowding out risk. That said, there is a risk that we could see government issuance crowding out the bond market, to a degree, for 2010, particularly, as companies seek to rebuild their balance sheets and as the economic environment improves in 2010.