BlueNotes Debate – The Outlook for 2015 Part Two: Stress Points

This an edited excerpt from our latest debate with McGrath Nicol executive chairman Peter Anderson, FTI Asia pacific chairman Rod Sutton, PwC partner John Fisk, Korda Mentha partner Mark Mentha, Deloitte partner David McCarthy and ANZ chief risk officer Nigel Williams. ANZ managing director global commercial banking Mark Whelan and ANZ International and institutional CEO Andrew Géczy also attended.

"You’ve got some unviable businesses continuing to operate only because liquidity has been as good as it has for as long as it has."
Peter Anderson, McGrath Nicol executive chairman

Also see the first in this series: Will 2015 belong to the bulls or the bears?

Cornell: We’ve heard some bearish views from the table and implicit in that is the idea that once the water goes out we’ll start to see the people who aren’t wearing bathers.

Some of the more familiar areas of concern are Chinese residential property - some of those empty towers in some of these second-tier cities and towns - and in Australia there’s also some stress points with commercial property in particular. But are there are other sectors that, if we are past midnight, you would be starting to watch very closely? Bearing in mind we seem to be seeing further weakness and deterioration in confidence?

Sutton: Big picture, the biggest stress point is obviously China – more than a third of all Australia’s goods are exported to China. Meanwhile, trade is expected expand under the new FTA from 2015, increasing Australia’s reliance of China.

At the same time, China’s domestic debt has ballooned to 216 per cent of gross domestic product and it has the largest corporate debt in the world estimated at more than $US14 trillion at the end of 2013.

Australian companies’ exposure to Chinese companies and therefore Shadow Banking will grow under the FTA. This is a concern as China sneezing may cause Australia to catch a cold.

The EU is a stress point for different reasons. Australia imports more than three times as much as it exports to the EU and it is important Australia seeks to rebalance its trade with Europe. However the EU economy, even with QE, looks weak and the geopolitical challenges – especially with Russia – are large.  It is important to remember the EU QE is likely to depress the value of the Euro, making sales from Australia into Europe even more difficult.

Taken together, and regardless of efforts at home, the challenges faced by Australia’s major trading partners may put a strain on Australian companies that could in turn force cost cutting, consolidation, contractual disputes, incentivise fraud or result in restructurings.

Fisk: I think the whole retail sector is something to watch closely. There are massive changes going on there.  The internet is just commonplace for everyone in New Zealand and no doubt Australia as well. So the High Street retailer is a species at risk if they have not adapted for the online market.

Geczy: I think the mining services industry. It may be very short term but we’ve seen all the challenges there. If you look at Caterpillar and “yellow” goods (large industrial vehicles), these businesses are down dramatically and they are businesses which support mining services. There’s another round of that kind of activity to come because it’s been such a quick shift and I don’t see that trend changing.

McCarthy: The big fall in commodity prices will see the world taking back some of that big pay rise they gave us over the past ten years. What worries me is the impact already stagnant national income and falling commodity prices are going to have on both State and Federal budgets in already fraught political environments.

This will only increase the size of the inevitable budget repair that will have to be dealt with at some point by politicians around the country. That horror story isn't going away and it's doing nothing for confidence.

It's not all bad news out there though - but we really need the good news areas to come on fast. The lower Australian dollar will help tourism and education, likewise lower fuel prices on transport. That can happen pretty quickly because we’ve already got plenty of good infrastructure for it and we’ve done it before.

Anderson: I don't think any of us are standing here saying we’re going to have global financial crisis-level of activity (in the corporate recovery sector). We’re just saying the current provisioning levels (at the banks) are not sustainable. You’ve got some unviable businesses continuing to operate only because liquidity has been as good as it has for as long as it has. It’s only the level of liquidity and the low cost of accessing it which has prevented those businesses from falling over.

What we are saying is that corporate distress will go back to a more normalised level. It might even surge a bit past that. We’re also saying that we’re closer to that happening than we are far away from it. I don't think anyone is saying we’re going to have pandemonium though.

Mentha: I absolutely agree there’s another level to come with resources because there’s a hell of a multiplier impact on the services that flow through supporting those mines and those operations as the investment boom winds up and commodity prices stay low.

It is those businesses which rely on people and so are affected when there’s less people, like childcare, service stations, chemists. You will see this in centres where population will fall off like in Mackay, in Gladstone, in Newcastle, in Geraldton, in Port Hedland and Karratha. It depends where you are in the cycle because as it moves from construction to production you go from maybe 4,000 workers to 150 workers.

It’s about how the economy adjusts through that process while you’re watching the dials in the cockpit to see where you are in terms of all of that supply chain that’s servicing that project. It’s the same at a lot of these big projects like Gorgon; it’s the same at Wheatstone; it’s the same at Curtis Island; it’s the same at Hay Point. It just depends where you are, they affect the towns nearby whether that’s Onslow, Gladstone, all those places.

And we are learning that the big gorillas, the BHPs, the Rios, the Chevrons, the big, big operators, are very good at pushing risk down all the way through the chain. They’re sitting up there with fixed price contracts already selling what’s meant to be built or delivered by a due date.

Everyone else down the chain is wearing more risk at a lower margin and a long, long way from the nearest capital city. It’s not without risk and it’s costly. There’s lots of good stuff but clearly the stress is going to increase, that’s my viewpoint.

Williams: We’ve touched on some issues where there is going to be credit pressure. We would subscribe to the view mining services is one but I think it is important to keep in perspective when and where these pressures will flow through. A number of businesses operating in the resources area are used to managing through tough periods but it is their downstream suppliers and small businesses that I fear for. Some of these businesses and their employees have geared up based on income higher than where it is today.

An example is leverage is occurring in new places, in particular consumer leverage. I encourage you all just to go and Google a self-managed super fund investment loan and you will find ANZ is the only retail bank not offering a retail investment product to gear your super fund to 80 per cent or 85 per cent.

We’ve gone from less than a billion dollars to $10 billion dollars at June and it is the fast growing part of the mortgage market. We shouldn’t under estimate that.

We looked at some of the securitisation vehicles, where 40 per cent of the mortgages were to non-residents with the balance largely to investors. Not all but some of these high rise apartments are 15 per cent overvalued to start off with because they are eligible for offshore investors and stamp duty exempt. In this environment an 80-85 per cent loan to valuation ratio doesn’t look that comfortable.

If we step back you see some segments of the consumer market with a mortgage, car loans, credit card, interest free loans on the appliances - and now they are being advised to gear their superannuation. Those businesses reliant on these consumer groups will face a tougher time.

Overall I’m positive that China and other places can actually pull some levers and the USA and India will provide growth. This however will not solve the overcapacity in a number of industries and subsequent margin pressure. I think we will be in for a period where business needs to manage with lower margins and growth.

Good examples are in both mining and agri – especially dairy where volumes are still high but the new supply has impacted price.

Sherman: I don't think it’s going to get any sweeter for the banks. If anything, they’re facing a difficult time to actually get capital out there and to work effectively, which says to me that something may have has to break before it gets any better for everyone.