As Westpac today rounds out official bank reporting season, our focus quickly shifts to tomorrow’s Federal Budget and the subsequent implications for debt investors. While the RBA and interest rate market have been in ‘watch and wait’ mode for the most part of 2017, recent economic releases have illustrated an uncertain future for the economy led by an underutilised labour force and weakness in the construction sector (building permits down almost 20% in March). However, in the wake of improved inflation figures (Q1-17 annualised: 2.2%), the RBA is now more optimistic about domestic economy updating its 2018 GDP growth expectations to 2.75-3.75% (May 2017 Statement on Monetary Policy).

Chart 1: Bloomberg AUSBond Composite Index (Monthly) Chart 2: Bonds vs Equities 2016/2017 (Monthly) Chart 3: Term Deposit Review – March

The Federal Budget Tomorrow marks one of the most anticipated dates on the Australian investment community’s calendar – The Federal Budget. Economist consensus indicates the Treasury is expected to announce the 2016-17 budget deficit of over $38.3 billion, $1.8 billion worse than the Government’s mid-year forecast. As we outlined last week, we expect structural implications in the labour market such as poor wage and job growth to impact the top line. However, in the short term, the big question on everyone’s mind is whether the Government will introduce a pipeline of infrastructure projects to promote the “Jobs and Growth” campaign. Domestic inflation expectations are tipped to increase on the back of such an announcement with interest rate markets gradually pricing in a steeper yield curve over the past few weeks. As a result, bond investors may be caught out similar to the weeks following the US election back in November 2016. Recent infrastructure projects announced such as the nation’s largest hydro-electric project, proposed inland rail system and second Sydney airport highlight a shift from the Government’s previous focus of quickly reining in the deficit. While the Treasurer has stated that the debt pile will be split into funding for day-to-day spending and borrowing for projects like road and rail, we will monitor the reaction of the rating agencies particularly whether this is a sufficient catalyst for downgrade of the sovereign credit rating.

Bank Reporting Season While bank reporting has been net-positive this week there is a noticeable (albeit slight) deterioration in asset quality across the banks. This is often not transparent in reporting as it is hidden in changes to provisions when bad loans are moved off balance sheet. The continual reduction in collective provisions across residential mortgages in order to meet bi-annual growth targets is becoming a concern. In our opinion the recent increases in mortgage rates across the banks is starting to cause stress on the bottom quartile of borrowers. Last week a Galaxy poll (commissioned by CoreLogic) noted that more than half of Australian borrowers would be under mortgage stress if interest rates rose by 2%. While we do not expect that sort of increase anytime soon it is in the interest of all debt and hybrid investors to be proactive rather than reactive when it comes to residential mortgage stress.

Suncorp Capital Notes Late on Friday afternoon, Suncorp announced the completion of its Capital Notes offer (ASX: SUNPF) raising $375 million (up from the indicative offer size of $300 million). The group allocated $300 under the Broker Firm and Institutional Offer and allocated $75 million under the Securityholder Offer. Soon after, the notes were issued (on the 5th of May 2017) and subsequently began trading at 10:00am this morning on a deferred settlement basis. Normal trading is expected to commence on Thursday. As expected, there has already been strong demand for the notes in the secondary market which are now trading close to ~$102 consistent with our recommendation. Click for Recent Corporate Announcements