Why markets are ignoring Victoria's second wave...

In the AFR this weekend I write that it now appears Victoria’s tragic second wave peaked around July 31. In early July we started applying our internal forecasting systems to Australia’s first episode of pervasive community transmission to understand when the peak might materialise. This was going to be a potentially important input for portfolio construction: one month later credit rating agency Standard & Poor’s put Victoria’s prized AAA credit rating on “negative watch” for a 50 per cent probability of a downgrade. Click on that link to read the column or AFR subs can click here. Excerpt enclosed:

These systems performed well in February and March, projecting the otherwise surprising early April 2020 peak of the first waves in Australia, Western Europe and the US. They did not, however, anticipate Victoria’s second wave, which was a shock to everyone and has since proven to be a regrettable artefact of sustained policymaking errors made by the Victorian government.

Looking back on the data, it is apparent that Victoria’s per capita COVID-19 testing performance between March and May was materially inferior to the Australian average and the numbers posted in New South Wales and Queensland. Indeed, the cumulative Victorian infection curve never actually flattened between March and May. Rather, it kept creeping higher in contrast to every other state and territory. With the benefit of hindsight, it did look like something was going systematically wrong. We now know that there was a sequence of policy snafus that led to this disaster. The latest reports that Victoria still has half the number of contact tracers as New South Wales only amplify the disbelief.

The forecasting models statistically identify the current pulse of the virus in the target region and then predict its future course based on previously observed experiences, or transmission trajectories, in countries that have already endured a first wave and thereafter contained the pathogen. The efficacy of these forecasts depends on the assumptions the analyst makes on the countries that are most likely to provide guidance on the infection trajectory in the target jurisdiction. The system allows one to select a single country as the future benchmark, or to use a multiplicity of blended regions. It also allows the analyst to apply assumptions about the containment efficacies of policymakers in the target country vis-à-vis the performance of policymakers in the benchmark nations.

In the case of Victoria, we publicly presented 14 different possible paths in early July that pointed to a peak sometime between July 13 to July 26. Yet every single one of the forecasts that benchmarked off Italy, South Korea, Germany, the UK and France (there were 10 in total) pointed to a late July peak between July 22 and July 26. By far the most predictions fingered July 26 (7 of the 14).

The small minority of more optimistic scenarios that anticipated a peak prior to July 20 were predicated on the past experience of Australia, which had never had pervasive community transmission, and China, where the data itself is questionable. The late July estimates now appear to have been close to the ultimate peak, which the systems suggest was around July 31. While we did not need to publish this research, my preference is to do so more often than not to foster education and debate, even if it does tend to open one up to vitriolic attacks. It’s like writing this column each week and presenting analysis in black and white that is on the record for anyone to judge: it would be a lot easier not to publicly engage in these intellectual battles, frankly speaking.

As it has transpired, markets have been less focussed on second waves, and more smitten with central bank asset purchases (QE) and the prospect of effective vaccines. During the week the Prime Minister Scott Morrison revealed he had negotiated 25 million vaccine doses with AstraZeneca with production slated to begin locally this year. While securing an effective vaccine in 2020 has been our heterodox central case, and the portents do appear promising, we await the results of the final phase three Moderna and Oxford trials. The key outstanding questions revolve around safety, efficacy and longevity.

With the central banks directly or indirectly funding so many businesses, the supply of new bond deals has been scarce in Australia outside of government issuers. And this has been especially true in respect of so-called "Tier 2", or subordinated, bond deals that typically carry juicer credit spreads. (A credit spread denotes the extra interest rate a company pays to borrow money from investors above a proxy for the cash rate called the bank bill swap rate.)

This week saw a welcome return of Tier 2 supply with three local transactions from IAG, QBE and ANZ, and a NAB issue in the US. There were also senior bonds offered by Goodman and Coles, which both ripped tighter in credit spread terms (higher in price) in subsequent secondary market trading. The Coles senior issue was a stonker with the 10 year security tightening in credit spread terms by as much as 11 basis points an hour after the deal closed (or higher in price by about 100 basis points).

ANZ’s Aussie dollar “sustainable” Tier 2 issue priced on a spread of 185 basis points, which was almost bang-on the secondary curve. It would be preferable to have seen a five basis point concession (ie, pricing at say 190 basis points) given Tier 2 spreads have compressed dramatically since their record March blow-out as a result of aggressive contrarian buying in the period since. I have no doubt that ANZ’s Treasurer Adrian Went has generously thanked these heterodox investors for the attractive cost of capital they bequeathed him on this latest Tier 2 trade, which is 215 basis points cheaper for ANZ than it would have been in March.

We bought the Coles, IAG and ANZ issues. In Euros we also purchased a decent chunk of another sustainable (or ESG) bond that had been issued by ANZ in late 2019 on spreads today that were more than 30 basis points wide of the Aussie dollar curve after hedging back to the local currency. The seller was presumably a cornerstone investor in that ANZ sustainable deal that for some reason decided to crystallise their losses.

The ASX hybrid market continues to perform, with the five-year spread on major bank hybrids contracting further to about 315 basis points, which is still materially wide of the 260 basis points observed last year and the post-GFC "tights" around 235 basis points. This contrasts conspicuously with the major banks’ senior bond markets, where the five-year curve has shrunk to just 50 basis points, inside previous post-GFC records.

When it comes to new bond deals, we encourage companies to be “long-term greedy”, especially when money is cheap, as it is right now. Look after your creditors with a decent new issue concession during the good times, and the smart ones will reciprocate with support during the tough times.

We look dimly on issuers that display myopic, zero-sum behaviours that seek to transfer the maximum possible value from creditors in every single trade. For example, I cannot stand it when a company launches a bond issue but refuses to tell us how much they want to borrow: how on earth can we price the fair interest rate if we don’t know the quantum of money they want to borrow? Imagine going to your bank and asking them to lend money at a certain interest rate, but refusing to tell them how much you want to borrow. They would not have a bar of it. 

Never miss an update

Stay up to date with my content by hitting the 'follow' button below and you'll be notified every time I post a wire. Not already a Livewire member? Sign up today to get free access to investment ideas and strategies from Australia's leading investors.