After two years of steep fallout in some sectors and soaring asset prices in others, issuers in Australia may be hoping for less interesting times. The spread of the omicron variant threatens to delay a broad recovery. S&P Global Ratings believes this could slow a transition to positive outlooks even as ratings appear more stable than during the COVID peak.

Some Australian state governments may take measures to reduce the impact of outbreak risk from the omicron variant; however, sweeping zero-tolerance policies won't be reimposed. The economic revival will progress, providing some benefit to the most disrupted sectors, from deficit-hit state governments to battered airports.

While monetary policy will likely remain supportive of credit conditions, rising market expectations of higher rates could help curb enthusiasm in some of the bubblier segments. This could be a positive in moderating market excesses. Our article outlines the views discussed at our recent webcast (for a replay, please click here). We also provide updates on these topics, given the fast-moving nature of fundamentals in a time of pandemic.

Uncertainty Still Stalks The Most Disrupted Sectors

We revised our sovereign outlook for Australia to stable last June to reflect our view that fiscal conditions will not take as long to recover as we originally projected. The progress is quite a feat, given how deeply the country dug into its pockets to blunt the impact of its lockdowns, which were among the world's strictest.

"Debt is rising pretty sharply, but debt at 30% of GDP is still not historically out of the ordinary for a country like Australia," said Anthony Walker.

The economy's resilience to lockdowns and other COVID-related pressure is one key factor underpinning the 'AAA' rating on Australia. So too is the swift fiscal recovery we expect, with deficits forecast to narrow materially by 2023. Strong labor market outcomes, a likely pick-up in consumption as people move about more, and record infrastructure spending should ensure a solid growth of 3.3% in calendar 2022.

We don't expect Australia's federal election, due by May 2022, to materially change our view on sovereign creditworthiness. However, both major political parties have not yet shared their policy platforms. Signs of higher, unfunded, spending that potentially weakens fiscal outcomes would be credit negative.

States and local councils

The overall outlook bias for Australian states has improved relative to 12 months ago. In our view, fiscal positions will benefit from the continued rollout of vaccines and the associated upswing in the national economy. The reopening of international borders will also help as migrants, workers, students, and tourists gradually return. Fiscal challenges remain, however. We anticipate record infrastructure spending and lower revenue streams over the next decade.

Our outlook bias for the credit ratings on New Zealand's local councils has turned slightly negative. The councils performed well during the pandemic. In 2022, a strong focus on increasing infrastructure spending is placing a burden on a small proportion of councils. We expect many councils to funds this through higher borrowings, reducing previous headroom within the ratings.

Various levels of repair for the most disrupted segments

Uncertainty continues to stalk the most disrupted sectors. The recovery in international flight traffic for both Australia and New Zealand will be even further prolonged as global omicron cases surge. "Many airports remain on negative outlook because of the uncertainty in tourism and travel," said Parvathy Iyer.

Table 1

Insurance is another sector facing many unknowns. At one level, premium growth is supported by greater demand for health and mortgage insurance coverage while insurers also increase premiums to cover the higher risk of claims. Higher claims are coming from reserves set aside for potential business interruption and mortgage insurance claims, both unresolved.

"We still foresee negative trends for the mortgage insurance sector–--recognizing the potential for some home loan defaults as bank payment deferrals wind back," said Craig Bennett.

Similarly for life insurers, we expect increases relating to latent claims in disability lines. All of this while returns on fixed income are at near all-time lows and equity markets remain somewhat volatile.

We continue to see strong reinsurance capacity for Australia and New Zealand insurers, to moderate the physical risks faced by insurers (see chart 1).

Chart 1

Structural challenges are likely to persist for office and mall landlords, particularly for those exposed to second-tier assets and markets. That said, we believe the "work from home" hit to office demand will be less than initially feared as employers weigh the cultural benefits of office collaboration against potential rent savings. Shopping-center owners are looking to mitigate the threat from online shopping by transforming their sites into multi-purpose town centers.

What About The High-Flyers?

Should property markets continue to run hot, the government will likely introduce further macroprudential measures, following a tightening of mortgage loans in October. Home prices soared 20% in calendar 2021 and Australia's household sector is one of the world's most indebted.

Further gains would subject banks and the general economy to the risk of a destabilizing correction in prices. A mitigating factor is strong prudential settings and good risk management at banks.

"Underwriting standards will remain conservative and banks will continue to price rationally for risk," said Nico DeLange.

Chart 2

We expect a stable performance for structured financial products tied to residential markets. Ratings for consumer-backed structured products have been stable globally, while in Australia last year we've had more upgrades than downgrades.

"This is due to the buildup of support in structures as well as stable collateral performance—which should continue in 2022," said Narelle Coneybeare. Australia's household savings rates rose in the past year, as did the proportion of prepayment of mortgage loans and delinquencies are at historically low levels. These factors are supportive of residential mortgage-backed securities and other asset-backed consumer products.

We don't anticipate that Australia will follow New Zealand in immediately raising rates. Our house view puts the first policy rate hike in first quarter-2023. Low interest rates have buoyed deal flow, as indicated by the active global private equity markets (see chart 3).

Chart 3

Common Challenges:ESG

Even as COVID risks continue, many companies will need to address pressing environmental, social and governance (ESG) issues. Richard Timbs explained that discussions about ESG issues are becoming an even greater feature of interactions with both issuers and investors.

The timely communication of emission reduction targets is becoming increasingly critical to maintaining investor support and access to capital. Laggards are likely to face intense pressure from their capital providers. The growth in green and sustainability-linked bonds highlights the market's shift towards environmentally friendly finance.

ESG matters continue to impact ratings. Prominent examples include the revision of our industry risk assessment for the oil and gas sector last year and reducing capital availability for coal-rated investments.

Proactive management can, however, help to lower ESG-related credit risks. For example, in recent months the oil and gas space has seen a lot of consolidation. The proposed mergers of Woodside/BHP Petroleum and Santos Ltd./Oil Search should provide these players with greater scale and internal cash flow generation to fund their growth pipelines (including carbon-reduction initiatives) and mitigate rising capital costs. We believe this is a sign that businesses are adjusting to environmental challenges. Mergers and consolidations can more quickly affect change than organic developments--they can also help diversify environmental exposures and earnings streams.

Cyber risks present a growing threat across sectors in Australia and New Zealand. In recent years, for example, hackers breached data at a number of universities including the Australian National University.

Accelerated digitalization and remote working arrangements since COVID-19 have increased such risks and could lead to more complex cyber-attacks that trigger higher losses. A large-scale cyber-attack can considerably increase the risk profiles of Australian banks and pose systemic risks. Financial institutions in particular need to be vigilant, and those with weak non-financial risk governance may be less prepared and more vulnerable to cyber-attacks.

Writing: Cathy Holcombe

Digital design: Evy Cheung

Related Research

• 2022 Outlook Assumptions For The Australian RMBS Market, Jan. 7, 2022
• Regulatory Reinforcements Loom To Allay Runaway Housing Risks For Australian Banks, Oct. 24, 2021
• Airports Face A Long Delay To Global Air Traffic Recovery, Sept. 24, 2021
• Australia's Coal Sector Looks To Dig Itself Out Of A Funding Hole, Sept. 14, 2021
• Australia Outlook Revised To Stable On Swift Economic Recovery; 'AAA/A-1+' Ratings Affirmed, June 6, 2021