![Nobody knows which Donald Trump will prevail when he enters the Oval Office on January 20.](/content/dam/images/g/t/u/d/6/j/image.related.afrArticleLead.620x350.gtuisc.png/1484891483562.jpg)
Portfolio performance in 2017 will likely hinge heavily on which version of Donald Trump prevails: the aspirational entrepreneur who concentrates on the economy, delegating non-core decision-making in high-tail-risk areas like foreign policy to subject matter experts; or the impulsive and erratic megalomaniac who ushers in extreme geopolitical volatility that whip-saws markets.
Since nobody knows which Trump will come to pass all we can do is mark-to-market his actions to determine the most likely path.
After some promising and conciliatory stability immediately post the election, capricious Trump "tape bombs" re-emerged over the past week with divisive remarks on Brexit (it will "end up being a great thing"), the European Union ("basically a vehicle for Germany"), NATO ("obsolete"), and German chancellor Angela Merkel, who had made a "very catastrophic mistake … taking all these illegals", and would be given no more credit than Russia's kleptocrat Vladimir Putin: "I [will] start off trusting both – but let's see how long that lasts". Oh, and throw in napalming the US dollar ("our currency is too strong and is killing us"), which put the greenback in a tail-spin.
While there is loads of latent event risk lying in wait in 2017 – Brexit, European elections, China-US relations and of course the inevitable "unknown unknowns" – investors seem to be assuming that the more reliable "pure American profit-maximiser" will reassert itself as Trump's dominant personality. I've argued this central case, but remain concerned about unanticipated shocks emanating out of the South China Sea.
Defence hawks know that America's geostrategic credibility rests on its preparedness to deploy its military might as a war fighter without peer to enforce its democratic, rules-based vision of a capitalist world. They also believe that China needs to be stopped from further imperilling prosperity via its erection of (now weaponised) artificial islands to brazenly steal international territories.
The worry is that the parochial and notoriously tough Chinese, emboldened by a modernised military that can go toe-to-toe with the US in the South China Sea, may not be convinced to cease and desist from empire-building through moral suasion alone. As ANU Professor Hugh White warns, the probability of some kind of kinetic conflict between the world's two largest economies is non-trivial under Trump. And after being insulated from global conflagrations in the past by the tyranny of distance, Australia will have to contend with the tyranny of proximity.
This is why I have been selectively taking chips off the table in my own fixed-income portfolios, which are holding the most cash they've had since mid-2014. It seems prudent to create ample capacity to capitalise on future dislocations.
Complacent regulator
One important question for 2017 is where the Australian Prudential Regulation Authority lands on its long-delayed definition of what an "unquestionably strong" bank constitutes. Recall that the financial system inquiry recommended that our banks should have unquestionably strong capital ratios back in December 2014. The government and APRA embraced this goal with the original expectation APRA would define what it means by the end of 2015.
More than two years since the FSI and the definition remains missing in action. "APRA has moved too slowly on this issue and risks losing focus," says one of its former masters.
A more bizarre decision has been APRA's finding this week that the banks' "counter-cyclical capital buffers", which are meant to increase when asset prices and credit expand rapidly, should be set at the lower bound of a possible 0 per cent to 2.5 per cent range. Since the end of 2012, national home values have jumped 42 per cent, including a 10 per cent appreciation last year, while the household debt-to-income ratio and dwelling price-to-income ratio have climbed to record highs on the back of unprecedented levels of speculative investment in bricks and mortar.
All three major credit rating agencies have warned that the banks' AA- ratings could be downgraded because of mounting housing imbalances, while the International Monetary Fund has called on the banks to raise more capital to obtain unquestionably strong status. According to Standard & Poor's, the build-up in private household debt is one of the key reasons why Australia could lose its AAA rating. And yet APRA reckons depositors don't deserve any extra equity capital to mitigate balance-sheet leverage at this very elevated juncture in the credit cycle!
Notwithstanding these concerns, the major banks' senior-ranking bonds do look cheap, with CBA recently issuing a floater paying almost 3 per cent annually compared to the 1.5 per cent cash rate (I invested). In December the interest rates on these bonds were pricing in a near-certain probability of a downgrade from AA- to A+, which is no sure thing.
Prime Minister Malcolm Turnbull and Treasurer Scott Morrison have a decent shot of keeping Australia's AAA rating if they can negotiate further savings with the Senate while capturing revenue upgrades from persistently lofty commodity prices, which they ignored in December's mid-year budget forecasts.
If the banks are compelled to accumulate more capital, Standard & Poor's may reward them with superior "standalone credit profiles" that would offset the impact of a sovereign downgrade on their senior bonds.
There are also grounds to believe new Reserve Bank of Australia governor Phil Lowe will be more sensitive to financial stability risks than his predecessor given he specialised in researching them. The RBA's rhetoric has been noticeably more hawkish since Lowe's ascent, and we could see a first rate hike in 2017.
The local housing exuberance, which is the rating agencies' chief anxiety, is bound to dissipate as banks jack-up lending rates to support returns on equity that are shrinking as APRA reduces balance-sheet leverage.
Finally, there is a consensus that when the too-big-to-fail "total loss-absorbing capacity" (TLAC) rules are introduced, they will involve breaking up the banks' senior debt into two parts: traditional preferred senior and a new non-preferred security with the latter subject to explicit bail-in. If this proves true, existing senior debt will benefit.
The author is a portfolio manager/director of Coolabah Capital Investments and Smarter Money Investments, which invest in fixed-income securities.
AFR Contributor