Frank Uhlenbruch, Investment Strategist in the Janus Henderson Australian Fixed Interest team, provides his Australian economic analysis and market outlook.
Market Review
A dovish monetary policy shift by the US Federal Reserve (Fed), with an elevated focus on full employment and shift towards a 2% average inflation target, buoyed risk appetite. Equity markets were firmer, while credit markets continued to perform as investors searched for yield. Increasing supply of government debt and a loosening in the Fed’s inflation objective led to a sharp lift in longer-dated yields and was a drag on sector returns. Inflation expectations also rose as observed through a lift in breakeven inflation rates. The Australian bond market, as measured by the Bloomberg AusBond Composite 0+Yr Index, ended August 0.42% lower.
“The role played by Government fiscal support via Jobseeker and Jobkeeper payments, as well as early access to Super, was evident in the 20% rebound in retail sales between April and June.”
Yields at the shorter end of the Australian government yield curve remained anchored by the Reserve Bank of Australia’s (RBA) forward guidance and yield curve control measures. After trading in a relatively narrow band, the three-year government bond yield ended the month 1 basis point (bps) lower at 0.26%.
There was significant movement further out along the yield curve as increasing government debt supply and the shift to an inflation averaging target by the Fed raised term compensation for inflation risk. The 10-year government bond yield ended 17bps higher at 0.98%, while the 30-year government bond yield ended 26bps higher at 1.91%.
Economic readings show that the national recovery, fuelled by easier fiscal policy, lost some momentum following the re-introduction of progressively tighter lockdown measures in Victoria. The Greater Melbourne area moved to a six-week period of Stage 4 lockdown in early August, whilst various state borders were also closed.
The role played by Government fiscal support via Jobseeker and Jobkeeper payments, as well as early access to Super, was evident in the 20% rebound in retail sales between April and June. While real retail sales fell 3.4% over the June quarter, this outcome was better than initial estimates for a much larger fall.
Labour market outcomes continued to improve, with the number of jobs lifting by 114,700, although the unemployment rate edged up to 7.5% in July. The underemployment rate of 18.7% was indicative of significant labour market slack. Wages growth was weak, rising by 0.2% over the June quarter and 1.8% over a year ago.
While government and central bank support has cushioned the fall in economic activity in the June quarter, partial demand indicators still point to an historically large drop in output in the upcoming release of the national accounts.
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Against this backdrop, money market rates were steady to slightly lower. The RBA left the official cash rate target at 0.25% and the interbank overnight cash rate ended the month unchanged at 13bps. Three-month bank bills ended the month 1bps lower at 9bps, while the six-month bank bill ended 3bps lower at 14.5bps. Cash rate expectations remained consistent with RBA forward guidance for no change in the cash rate until the labour market and inflation outlook improved.
Credit markets continued to recover following the COVID-19 shock that occurred in March, with the iTraxx Index ending the month 11bps tighter at 65bps. Despite the setbacks regarding the second lockdown in Victoria and the impact this will have on the credit profiles of corporate Australia, credit investors generally looked through this weakness.
Companies announced their full year results in August and this was dominated by COVID-19 related impacts and the uncertainty regarding FY21 profit guidance. Not all sectors were impacted equally. The spectrum ranged from some COVID-19 winners, such as non-discretionary retailers, to some where the impact was yet to fully play out (such as the major banks) to others where the current operating conditions are stretching financial profiles (such as airports). Despite most companies being generally well-funded, the announcement of financial results provided the window for companies to access primary markets. Issuance was dominated by insurance companies with IAG, QBE and Suncorp all issuing subordinated bonds to raise capital. Another point of interest was that ANZ raised the first Australian dollar bank bond where the proceeds were to be used to meet part of the United Nations’ Sustainable Development Goals.
Market outlook
We look for the economy to contract by up to 7% in the June quarter and fall again in the September quarter before rebounding as Victorian lockdown measures are eased. For 2020 we look for GDP to fall by 5.75% before lifting by 5.50% in 2021. The economy is expected to take until Q1 2022 to recapture end of 2019 levels.
This implies a massive build up in slack that will take years to absorb and will exert downward pressure on wages and inflation. The RBA have the unemployment rate peaking at 10% at the end of this year and falling to 7% by end 2022. That level remains well above the 4.5% estimate for the neutral unemployment rate and will require an extended period of highly accommodative policy settings to drive that rate lower.
While the RBA has signalled that it is comfortable with its current portfolio of strategies and advocates that fiscal policy is best positioned to boost aggregate demand, the RBA Governor has signalled that the RBA would be prepared to provide further support if they felt any additional measures would gain traction.
With the Governor again noting that negative interest rates remain “extraordinarily unlikely”, additional initiatives are most likely to come in the form of measures that support the smooth functioning of markets and lower borrowing costs across the economy, be it for banks, corporates, individuals or state governments. Further steps could include extending forward guidance, yield curve control and Term Funding Facility measures.
We see the lift in longer-dated government bond yields, following the Fed’s dovish policy shift, as reducing fiscal space and inconsistent with the RBA’s accommodative policy objective. We see scope for them to use their balance sheet to purchase government bonds out to 10 years.
We remain attracted to spread sectors, but have shifted from accumulating holdings following the widening in spreads over March, to becoming more selective about the names and tenors we are adding. Despite ever-present solvency risks, we expect spread sectors to be shored up by the outlook for an extended period of low yields on government securities and unprecedented levels of central bank support for both sovereign and non-sovereign debt markets.
We remain mindful that massive fiscal easing, burgeoning money supplies, geo-strategic supply chain reconfigurations and the blurring between monetary and fiscal policy in some jurisdictions raises medium to longer term inflation risks. Add to that the Fed’s shift to an inflation averaging target where it stated that it will tolerate a period of inflation over 2%. Against this mix of cyclical and structural factors we think it remains prudent to hold a core exposure to inflation-protected securities while inflation protection remains cheap.
