Frank Uhlenbruch, Investment Strategist in the Janus Henderson Australian Fixed Interest team, provides his Australian economic analysis and market outlook.
Market review
A shift to a more hawkish stance by offshore central banks, higher energy prices and disruptions to global supply chains led to heightened financial market volatility. Equity and credit markets were weaker while inflation expectations edged higher. Yields lifted meaningfully across the government yield curve, with the largest moves at the longer end of the curve. The Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index fell by 1.51% over September.
The Australian economy will likely contract around 3% in the September quarter but rising vaccination rates and roadmaps out of NSW and Victorian lockdowns mean that the economy is far from out.”
Three-year government bond yields traded in a 12 basis points (bps) range, falling on dovish Reserve Bank of Australia (RBA) guidance, before ending the month 7bps higher at 0.31% as NSW and Victoria announced roadmaps out of lockdown. Further out along the curve, a lift in term premia on more persistent than expected global inflation pressures saw 10-year and 30-year government bond yields end 33.5bps and 35bps higher at 1.49% and 2.37%. Inflation expectations edged higher, with the 10-year breakeven inflation rate rising 1bp to 1.97%.
Economic data painted a picture of an economy doing well pre-lockdowns followed by a sharp fall in activity in lockdowns with activity looking to have troughed in August. For the June quarter, economic growth of 0.7% was stronger than expected.
Higher frequency business sector indicators point to a troughing in activity around August. The NAB Business Survey reported a slight lift in conditions while the Markit Composite PMI rose in September after earlier falls. Labour market conditions deteriorated in August with hours worked and employment down sharply. By the end of August, weekly payrolls had fallen for 10 weeks by a cumulative 4.2%, weakness was most evident in the locked down states, NSW and Victoria.
While the economy is poised to fall by around 3% in the September quarter, some indicators, like retail sales, did not fall by as much as markets expected. This reflected the two-speed nature of the economy with activity levels holding up in the non-locked down states.
Short-term money market rates remained very low given the 0.10% official cash rate, dovish RBA commentary and the recent deterioration in the near-term growth outlook. Three-month bank bills ended the month 1bp higher at 2bps, while six-month bank bills ended 2bps higher at 5bps. Despite the RBA Governor questioning the early timing amount of tightening priced into markets, markets are still pricing the first tightening by end 2022.
Credit markets adopted a decidedly more cautious tone, digesting the implications of US Federal Reserve tapering and the potential for the default of a major Chinese property developer, all at a time of historically tight valuations. Closer to home, investors had to consider jumbo M&A news particularly in the infrastructure space, the imminent return of macro-prudential policy measures to cool a red-hot housing market, the earlier than expected wind-down of the Committed Liquidity Facility, and a sharpening focus on all things related to ESG. Softer conditions resulted in the Australian iTraxx Index widening by 2bps adjusting for the contract roll, while Australian fixed and floating rate credit indices closed 3bps wider and 7bps wider, respectively.
As we anticipated, there was a ramping up of domestic primary issuance over the month. The major banks were active, issuing both offshore and in AUD. Notable domestic transactions included CBA pricing a $500m 5-year senior unsecured Green Bond at BBSW+41bps, and Westpac issuing the first Major Bank RMBS transaction since pre-COVID. The latter’s $1.2b size was underwhelming, and while pricing at post-GFC tights (senior AAA notes priced at BBSW+55bps), came wider than investors had anticipated. The market attributed this in part to the winding down of the Committed Liquidity Facility, reducing demand for RMBS from bank balance sheet investors.
Continuing on the ESG theme, Woolworths Group issued its inaugural AUD sustainability-linked bond in 6 and 10-year tenors, Pricing at swaps +75 and +117 respectively, each tranche was heavily over-subscribed by 4x, demonstrating significant appetite for ESG labelled issuance from the domestic investor base. Lastly, positive news from offshore on vaccine-led travel re-openings, allowed Qantas Group to issue a 7-year senior unsecured bond at swaps +210bps. This transaction was likewise heavily over-subscribed at 4x, with the investors demonstrating optimism around a future living with COVID.
Market outlook
The Australian economy will likely contract around 3% in the September quarter but rising vaccination rates and roadmaps out of NSW and Victorian lockdowns mean that the economy is far from out. We look for these two states to gradually reopen over the December quarter and enter into “catch up mode”.
We look for the Australian economy to grow by around 1.75% over 2021 but for growth to lift to around 5.25% over 2022, before easing back to around 3% over 2023. Base effects flatter the 2022 growth number, but the pace of activity should be less volatile than lockdown impacted 2021.
Such a profile implies a recovery in the real economy which should eventually lead to the RBA tightening trifecta conditions of: i) an unemployment rate close to 4%; ii) wages growth of at least 3%; and iii) actual inflation at 2% or above on a sustainable basis, being met.
Our expectation for a lift in yields and curve steepening were largely realised over September. We see the three-year government bond yield at 0.30% at the time of writing as beginning to offer a hint of value. Our base case still has the first tightening in a cycle that takes monetary conditions from accommodative to neutral starting in H1 2024. The introduction of further housing macro-prudential measures and upcoming fiscal tightening also argue for a later lift off in the cash rate.
The sharp lift in 10-year government bond yields to 1.49% has restored significant value and compensation for term risk. We still see some modest upside risk as markets continue to adjust to conventional and unconventional monetary policy normalisation by a number of key offshore central banks.
Spread sectors are likely to remain well-supported, with corporates in particular, continuing to benefit from the tailwinds of a cyclical recovery and persistent accommodative policy settings. Nevertheless, with the spread cushion for investors within pockets of credit having narrowed substantially, we continue to remain very active and selective in this environment. While the market searches for any yield advantage, we remain discriminate, avoiding lower quality borrowers.
We remain attracted to semi-government securities in the current low yield environment, particularly those issued by NSW which is close to coming out of lockdown. Though breakeven inflation rates have edged up towards the bottom end of the RBA’s 2-3% target band, we still see a role for some inflation protection given latent inflation pressures from a lower currency, challenged global supply chains and the wider opening up of the economy over 2022.
Views as at 30 September 2021.
