Frank Uhlenbruch, Investment Strategist in the Janus Henderson Australian Fixed Interest team, provides his Australian economic analysis and market outlook.
Market review
Inflation fears led markets to ignore Reserve Bank of Australia (RBA) forward guidance and bring forward ‘lift-off’ in the cash rate to mid next year. Yields rose sharply across the government yield curve, with the largest moves at the shorter end of the curve. Rates volatility buffeted risk markets, which had earlier found support from improving Northern Hemisphere corporate earnings. The Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index fell by 3.55% over October, mirroring February’s falls.
“The tightening profile implied by the market risks triggering a major slowdown over 2023.”
Three-year government bond yields ended the month 0.91% higher at 1.22%. The dramatic move reflected the market bringing forward tightening expectations to mid-2022 and was compounded by the lack of RBA’s defence of its 0.1% three-year government yield curve control target.
The government bond yield curve flattened as the rise in longer-dated yields was not as great. 10-year and 30-year government bond yields ended 60 basis points (bps) and 41bps higher at 2.09% and 2.78%. Inflation expectations surged, with the 10-year breakeven inflation rate rising 18bps to 2.15%.
Activity indicators point to a turnaround late in the September quarter as roadmaps out of lockdown in mainland South East Australia began to be released. The NAB Business Survey reported a strong lift in confidence over September, while the preliminary Markit Composite PMI rose again in October following strong gains in the previous month. Labour markets have yet to turn, with jobs down a more than expected 138,000 over September. A sharp fall in the participation rate limited the rise in the unemployment rate to 4.6%. Consistent with the turning point theme, retail sales rose 1.3% in September, the first positive month since May.
On the prices side of the economy, a slightly higher than expected core inflation reading saw the market shorten the timeframe to the start of the next tightening cycle. While the 0.8% lift in the Consumer Price Index (CPI) over the September quarter was in line with expectations, the 0.7% lift in the RBA’s statistical measures was higher than market and RBA forecasts. Higher energy, timber and durable goods prices were major contributors, with supply chain pressure evident as economies open up.
Short-term money market rates began to reflect the expectations shift, with yields lifting above the RBA’s 0.10% official cash rate. Three-month bank bills ended the month 5bps higher at 7bps, while six-month bank bills ended 15bps higher at 20bps. Despite RBA forward guidance for no change to the cash rate till 2024, markets moved to price in a 0.25% cash rate by May 2022 and a 1.25% cash rate by the end of 2022.
October brought Northern Hemisphere quarterly corporate earnings, which for the most part were strong. Of note, management teams reported cost pressures across the board, together with varying abilities to pass them on in the form of higher prices. Notwithstanding generally improving corporate fundamentals, inflation concerns buffeted global fixed interest markets. Local credit was not spared. Australian fixed and floating rate credit indices both ended the month 5bps wider, while the local iTraxx Index closed 2bps tighter.
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Positive sentiment from the re-opening of NSW and VIC, including to international travel for vaccinated passengers, was overshadowed by bond volatility and macroprudential measures introduced by APRA. Negative momentum in bank credit spreads continued, which was highlighted by a primary transaction by Bank of Queensland five year senior notes at BBSW+80bps. The issue offered a new issue concession of 17bps versus the issuer’s secondary curve to attract appropriate demand in the environment. This catalysed a broad-based re-pricing in domestic bank senior and tier 2 paper, with some flow-on impact into non-financial corporate credit spreads.
The trend towards ESG themed issuance continued. Off the back of an improving outlook for the Office sub-sector, Investa Commercial Property Fund and GPT Wholesale Office Fund issued nine-year and 10 year green bonds at swaps+120bps and +132bps, respectively. Similarly, A- rated Australian Prime Property Fund Commercial issued a 10-year sustainability-linked bond at ASW+145bps. Corporate activity continues apace as companies look to take advantage of cheap funding to pursue inorganic growth. This should be positive for the outlook for primary issuance, including possibly in corporate subordinated debt. While we remain constructive on spread sectors, we are closely monitoring credit trends for early signs of deterioration, particularly as management teams look to optimise their capital structures to drive returns on equity.
Market outlook
‘One swallow does not a summer make’, nor does one slightly higher core inflation reading mean that the RBA will lift the cash rate to 1.25% by end of next year or to 1.75% by the end of 2023. To make sense of the profound shift in market expectations, it’s worth reviewing the prospects for the economy and the RBA’s tightening pre-conditions.
On growth, the economy is only just turning the corner after a likely fall of around 3% in the September quarter. We expect growth to surge late this year and early next year as mainland South East Australia exits lockdowns and makes up for lost time.
For 2021 we look for the economy to grow by a sub-trend 1.75%. For 2022, the economy is expected to reach mid 2021 levels by around mid-year and grow by a flattering 5.25% over 2022. Once the economy has fully opened up and made up for lost time, growth should ease back towards trend levels quickly over 2023.
How quickly growth eases over 2023 will be determined by a range of factors. Recent macro-prudential tightening will act as a break on housing. Fiscal policy will also act as a drag on growth as pandemic income support is removed and the budget deficit shrinks. Then the stance of monetary policy and its famous long and variable lags has to be added to the mix.
Our view is that the tightening profile implied by the market risks triggering a major slowdown over 2023, making it difficult for the RBA to meet its tightening pre-conditions of an unemployment rate below 4% and wages growth above 3%. An argument could be made that inflation will stay in the RBA target band while supply chain issues are resolved, but once they are, a source of prices impetus will be removed. Premature tightening will make it harder for inflation to sustainably stay in the target band.
Faced with these uncertainties, we expect the RBA to make haste slowly initially exiting unconventional policy measures and commencing a tightening cycle from mid-2023 onwards. Given that we have lift-off in the cash rate around a year later than current market pricing, we see value in a three-year government bond at month end levels of 1.22%. At the longer end, we also see value beginning to emerge with the ten-year government bond yield at 2.09% at the end of the month.
Spread sectors are likely to remain well-supported, with corporate fundamentals continuing to benefit from the tailwinds of a cyclical recovery and accommodative policy settings. Nevertheless, with the spread cushion for investors within pockets of credit having narrowed substantially, we expect some normalisation in spreads and liquidity premia as unconventional policies are unwound. We continue to remain very active and selective in this environment. We favour positioning in sub-sectors set to benefit from increased people movement that present good relative value, and those issuers with idiosyncratic catalysts for spread compression and ratings upgrades.
We remain attracted to semi-government securities, particularly those issued by NSW as it comes out of lockdown. Though breakeven inflation rates have moved into the bottom end of the RBA’s 2-3% target band, we still see a role for some modest inflation protection given cyclical pressures from challenged global supply chains and the wider opening up of the economy from late 2021.
