Emma Lawson, Fixed Interest Strategist – Macroeconomics in the Janus Henderson Australian Fixed Interest team, provides her Australian economic analysis and market outlook.
Market Review
Persistent core inflation is keeping central banks guessing and became the biggest worry for markets in June. Central banks reassessed their risks and came down on the side of higher policy rates. Markets responded by moving yields higher and pushing back the easing cycle. Short and longer dated government bond yields rose sharply after last month’s modest moves. Against this backdrop, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, fell 1.95%.
We raised our peak Reserve Bank of Australia cash rate, to incorporate a further 50 basis points of hiking, to 4.60%… these hikes are likely to come in July and August, but there may be a pause at any of the next three meetings.
In what was a self-declared close call, the Reserve Bank of Australia (RBA) opted to raise the cash rate by another 25 basis points (bps), to 4.10%. Three- and 10-year government bond yields ended the month 68bps and 42bps higher at 4.05% and 4.02%.
The RBA are cautiously feeling their way as they weigh up inflation risks against the economic softening impact of policy tightening. Governor Lowe was seemingly more concerned about inflation given the higher-than-expected Fair Work Commission award wage outcome, a rise in some sectoral inflation expectations and the indexation of some price setting in the economy. Global persistence of core inflation, reflecting wage induced services inflation, has increased inflation risk across the world, and the RBA are not immune.
The Australian labour market remained resilient, with the unemployment rate at 3.6%. The positive income pulse is added to by population growth, which boosts the economy. This feeds into inflation, and the monthly CPI came in at 5.6% year on year (yoy) with services inflation remaining sticky.
Balancing this is the uncertain state of the household sector. The RBA is monitoring household spending, and after a flat period retail sales rose by a stronger than expected 0.7% over May as consumers took advantage of a period of heightened promotions. The quarterly national accounts showed a sharp drop in the savings rate to 3.7%, while household mortgage payments as a percent of income rose to 9% in Q4 2022 and are expected to track to new record highs. Combined with the rollover from fixed to variable mortgages on a sizable proportion of the market, the RBA is concerned about the pace of slowing of economic demand as interest rates move higher.
Post the early June RBA meeting, markets were surprised by RBA hawkishness and short-term money markets responded by moving to price in close to two more interest rate hikes, to near 4.60%. Against the current cash rate of 4.10%, three-month bank bills ended 37bps higher at 4.35%. Six-month bank bill yields ended 53bps higher at 4.7%.
In credit markets the grind tighter in financial conditions is starting to have an impact with rising corporate distress in the form of defaults and bankruptcies, particularly in the more leveraged areas of the market. Markets were briefly jolted by Russian political machinations, but credit investors appeared to take all this in their stride, choosing to focus instead on the most attractive yield levels in years.
Globally, primary credit markets were very active. A similar theme played out domestically. Banks continued to be active issuers. Underlining the attractive compensation on offer for investment grade debt, notable transactions included Westpac issuing $2.9 billion of BBB+ rated Tier 2 subordinated debt callable in five- and 10-years. Coupons were in the mid and high 6%’s respectively. Leading insurer QBE issued $300m of BBB- rated subordinated debt callable in five-years, at a credit spread of +310bps (initial coupon of 7.4%).
In the non-financial corporate space, regulated utilities Transpower New Zealand (Crown-owned monopoly electricity transmission network owner), Endeavour Energy (NSW electricity distribution network owner) and AGIF (Australian gas infrastructure network owner) issued in seven-year formats. Rated AA, Baa1 and BBB+ respectively, these high-quality fixed rate bonds were issued at attractive coupons of between ~5.2% and 6.1%. Lastly, in the securitisation market, HSBC issued its latest residential mortgage-backed securities (RMBS) transaction with the senior AAA notes pricing at a very attractive margin of +120bps over the one-month bank bill swap rate.
Closing off a highly eventful month (and financial year), the Australian iTraxx Index ended 2bps tighter at 81bps, while the Australian fixed and floating credit indices returned -1.08% and +0.41% respectively.
Also read: Four Themes Shaping Global High Yield Bonds Opportunities
Market outlook
We raised our peak RBA cash rate, to incorporate a further 50bps of hiking, to 4.60%, as the RBA warned of a bias toward reining in inflation faster than they had previously been comfortable with. We anticipate that these hikes are likely to come in July and August, but there may be a pause at any of the next three meetings. This comes about with higher peer policy rates, as the US Federal Reserve, the European Central Bank and others, also turned more hawkish on the back of stubborn core inflation.
We see a relatively smaller risk to the upside for the RBA from our baseline scenario. We have a modest tilt to the higher case of a peak in the cash rate of 5.10% if services inflation persists. This is most likely to occur if productivity in the economy remains moribund.
The RBA are now monitoring the balance between the slowing household sector, the strong labour market, and high wages growth. We know that the labour market lags the economy, reflecting the monetary policy conditions seen almost a year before, but the turn is difficult to pinpoint. We remain in the midst of the peaking of the economy but believe that policy will continue to grip and slow economic growth, with a shallow recession starting late this year not off the table. Indeed, the higher policy profile leads us to believe there is more downside to the rates path through 2024, as the RBA will need to set policy for an economy nearing stall speed.
We currently see market pricing of at least one rate increase with the chance of another as reasonable. We currently see the Australian yield curve as slightly under-valued. We remain on the lookout for tactical opportunities to add further duration on spikes in yields triggered by central bank signalling and data flows.
As the cumulative impact of tighter financial conditions continues to grip and the cycle ages, our focus in the credit space is towards defensiveness, with a keen focus on risk-adjusted returns. Our strong bias is towards high-quality, liquid credit and issuers that can survive and thrive through a range of macro-economic scenarios.
We are avoiding illiquidity, complexity and leveraged sectors, where we anticipate balance sheets will have to contend with a painful period of adjustment in a higher cost of capital environment. Lastly, by adopting a patient and disciplined approach to extending risk and reserving ample investment capacity we will be well placed to take advantage of any further market dislocations.
Views as at 30 June 2023.
