Frank Uhlenbruch, Investment Strategist in the Janus Henderson Australian Fixed Interest team, provides his Australian economic analysis and market outlook – September 2021.
Market review
Markets and central bankers shifted into a more cautious mode while awaiting more clarity on the tussle between the growth-dampening Delta COVID-19 variant and rising vaccination rates. Despite a relatively robust earnings season, credit markets were subdued. Inflation expectations edged lower despite stressed supply chains. Yields edged marginally lower after some intra-month volatility, more so at the longer end of the government yield curve. The Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index rose by 0.09% over August.
Three-year government bond yields traded in a 14 basis point (bps) range on mixed economic data and evolving lockdowns, before ending the month largely unchanged at 0.24%. Further out along the curve, 10-year and 30-year government bond yields traded in similar ranges, ending 2.5bps and 2bps lower at 1.16% and 2.02% respectively. Inflation expectations edged lower, with the 10-year breakeven inflation rate falling 4bps to 1.96%.
Economic releases painted a picture of an economy losing momentum from mid-year following a period of rolling lockdowns and extended lockdowns in NSW and Victoria. While labour market outcomes were better than expected in July, with an unexpected small gain in employment and fall in the unemployment rate to 4.6%, large falls in weekly payroll data point to a sharp fall in hours worked and weaker labour market outcomes over the months ahead.
Despite very strong business survey readings, the upcoming release of the June quarter national accounts is likely to show only modest growth of around 0.5%, with the external sector and stocks major drags on growth. Falling business conditions, retail sales and dwelling approvals point to a significant fall in economic output in the September quarter.
Wages data for the June quarter was subdued despite an earlier period of strong employment growth. The wage price index rose by a less than expected 0.4%, with the 1.7% yearly rate still well below the Reserve Bank of Australia’s (RBA) 3%+ rate that would be consistent with its inflation target.
Short-term money market rates remained very low given the 0.10% official cash rate and the deterioration in the near-term growth outlook. Three-month bank bills ended the month 1bp lower at 1bp, while six-month bank bills ended 3bps lower at 3bps. Further out, markets are still pricing the first tightening from late 2022/early 2023.
August was a reporting-heavy month for corporates domestically and offshore. While strong earnings provided fundamental support to credit markets, Eastern state lock-downs muddied outlooks and pushed back previously bullish recovery/growth expectations. Elevated uncertainty has not prevented many Management teams from engaging in equity-friendly activity, including record dividends and buy-backs.
Separately, technical liquidity conditions have weakened, driven in part by the Northern Hemisphere summer holiday lull spilling over into domestic markets. Against this mixed backdrop, the Australian iTraxx Index ended the month 4bps tighter, while Australian fixed and floating rate credit indices closed 1bp wider and 1bp tighter respectively.
Immediately post earnings releases, three of the four major banks returned to the primary market. Notable transactions included NAB pricing the first AUD 5-year major bank senior unsecured bond issue since the pandemic began, at BBSW +41bps. CBA progressed its T2 issuance task with a 10-year (callable at five years) transaction at BBSW +132bps. Westpac launched its Capital Notes 8 ASX listed hybrid at BBSW +290bps (including franking), as did Macquarie Bank with its own ASX listed transaction at an identical initial margin. All attracted strong demand.
Elsewhere, the new issuance pipeline in the securitisation market remained very active, while in contrast non-financial corporates remained relatively muted. That said, with reporting season coming to an end, we do expect the latter to pick-up, presenting opportunities to selectively add to our portfolios.
Market outlook
There is an element of ‘Groundhog Day’ to the latest round of Delta lockdowns. The economy will contract sharply in the September quarter, with both NSW and Victoria locked down and the fall in the level of activity occurring then. As vaccination rates rise to 70-80% during the middle of the December quarter and restrictions begin to ease, activity will rebound quickly as the economy makes up for lost time. Our view is the economy will be back at June quarter 2021 levels by the March quarter 2022 and that economic growth over 2022 will be stronger and less volatile than 2021.
Faced with increasing uncertainty about the near-term outlook, we expect the Reserve Bank of Australia (RBA) to remain circumspect, reinforcing its message that monetary policy decisions would be ‘data’, not ‘date’ driven.
Our base case still has the first tightening in a cycle that takes monetary conditions from accommodative to neutral starting in H1 2024. By then we expect that the 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, will have been met.
Despite increasing uncertainty about the near-term outlook, markets are factoring in a 0.25% cash rate by the end of 2022, which we regard as being on the optimistic side. Nevertheless, we see the balance of risks tilted towards yield curve steepening over time as growth and inflation expectations are revised up as vaccination rates lift.
Spread sectors are likely to remain well-supported, with corporates in particular, benefiting from the tail winds 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. Inflation protection has cheapened, with breakeven inflation rates falling below the bottom of the RBA’s 2-3% target band. This was despite latent inflation pressures from a lower currency, challenged global supply chains and the wider opening up of the economy over 2022.
