Emma Lawson, Fixed Interest Strategist – Macroeconomics in the Janus Henderson Australian Fixed Interest team, provides her Australian economic analysis and market outlook.
Market Review
As central banks edge closer to their policy peak, markets are starting to hope that the inflation genie is back in the bottle, without much detriment to economic growth. This allowed for some divergence across bond tenors. Shorter dated markets see a near term peak in policy, but policy held steady for longer, while longer dated markets eased long term risks. Against this backdrop, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, rose 0.5%.
The economic signals are mixed at present, and the Reserve Bank of Australia (RBA) are weaving through the conflicting signals. The RBA are monitoring the balance between the slowing household sector, the strong labour market, and high wages growth. We expect one more hike, to 4.35%.
In yet another very close call, the Reserve Bank of Australia (RBA) chose to pause its hiking cycle, at 4.10% at their July meeting. They are highly data dependent and assessing the two-sided risks in the context of an already historic hiking cycle. Three-year government bond yields ended the month 18 basis points (bps) lower at 3.87%, while 10-year government bond yields were 4bps higher at 4.06%.
The economic signals are mixed at present, and the RBA are weaving through the conflicting signals. In pausing at their meeting, they highlighted the peak in inflation. The headline Consumer Price Index (CPI) print is coming lower, faster than they expected, which is encouraging. This has been a global theme. However, the stickiness of services inflation, which rose in Q2, underpins their concerns surrounding low productivity growth and high wages growth. Q2 CPI was 6% year on year (yoy), down from 7%, so going in the right direction, while the trimmed mean was 5.9% yoy. However, services CPI rose to 6.3% yoy, the highest since 2001.
The labour market remains remarkably tight, with yet another month of outsized employment gains and the unemployment rate dropping to 3.5%. The labour market is a lagging indicator, and while strong, the forward indicators suggest the peak may be in. Job ads are lower, as is the NAB business survey employment intentions series. Wage growth is likely to remain high, with some notable enterprise agreements struck in the month. The RBA’s expressed concern is that high wages growth is inflationary if productivity remains well below averages. This remains a key inflation risk.
The fate of households and their tolerance to run down savings remains the key uncertainty. Household spending is slowing. Goods retail sales fell 0.8% month on month (mom) in June, while consumer confidence remains poor. The Australian Bureau of Statistics (ABS) and RBA have increasingly cited cost of living pressures, due to high food and rent inflation, as a key factor in deteriorating data.
The month also saw changes at the RBA. Governor Lowe will end his term in September, and Deputy Governor Bullock will become Governor in October. This allows for continuity of policy at the RBA. Dr Lowe announced some operational changes arising from the review, starting 2024. There will be fewer meetings (8) per year, and more press conferences, amongst other changes. These have no near-term policy implications and removes a source of uncertainty.
As the US Federal Reserve and other major central banks near their peak, amid the RBA pause, markets have elongated the expected RBA cycle. Pricing in a peak just under 4.35% but not until Q1 2024. There is just over one cut in 2024 now. Against the current cash rate of 4.10%, three-month bank bills ended 9bps lower at 4.26%. Six-month bank bill yields ended 6bps lower at 4.64%.
A risk-on tone returned to markets during the month. Investors were buoyed by a powerful combination of Artificial Intelligence (AI)-driven exuberance in the US large-cap technology sector, broadly decent Northern Hemisphere corporate earnings, moderating inflation data and solidifying expectations that Central Banks will be able to engineer soft-landing scenarios. While primary markets were active in US and Europe, the domestic market was quiet as issuers went into their black-out periods ahead of the upcoming Australian full-year earnings season.
A notable exception was Suncorp Bank issuing $1 billion of covered bonds. These five-year AAA rated instruments were issued in both floating and fixed rate formats at an attractive spread / coupon of +105bps and 5.2% respectively. New Zealand’s Local Government Funding Agency also issued an inaugural $1 billion five-year AA+ rated fixed rate note at an attractive coupon of 4.7%. Both transactions attracted strong investor interest.
Looking ahead, investors will be closely reviewing Australian company reporting and probing for any signs of weakness. Margins, the health of the consumer, and outlook commentary will be among the areas most carefully scrutinised. Our expectation is for the domestic primary market to re-open post reporting with a range of issuers coming to market. Against a complex macro backdrop, the combination of higher yields, attractive spreads and solid credit quality should result in Australian Investment Grade credit continuing to form attractive sources of return for investors.
The Australian iTraxx Index ended 9bps tighter at 72bps, while the Australian fixed and floating credit indices returned +0.85% and +0.46% respectively
Also read: Credit Quality Weaker Than Market Realises
Market outlook
We have reduced the probability of the very last hike in the cycle, with our central case now seeing one more hike in August to 4.35%. Although, we acknowledge that it may come a month later. However, the longer the RBA leave it, the worse the coincident economic data appears and the harder it is for them to raise rates to tackle inflation.
We see a relatively small 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 4.85% if services inflation persists. This is most likely to occur if productivity in the economy remains moribund. We presently expect the RBA to be easing policy in Q2 2024, but earlier and harder if the high case eventuates and the RBA place extra pressure in the interest rate sensitive parts of the economy.
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 early next year not off the table.
We currently see market pricing of one more rate hike, but delayed until 2024, and then policy held for an extended time, as underestimating the economic headwinds in 2024. We currently see the Australian yield curve as modestly 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 31 July 2023.
