Frank Uhlenbruch, Investment Strategist in the Janus Henderson Australian Fixed Interest team, provides his Australian economic analysis and market outlook.
Market Review
Yields drifted lower after an earlier lift as markets increasingly took the view that the pace of central bank tightening was set to moderate. Risk appetite continued to recover, with both equity and credit performing strongly. Against this backdrop, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, rose 1.55%.
“With few signs yet of a significant slowing in activity and the risk that the latest round of inflation pulses end up being recycled into a higher core inflation rate via pass-through effects, the RBA has little choice but to tighten monetary conditions further.”
The Reserve Bank of Australia (RBA) lifted the cash rate by a widely expected 0.25% increment in early November, taking the cash rate to 2.85%. While noting monetary policy was not on a pre-set path, the RBA signalled that further tightening was likely over the period ahead.
Strong central bank messaging, especially after the US Federal Reserve (Fed) lifted the Fed funds rate by 0.75%, pushed yields higher early in the month. Thereafter, yields began to drift lower as markets reassessed the amount and pace of further monetary tightening following better than expected inflation readings.
At the shorter end of the yield curve, the three-year government bond yield rose to as high as 3.51%, before ending the month 13 basis points (bps) lower at 3.17%. Further out along the curve, 10- and 30-year government bond yields peaked at 4.04% and 4.37%, before ending at 3.53% and 3.88%.
On the data front, activity-based measures point to solid, but moderating, growth going into year end. Business conditions in the October NAB Business Survey remained at elevated levels though there was some easing in forward orders.
There were further signs that rising cost of living pressures and tighter monetary conditions were having an impact, with business confidence belatedly following consumer sentiment lower. Real retail sales rose by only 0.2% over the September quarter, while October sales surprised by falling 0.2%.
Labour market conditions remained strong, with employment lifting by 32,200 in October, whilst the unemployment rate edged lower to 3.4%. Strong 1.2% growth in private sector wages helped offset softer public sector gains and lift the September quarter Wage Price Index by 1% for a 3.1% yearly rate, the highest yearly rate since the March quarter in 2013.
In a break from months of large gains in yields, as the RBA lifted the cash rate and markets factored in a vigorous tightening cycle, short-term money market yields were flat to lower in November. Three-month bank bills ended largely unchanged at 3.09% while six-month bank bill yields ended the month 10bps lower at 3.56%. In terms of the tightening cycle, markets are looking for the cash rate to peak at around 3.85% in late 2023.
In credit markets, investor focus is shifting from the macro to the micro. Cognisant that the impacts of slower growth will be unevenly distributed and disproportionately felt, the trajectory of corporate earnings and credit fundamentals across sectors and sub-sectors are being closely scrutinised.
Domestically, primary markets were active, but limited to the financials and government-linked sectors, while non-financial corporates remained on the side-lines. Notable transactions included Westpac, NAB, Airservices Australia and Transpower New Zealand issuing senior unsecured bonds, and ING Bank issuing covered bonds, all at attractive levels. CBA also issued a large Tier 2 transaction at a margin of 2.7% (just 15bps lower than their recent hybrid), with a generous fixed rate coupon of 6.9%, just prior to APRA serving a reminder to the market about navigating capital instrument risks through a potentially challenging market environment ahead.
Early indications of a slowing in the pace of rate tightening globally, broadly conservative balance sheet settings, combined with attractive all-in yields, drove strong demand for credit into month-end. The Australian iTraxx Index closed 40bps tighter at 90bps, while the Australian fixed and floating credit indices returned +1.35% and +0.43% respectively.
Also read: We Have Been Expecting You, Mr Bond!
Market outlook
We expect to see the impacts of rapid monetary tightening progressively show up as we go through 2023. With tightening monetary conditions and slowing consumer spending, we see the rate of economic growth halve to 1.5% over 2023. Such a growth rate is below Australia’s trend growth rate, and we should see some slack emerge that helps resolve demand and supply imbalances. While a recession is not our base case, it remains a significant risk given the uncertain paths for the Ukrainian War, energy prices and offshore central bank tightening.
Inflation is yet to be vanquished, but is set to slowly ease towards the top end of the RBA’s 2%-3% target band over the next couple of years. Nearer term, inflation pulses are expected to come from higher fruit and vegetable prices following recent flooding and the re-introduction of fuel excise rates in the December quarter. Higher gas and electricity charges will also be a significant driver of inflation over 2023.
With few signs yet of a significant slowing in activity and the risks that the latest round of inflation pulses end up being recycled into a higher core inflation rate via pass-through effects, the RBA has little choice but to tighten monetary conditions further.
Our base case view is that the cash rate peaks at a moderately restrictive 3.6% in mid-2023. That would make the current tightening cycle the largest and fastest in the monetary policy inflation targeting era. As we expect to see growth and inflation to decelerate over 2023, the door opens for the RBA to take its foot off the monetary breaks over 2024 and begin bringing monetary settings back towards more neutral levels.
After pricing in a 4.4% long run cash rate (using the 8-year rate 2-year forward as a proxy) in mid-November, markets appear to be finally acknowledging that tight monetary conditions will have an impact. At the time of writing, this rate had fallen to 3.91%, releasing a large chunk of the value that we had seen building up.
In navigating the environment ahead, investors should be on the lookout for improved compensation for risk as monetary policy tightens further. We observe that the repricing across different pockets of credit and risk premia have not been simultaneous, providing outperformance opportunities through active rotation.
Attractive yields on high-quality credit spreads have seen demand return from defensive income investors. In our view, the more illiquid, structured, and levered sectors of the market are yet to adequately reprice. We believe this is a process that will occur in due course as earnings outlooks weaken. We anticipate that as conditions tighten further, global spreads will suffer decompression where high-quality liquid credit outperforms lower quality as compensation for default risk and illiquidity needs to increase. We continue to favour being positioned up in quality and seniority in capital structures, leaving powder dry for when compensation for investors escalates.
