Liz Harrison, Fixed Interest Analyst – ESG in the Janus Henderson Australian Fixed Interest team, provides her Australian economic analysis and market outlook.
Market review
The reflation trade gathered momentum over the month and bond markets sold-off sharply in February. Given the rapid pace of the vaccine rollout offshore and the commencement locally, markets responded to the idea that the global economic recovery will be strong as lockdowns end and inflation is expected to lift higher. This is buoyed by a backdrop of expansionary monetary and fiscal policies, with markets challenging central banks on whether they’ll stay the course with forward guidance and yield curve control over the next three years. Credit markets were relatively stable considering the tightening of financial conditions in the rates market. The Australian bond market had its largest negative monthly drawdown since 1983, with the Bloomberg AusBond Composite 0+ Yr Index ending February 3.58% lower.
“The Australian bond market had its largest negative monthly drawdown since 1983, with the Bloomberg AusBond Composite 0+ Yr Index ending February 3.58% lower.”
Yields at the shorter end of the yield curve drifted higher than the Reserve Bank of Australia’s (RBA) 0.10% cash rate and three-year government bond yield target. The three-year government bond edged up to 0.127% before ending the month at 0.117%. Longer-dated government bond yields lifted to their highest level in two years, with fears that policy makers have over-stimulated. The Biden administration’s US$1.9 trillion COVID-19 relief bill awaiting to be passed by the senate comes at a time when the private sector is rebounding and the labour market is recovering. Dovish central bank commentary by the US Federal Reserve (Fed) and RBA did little to ease the falling bond market. The 10-year Australian government bond yield ended the month 78 basis points (bps) higher at 1.91%. The 30-year Australian government bond finished 77bps higher at 2.91%.
New business capital expenditure rose by 3% in the December quarter to $29.4 billion, beating expectations of a 1% rise. Business investment on equipment, plant and machinery grew by 5.7%, indicating that the Federal government’s business investment incentives may be having an impact. This is on top of the previous significant rise in residential building approvals.
Following the fall in the unemployment rate in the December quarter from 7.4% to 6.4%, domestic wages surprised to the upside, with a 0.6% rise. This exceeded expectations by double, pushing the annual wage growth rate up to 1.4%. Most of this was in the private sector as labour shortages were reported and many businesses lifted short-term wage reductions back to pre-pandemic levels.
Iron ore prices continued their upward trajectory over the month. While China still accounts for 50-60% of iron ore demand, growing demand has picked up outside of China. This fuelled the recovery story for the Australian economy, given the benefit to the budget from stronger company tax revenues, notwithstanding the negative impact from the stronger Australian dollar.
Money market rates remained very low given the 0.10% official cash rate and RBA forward guidance for an extended period of highly accommodative policy. Three-month bank bills ended the month higher at 3bps, while six-month bank bills rose 0.5bps to 2bps.
Credit markets continued their string of positive returns above government equivalents in February, with Australian and global credit markets finishing the month tighter in spread. Floating rate notes (FRN) outperformed fixed coupon bonds as the negative return contribution from the sharp rise in bond yields more than offset the positive contribution from income and credit spread compression. Spreads on Australian investment grade credit tightened 4bps due to outperformance in A and BBB rated sectors, which showed some resilience during the recent reporting season. Bank FRN spreads were wider by 2bps, unable to sustain their very tight levels as liquidity conditions became more challenging late in the month.
Higher yielding spread sectors like bank hybrids and subordinated notes returned between 0.2-0.5% as a reasonable level of income remains in high demand, with term deposit rates remaining very low and banks still reporting very high levels of liquidity and capital. The iTraxx Australia Index was unchanged on the month. After tightening 6bps to 57, the Index weakened to finish back at 63 during the more volatile final week.
Primary issuance picked up in February, with a number of issuers attempting to capitalise on the tight spread environment post reporting. In local financials, we saw Suncorp-Metway issue a five-year deal at a margin of 45bps, while Macquarie was active in capital notes issuing a Group hybrid at 290bps and a US dollar Bank Tier 2. Offshore banks were also active, with BNP, UBS and Svenska Handelsbanken all coming to the Australian dollar market. Charter Hall Long WALE REIT, with their inaugural bond deal was the long awaited first corporate issuer of the year which saw strong demand for both seven- and 10-year bonds issued at margins of 95bps and 115bps respectively. The book was three times oversubscribed for the $500 million of bonds available.
Market outlook
We see 2021 as a reopening year, as the vaccine programs continue to roll out, lockdowns become obsolete or less frequent and policy settings remain supportive. Cheap money will likely have a large effect on asset prices, as already demonstrated by the rise in the domestic housing market. Building approvals have risen sharply and this trend is set to continue. This has a multiplier effect as industries of design, planning, raw materials and furnishings benefit.
With the pick-up in economic activity comes a narrowing of spare capacity in the labour market. Adding to this is the build-up in household savings from government handouts, lockdowns, inability to travel overseas and cautionary savings. As the pressure valve is released on pent up savings, this is likely to give a sugar hit to discretionary goods and services, with figures already showing a lift in credit card spending on restaurants and cafés. Spending will likely discriminate, as businesses reliant on offshore tourism will continue to struggle. We look for the economy to lift by 5% this year, which should see the economy return to the same size it was at the end of 2019. Of course, risks around the effectiveness of vaccines against COVID-19 mutations and the vaccine’s rollout remain.
The global and domestic yield curve (cash – 10-year spread) has steepened since late 2020 as markets factored in a cyclical rebound and greater tolerance by central banks for inflation to run higher. The violent sell-off in bond markets (yields materially higher) in February has markets pricing in an earlier return to the RBA tightening monetary policy than the 2024 conditional commitment. Bond yields rose despite the asset purchase programs and dovish rhetoric from central banks.
While a higher rate regime and steeper curve is somewhat expected given the improved outlook, we are mindful that the markets may have got ahead of themselves. A tightening of monetary conditions through the higher yields and currency strength should act as a drag on growth and require the RBA to keep monetary conditions accommodative. An expansion/extension of its quantitative easing program may be warranted to support medium-term growth prospects and support lower yields.
The broad macro-economic environment is positive for risk assets. A synchronised global growth recovery and fiscal and monetary policies that concur on “whatever it takes” should be supportive for credit. Corporates are in good health as liquidity buffers and debt tenors are extended and earnings recover. Notwithstanding, market dynamics are weakening. Rising bond yields have tightened financial conditions and valuations, and while still attractive to risk-free are now less compelling.
