Frank Uhlenbruch, Investment Strategist in the Janus Henderson Australian Fixed Interest team, provides his Australian economic analysis and market outlook.
Market review
Volatility returned as markets tried to discount the impact of Russia’s invasion of the Ukraine on the global growth and inflation outlook and on central bank tightening timelines. Risk appetite weakened, with credit markets softer. Australian yields rose as rising inflation concerns more than offset periodic safe-haven flows. The Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index fell by 1.21% over February.
“Russia’s invasion of the Ukraine, persistent inflation concerns and expectations of aggressive near-term rate hikes by developed market central banks led to risk-off conditions in credit markets.”
The three-year Australian government bond yield rose to as high as 1.74% as inflation fears peaked before easing back late in the month as sanctions on Russia ratcheted up. Despite a late month rally, the three-year government bond yield ended 23 basis points (bps) higher at 1.54%. At the longer end of the yield curve, 10- and 30-year government bond yields lifted by 24bps and 16bps to end the month at 2.14% and 2.63%, respectively.
Partial demand indicators point to a strong rebound in economic growth over the December quarter. While employment growth surprised on the upside in January and the unemployment rate remained at 4.2%, the key news was the 8.8% Omicron-induced fall in hours worked. Slowing activity early in the new year was also picked up by a solid fall in business conditions in the NAB Business Survey. Elsewhere, strong labour market conditions had yet to spill over into accelerating wages growth. The Wage Price Index lifted by 0.7% over the December quarter for a yearly rate of 2.3%.
Short-term money market rates were relatively steady, with three-month bank bills ending the month 0.5bps higher at 8bps, while six-month bank bills ended unchanged at 25bps. Markets continued to discount an aggressive tightening cycle, with cash futures pricing a 1.0% cash rate by December and 2.0% cash rate by mid-2023.
Russia’s invasion of the Ukraine, persistent inflation concerns and expectations of aggressive near-term rate hikes by developed market central banks led to risk-off conditions in credit markets. The Australian iTraxx closed 18bps wider, while Australian fixed and floating rate credit indices closed 7bps and 5bps wider, respectively.
In the domestic market, bank reporting highlighted net interest margin (NIM) headwinds and continued intense competition in mortgages, while at the same time, asset quality and capitalisation levels remained robust. NAB came to the primary market shortly after, issuing $4bn of three- and 5-year senior unsecured bonds at ASW +47bps and +72bps, respectively, in fixed and floating rate format. ANZ launched and priced an ASX Listed AT1 refinancing transaction, ANZPJ, at BBSW +270bps. Supra-nationals and several Japanese, French and Singaporean banks also issued, taking advantage of a favourable cross-currency basis.
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Key themes emerging from corporate earnings reports included cost inflation, supply chain pressures and other Covid-related frictions impacting margins and cashflows. Otherwise, balance sheets remain healthy and liquidity ample. While issuers have remained on the sidelines electing to wait-out current market volatility, we expect the primary pipeline to pick up in the near-term.
The securitisation market on the other hand was very active, with a number of transactions pricing together across prime and non-conforming RMBS and ABS. Notably, transactions being marketed include two prime RMBS from Macquarie Bank and AMP Bank. These should provide pricing transparency for bank prime senior AAA RMBS in a post-Term Funding Facility environment and will be closely watched by investors.
Market outlook
Prior to Russia’s invasion of Ukraine, both the Reserve Bank of Australia (RBA) and Treasury were signalling that there was a unique opportunity to find out where Australia’s natural unemployment rate was. Premature tightening runs the risk of permanent welfare losses by limiting possible non-inflationary employment gains. Against the reward of full employment is the risk that the Phillips Curve could steepen suddenly, with inflation breaking out, leaving the RBA well behind the required tightening curve.
The breakout of the latest war brings with it seismic shifts in the global power balance and relevance of rules-based systems along with more ‘mundane’ supply side shocks and the negative impact of sanctions on global growth.
We suspect that faced with this additional uncertainty, the RBA will leave monetary settings ‘on hold’ until later in the year before commencing ‘lift-off’ in November. Such a pause gives the labour market the best chance to reach full employment and provides a buffer against the confidence sapping effects of geo-political uncertainty. A key judgement for this scenario to hold is that near-term inflationary pressures are of a cyclical supply side nature rather than structural nature.
Once the tightening cycle commences, we look for a fairly rapid transition from accommodative to more neutral settings, with the cash rate projected to reach 1.75% by H1 2024. Markets continue to price RBA moves more in line with those of the US Federal Reserve despite the Australian nominal recovery being less advanced. Futures markets are building in a cash rate of at least 2% by mid-2023 and a terminal cash rate of around 2.5% according to five-year forward rates.
While we look for policy normalisation, we remain sceptical of the speed and quantum of tightening currently priced in. Hence, we see some value at the shorter end of the yield curve. We see 10-year government bond yields at month end levels of 2.14% as broadly fairly valued, providing investors with term premia at a time of heightened inflation risk.
While we remain mindful of bouts of volatility caused by geo-political events and central bank actions, we remain on the lookout for periods of excessive spread widening given the favourable medium-term economic outlook and policy focus on extending rather than ending the current recovery phase. As valuations normalise in the financials space, this should present opportunities to add quality credit which, from a fundamental perspective, should benefit from a tightening labour market exhibiting increasing wages and low levels of unemployment.
We continue to remain very active and selective in this transitional environment, favouring relative value within sub-sectors, whilst being cautious on overall credit beta. We retain capacity and liquidity to access higher spreads during periods of volatility as corporate demand for capital and primary supply ramps up over 2022. Markets will also have to adjust from having lenders of last resort with deep pockets, to finding market-based clearing levels for risk and liquidity.
We remain attracted to semi-government securities, particularly those issued by NSW, as market pricing has adjusted to the removal of formal Quantitative Easing from the RBA. We hold onto our inflation protection strategies, especially as the Russian invasion elevates oil prices and exacerbates supply chain pressures. Furthermore, there remains the tail risk that the RBA allows the labour market to overheat and lead to an upward wage/price spiral.
