Frank Uhlenbruch, Investment Strategist in the Janus Henderson Australian Fixed Interest team, provides his Australian economic analysis and market outlook.
Market Review
Stubborn inflation and hawkish central banks led to higher yields as markets moved to discount further monetary tightening. Risk appetite waned, with both equity and credit markets softening. Against this backdrop, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, fell 1.32% after gaining 2.76% the previous month.
A hawkish Reserve Bank of Australia, clearly anxious about the inflation outlook and indicating that work still needs to be done, has led us to factor in a 4.1% peak in the cash rate by mid-year.
While February’s 0.25% lift in the cash rate to 3.35% was widely anticipated, subsequent hawkish messaging from the Reserve Bank of Australia (RBA), including that they considered a 0.5% move, led markets to reassess the likely peak in the cash rate. Three and 10-year government bond yields ended the month 42 basis points (bps) and 30bps higher at 3.60% and 3.85%.
Activity based measures indicated that the economy looked to have gained some momentum early in the new year. Labour market conditions continued to ease slightly from extremely tight levels, with employment falling modestly for the second month in a row and the unemployment rate lifting to 3.7%. The Wage Price Index for the December Quarter came in at 0.8%, slightly lower than the RBA’s and market’s estimate. Despite tighter monetary conditions, private capital expenditure intentions remain strong.
Short-term money markets remained volatile as monetary tightening expectations pivoted on RBA signalling. Three- and six-month bank bill yields ended 19bps and 21bps higher at 3.56% and 3.93%. In terms of the tightening cycle, markets are now looking for the cash rate to peak around 4.25% during the second half of the year.
In credit markets, investors re-evaluated the implications of a ‘higher for longer’ interest rate regime for economic growth, margins, earnings and cashflows. Concurrently, a number of corporate treasurers utilised a window of opportunity to access the global primary debt markets in order to get ahead of further anticipated rises in the cost of debt. The new supply was relatively easily absorbed by investors eager to deploy elevated cash holdings into assets with attractive outright yields.
In the domestic credit market, Westpac followed on from CBA a month earlier, issuing $4.25 billion of senior unsecured bonds across three- and five-year tenors in both floating and fixed rate formats. Similarly meeting solid demand (~$7.5 billion order book), these bonds priced at credit spreads of +78bps and +95bps, and fixed rate coupons of 4.6% and 4.8% respectively.
Two other notable transactions were both undertaken by rival Big Four bank, ANZ. The first was a $1 billion fixed rate Tier 2 bond callable in 10 years, with an attractive credit spread of +280bps / yield of 6.736%. This was closely followed by a $1.5 billion ASX-listed Capital Notes 8 transaction sitting lower down in ANZ’s capital structure, at an almost equivalent credit spread of +275bps, callable in seven years. This pricing disconnect reflects differences in demand between institutional and retail investor buyer bases for these complex bank capital instruments.
The Australian iTraxx Index closed 5bps wider at 87bps, while the Australian fixed and floating credit indices returned -0.62% and +0.43% respectively.
Also read: Market Risks: A Golden Era No More
Market outlook
A hawkish RBA, clearly anxious about the inflation outlook and indicating that work still needs to be done, has led us to factor in a 4.1% peak in the cash rate by mid-year.
While monetary policy is a blunt instrument and operates with long and variable lags, it seems the slowdown in activity late last year hasn’t carried over into early 2023. Despite low levels of consumer sentiment and cost of living pressures, the January NAB Business Survey recorded improving business conditions, forward orders and capacity utilisation. Labour and purchase costs continued to lift at a fast pace.
This resilience was also evident offshore, particularly in the US, where markets shifted from looking through the tightening cycle to building in more tightening. Central banks, including the RBA, look set to continue their strategy of providing a dose of concentrated tightening, risking recession, to stop higher inflation from becoming entrenched.
We still think the most likely scenario is for a growth slowdown that sees demand fall to below trend and allows inflation to fall back into the top of the RBA target band. In their latest forecasts, which used a cash rate peak of around 3.75%, the RBA had core inflation falling to 2.9% by mid-2025. If the cash rate peaks higher, as we and the market expect, then the prospect of inflation falling into the top of the target band increases.
Nevertheless, with the cash rate expected to peak at 4.1% mid-year, the biggest and fastest tightening in the inflation targeting era, the risks of a hard landing from mid this year onwards have increased, but not enough to be our base case. We do not see the conditions in place for monetary easing until mid-2024.
Given the change to our cash rates forecasts, we currently see yields as broadly fairly valued. We remain on the lookout for opportunities to add duration on spikes in yields as we enter the more mature phase of the tightening cycle.
Investors should remain focused on improved compensation for risk as monetary policy tightens further. We continue to observe that the repricing across different pockets of credit and risk premia remains uneven, 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. This is 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.
Views as at 28 February 2023.
