Frank Uhlenbruch, Investment Strategist in the Janus Henderson Australian Fixed Interest team, provides his Australian economic analysis and market outlook.
Market Review
Volatility eased as offshore banking sector concerns faded, allowing for a recovery in risk appetite that supported equity and credit markets. Markets took Reserve Bank of Australia (RBA) reforms in their stride and held onto the view that the peak in the current cycle had been reached. Short and longer dated government bond yields rose modestly after last month’s large falls. Against this backdrop, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, rose 019%.
The current tightening cycle is maturing and heading towards the plateau phase.
The RBA left the cash rate unchanged at 3.60% in early April, ending a run of consecutive tightenings beginning in May 2022. Whilst pausing, the RBA kept a strong tightening bias noting that further tightening may well be needed to ensure that inflation returns to target. Three- and 10-year government bond yields ended the month 6 basis points (bps) and 4bps higher at 3.00% and 3.34%.
Economic data painted a picture of ongoing resilience, with the March NAB Survey recording above average business conditions and the preliminary April Judo Bank composite PMI moving back into expansion territory. Labour market conditions remain strong, with employment in March lifting by a stronger than expected 53,000. The unemployment rate remained low at 3.5%.
On the prices side of the economy, the Consumer Price Index (CPI) showed moderating but broad-based inflation. The headline inflation rate lifted by 1.4% over the March quarter for a yearly rate of 7%, still well above the mid-point of the RBA’s 2% to 3% target band.
Short-term money markets continued to discount no further near term moves in the cash rate. Against the current cash rate of 3.60%, three-month bank bills ended 4bps lower at 3.68% and six-month bank bill yields ended 7bps higher at 3.86%.
Credit markets calmed down in April as investor focus shifted from recent offshore banking crises to northern hemisphere Q1 corporate earnings. Mid-way through the reporting season, results have in aggregate been decent. That said, forward looking statements continue to emphasise a highly uncertain macro-economic backdrop and a resultant cautious tone. There were also indications that the US regional banking crisis may not be completely over, with First Republic Bank’s challenges featuring heavily in news flow.
Primary markets re-ignited, with well-known Australian investment grade corporate issuers Transurban, Sydney Airport and Telstra electing to issue bonds in Europe. Each deal was well-received, demonstrating strong global debt investor appetite for high quality infrastructure type issuers with hard asset backing and elements of inflation protection within cashflows.
In the domestic primary market, notable transactions included Stockland issuing an A- rated seven-year bond at a reasonably attractive credit spread / coupon of +170bps / 5.45%, while Worley issued a BBB rated five-and-a-half-year sustainability-linked bond at a credit spread / coupon of +250bps / 5.95%. In structured credit markets, Suncorp issued a prime bank residential mortgage backed security (RMBS) transaction with senior AAA notes paying a margin of +130bps over the one-month bank bill swap rate, whilst Bank of Queensland issued a five-year conditional pass-through AAA rated covered bond at margin of +120bps over the three-month bank bill swap rate. Looking ahead, three of the four major banks hand-down their half-results shortly, following which further new issuance is anticipated.
The Australian iTraxx Index closed 2bps tighter at 89bps, while the Australian fixed and floating credit indices returned +0.45% and +0.46% respectively.
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Market outlook
The current tightening cycle is maturing and heading towards the plateau phase. While the March quarter CPI recorded broad based inflation, the rate of inflation has begun to slow, and with trimmed inflation lifting by 1.2%, the RBA doesn’t have the smoking gun needed to make a May tightening a certainty. We still think there is a case for one final tightening taking the peak to 3.85% given labour market strength and building wage pressures. Furthermore, activity measures remain strong at the margin.
After warning of the dangers and economic cost of not tightening enough to crush inflation with the first pulse of tightening, there is the risk that stopping at 3.60% is premature. Though monetary policy is restrictive, it may not be restrictive enough and a near term move would allay that risk and allow for a more confident pause to assess the outlook.
If the RBA chooses to pause in May, we would expect them to maintain a strong tightening bias with a move in June or July likely. We suspect that policy conditions are tight enough to push the economy into a period of sub trend growth rather than outright recession. In our view, monetary easing is unlikely this year with the window for easing opening in the first half of 2024 as a building output gap reinforces the trend of disinflation.
We currently see market pricing of a small chance of one further tightening, with an easing fully priced by April 2024 and a cash rate of around 3.10% by the end of 2024 as not that wildly off the mark. We currently see the Australian yield curve as broadly valued. We remain on the lookout for tactical opportunities to add duration on spikes in yields on 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 30 April 2023.
