Frank Uhlenbruch, Investment Strategist in the Janus Henderson Australian Fixed Interest team, provides his Australian economic analysis and market outlook.
Market Review
Markets remained volatile, with yields surging on hawkish US Federal Reserve (Fed) commentary and retreating on expectations that the pace of global tightening may slow. Risk appetite recovered from September’s fall, with equity markets higher while credit markets remained volatile. Against this backdrop, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, rose 0.93%.
The Reserve Bank of Australia (RBA) lifted the cash rate by a less than expected 0.25% increment in early October, taking the cash rate to 2.60%. In subsequent commentary, the RBA noted that it was mindful of the impacts of the size and speed of policy withdrawal since May, both on the economy and relative to other central banks that did not meet as often.
Yields continued to trade in wide ranges, with UK political and policy instability, along with hawkish Fed guidance, driving US and domestic yields to their highs. UK fiscal policy reversal and a new UK Prime Minister, along with early signs of slowing in the pace of the global tightening cycle, saw yields fall towards month end. At the shorter end of the yield curve, the three-year government bond yield rose to as high as 3.76%, before ending the month 23 basis points (bps) lower at 3.29%. Further out along the curve, 10- and 30-year government bond yields peaked at 4.20% and 4.53%, before ending at 3.76% and 4.07%.
On the data front, activity-based measures point to solid growth over the September quarter, with the NAB Business Survey recording another month of very strong conditions in September. However, mounting headwinds from falling confidence, tightening monetary conditions and rising cost of living pressures may be starting to weigh on activity, with the preliminary October S&P Global Australian Composite PMI falling to a contractionary 49.6 from 50.9 in September.
There were also early signs that the labour market had begun to plateau after a strong expansion phase. Total employment rose by 900 in September, below expectations for a 25,000 gain. Both the unemployment and participation rate remained unchanged at 3.5% and 66.6%. Forward labour demand indicators appear to be softening from very strong levels.
The economy continued to experience broad based price pressures, with the headline consumer price index (CPI) lifting by 1.8% over the September quarter and 7.3% over a year ago. Core inflation remained elevated as well, with the average of the RBA’s statistical measures lifting by 1.6% over the quarter and by 5.5% over the year, well above the top of the RBA’s inflation target band.
Short-term money market yields initially fell on the smaller than expected RBA tightening, but climbed again following hawkish Fed signalling and RBA guidance that it would continue to tighten further to bring demand and supply into better balance. After falling to as low as 2.85% and 3.29%, three and six-month bank bill yields ended the month 2bps and 9bps higher at 3.09% and 3.66%. In terms of the tightening cycle, markets are looking for around a 3.1% cash rate by year’s end and for a further 100bps of tightening over 2023.
Credit investor focus turned to fundamentals as the northern hemisphere 3Q earning season commenced. Early results suggest companies in general continuing to outperform low expectations, while management outlook statements reflect concern around the potential for a 2023 global recession.
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Valuation divergence appears to be opening up in credit markets. In higher quality investment grade markets, a combination of higher base rates, wider credit spreads, and new supply, are resulting in increasingly attractive all-in yields not experienced for the last decade. Whereas in the more economically sensitive sub-investment grade markets, including the High Yield bond market, credit spreads have not pushed much beyond historical averages, in part reflecting muted supply as companies struggle to issue debt.
Domestically, significant supply resumed with two of the Major Banks (CBA and ANZ) combining to issue senior unsecured, tier 2 subordinated debt and additional tier 1 securities. The senior unsecured and subordinated debt were priced with significant new issue concessions and reset credit spreads across the broader corporate debt market.
Risk sentiment recovered somewhat towards the end of the month. Perhaps understating volatile and thinly traded markets, the Australian iTraxx Index closed 14bps tighter at 130bps, while the Australian fixed and floating credit indices returned +0.39% and +0.16% respectively.
Market outlook
While much of the heavy lifting has been done, persistent and broad-based price pressures, evident in the latest CPI, mean that the RBA will need to push monetary conditions into restrictive territory. We have revised our base case view to build in 25bps of tightening in November (delivered on Cup Day), December and February.
This would take the cash rate to 3.35% and into moderately restrictive territory and we expect the RBA to keep policy tight until the first half of 2024. While activity levels remain high at the margin, we anticipate growth to slow from around 3% over 2022 to a below trend 1.5% over 2023. A period of softer growth will help the supply side catch up to demand and relieve a source of pressure on inflation.
Gauging the economy’s underlying run rate nearer-term will be made more difficult by disruptions caused by recent flooding, the impact on consumption from higher variable mortgage rates and the large cohort that face moving from low fixed rates to current market rates. Given these uncertainties and the long and variable monetary policy lags, we still think it prudent for the RBA to pause after tightening in February and see how the economy responds to the fastest and largest tightening in the inflation targeting era.
Market pricing remains more aggressive, with the cash rate priced to peak at around 4.00% in H2 2023. As has been the case for several months, domestic markets continue to price the cyclical peak in the cash rate as the new normal, with forward rates projecting around a 4% cash rate for the next decade. During the spike in yields mid-October, this rate rose to 4.5%, making the mid-to-longer part of the yield curve attractive. While some of the value we saw then has been released, this type of volatility is a source of value for investors with a longer-term focus.
The commitment by central banks to tackle high inflation through tightening global liquidity conditions continues to generate volatility in credit markets. To navigate the environment ahead, investors should look for improved compensation for risk. 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.
Views as at 31 October 2022.
