Emma Lawson, Fixed Interest Strategist – Macroeconomics in the Janus Henderson Australian Fixed Interest team, provides her Australian economic analysis and market outlook.
Market Review
September started with a jump higher in yield and just kept on going. Led by the US, markets are increasingly factoring in higher-for-longer policy rates and adjusting long term expectations. There was a sharp steepening of curves, amid lengthening of central bank cycles. Against this backdrop, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, fell -1.53%.
Australian markets are tilted towards the global trend. A whole Reserve Bank of Australia hike is priced by the end of April 2024, while easing is not priced until 2025.
Bond market volatility continued, with the August price gains reversing in September and the sell-off extended late in the month. The Reserve Bank of Australia (RBA) remain uncertain, and continued their cautious pause, at 4.10%, at their September meeting. Three-year government bond yields ended the month 34 basis points (bps) higher at 4.08%, while 10-year government bond yields were 46bps higher at 4.49%.
Markets have increasingly moved towards a “higher for longer” theme, pricing in marginally more central bank tightening, but elongating the cycle. RBA pricing has one more hike priced by April 2024 with no cuts priced for 2024 and minimal in the US. Meanwhile, longer dated yields have risen sharply, amid commentary of a return to the pre-great moderation levels of yields, reflecting higher real yields over time. This has steepened the Australian yield curve and resulted in less of an inversion in the US.
The key global economic uncertainties remain, but a solid rise in oil prices have markets worried about inflation pressures returning. Indeed, Australia’s monthly Consumer Price Index (CPI) was dominated by a rise in fuel prices. However, at an annual rate of 5.2% year on year (yoy) and the core measures moderating, the RBA will be monitoring rather than reacting at this stage. The labour market is slowing, but from high levels suggesting modest wage growth. Forward indicators such as the underemployment rate, job vacancies and job ads are off their highs and pointing to moderation ahead. The unemployment rate, at 3.7% is still clearly in full employment territory.
Australian economic growth remains patchy. Q2 GDP was as expected at 2.1% yoy, with household consumption modest and inventories a big drawdown. Investment was supported by the public side. At 0.4% quarter on quarter (qoq), it is running below average. Net exports have been supportive, and while exports are moderating, imports are falling faster. With the decline in the Australian dollar, that trend can be expected to continue. The consumer side remains weak under the headlines supported by a variety of one-off entertainment supports. Momentum is slowing, and we see that past consumption has been drawing down aggregate savings for the first time since 2007. The decline in real disposable income points to a continuation of that theme.
Australian markets are tilted towards the global trend. A whole RBA hike is priced by the end of April 2024, while easing is not priced until 2025, and a very shallow one at that. Against the current cash rate of 4.10%, three-month bank bills ended 1bp higher at 4.14%. Six-month bank bill yields ended 3bps higher at 4.40%.
Typical for this time of year, markets were downbeat as investors returned from the northern hemisphere summer break and contemplated a murky forward macro outlook. Sentiment was further weakened by a sharp rise in bond yields towards month / quarter end, and building evidence of slowing global growth. Soft-landing probabilities were re-assessed as market participants considered a wider range of alternative scenarios. Amongst these are an increasingly credible scenario of weaker growth alongside a higher-for-longer rate environment to combat sticky inflation (i.e. Stagflation), with consequent negative implications for risk assets more broadly.
Notwithstanding these complexities, primary markets re-opened globally with a raft of new issuance. The domestic market was no exception and a number of financial and non-financial corporates issued bonds. Notable transactions included Westpac who issued a $2.4 billion five-year AA- rated senior unsecured bond at a credit spread / coupon of +93 bps / 5% respectively. Leading general insurer Suncorp Group issued a $600m A- rated Tier 2 floating rate bond callable in 5.75 years at a credit spread of +235bps above swaps. Lastly, Sydney toll-road group WestConnex returned to the market with its second Australian Dollar denominated bond transaction. Rated BBB+, this $550m seven-year fixed rate senior secured noted was issued at an attractive credit spread / coupon of +170 bps and 6.15% respectively. The popular transaction attracted strong investor demand, demonstrating significant lending appetite for infrastructure businesses with resilient, inflation protected cashflows.
Securitisation markets were also active. Of note, Volkswagen Financial Services Australia returned to market to issue its Driver 8 Auto Asset-Backed transaction. Senior AAA notes were issued at an attractive margin of +130 bps over the one-month bank bill swap rate.
Adjusted for the semi-annual roll, the Australian iTraxx Index ended 3bps wider at 88bps, while the Australian fixed and floating credit indices returned -0.58% and +0.37% respectively.
Also read: The Fed’s Inflation Fight: No Victory … Yet
Market outlook
We continue to see the most likely outcome as one in which the RBA remains on hold at 4.10% until the second half of 2024. We have a modest easing cycle on late 2024, predicated on a slowing in economic growth as it responds to the current contractionary stance of monetary policy.
We see a relatively small risk to the upside for the RBA from our baseline scenario. We have a modest tilt to the higher case of a peak in the cash rate of 4.35% if services inflation persists. This is most likely to occur if productivity in the economy remains moribund.
The RBA are now monitoring the balance between the slowing household sector, the strong labour market, and high wages growth. We remain in the midst of the peaking of the economy but believe that policy will continue to grip and slow economic growth, with a shallow recession starting early next year not off the table. The RBA are closely monitoring the rise in oil prices as well as global economic slowing as risks to the outlook.
We currently see market pricing of one hike and easing in 2025 as underestimating the economic headwinds in 2024. We currently see the Australian yield curve as under-valued at points in the curve. We remain on the lookout for tactical opportunities to add further duration on spikes in yields triggered by central bank signalling and data flows.
In recognition of the complex investment environment, our credit strategy remains skewed towards high-quality, investment grade issuers with resilient business models, solid earnings power and conservative balance sheets. We have been actively and selectively taking advantage of the attractive yields on offer in highly rated corporate bonds and structured credit, particularly in the primary markets where transactions have come with new issue concessions. While we believe that the cumulative impacts of tightening financial conditions will increasingly become evident, we remain open-minded to a wider range of potential economic outcomes that include scenarios less dire than ones revolving around deep recession.
Backed by fundamental research and experience, we have and continue to identify pockets of opportunity where perceived risks have been overly discounted into the valuations of what would traditionally be considered stable and sustainable credits. In such instances, a strong case can be made for capital gains over-and-above already attractive cash yields, setting up for outstanding risk adjusted returns for patient investors with a medium term investment horizon. We have judiciously begun to access such opportunities, while also preserving significant capacity to take advantage of opportunities arising through future market dislocations.
Views as at 30 September 2023.
