Emma Lawson, Fixed Interest Strategist – Macroeconomics in the Janus Henderson Australian Fixed Interest team, provides her Australian economic analysis and market outlook.
Market Review
There has been an almost round trip in yields through August, with early month focus on higher central bank policy fading in light of data uncertainty and poor economic news out of China. Shorter dated tenors retraced the moves and more, while lingering structural factors kept longer date yields tighter. Against this backdrop, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, rose 0.74%.
Markets are balancing the uncertainties, pricing only a fraction of a hike for the Reserve Bank of Australia before modest easing late 2024.
It has been a volatile month for bond yields, moving back to cyclical highs and then dropping again. The economic narrative is uncertain, and markets reflected that. The Reserve Bank of Australia (RBA) are also uncertain, and continued with their cautious pause, at 4.10%, at their August meeting. Three-year government bond yields ended the month 13 basis points (bps) lower at 3.74%, while 10-year government bond yields were 3bps lower at 4.03%.
Early in the month, the prevailing economic commentary surrounded the US economy’s non-landing, where the economy doesn’t slow, despite the rise in the Federal Reserve funds rate. This prompted a rise in yields driven by expectations of more rate hikes in the US. There was concern around US bond issuance as the fiscal deficit outlook worsened. Global inflation moderated, but not rapidly and some of the easy price moderation gains from easing supply chain pressures have abated. This worried markets and held up central bank rate expectations. There was a strong belief that US Federal Reserve Chair Powell would outline a higher US neutral interest rate at the annual Jackson Hole conference.
Also read: Reassessing The Outlook For Yields
The mood changed as Powell remained highly data dependent at that speech. Then news out of China dominated the macroeconomic landscape and has implications for Australia. China’s ongoing property sector woes worsened, with corporate property developers under pressure, filtering through to the financial sector. The People’s Bank of China has lowered very targeted interest rates but there has been no wholesale easing of policy in China. The global purchasing manager indices have also moderated, with services in particular falling. This will get the RBA’s attention through the impact on exports and mining investment. Australia’s exports fell 2% year on year (yoy) in June.
The RBA are balancing the inflation risks against the weakening household sector. On inflation there was mixed news, as the monthly Consumer Price Index was lower than expected, rising 4.9% yoy in July, from 5.2% yoy in June. The core measure remained sticky, with rent and energy costs rising strongly. Wages were solid, rising 3.6% yoy although the big gains are expected in the third quarter, post the rise in award wages. Things aren’t so rosy on the household sector, with second quarter real retail sales falling 0.5% quarter on quarter (qoq), the nominal monthly retail sales rose, buoyed by the World Cup, and difficult seasonality factors. The partial indicators suggest further weakness.
Markets are balancing the uncertainties, pricing only a fraction of a hike for the RBA, peaking at 4.16% in early March 2024. A whole RBA cut is not priced until late 2024. Against the current cash rate of 4.10%, three-month bank bills ended 13bps lower at 4.13%. Six-month bank bill yields ended 27bps lower at 4.37%.
Throughout the month, credit markets were relatively resilient despite sharp gyrations in bond yields. Investor expectations swivelled between soft-landing, recession and deflationary scenarios, depending on the day. Against this back-drop, many Australian Companies handed down their full-year results for the financial year ended 30 June 2023. In what has been a recurring theme, earnings broadly continued to fare better than initially feared. However, in the detail, there is evidence emerging that rising costs of living and tighter financial conditions are finally starting to impact consumers and corporates alike, though impacts are being felt highly un-evenly.
The Australian primary market was active post corporate reporting. New issuance was readily absorbed by investors (including non-traditional cross-asset ones) attracted by the combination of higher base rates and decent spreads on offer in investment grade credit. Notable transactions included CBA issuing a jumbo $5 billon deal comprising three- and five-year AA- rated senior unsecured bonds at credit spreads of 75bps and 95bps above swaps respectively. These attracted record demand of ~$7.8 billion.
Lower down the capital structure, UK national champion bank Lloyds Banking Group issued an inaugural $750m BBB- rated Australian Dollar denominated Tier 2 bond callable in five years, at an attractive yield of 7.086% (swaps +290bps). NAB issued its latest AT1 ASX Listed Hybrid, NAB Capital Notes 7. Similarly rated BBB-, this $1 billion transaction was issued at margin of +280bps over the three-month bank bill swap rate (including franking). Lastly, structured credit markets were also active with a notable transaction being ING Bank’s $2 billion IDOL RMBS deal where senior AAA notes were issued at a margin of +110bps over the one-month bank bill swap rate.
The Australian iTraxx Index ended 5bps wider at 78bps, while the Australian fixed and floating credit indices returned +0.99% and +0.46% respectively.
Market outlook
We have formally removed the last RBA rate hike from the base case profile, as the inflation data moderates, and the underlying data softens from solid levels. The RBA are clearly concerned about the impact of prior hikes on the household sector and are presently in wait and see mode. We see the RBA on hold until mid-2024 when they commence a modest easing cycle.
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 will now be monitoring the global economy closely for signs of faster than expected slowing.
We currently see market pricing of less than one hike and easing in very late 2024 as underestimating the economic headwinds in 2024. We currently see the Australian yield curve as under-valued. 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 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 31 August 2023.
