Emma Lawson, Fixed Interest Strategist – Macroeconomics in the Janus Henderson Australian Fixed Interest team, provides her Australian economic analysis and market outlook.
Market Review
Markets have completed the turn, signalling an end to hiking and anticipating a full easing cycle, with Australia being pulled along for the ride. Against this backdrop, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, rose +2.69% in December.
Pricing for the Reserve Bank of Australia is modest, with the first cut expected in May 2024. Our base case is for the Reserve Bank of Australia to remain on hold at current rates before commencing an easing cycle in September 2024.
While the Reserve Bank of Australia (RBA) are right to continue to monitor for elevated inflation risks, the slowdown in economic growth and lower global inflation allows for the balance of risks to turn to the next phase of the cycle. With risks more balanced, the RBA kept the cash rate unchanged at their December meeting. Three-year government bond yields ended the month 40 basis points (bps) lower at 3.61%, while 10-year government bond yields were 45bps lower at 3.96%.
Against the current cash target rate of 4.35%, three-month bank bills ended 1bp lower at 4.36%. Six-month bank bill yields ended 13bps lower at 4.45%.
Another strong rally in bond markets, for the second month in a row, has been precipitated by the moderation in global inflation measures, and a seeming pivot in the US Federal Reserve’s (Fed) monetary policy stance. Lower economic growth signals, and moderating inflation have allowed markets to price a series of central bank interest rate cuts. The Fed reinforced that by including estimates of a full easing cycle in 2024 into their “dot plots” forecasts.
Local markets are pricing a less aggressive path for the RBA compared to global peers, but easing nonetheless. The local GDP data was weaker than expected for Q3, while forward indicators such as job ads and business confidence have also moderated more than expected. The RBA continue to monitor elevated services inflation but should be comfortable with the drop in inflation expectations.
Risk markets rallied hard in December as the Fed telegraphed an end to the rate-rising cycle, and markets quickly moved to price-in rate cuts in 2024. The long-awaited passing of the baton from the Macro to the Micro caused investors to re-evaluate their year-ahead investment outlooks.
Consensus is increasing around the achievement of a benign soft-landing scenario notwithstanding a persistent backdrop of slowing growth, restrictive financial conditions and a geopolitical back-drop showing little signs of calming. In credit markets, bifurcation is expected to persist into the new year. Returns on offer in low / no default risk Investment Grade bonds and upper echelons of securitised markets remained attractive on a risk-adjusted basis. Whereas in leveraged and sub-investment grade markets, credit spreads appear not to adequately reflect deteriorating fundamentals, rising defaults and upcoming sizeable maturity walls.
After several months of high activity, the domestic primary market was very quiet in December as market participants drew a line under an extraordinary 12 months. The Australian iTraxx Index ended 6bps tighter at 68bps, while the Australian fixed and floating credit indices returned +2.10% and +0.51% respectively.
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Market outlook
Most G10 markets moved to more aggressive easing priced in for 2024, with the Fed expected to start cutting rates in March. Pricing for the RBA is far more modest, with the first cut expected in May 2024. Our base case is for the RBA to remain on hold at current rates before commencing an easing cycle in September 2024. We price a more modest than average easing cycle, of around 175bps, spread over 12 months. We now see the risks skewed to the downside, with a rising probability that the RBA may have to move earlier and slightly faster than our base case. In this scenario, the RBA starts moving in August 2024, with a total of 250bps of cuts, to below neutral interest rates.
The RBA continue to monitor the balance between the slowing household sector, the strong labour market, and high wages growth. There are broadening signs of slowing in the economy through the household sector and the start of the business sector. This continues to be balanced against the stickiness of services inflation, and that will keep the RBA cautious until there is a clearer signal of downside risks and / or lower inflation.
We see the very near-term RBA pricing as a little premature, but the expectation of policy rates held above neutral over a period of years as underestimating the cyclical risks. We currently consider the Australian yield curve as under-valued at points in the curve. We remain on the lookout for tactical opportunities to add further duration, with an acknowledgement of the rally already completed.
In recognition of the complex global 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 restrictive financial conditions will become evident, we are mindful of a healthy starting point of above full employment and remain open-minded to a wider range of potential economic outcomes including those involving a soft-landing.
Backed by fundamental research and experience, we also 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 continue to judiciously seek out, create and access such opportunities, while simultaneously preserving significant capacity to take advantage of opportunities arising through future market dislocations.
Views as at 31 December 2023.
