Frank Uhlenbruch, Investment Strategist in the Janus Henderson Australian Fixed Interest team, provides his Australian economic analysis and market outlook: February 2022.
Market review
A hawkish pivot by the US Federal Reserve (Fed) in the face of persistent inflation drove yields higher. In turn, higher US yields spurred risk-off sentiment in equity and credit markets. Australian yields rose following offshore leads and strong domestic inflation readings. The Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index fell by 1.02% over January.
The three-year government bond yield rose by 40 basis points (bps) to end at 1.31%. Markets moved to factor in an imminent and aggressive tightening cycle by the Reserve Bank of Australia (RBA) following domestic data readings and hawkish Fed guidance. There was some flattening in the yield curve, with 10 and 30-year government bond yields lifting by 22.5bps and 7bps to end the month at 1.895% and 2.465% respectively.
December labour force and December quarter CPI were key releases. Labour market data needs to be viewed with the caveat that the sampling period pre-dated the Omicron surge late in the month. Employment rose by a healthy 64,800, while the unemployment fell by more than expected to 4.2%.
Prices data was stronger than both market and RBA estimates. The headline CPI rose by 1.3% over the quarter for a 3.5% yearly rate. Core inflation measures were also strong, with the trimmed mean rising by 1% for a 2.6% yearly rate. Key drivers were higher fuel, home building and domestic holiday prices.
Short-term money market rates continued to edge higher on economic readings and offshore central bank leads. Three-month bank bills ended the month 0.5bps higher at 7.5bps, while six-month bank bills ended 4bps higher at 25bps. Markets continued to bring forward RBA lift-off, with cash futures pricing in a 0.25% cash rate by May, 1% by November and 1.5% by May 2023.
Credit markets became more volatile and risk sentiment soured following the Fed’s hawkish pivot and rising geopolitical instability caused by the potential for armed conflict in Eastern Europe. The Australian iTraxx Index closed 12bps wider, while Australian Fixed and Floating Rate credit indices closed unchanged and 1bps wider respectively.
The domestic primary market was very active in the first three weeks of January, before grinding to a halt towards month-end as market conditions worsened. Even so, new issuance which was dominated by financials and supra-nationals, achieved a monthly record (highest since 2009). As was widely anticipated, two of the four Australian major banks came to market with five-year senior unsecured floating and fixed rate transactions, resetting the bank funding curve in a post Term Funding Facility (TFF) environment. Both CBA and Westpac priced their respective issuances at three-month BBSW +70bps, with CBA’s jumbo $4 billion transaction (split $3.1 billion floating and $0.9 billion fixed) setting transaction size records amid substantial investor demand.
Looking ahead, investors will be kept busy digesting earnings updates as companies offshore and domestically commence their reporting cycles. Corporates are generally in good health. Notwithstanding, inflation has begun to impact margins, profitability, discount rates and valuations, while many management teams concurrently pursue growth/shareholder-friendly activity. Specifically, in relation to corporate credit, results and outlook statements will be closely scrutinised for any early indications of peaking in fundamentals.
Market outlook
Monetary normalisation is coming, with the first cab off the rank being the upcoming decommissioning of remaining quantitative measures. While we also expect the RBA to pivot to a more hawkish stance following upward trending core inflation readings, we remain in the cash rate ‘lift-off’, not ‘blast-off’ camp.
We have brought forward the timing of the first tightening from early 2023 to November this year and look for a steady tightening cycle that takes the cash rate to 1.75% by early 2025. Markets are pricing an earlier and more aggressive tightening cycle, with the cash rate topping at 2.25% mid-2025. A cash rate at that level would be a restrictive setting and the cycle move of 225bps much more than the last cycle move of 175bps.
Given that the starting point for this cycle is an economy that is only the same size as it was in late 2019, is still digesting Omicron disruptions and given that most inflation reflects temporary supply side factors, the markets pricing for ‘blast-off’ tightening is perplexing. With fiscal stimulus waning, tightening too aggressively runs the risk of choking off any post-pandemic bounce.
While we have sympathy for the cash rate lifting narrative, current market pricing at the shorter end of the yield appears too aggressive in our view and we see the three-year government bond yield of 1.31% (at month end) as beginning to offer value. At the longer end, we see the 10-year government bond yield at 1.895% (month end levels) as being broadly fairly valued with the recent sell-off restoring term premia at a time of heightened inflation risk.
Though monetary conditions are set to normalise and bond yields exhibit elevated levels of volatility, it is worth bearing in mind that overall settings still remain accommodative and pro-cyclical. We continue to remain positive on domestic credit fundamentals as the economy navigates living with COVID, and the economic outlook remains positive over the medium term. As valuations normalise in the financials space, this should present opportunities to add quality credit which, from a fundamental perspective, should benefit from a tightening labour market exhibiting increasing wages and low levels of unemployment.
We continue to remain very active and selective in this transitional environment, favouring relative value within sub-sectors whilst being cautious on overall credit beta. We retain capacity and liquidity to access higher spreads should volatility permeate across credit markets as corporate demand for capital and primary supply ramps up in 2022. We also expect this to occur against the backdrop of sharper bouts of volatility as market sentiment adjusts from having lenders of last resort with deep pockets, to finding market-based clearing levels for risk and liquidity.
We continue to be attracted to semi-government securities, particularly those issued by NSW as market pricing has adjusted with the impending removal of formal QE from the RBA. Our inflation protection strategies continue to bear fruit, with breakeven inflation rates moving up towards the middle of the RBA’s 2-3% target band. We still see a role for some modest inflation protection given the risk of cyclical price pressures finding their way into both higher core inflation and inflation expectations.
