Frank Uhlenbruch, Investment Strategist in the Janus Henderson Australian Fixed Interest team, provides his Australian economic analysis and market outlook.
Risk appetite surged on positive vaccine announcements and allowed markets to look through surging European and US COVID-19 infection rates. Equity markets roared ahead, delivering double digit returns in many countries. Positive sentiment cascaded over into credit markets, where spreads continued to tighten and there was also a lift in inflation expectations. The Australian government bond yield curve steepened following an easing in monetary conditions and lift in longer-dated offshore yields. The Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, ended November 0.11% lower.
“With the cash rate now at 0.1% and the RBA reluctant to move into a negative rate regime, further easing if needed is likely to come in quantitative form.”
The Reserve Bank of Australia (RBA) announced a package of easing measures early in the month. The cash rate target, the three-year government bond yield target and rate on new drawings under the Term Funding Facility (TFF) were all cut from 25 basis points (bps) to 10bps. With these moves already priced in, the three-year government bond yield ended the month only 1bps lower at 0.11%.
In contrast, longer-dated government bond yields were very volatile and traded the month in a 25bps range. The 10-year government bond yield fell to as low as 74bps following the RBA’s QE announcement of a six month, $100 billion bond purchase program focusing on 5-10 year government and semi-government debt. News of successful vaccination trials saw the 10-year government bond yield spike up to 99bps before closing the month 7bps higher at 90bps. The 30-year government bond finished 9bps higher at 1.89%.
Economic readings pointed to an economy regaining momentum following the reopening of the Victorian economy. Business conditions and confidence improved in the October NAB Business Survey and consumer confidence lifted sharply in November. The impact of government income support was evident in the 6.5% gain in real retail sales over the September quarter. This strong rise occurred despite an anaemic 0.1% lift in the Wage Price Index over the same period.
Labour market conditions continue to show signs of improvement. Employment rose by 179,000 over October despite Victorian lockdown measures. A lift in the participation rate from 64.8% to 65.8% meant that the unemployment rate edged up from 6.9% to 7%.
Money market rates adjusted to RBA policy moves, flush liquidity conditions and forward guidance for an extended period of highly accommodative policy. Three-month bank bills ended the month 4bps lower at 2bps, while six-month bank bills ended 4bps lower at 2.5bps.
The additional income available from the credit market remained attractive in the current environment and returns were buoyed by a decent tightening in credit spreads. The iTraxx Australia Index tightened 10bps to 60bps, while corporate bond spreads rallied 18bps with COVID-19 impacted sectors like Airports, Airlines, Energy and REITs performing the strongest on vaccine and border reopening news. Primary markets remained active as issuers sought to access the strong investor appetite for credit assets before market liquidity slows into the holiday season ahead.
Bank capital investors were kept busy with two ASX-listed hybrid deals from Westpac and NAB which were keenly sought after. Three of the major banks also issued Tier 2 subordinated bonds across the Australian and US dollar markets after reporting their results. Inaugural infrastructure issuers NBN Co. and Australian Gas Infrastructure Group collectively raised close to $2 billion, while several other corporate deals were also looking to launch in early December.
After falling sharply over 2020, we expect the Australian economy to rebound by around 5% over 2021. Large government transfers to households were saved mid-2020, with the household savings ratio climbing to an extraordinarily high 20%. Strengthening sentiment towards the end of the year suggests that the consumer’s mindset is shifting from ‘savings’ to ‘spending’ mode and this should underpin a vigorous rebound in consumption over 2021.
We also look for policy support to help drive positive contributions to growth from housing, business investment and public demand. Given the rundown in stocks and rebound in domestic demand, imports are expected to rise strongly and result in the external sector being a drag on overall growth over 2021.
While a 5% growth rate looks very high, we don’t expect the economy to reach end of 2019 levels until the first half of 2022. This means that the economy will have built up considerable slack and this will continue to show up in an elevated unemployment rate and inflation rate below the RBA’s 2% to 3% target band.
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With the cash rate now at 0.1% and the RBA reluctant to move into a negative rate regime, further easing, if needed, is likely to come in quantitative form. For example, the RBA could choose to increase the amount or extend the duration of its November 2020 program to buy government and semi-government bonds to the tune of $100 billion over six months.
A key takeaway for investors is that the low risk-free interest rate regime will persist for at least the next couple of years and drive demand for income-producing assets. The preconditions for a shift in accommodative policy is now ‘outcome’ based. Fiscal policy will move from accommodation to consolidation only when the unemployment rate falls below 6%.
Monetary conditions will only normalise (first tightening in a new cycle) when actual inflation is sustainably in the 2% to 3% RBA target band and the labour market is at full employment. We do not see these outcomes being achieved over the next several years.
While vaccine euphoria has led markets to price in better growth prospects, we see the current steepness in the Australian yield curve where the 10-year government bond is around nine times the cash rate, as more than compensating investors for term risk. Furthermore, the RBA’s QE program should also act to keep a lid on how high longer-dated yields can rise from current levels.
Despite ever-present solvency risks, we expect spread sectors to be shored up by the outlook for an extended period of low yields on government securities, unprecedented levels of central bank support for both sovereign and non-sovereign debt markets and investor demand for income.
We remain mindful that massive fiscal easing, burgeoning money supplies, geo-strategic supply chain reconfigurations and the blurring between monetary and fiscal policy in some jurisdictions raises medium to longer term inflation risks. Against this mix of cyclical and structural factors, we think it remains prudent to hold a modest core exposure to inflation-protected securities.