Frank Uhlenbruch, Investment Strategist in the Janus Henderson Australian Fixed Interest team, provides his Australian economic analysis and market outlook.
Despite ongoing COVID-19 outbreaks, the commencement of vaccination programs and another round of fiscal easing in the United States helped buoy investor sentiment. Equity markets had another strong month, while credit markets remained firm. Expectations for a post-vaccine global rebound and burgeoning sovereign debt supply saw yield curves steepen and inflation expectations lift. The Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, ended December 0.27% lower but was up 4.48% over the year.
“While the Australian economy is recovering, the latest COVID-19 outbreaks in Sydney and Melbourne and simmering trade tensions with China are reminders are that we are not completely out of the woods yet.”
Yields at the shorter end of the yield curve remained anchored as the Reserve Bank of Australia (RBA) reaffirmed its 0.10% cash and three-year government bond yield target. The three-year government bond drifted up to 0.14% before central bank action saw it end the month at 0.106%, in line with the target.
Longer-dated government bond yields rose, mimicking offshore moves as growth expectations were revised up, US fiscal policy eased and the US Federal Reserve (Fed) and RBA didn’t increase their current QE programs. After lifting to as high as 1.04%, the Australian 10-year government bond ended the month 7 basis points (bps) higher at 97bps. The 30-year government bond finished 6bps higher at 1.96%.
Economic growth surged more than expected in the September quarter, with real output lifting by 3.3%. This move followed the significant lock-down related 7% plunge in the June quarter. Partial demand indicators pointed to strong momentum over the December quarter, with strong gains in business conditions and business and consumer confidence. Anecdotal reports suggest that retail spending was strong over the Christmas period.
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Labour market outcomes were also better than expected with the number of jobs lifting by 90,000 in November, building on the previous month’s 180,000 gain. The unemployment rate edged down to 6.8% from 7%, while the participation rate lifted to 66.1%, a level not seen since January 2020.
Money market rates remained very low given the 0.10% official cash rate and RBA forward guidance for an extended period of highly accommodative policy. Three-month bank bills ended the month 1bps lower at 1bps, while six-month bank bills ended 0.5bps lower at 2.0bps.
The environment remained supportive for credit assets, with spreads on corporate investment grade bonds tightening 5bps during the month to finish 12bps tighter over 2020. Bank floating rate note (FRN) spreads underperformed as spreads widened 4bps from very low levels on profit taking after a very strong year. Over the year, however, FRN spreads tightened 29bps thanks largely due to the RBA’s Term Funding Facility supporting bank liquidity.
Despite the pandemic escalating again in the northern hemisphere, higher yielding markets outperformed, with spreads tightening 37bps, continuing the strong momentum from the prior month. The improving market environment in the December quarter helped global high yield spreads claw their way back to finish only 47bps wider over 2020 after starting the year at very tight levels.
Issuers remained active in the domestic primary market in the early part of the month before market liquidity slowed into the holiday season. The market saw strong demand for higher credit quality spreads, with Western Sydney University, University of Wollongong and SMHL RMBS (ME Bank) pricing 10-15bps tighter than initial price guidance, while NBN Co. managed to come back to the market for the second time in as many months and Macquarie Bank issued $1.45bn of a five-year FRN. Industrial property exposure continued to be highly sought after by investors due to the relative lack of impact from the pandemic and a rare issuer, Goodman Australia Industrial Fund, raised $400 million but left a further $1.3 billion of demand from investors unfilled.
It appears aggressive fiscal and monetary measures have limited the damage caused by public health measures and helped boost business and consumer confidence. Growth and labour market outcomes at the end of 2020 were stronger than forecast six months ago and mid-year hopes for an effective vaccine were replaced by the commencement of vaccination programs, although these programs are expected to take years to complete.
While the Australian economy is recovering, the latest COVID-19 outbreaks in Sydney and Melbourne and simmering trade tensions with China are reminders are that we are not completely out of the woods yet.
We still look for the Australian economy to rebound by around 5% over 2021, though the latest outbreaks and reintroduction of state border controls have increased downside risks. While a 5% growth rate looks very high, we don’t expect the economy to reach end of 2019 levels until late 2021. This means that the economy will have built up considerable slack and this will continue to show up in an elevated unemployment rate, low rate of wages growth and inflation rate below the RBA’s 2% to 3% target band.
With the cash rate now at 0.10% 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 ongoing demand for income-producing assets. The preconditions for a shift in accommodative policy remain ‘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 couple of 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 ten times the cash rate, as providing investors more than adequate compensation for term risk. Nearer term inflation risks are low, with the stronger currency acting as a break on both activity and inflation.
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.