Frank Uhlenbruch, Investment Strategist in the Janus Henderson Australian Fixed Interest team, provides his Australian economic analysis and market outlook.
Renewed COVID-19 outbreaks across the globe and a lift in geo-political tensions saw risk appetite wane. Equity markets were weaker, inflation expectations declined and there was some widening in credit spreads as investors adjusted to a more uncertain economic outlook. Australian government bond yields fell sharply as expectations for a near-term easing in monetary conditions rose. The Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, ended September 1.08% higher.
“With the upcoming budget due in early October, the stage is set for fiscal policy to carry the burden of pivoting policy from a ‘support’ to a ‘rebuilding’ role.”
Yields at the shorter end of the Australian government yield curve rallied following a speech by the Reserve Bank of Australia’s (RBA) Deputy Governor which outlined further conventional and unconventional easing steps the RBA could take if warranted. After trading in a relatively narrow band around the 0.25% three-year government bond yield target prior to the Deputy Governor’s speech on the 22nd September, the three-year government bond yield ended the month 10 basis points (bps) lower at 0.16%.
There was also significant movement further out along the yield curve, with longer dated government bonds benefitting from flight-to-quality flows during risk-off periods, falling growth and inflation expectations and the possibility of the RBA extending the duration of its yield curve control targets. The 10-year government bond yield ended 19bps lower at 0.79%, while the 30-year government bond also ended 19bps lower at 1.72%.
The Australian economy contracted by a record 7% over the June quarter. Massive government transfers supported household incomes and helped cushion the blow from nationwide lockdown measures. Partial demand indicators point to the rebound in activity over June/July losing some momentum following the imposition of Victorian mobility restrictions and border closures.
Labour market outcomes were not as dire as expected with the unemployment rate falling to 6.8% in August from 7.5% the previous month. Significant slack remains and the tapering of government support measures and a lift in labour force participation as mobility restrictions ease, could see the unemployment rate lift again in the nearer term.
Surveys point to low levels of consumer and business confidence with the risk that consumers save rather than spend their government transfers and that businesses defer investment decisions. Credit growth remains weak. In a bid to make lenders less risk-averse, the Government announced it would move to repeal the current Responsible Lending Obligations regime.
Money market rates moved to factor in an imminent easing in monetary conditions. While the three-month bank bill ended the month unchanged at 9bps, six-month bank bills ended 2bps lower at 12.5bps. The November 30-day cash futures contract fell from 11.5bps to 8.5bps with markets factoring in a 7bps cash rate end 2021.
After the strong rally experienced by credit markets over the previous five months, September saw a slight weakening in market conditions with the iTraxx Index ending the month 5bps wider at 76bps (when adjusting for the roll of the iTraxx contract).
Primary markets were reasonably active following August’s reporting season. Firms sought to take advantage of robust conditions by getting an early start on their 2021 financial year funding tasks. For example, Qantas took the opportunity to issue two new bonds over the month. Another interesting development was that two companies; Scentre Group and AusNet Services, issued subordinated bonds with the result being that half of the proceeds were being counted as equity credit from a credit rating agency perspective.
With the upcoming budget due in early October, the stage is set for fiscal policy to carry the burden of pivoting policy from a ‘support’ to a ‘rebuilding’ role. As temporary income and job support measures begin to taper before COVID has been fully vanquished, fiscal policy can play a role in boosting the supply side, as well as the demand side of the economy. We look for a stimulatory budget that will keep the fiscal pulse positive and an unprecedented build up in government debt stocks.
We see monetary policy as playing a secondary supporting role and following the Deputy Governor’s recent speech, we have factored in an easing in monetary conditions in November. This timing would allow the budget to take centre stage and allow for the RBA to re-tune the economic scenarios that they will release in the November Statement on Monetary Policy.
Easing is most likely to take the form of a cut in the cash rate, three-year government bond yield target and Term Funding Facility rate by 15bps from 0.25% to 0.10%. Negative rates remain highly unlikely and we suspect the door remains open to the RBA extending its Quantitative Easing (QE) programme to purchase government bonds in the 5- to 10-year part of the yield curve.
Given that cyclical and structural factors point to many years of low rates, we remain attracted to duration and regard periods of excessive curve steepening as opportunities.
We remain attracted to spread sectors but have shifted from accumulating holdings following the widening in spreads over March, to becoming more selective about the names and tenors we are adding. 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 and unprecedented levels of central bank support for both sovereign and non-sovereign debt markets.
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 while inflation protection remains cheap.