Frank Uhlenbruch, Investment Strategist in the Janus Henderson Australian Fixed Interest team, provides his Australian economic analysis and market outlook.
Market Review
Hawkish US Federal Reserve (Fed) forward guidance and an ill-timed UK fiscal package that triggered Bank of England support saw yields lift sharply over the latter part of the month. Risk appetite fell as more aggressive policy tightening was seen as lifting recession risks. Equity markets fell sharply, while credit markets weakened, with spreads widening. Against this backdrop, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, fell 1.36%.
“Against the backdrop of peaking inflation, global tightening, European energy shortages and the ongoing Ukrainian War, the RBA must decide how hard to step on the monetary brakes.”
The Reserve Bank of Australia (RBA) lifted the cash rate by another widely expected 0.50% increment in early September to 2.35%. After remaining relatively steady, yields surged higher following hawkish Fed signalling and dislocation in the UK bond market following the release of an expansionary mini budget. At the shorter end, the three-year government bond yield rose to as high as 3.72% before ending the month 32 basis points (bps) higher at 3.52%. Further out along the curve, 10- and 30-year government bond yields ended 29bps and 26bps higher at 3.89% and 4.08%.
On the data front, the economy expanded by 0.9% over the June quarter, driven primarily by consumption and the external sector. Momentum appears to be carrying over into the September quarter, despite very weak consumer sentiment, heightened cost of living concerns and tightening monetary settings.
Business conditions, labour demand and capacity utilisation remained well above long run levels over July/August according to the NAB Business Survey. Employment lifted by 33,500 in August, with the unemployment rate edging up to 3.5% as labour force participation rose. Strong labour market conditions are helping boost household incomes and driving consumption, with retail trade lifting by a stronger than expected 0.6% over August.
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Short-term money market yields continued to climb as markets discounted further tightening. The three-month bank bill yield ended the month 61bps higher at 3.06%, while six-month bank bills ended 56bps higher at 3.57%. In terms of the tightening cycle, markets increased the pace and quantum of tightening, with a 3.32% cash rate priced by year end and 4.10% in mid-2023.
Already showing signs of increasing fragility, risk markets were further rattled by a material escalation in the Russia/Ukraine conflict. On the corporate front, investors keenly await Northern Hemisphere third quarter earnings. Several high-profile companies pre-reported disappointing numbers and outlooks. Expectations are for rapidly tightening financial conditions to drive weaker top and bottom-line results, lowered guidance, and earnings downgrades.
In global credit, ratings agency downgrades (in North America), have outpaced upgrades by a ratio of almost 2 to 1. Cracks have also started to appear in the global leveraged finance / high yield market. Domestically, Investment Grade issuers are mostly flush with liquidity and are facing into a difficult near-term environment from a position of balance-sheet strength. Reflecting challenging market conditions, the Australian iTraxx Index (adjusted for rolls) closed 27bps wider at 144bps, while the Australian fixed and floating credit indices returned -1.01% and +0.12% respectively.
Market outlook
Central bank actions and forward guidance remain hawkish. After responding slowly to a larger than expected inflation shock, the pace of tightening has sped up, with history reminding policy makers that the costs of fighting inflation are not diminished by drawn out tightening cycles. While the European Central Bank (ECB) has begun removing monetary accommodation, the Fed is more advanced, following its recent 0.75% lift in the US cash rate to 3.12%.
While the Fed move was expected, markets were caught out by Fed estimates for a ‘higher for longer’ profile for the US cash rate. Fed participants now look for the US cash rate to climb to 4.6% next year and then fall to 3.9% in 2024 and still remain above trend in 2025 at 2.9%. While such a restrictive profile sees core inflation fall back to 2% by 2025, it comes at the cost of lower GDP growth and a lift in the unemployment rate from 3.8% at the end of this year to 4.4% in 2024. In our view, the Fed is downplaying the risk of a hard landing in 2023, but this is a cost they are willing to bear to beat inflation and re-anchor inflation expectations at around 2%.
Against the backdrop of peaking inflation, global tightening, European energy shortages and the ongoing Ukrainian War, the RBA must decide how hard to step on the monetary breaks. With September’s tightening to 2.35% bringing the cash rate into the neutral range, the RBA has signalled that while further tightening moves lie ahead, some slowing in the pace of increases was likely as the level of the cash rate rose higher.
Given Fed signalling, we now look for a 50bps tightening from the RBA in October, which would take the cash rate to 2.85% and policy settings into mildly restrictive territory. The RBA is projected to tighten again in November, but by a more ‘business as usual’ 25bps. We look for the final move in this tightening cycle in February, which would see the cash rate peak at a moderately restrictive 3.35%. This would make the current tightening cycle the largest and fastest since the adoption of the inflation targeting regime.
In our view, it would be judicious for the RBA to pause from February 2023 and see how the economy responds given the long variable lags involved with monetary policy. Our base case view has economic growth falling below trend over 2023, paving the way for a return to more neutral monetary settings over 2024/25.
Market pricing remains more aggressive, with the cash rate priced to peak at 4.10% in mid-2023. Unlike the US, where markets are discounting a falling cash rate after its cyclical peak, domestic markets are pricing the cash rate to hold around the cyclical peak for the rest of the decade. Such a profile, which has the cash rate almost 200bps above estimates of the neutral cash rate, seems implausible and likely to push the economy into recession. Accordingly, we see value beginning to emerge from the short to mid part of the curve onwards.
Commitment to tackle high inflation through tightening global liquidity will continue to generate volatility in credit markets. To navigate the environment ahead, investors should look for improved compensation for risk. We observe that the repricing across different pockets of credit and risk premia have not been simultaneous, providing outperformance opportunities through active rotation.
Attractive yields on high quality credit spreads have seen demand return from defensive income investors. In our view, the more illiquid, structured, and levered sectors of the market are yet to adequately reprice. We believe this is a process that will occur in due course as earnings outlooks weaken. We anticipate that as conditions tighten further, global spreads will suffer decompression, where high quality liquid credit outperforms lower quality as compensation for default risk and illiquidity needs to increase. We continue to favour being positioned up in quality and seniority in capital structures, leaving powder dry for when compensation for investors escalates.
Views as at 30 September 2022.
