Frank Uhlenbruch, Investment Strategist in the Janus Henderson Australian Fixed Interest team, provides his Australian economic analysis and market outlook.
A downward revision to the growth outlook following ‘Delta’ strain outbreaks led to sharp falls in domestic yields and a flattening in the yield curve. A strong offshore earnings season helped support risk appetite, with the domestic equity market firmer. After a strong run, credit markets softened, with a modest widening in spreads. Inflation expectations edged slightly lower. The Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, performed strongly, climbing by 1.76% over July and has since clawed back all of February’s 3.58% fall.
After a vigorous first half of economic and employment growth, rolling ‘Delta’ lockdowns mean that the economy will hit a significant air pocket."
Following a period of rolling lockdowns, and with New South Wales set to run for longer, markets began to push back both the start date of the next tightening cycle and the amount of likely tightening. These expectation shifts were behind the 17 basis point (bps) fall in the three-year government bond yield, which ended the month at 0.24%.
The fall in yields was more pronounced at the longer end of the curve despite higher offshore and domestic inflation readings, which were seen as temporary. The 10-year government bond yield ended 34bps lower at 1.18%, while the 30-year government bond ended 24bps lower at 2.04%. Inflation expectations edged lower, with the 10-year breakeven inflation rate falling 6bps to 2.00%.
Partial demand indicators suggest that the economy had considerable momentum before hitting the latest air pocket caused by rolling lockdowns. Business surveys point to another quarter of strong growth in the June quarter with activity, forward orders and labour demand at high levels. Strong labour demand was reflected in June labour force data, where employment rose by 29,100 and the unemployment rate fell to 4.9%.
However, there were early signs of the lockdown impact showing up in falling levels of business confidence, weekly payrolls and hours worked. On the prices side of the economy, higher fuel and fruit and vegetable prices pushed the headline inflation rate up by 0.8% over the June quarter, with base effects contributing to the 3.8% yearly rate. Core measures were more muted, with the average of the Reserve Bank of Australia (RBA) statistical measures up 0.5% for a 1.7% yearly rate.
Short-term money market rates remained very low given the 0.10% official cash rate and the deterioration in the near-term growth outlook. Three-month bank bills ended the month 1bps lower at 2bps, while six-month bank bills ended 1.5bps lower at 5bps. Further out, markets pushed back the timing of the first tightening from late 2022 into early 2023.
Renewed lockdowns weighed on investor sentiment in credit markets, which had been buoyed by the rebound in growth and an improving outlook for corporate earnings. The Australian iTraxx Index ended the month 5bps wider, while Australian fixed and floating rate credit indices closed flat and 3bps tighter respectively.
While COVID-impacted sectors such as airports, REITs and the universities faced elevated volatility, investors have significantly more confidence today relative to 12-18 months ago, armed with clear evidence of demand coming back strongly as vaccines get rolled out and lockdowns are lifted. This allowed issuers such as Dexus Wholesale Property Fund and Edith Cowan University to come to market with attractively priced (from a “through the cycle” perspective) deals. The airport sector was boosted by potential M&A for Sydney Airport, demonstrating strong demand for essential infrastructure assets.
A muted corporate primary market ahead of full-year reporting was trumped by a very active primary securitisation market, with investors attracted to solid housing market fundamentals. A stand-out was Macquarie Bank closing its most recent PUMA transaction at $3.75 billion, meeting strong investor demand for high quality AAA rated bank RMBS at 55bps over one-month bank bill swap rates. Another notable item was Zip Master Trust achieving credit rating upgrades to Aaa for the senior notes in its three outstanding public securitisation transactions.
After a vigorous first half of economic and employment growth, rolling ‘Delta’ lockdowns mean that the economy will hit a significant air pocket. With the Sydney outbreak proving more persistent, we look for the economy to contract by between 1%-1.5% over the September quarter.
As has been the case in other periods of lockdowns, post-lockdown rebounds are vigorous as the economy shifts into ‘catch up’ mode. As vaccination rates rise, the pace of recovery over 2022 should be less volatile than for 2021. Even after allowing for a negative September quarter, we still look for the economy to grow by around 3.75%-4% over 2021 (this was 4.75% pre lockdowns). For 2022 we expect the economy to grow by around 3.5% and for the unemployment rate to fall to around 4.5%.
The RBA Governor recently indicated that monetary policy decisions would be ‘data’, not ‘date’ driven. Since those comments were made in early July, the near-term outlook has worsened and we expect that deterioration to be acknowledged at the upcoming August RBA Board meeting via dovish signalling and a less urgent wind-down of quantitative policies. We also expect the RBA to look through the June quarter spike in the yearly headline inflation rate to 3.8%.
Our base case still has the first tightening in a cycle that takes monetary conditions from accommodative to neutral starting in H1 2024. By then we expect that the tightening trifecta conditions of: i) an unemployment rate close to 4%; ii) wages growth of at least 3%; and iii) actual inflation at 2% or above on a sustainable basis, will have been met.
We regard the market pushing back the commencement of the tightening cycle to early 2023 as still being on the optimistic side. Nevertheless, the rally in the three-year government bond yield down to 0.24% at the time of writing has released any built-up value and taken valuations to mildly expensive. At the longer end of the curve, the fall in the 10-year government bond to 1.17% has taken them to outright expensive levels in our view and vulnerable to a lift in growth and inflation expectations as vaccination rates progress.
Spread sectors are likely to remain well-supported, with corporates in particular, benefiting from the tail winds of a cyclical recovery and persistent accommodative policy settings. Nevertheless, with the spread cushion for investors within pockets of credit having narrowed substantially, we remain very active and selective in this environment. While the market searches for any yield advantage, we remain discriminate, avoiding lower quality borrowers. The need for inflation protection has diminished somewhat, with breakeven inflation rates moving back into the lower end of the RBA’s 2% to 3% target band.
Views as at 31 July 2021.