Liz Harrison, Fixed Interest Analyst – ESG in the Janus Henderson Australian Fixed Interest team, provides her Australian economic analysis and market outlook.
Following on from the inflation frenzy that was October, and the aggressive pricing in of rate hikes by markets, the start of November saw the bond market quickly retreat and reprice as yields fell across the curve. After the initial snap back in the rates market, rates have continued to be buffeted around throughout the month. Dovish commentary from the Reserve Bank of Australia (RBA) and other central banks (including the Bank of England, which failed to lift rates as expected) was pegged against high inflation prints coming out of Europe, the US and Asia. Domestically, the reopening of the eastern states saw early-stage recovery underway, with promising economic activity. Offshore, higher COVID-19 cases resulted in lockdowns for the Netherlands, Slovakia and Austria and rising cases elsewhere in Europe and parts of Asia. These factors added volatility, before yields took a further leg down as the threat of the new variant, Omicron, spooked markets towards the end of the month. In the final hours of trade for the month, the US Federal Reserve (Fed) chair stirred up markets further, commenting that bond purchases might be tapered earlier and that it was time to retire the word ‘transitory’ regarding inflation. The Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index rose by 2.08% over November, recovering more than half the fall from October.
The profound shift in market expectations for rate rises by the end of October was overdone in our view, with markets pricing in an overly buoyant pathway by the RBA."
Three-year government bond yields ended the month 36 basis points (bps) lower at 0.865%. The dramatic move reflected the market winding back tightening expectations. Dovish RBA minutes and a speech by Governor Philip Lowe in the month stated that a rate hike in 2022 was ‘extremely unlikely’, whilst acknowledging that ‘it is now plausible that a lift in the cash rate could be appropriate in 2023’. COVID-19 concerns also weighed on yields, as markets considered a potential delay to the reopening and activity by global central banks in light of the new Omicron strain.
The government bond yield curve flattened as the fall in longer-dated yields outpaced the short end. 10-year and 30-year government bond yields ended 40bps and 47bps lower at 1.69% and 2.31%. Inflation expectations eased, with the 10-year breakeven inflation rate falling 10bps to 2.05%.
Early in November, activity indicators showed positive signs of the reopening, as mainland south east Australia had its first full month out of lockdown. The NAB Business Confidence Index lifted strongly in October, while the Westpac Consumer Confidence Index rose 0.6% month on month (m/m) in November to 105.3. This increase was driven by a surge from NSW (+4.4%) and puts the survey in line with where consumer confidence was in 2018. Retail sales surprised to the upside, rising 4.9% m/m in October. This was despite Sydney and Melbourne only coming out of lockdown part way through that month.
The labour market results are still lagging, as employment fell 46,000, given Sydney, Melbourne and Canberra were still locked down during some of the reference period. The unemployment rate rose 0.6% to 5.2%, as the participation rate steadied. Encouragingly, the Wage Price Index released in November met expectations, rising to 2.2% year on year (y/y), up from 1.7%. Despite lockdowns, NSW, Victoria and the ACT recorded quarterly wages growth in line or above the national average. Wage growth above 3% is one of the RBA’s tightening pre-conditions.
On the prices side of the economy, global inflation reads continue to present. In Germany, inflation rose to 6% in November (up from 4.4% in October), as prints above 5.5% came out for Belgium and Spain. Consumer prices in Canada, Italy and Singapore hit lofty heights, while US headline inflation hit 6.2% y/y in October. US core inflation rose to 4.3% y/y, which is the biggest jump in core CPI since 1991. The strength of commodity prices, shortages of key inputs and shipping disruptions, labour shortages and elevated energy prices have all contributed to the high global inflation story as economies re-open.
Short-term money market rates paired back the normalisation of rates by the RBA. Three-month bank bills ended the month 2.5bps lower at 5bps, while six-month bank bills ended 6bps lower at 14bps.
Throughout November, credit markets grappled with rising global inflation fears, higher rate expectations, and a surge of COVID-19 cases in the northern hemisphere. A significant risk-off tone developed towards month-end, with the discovery of the Omicron virus variant intersecting with tight valuations and thin liquidity conditions around the Thanksgiving holiday. Amid elevated volatility, the Australian fixed and floating rate credit indices, and the local iTraxx Index closed 7bps, 3bps and 6bps wider, respectively.
Domestically, three of the four major banks handed-down their full year earnings. While credit fundamentals were robust, the expected gradual resumption of annual funding tasks to pre-pandemic normal levels, pressured bank spreads over and above general market conditions. Five-year senior unsecured debt and closely related three-year AAA RMBS, ended the month approximately 5bps wider at ASW+66bps and +69bps, respectively. Notwithstanding, Westpac had no trouble issuing in the US dollar market during the month across senior and subordinated debt in multiple tenors at attractive levels, tangibly demonstrating strong global investor appetite for Australian major bank paper.
Non-financial corporate issuers continued to be active during the month, as companies looked to lock-in term debt in anticipation of higher rates. Of note, Melbourne Airport issued a $700m, 10-year senior secured BBB+ rated bond at a spread of ASW+167bps mid-month (which closed the month at equivalent levels). At $700m, it is the largest 10-year corporate bond deal issued in the domestic market to date. Strong support from investors seeking exposure to high quality, long-lived, albeit temporarily COVID-impacted infrastructure assets, allowed final pricing to tighten 13bps from initial marketing. A recurring theme, ESG issuance during the month included Optus issuing an A- rated seven-year Sustainability-Linked Bond at ASW+77bps and Kiwi renewable energy gentailer (generator and retailer), Mercury NZ, issuing a BBB+ rated 7-year Green Bond, at ASW +118bps.
The profound shift in market expectations for rate rises by the end of October was overdone in our view, with markets pricing in an overly buoyant pathway by the RBA. While we have been optimistic about the re-opening, we were cognisant of markets over pricing the RBA’s pathway for rates, with or without the Omicron variant proving to be a threat to the global recovery. While it is too early to comment on the effect this strain will have, we are reminded of the pre-conditions for the RBA to raise rates, which is consistent with the timeline outlined in dovish commentary that a rate rise in 2022 is ‘extremely unlikely’, which was echoed in this months’ monetary policy statement.
We look for the Australian economy to grow above 2% over 2021, but for growth to lift to around 5.25% over 2022, before easing back towards trend levels in 2023. Imminently, however, we will see a weaker GDP print for the September quarter, with a fall of 2.0-3.0% expected given the lockdowns that prevailed during the reporting period. We expect growth to surge in the latter weeks of 2021 and early next year as mainland south east Australia enjoys being out of lockdown, noting the heightened possibility that this new variant (or subsequent ones) may railroad this recovery. At the time of writing, we are already seeing a setback to the reopening as Australia shuts its international borders (at this stage temporarily for two weeks). This will impact tourism and delay the arrival of skilled migrants and international students, while the risk of further closures to state borders becomes heightened. While further lockdowns are an option, we envision unwillingness by the state governments (especially NSW and Victoria, which have high vaccination rates) to lock things down again.
The pullback in rates over November is more in line with our view on the likely tightening profile by the RBA. We viewed the aggressive tightening cycle implied by markets in October as potentially triggering a major slowdown over 2023, which would make it difficult for the RBA to meet its tightening ‘trifecta’ pre-conditions of an unemployment rate below 4%, wages growth above 3% and actual inflation above 2% on a sustained basis. We acknowledge the inflationary pressures playing out around the world from supply side issues. Domestic inflation may stay or drift above the RBA target band until the supply chain issues are resolved, resulting in this part of the trifecta being more likely to be met prematurely.
Our expectation for a fall in yields was realised over November. Even with the pullback, we see the three-year government bond yield at 0.90%, at the time of writing, as still offering value. Market reactions are front-end loaded and given the short end of the curve has not pulled back at the same pace as the longer end, we view the risk to further rate rises in this part of the curve as asymmetrical. The rising COVID-19 cases in Europe and emergence of this new strain are likely to delay any central bank action and make them guarded about what they communicate.
The fall in 10-year government bond yields to 1.69% (at time of writing) is where we consider fair value and offers adequate compensation for term risk. Markets appear unsure of the next direction, as the current uncertainties from the COVID-19 situation will tussle against global inflationary forces.
If fears regarding the Omicron variant settle, spread sectors are likely to remain well-supported, with corporate fundamentals continuing to benefit from the tailwinds of a cyclical recovery and accommodative policy settings. That said, some pockets of credit have widened as we end November, and we expect some further softening as markets reconcile the ongoing threat of the pandemic and seek liquidity premium in a backdrop of unconventional policies being unwound. We continue to remain very active and selective in this environment. We favour cautious positioning in sub-sectors set to benefit from the reopening theme, whilst being ready to act should the alternate scenario play out.
We remain attracted to semi-government securities, particularly those issued by NSW as it comes out of lockdown. Though breakeven inflation rates have moved into the bottom end of the RBA’s 2-3% target band, we still see a role for some modest inflation protection given cyclical pressures from challenged global supply chains and the wider opening up of the economy from late 2021.
Views as at 30 November 2021.