Frank Uhlenbruch, Investment Strategist in the Janus Henderson Australian Fixed Interest team, provides his Australian economic analysis and market outlook.
Investor sentiment was buoyed by signs that economies were beginning to recover as lock down restrictions were lifted. Equity and credit markets started the month on a strong footing, while longer-dated government bond yields rose. However, a lift in COVID-19 infection rates saw some volatility re-emerge, which led to longer-dated government yields unwinding earlier rises. The Australian bond market, as measured by the Bloomberg AusBond Composite 0+Yr Index, ended June 0.31% higher and was up 4.18% over the financial year.
While partial demand indicators suggest that the economy troughed in May/June, the overall contraction in activity from social distancing measures will be the largest since the Great Depression.”
Yields at the shorter end of the Australian government yield curve remained firmly anchored by Reserve Bank of Australia (RBA) forward guidance and yield curve control measures. After edging up to an intra month high of 0.28%, the yield on a three-year Australian government bond ended the month in line with the RBA’s 0.25% target.
There was more movement further out along the yield curve. The curve initially steepened as the 10-year Australian government bond rose to as high as 1.09% on better economic news and increasing US Treasury supply. A rise in infection rates over the latter part of the month saw investor sentiment weaken and demand for government debt rise. These factors helped push the 10-year government bond yield down to 0.87% by month’s end.
The Australian economy entered into recession, with economic growth falling 0.3% in the March quarter. Sharp falls in consumption and a rundown in stocks were only partly offset by positive contributions to growth from public demand and net exports.
While partial demand indicators suggest that the economy troughed in May/June, the overall contraction in activity from social distancing measures will be the largest since the Great Depression. According to the NAB Business Survey, business conditions plummeted to -34 in April but regained some ground in May coming in at -24
Improving consumer sentiment in June and a rebound in preliminary May retail sales suggest that strong policy measures have had a positive effect. Nevertheless, the lift in the labour force under-utilisation rate to a record high of 20.2% in May suggests that the economy has built up considerable slack that will act to keep wages and inflation subdued for some time.
Against this backdrop, money market rates were relatively steady. The RBA left the official cash rate target at 0.25% and the interbank overnight cash rate ended the month unchanged at 14 basis points (bps). Three- and six-month bank bills also ended the month largely unchanged at 10bps and 16bps. Cash rate expectations remained consistent with RBA forward guidance for no change in the cash rate until the labour market and inflation outlook improved.
Credit markets continued to recover following the COVID-19 shock that occurred in March, with the iTraxx Index ending the month 15bps tighter at 87bps. As lockdown restrictions were slowly being lifted around the country, credit investors were grappling with the still uncertain outlook and the impact this has on corporate profitability versus the strong support provided by central banks and its impact on credit pricing. Despite the improvement in risk sentiment, corporates in general didn’t feel a great desire to access public markets, with the primary market in Australia relatively subdued. We expect this to continue next month as companies head into blackout ahead of reporting season.
The International Monetary Fund (IMF) downgraded the near-term growth outlook as the spread of COVID-19 saw more countries enact lockdown measures. They now look for global growth to fall by as much as 4.9% in 2020 before the global economy regains some lost ground as lockdown measures are progressively wound back. For 2021, they see world growth lifting by 5.4%, but warn that in a second wave scenario most of that growth would be given up. The global policy response to this health crisis has been profound, with the running tab reaching US$11 trillion, split evenly between fiscal and liquidity support measures.
Policy makers, including the US Federal Reserve (Fed), have expressed concerns about the broader welfare implications for workers who, through no fault of their own, lost their jobs and may struggle to re-enter the labour force. Building on those concerns, the RBA remains wary of behavioural changes and a lack of ‘animal spirits’ as factors that could limit the speed and sustainability of growth after the initial bounce as social distancing measures are wound back.
For markets, this means that policy will remain accommodative. While the supply of government debt is set to expand and place upward pressure on term premiums, we see central banks stepping in to cap excessive yield curve steepening. Higher yields mean higher interest payments and a reduced ability for fiscal policy to support aggregate demand.
Cyclical and structural factors point to a low rate regime that should persist for many years and see income producing assets bid. The two preconditions for an RBA rate rise are a return towards full employment and inflation returning on a sustainable basis to the 2% to 3% target band. We see neither of these preconditions being met for several years given the amount of spare capacity in the economy.
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.
That said, we remain mindful that massive fiscal easing and the blurring between monetary and fiscal policy in some jurisdictions raises term risk. Stimulus, interventions that politicians may find difficult to unwind and supply chain reconfigurations raise medium-term inflation risks, so we remain attracted to maintaining a core exposure to inflation-protected securities.
Views as at 30 June 2020.