Frank Uhlenbruch, Investment Strategist in the Australian Fixed Interest team, provides his Australian economic analysis and market outlook.

Market review

Australian government bond yields rallied to historical lows as confidence in the durability of the global and domestic economic expansion waned and market expectations for another burst of monetary easing strengthened. Supportive central bank actions, along with steps taken by Chinese policy makers to bolster the growth outlook, helped support risk appetite. Equity markets were generally firmer and there was some further tightening in credit spreads. The Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, had an exceptionally strong month, gaining 1.8% with price appreciation from lower yields boosting the income return.

The key data release to catch the market’s attention and help bring forward monetary easing expectations was softer than expected economic growth in the December quarter. Sluggish consumption fuelled concerns that the slowing in the household sector over the second half of 2018 could be of a more permanent nature, rather than just a cyclical event. The economy grew by only 0.2% over the December quarter, with the yearly rate slowing to a below-trend 2.3%.

While patchy, partial demand indicators for the March quarter point to a modest pick-up in the rate of growth from the low levels experienced late last year. The trade balance moved further into surplus over January, while building approvals lifted 2.5%. Business surveys continue to paint a picture of a move from above trend levels over the first half of 2018 to around trend levels.

Consumption started the quarter on a soft note, with retail sales lifting by a less than expected 0.1% in January. Consumer sentiment, which recovered strongly in February, gave those gains back in March following poor headlines associated with the weaker GDP print. Wealth effects were mixed, with the rate of house price falls moderating while the total return from the S&P/ASX 300 Index was 10.9% over the March quarter.

In contrast to moderating activity based measures, labour market conditions appear to be holding up. The unemployment rate fell from 5.0% to 4.9% in February, though the rate of job gains eased from 38,300 in January to 4,600 in February. Unlike the previous month, part time jobs were stronger, lifting by 11,900, while full time jobs fell by 7,300 following a booming gain of 65,600 in January. Jobs vacancies rose by 1.4% over the three months ending in February, down slightly from November’s 1.6% gain. Forward labour demand indicators have eased, but are still consistent with job gains sufficient to hold the unemployment rate steady to slightly lower.

Against this softer global and domestic backdrop, three and 10 year government bond yields ended the month 24 basis points (bps) and 32bps lower at historically low yields of 1.39% and 1.78%. After outperforming US treasuries over February, the move lower in Australian government yields was similar to those in the US where two and 10 year treasuries ended the month 25bps and 31bps lower, at 2.26% and 2.41%.

Money market yields continued to ease as markets both brought forward the timing of the first easing from February 2020 to August 2019 and moved to price further easing, assigning a 90% chance of a cut in the Reserve Bank of Australia (RBA) cash rate to 1% by May 2020. Three and six month bank bills ended the month 10bps and 16bps lower at 1.77% and 1.84%.

Credit markets had a quiet month, with credit spreads largely range-bound and slightly tighter compared to a month earlier. While primary market activity was lower, there were some notable transactions from companies rated in the BBB area. The theme of domestic investors favouring infrastructure assets continued, with ConnectEast (rated BBB), the owner of the East Link toll road concession, issuing $250m of bonds with a seven year maturity and they garnered around $1bn worth of demand. Incitec Pivot, also rated BBB, managed to issue $450m of new bonds, with a seven year maturity to strong investor demand.

Market outlook

The RBA policy path has become more uncertain, with the RBA’s Luci Ellis, Assistant Governor (Economic), noting in a recent speech that “outside the household sector, the economy is not doing too badly”. In a deep-dive into the household sector, she noted that slow income growth was a drag on household spending and there was a risk that consumers would see lower incomes as permanent and adjust their consumption lower.

A key driver of recent weakness in household disposable incomes and offsetting modest improvement in labour income has been a sharp lift in the tax-to-income ratio. The consumers’ loss has been the Government’s gain, with the Budget position improving faster than expected. Fiscal, not monetary policy, is best equipped to deal with this drag on household incomes.

Fiscal easing, combining tax cuts skewed towards low to middle income earners and increased government spending is on cards as both major parties make their pre-election pitches. With an election likely to be called in the first half of May, we expect the RBA to factor in changes in the fiscal stance in its monetary policy deliberations.

While the market has largely factored in two 25bps cuts to the cash rate, whether we get these will depend on how the output/employment gap that has opened up resolves itself. In the RBA’s view, monetary policy is currently accommodative and their base case view calls for further labour market tightening that gradually lifts wages and inflation. There are signs that this is happening on the wages front, but progress is slower than the RBA would like.

With labour demand holding up at the margin, there does not appear to be a near term case for any easing, though the RBA may use the May Statement of Monetary Policy to trim its growth and inflation forecasts and potentially signal an easing bias.

Our base case has the RBA on hold out to 2021 against the backdrop of fiscal easing, a manageable correction in the housing sector and a global economy responding to easier policy settings and a likely mid-year trade deal between the US and China.

We see the balance of risks tilted to the downside, with inversion in the US yield flashing a warning light about future US and world growth. Domestically, monetary policy may have to be eased further to reinforce easier fiscal policy if there is a negative global shock or the output /employment gap is resolved by labour market weakening.

We currently see three year government bond yields at 1.41% (at the time of writing) as being in our fair value range. The scope for any significant lift is limited given that the outlook for the path of the cash rate over the next couple of years is steady to lower. Further out along the yield curve, we see the yield on a 10 year government bond of 1.79% (at the time of writing) as being expensive and would need a global recession and significant downgrading of Australia’s neutral cash rate to justify current valuations.

Views as at 31 March 2019.