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

Market review

The ongoing rally in Australian government bond yields received a further boost following an escalation in US-China trade tensions and forward guidance from the Reserve Bank of Australia (RBA) that an extended period of low interest rates was required for it to meet its employment and inflation objectives. Sentiment shifted from ‘risk-on’ to ‘risk-off’, with equity markets weaker and credit spreads widening. The Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, gained 1.51%, with price appreciation from lower yields boosting the income return. Over the past year, the bond market has returned 11.2% with over 80% of the performance coming from capital gains as bond yields fell.

Three and 10 year government bond yields rose to their month highs of 0.84% and 1.21% early in the month after it appeared as though trade relations were on a steadier course following the late July G-20 meeting. However, the decision by President Trump to extend tariffs on Chinese goods and label China a currency manipulator triggered a rally in offshore and domestic sovereign bond markets.

In the US, fears of a recession were heightened as the US yield curve initially flattened and then inverted. Global and domestic central bank commentary became increasingly dovish noting that trade and technology uncertainty could spill over from the trade and manufacturing sectors into the broader economy.

Australian three and 10 year government bond yields ended the month 14 basis points (bps) and 30bps lower at 0.67% and 0.89%. While Australia’s yield curve flattened, it still ended the month positive at 22bps. In the US, both two and 10 year Treasuries ended the month 32bps and 51bps lower at 1.52%, with no spread between two.

Australian economic readings continued to provide mixed signals and partial indicators point to another quarter of sub-trend growth in the upcoming release of the June quarter national accounts. While retail sales rose by a better than expected 0.4% in the month of June, volume growth over the quarter was up by only 0.2% and points to sluggish consumption growth.

Construction work done data for the June quarter was softer than expected, falling 3.8%. Total residential spending fell 5.1% and points to dwelling investment being a drag on economic growth over the June quarter. Business investment remains sluggish, with private capital expenditure falling 0.5% over the June quarter.

On the stronger side was Australia’s trade balance, which moved from a $6.1bn surplus to an $8bn surplus in June. Net exports are poised to add to economic growth over the June quarter.

Labour market conditions remained firm with 41,100 jobs added in July. Full time jobs rose by an unexpected 34,500 and helped drive a 0.5% lift in hours worked. The labour market continues to draw in new entrants, with the participation rate lifting to a record high of 66.1%. The unemployment rate remained unchanged at 5.2%. Forward labour market indicators point to a moderation in the pace of jobs growth.

There is little sign of strong jobs growth spilling over into wages, with the Wage Price Index lifting by 0.6% over the June quarter to keep the yearly rate at 2.3%.

Money market yields reacted to offshore developments and dovish RBA signalling by building on the amount of monetary easing expected over 2020. Markets continue to price in a 0.75% cash rate by November and brought forward the next easing to February 2020 and moved to price in around a 50% chance of a 0.25% cash rate by August 2020. Three and six month bank bill yields fell by 3bps and 4bps to end the month at 0.97% and 0.99%.

Credit markets were not immune from the ‘risk-off’ sentiment experienced during periods of trade turmoil, with the Australian iTraxx Index widening 4bps to end August at a spread of 63bps. The domestic reporting season occurred over the month and while many companies pointed to a cautious consumer, overall company balance sheets remain robust. Given the reporting season, primary markets were quiet, but one noteworthy new deal was done by global investment bank UBS, which issued its first Tier 1 security in the Australian market. Investor demand was strong, with over $4bn of interest and this allowed UBS to price its bond a significant 75bps tighter than the initial price guidance.

Market outlook

Policy makers are becoming more concerned that the accumulation of trade and technology uncertainty and unresolved geo-political developments could spill over from weakening trade-exposed manufacturing sectors into the broader economy. To offset this drag, global central banks have eased or about to ease monetary conditions in a very coordinated manner while fiscal options are also being explored, particularly in Germany and the US.

Against this backdrop, the RBA released its updated economic forecasts. Their central case view is for economic growth to lift from 2.5% in 2019, to 2.75% in 2020 and 3% in 2021. Given the amount of slack that still has to be absorbed, the RBA have inflation lifting at a slower rate, with core inflation only reaching 2% in the second half of 2021.

The RBA also reviewed offshore unconventional policy measures which included; very low and negative policy interest rates; explicit forward guidance; lowering longer-term risk-free rates by purchasing government securities; providing longer-term funding to banks to support credit creation; purchasing private sector assets; and foreign exchange intervention. They concluded a package of measures reflecting local factors tended to be more effective and these needed to be communicated clearly and concisely by the central bank.

In Australia’s case, the RBA Governor thought that in the unlikely case those unconventional measures were needed, the first set of responses would be to take the cash rate down to a very low level and possibly take action to lower risk-free rates further out along the term structure.

Given such a profile and near-term downside risks from offshore developments, the RBA kept an easing bias, noting that it will “monitor developments in the labour market closely and ease monetary policy if needed” and that “it is reasonable to expect that an extended period of low interest rates will be required”.

In light of offshore and domestic developments, we have built in a further two cuts in the cash rate, with a move to a 0.75% cash rate in November and a move to a 0.50% cash rate in February 2020. This stimulus will build on the pro-cyclical pulse the economy is receiving from earlier cuts to the cash rate, the first tranche of tax relief worth around 0.5% of GDP, a relaxation in macro-prudential policies, a lower exchange and stabilisation in house prices.

Thereafter, we look for the cash rate to remain at 0.50% for an extended period. Accommodative policy should help absorb remaining slack, with the RBA Governor noting that monetary policy will not be tightened until the RBA was confident that the inflation rate was headed for the mid-point of the RBA’s 2% to 3% range.

Views as at 31 August 2019.