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

Market review

Australian government bond yields rose sharply following a reduction in geo-political uncertainty, central bank signalling of a pause in the current easing cycle and better than expected labour force data. The announcement of the widely anticipated Phase One trade deal between the US and China had limited impact on equity markets, while domestic credit spreads edged tighter.

Overall, the Australian bond market… fell by 1.64% over December, the largest monthly fall since September 1994.”

Overall, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+Yr Index, fell by 1.64% over December, the largest monthly fall since September 1994. Nevertheless, the yearly return of 7.52% was exceptionally strong, boosted by the fall in yields over 2019.

Australian three and 10 year government bond yields ended the month 25 basis points (bps) and 34bps higher at 0.90% and 1.37%. After trading in relatively tight ranges, bond yields lifted steadily following better than expected labour force data and an upward reassessment of the global growth outlook.

Australian data releases remained consistent with growth running at a sub-trend rate, with limited signs of recent fiscal and monetary easing boosting domestic demand. The economy grew by 0.4% over the September quarter and 1.7% over a year ago. Public sector demand and net exports were the main positive contributors to the outcome. Consumption also made a weak positive contribution, consistent with sluggish retail sales readings. Both housing and business investment detracted from GDP growth over the September quarter.

Partial demand indicators point to another modest quarter of growth in the December quarter. Consumers remain in a defensive mind-set, with retail sales flat in October and consumer sentiment falling in December to remain below longer run levels. While there was a marginal lift in business conditions over November according to the NAB Business Survey, they also remained slightly below longer run levels, though capacity utilisation was running in line with longer run levels.

Labour market data surprised on the upside as the number of employed rose by 39,900 against expectations for a 15,000 gain. The composition of job gains was skewed towards part-time jobs which gained by 35,700. The number of full-time jobs rose by 4,200. With the participation rate holding steady at 66%, the lift in jobs meant that the unemployment rate fell from 5.3% to 5.2%.

Even though forward labour market indicators point to more subdued rates of hiring, markets began to wind back their expectations for the prospective amount of monetary easing. The chance of a February 2020 cash rate cut fell from 60% at the end of November to around 35% at the end of December. For May 2020, markets moved from fully pricing in a cash rate cut to 0.50% to around a 65% chance. By the end of 2020, markets moved from discounting a 40% chance of the cash rate falling to 0.25% to a 70% chance of a 0.50% cash rate. In money markets, three and six month bank bills ended the month 3bps and 8bps higher at 0.92% and 1.03%.

Credit markets carried forward their strong performance from last month and ended the year on a positive note, with the Australian iTraxx Index finishing at 48bps. This marks the lowest close since the Global Financial Crisis and caps off a strong year for investment grade credit, with the iTraxx Index starting this year at a spread of 95bps. Despite the positive sentiment regarding the Phase One trade deal between the US and China, as well as some clarity in the UK political landscape, primary markets were extremely quiet. However, one noteworthy transaction was NAB, which issued $500m in a Tier 1 capital note in the wholesale market, rather than the traditional ASX listed vehicle.

Market outlook

The recent back up in domestic yields has restored value across the yield curve. Given we are looking for growth of 2.5% over 2020 lifting to 2.75% in 2021, we still see the economy as having some slack and in need of policy support. While the Reserve Bank of Australia (RBA) have signalled they are prepared to wait and see how the economy responds to earlier stimulus, there appears to be little pass-through to real activity, though asset prices have responded and consumption may lift with a lag to improving wealth effects.

With forward labour market indicators softening and private final demand slightly negative, we think on balance the RBA will ease again before the next Federal Budget in May 2020. While the Government has re-iterated its desire to get the Budget in surplus and hosed down expectations for bringing forward personal tax cuts, what it actually delivers on Budget night will determine how much more work the RBA has to do.

We suspect the Government will deliver modest fiscal stimulus aimed at boosting near term demand and that will mean the RBA will maintain the cash rate at 0.50%, with an easing bias for an extended period. A failure to provide any stimulus would put more pressure on the RBA, with the cash rate likely to fall to 0.25% in the second half of the year and raise expectations for unconventional monetary policy measures.

While a case could be made for holding the cash rate unchanged at 0.75% and signal a long period of stability to support savers and signal confidence in the outlook, we don’t see that as the most likely outcome and runs the risk of currency appreciation. Therefore, we see the yield on a three year government bond yield of 91bps at the time of writing as beginning to offer value. Further out along the yield curve, we see the ten year government bond yield of 1.4% at the time of writing as having moved from being outright expensive to fairly valued.

We remain attracted to maintaining a core exposure to inflation-protected securities in an environment where policy is being firmly directed to boosting growth and lifting inflation back towards central bank targets. Despite a modest and ongoing lift in breakeven inflation rates from the record low levels experienced in late August, current pricing suggests markets still have little confidence that recent policy moves will gain much traction. The cost of holding inflation protection remains low and we feel it remains sensible to position for the prospect of a cyclical lift in inflation over the next few years, especially if one contemplates even more extreme policy measures to reflate economies.

Views as at 31 December 2019.