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 rallied over the month, initially on a flare up in tensions between the US and Iran and then on bushfire concerns and the spreading of the coronavirus, which had its epicentre in the Chinese city of Wuhan. Despite uncertainty of the economic impact of the virus, risk appetite was relatively resilient until later in the month when both equity and credit markets weakened. Overall, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+Yr Index, more than recovered December’s 1.64% fall, gaining 2.33% over January. This is the largest monthly gain since May 2012 when concerns over Europe’s prospects were elevated.

Overall, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+Yr Index, more than recovered December’s 1.64% fall, gaining 2.33% over January. This is the largest monthly gain since May 2012 when concerns over Europe’s prospects were elevated.”

Australian three and 10 year government bond yields rallied steadily to end the month 29 basis points (bps) and 42bps lower at 0.62% and 0.95%. Despite Australia’s close economic links to China, the fall in domestic yields was similar to that in the US where their two and 10 year Treasuries rallied 26bps and 41bps to end at 1.31% and 1.51%, respectively.

Domestic data readings pre-date the escalation in bushfire activity early in the New Year and the coronavirus, which should act as a moderate drag on economic growth in the March quarter. Of the more interest rate-sensitive sectors of the economy, there was a strong 11.8% rebound in November building approvals. It appears as though consumers held off spending tax break gains until the Black Friday sales, with retail sales jumping an unexpected 0.9% in November.

Labour force data for December was also stronger than expected, with the unemployment rate falling from 5.2% to 5.1%. Employment rose by 28,900, with part time jobs very strong, gaining by 29,200, while the number of fulltime jobs edged slightly lower. This data did lead to some watering-down of expectations for a February cash rate cut.

The release of a higher than expected 0.7% lift in the December quarter consumer price index (CPI) was also seen as not providing the Reserve Bank of Australia (RBA) with the smoking gun needed for a February rate cut, even though underlying inflation remains contained, gaining an expected 0.4%.

While markets largely priced out the chance of a rate cut in February, expectations for further easing over the year strengthened. Markets are now fully pricing in a 0.5% cash rate by mid-year and around a 50% chance of a 0.25% cash rate by the end of the year. In money markets, three and six month bank bills ended the month 4bps and 13bps lower at 0.88% and 0.90%.

Coronavirus fears also impacted credit markets late in January, with the iTraxx Index ending the month 8bps wider at 54bps. The major banks usually start their funding programs each year quite early, with both domestic and overseas bond deals and this year was no exception, with new deals ranging from residential mortgage backed securities to subordinated bonds being issued. February marks the domestic half year reporting season and while we expect credit quality to remain relatively robust, we anticipate company outlooks to be guarded given the negative impacts of the bushfires and the coronavirus on domestic activity.

Market outlook

The recent rally in yields has released some of the value that we saw build up during December’s sharp sell-off. We have responded to the bushfires and coronavirus outbreak by downgrading our expectations for December and March quarter economic growth. We now look for the Australian economy to have expanded by 2% over 2019 and look for growth of around 2.25% for 2020 (previously 2.5%). Our expectations for 2021 GDP growth remains unchanged at 2.75%.

How much work the RBA will have to do with monetary policy this year will largely depend on the direction that fiscal policy takes. The appropriate policy response to natural disasters is fiscal policy and to date at least $3 billion in support has been forthcoming. This spending will eat into the fiscal headroom that the government has in the upcoming May Budget, more so if it prioritises a surplus as some ratings agencies have urged. A pothole in Chinese growth from the virus that drags iron ore prices and Chinese inbound tourism lower would also put further near-term pressure on the Budget bottom line.

While the RBA has signalled a pause to assess the flow-through of recent tax cuts and lower mortgage repayments, we suspect recent events and the upcoming data flow to test their patience, and still look for a cut in the cash rate to 0.5% by May at the latest. Our base case view has the government adding further fiscal stimulus in the May Budget to shore up the economic outlook. Such policy action would take the pressure off the RBA to ease further and in such a scenario we would see an extended period of the cash rate at 0.5% and the low point for this extended easing cycle.

We see the risks towards our low case scenario as having risen. In this scenario, the government is tardy on the fiscal front and/or the near-term shock to the domestic and global economy from the coronavirus is more persistent than expected. In this scenario, we look for the RBA to cut the cash rate down to 0.25% and keep it there for an extended period.

While some of the value that we saw building up at the shorter end of the government yield curve has been released, we regard three year government bond yields of 0.56%, at the time of writing, as being towards the expensive end of our fair value band, rather than outright expensive.

Further out along the yield curve, we see the 10 year government bond yield of 0.89%, at the time of writing, as having moved from being fairly valued to modestly expensive and vulnerable to an upward reassessment of growth prospects as the period of peak pessimism associated with the coronavirus passes.

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 January 2020.