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 initially lifted as markets wound back easing expectations following more upbeat commentary from the Reserve Bank of Australia (RBA). Towards the end of the month, markets reacted strongly to a change of state in the COVID-19 virus after it appeared outside China. Both US and Australian government bond yields rallied to new historical lows, while equity markets fell heavily and credit markets weakened. Overall, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+Yr Index, reversed earlier losses to end February 0.86% higher.

The widening reach of the COVID-19 virus has changed the outlook from a moderate recovery in world and domestic growth (responding to a lessening in geo-political tensions and monetary easing over 2019), to one more uncertain, with elevated near-term recession risks.”

Australian three and 10 year government bond yields lifted to as high as 0.76% and 1.09% following commentary from the RBA Governor that policy was accommodative and that with low rates it was possible to have ‘too much of a good thing’. Market direction changed sharply once COVID-19 broke containment lines in China. Domestic three and 10 year government bond yields ended the month 12 basis points (bps) and 13bps lower at 0.50% and 0.82%.

Domestic data readings printed on the softer side, with early signs of the drag to growth from Australia’s natural disasters showing up in a greater than expected 3% fall in December quarter construction work done data. Capital expenditure was also weaker than expected, falling 2.8% in the December quarter. Encouragingly, plans for the financial year ahead rose strongly and was boosted by the pick-up in resource investment that the RBA had been looking for in their optimistic growth forecasts.

Retail sales fell 0.5% in December after strong gains in the previous month. For the quarter, retail sales volumes rose by 0.5% after being down 0.1% in the previous quarter, suggesting consumption will stage a modest rebound in the upcoming December quarter national accounts. Likewise, trade data also pointed to net exports making a small positive contribution to economic growth. All up, partial indicators point to another quarter of sub-trend economic growth of around 0.4% in the December quarter.

Labour market conditions remain consistent with some slack. A lift in the participation rate back towards historically high levels and a 13,500 lift in the number of jobs were not enough to stop the unemployment rate lifting from 5.1% to 5.3%. Wages growth remains modest, with the Wage Price Index up 0.5% over the December quarter, for a yearly rate of 2.2%.

Markets initially looked through sluggish data and began to wind back the amount of easing priced in after RBA commentary earlier in the month. However, easing expectations began to build again following the lift in the unemployment rate and strengthened further following the spread of the COVID-19 virus. By month end, markets were fully factoring in a 0.5% cash rate by June and around an 80% chance of a 0.25% cash rate by November. In money markets, three and six month bank bills both ended the month 7bps and 9bps lower at 0.81%.

Risk-off sentiment cascaded into credit markets, with the iTraxx Index ending February 15bps wider at 69bps. Reporting season took place over the month and, generally, Australian corporate credit profiles remain sound, notwithstanding the anticipated decline in revenue many companies will experience as a result of the coronavirus’ impact on end demand. Within credit markets, higher quality investment grade bonds performed relatively well, while lower rated bonds such as ASX listed Tier 1 capital instruments weakened considerably. Primary markets were understandably quiet, with the volatility in markets not providing company treasurers with sufficient comfort that any new bond deal would garner sufficient demand.

Market outlook

The widening reach of the COVID-19 virus has changed the outlook from a moderate recovery in world and domestic growth (responding to a lessening in geo-political tensions and monetary easing over 2019), to one more uncertain, with elevated near-term recession risks.

The virus is a supply side shock, with output and hours worked lost as regions are quarantined. Once the virus has passed, production will recommence and hours worked may be boosted by overtime as producers try to catch up on lost production and fill backorders. Such a shock creates a “V” shaped profile for growth. A sequencing of these outbreaks over time when added together could create a more “U” shaped profile for growth. We are currently in the discovery phase of how deep the “V’s” are and how many there will be.

The challenge for policy makers is how to respond to a global biological shock. Public health management is the government’s domain. For central banks, the starting point is that easing monetary policy will not make someone better quicker. At some point a vaccine will become available and output will normalise.

Where policy makers become involved is when the biological shock gets into the demand side of the economy. There are early signs of this happening, with a sharp deterioration in financial conditions, which if persistent, could lead to a loss of business and consumer confidence. Both easier fiscal and monetary conditions could play a role in stabilising confidence and supporting activity.

We see most of the recent rally in yields as legitimately responding to the COVID-19 virus breaking containment lines. There is scope for central banks to provide some insurance and fiscal policy to provide targeted support to sectors under pressure. That said, we see some signs that what is a temporary shock (reports are that a vaccine will be available in a year or so) is being priced in over longer time periods. Five year five year forward sovereign rates, a proxy for the longer run cash rate, are around 75bps lower at the time of writing than at the start of the year.

Markets have factored in a lot of bad news and an aggressive policy response from the RBA. So much so that markets are assigning some chance to the cash rate going below the RBA’s 0.25% effective lower bound for the cash rate by July. At one stage the domestic 10 year government bond dipped to as low as 0.69%, levels more consistent with an unconventional policy regime and RBA steps to flatten the yield curve. At these levels, we see yields heading into expensive territory.

We remain attracted to maintaining a core exposure to inflation-protected securities. The advent of the COVID-19 virus and its disruption to global supply chains, along with the periodic scarcity of some goods and services could add to inflation. A lower Australian dollar adds to upside inflation risks via the tradeables channel as does a recovery in housing prices. The cost of holding inflation protection remains very 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 29 February 2020.