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

Market review

Financial markets began to settle following unprecedented fiscal and monetary support and signs that lock-down measures were leading to a levelling off in the rate of COVID-19 infections in a number of countries. Risk appetite improved, with equity markets rallying strongly. Credit markets were supported by central bank actions and investors’ search for yield. The Australian bond market, as measured by the Bloomberg AusBond Composite 0+Yr Index, ended April 0.07% lower, with a lift in longer-dated government bond yields a drag on returns.

For the Australian economy, we continue to look for a ‘U’ shaped profile for growth over the period ahead. Higher frequency economic indicators show that the restrictions on population mobility will push the economy into a sharp and deep recession.”

The Australian government bond yield curve steepened over the month. At the shorter end of the curve, three year government bond yields traded in a narrow range around the Reserve Bank of Australia’s (RBA) yield curve control target and ended the month bang on target at 0.25%. As liquidity conditions improved, the 10 year government bond yield rose from an early month low of 0.68% to finish the month 13 basis points (bps) higher at 0.89%.

Economic readings had limited market impact, but the timeliest indicators suggest social distancing measures will lead to the biggest economic contraction since the Great Depression. Consumer sentiment fell to 90’s recession levels in April. In the NAB Business Survey, business conditions fell precipitously from 0 to -21 over April, with forward orders falling to the lowest level on record.

The labour market held up in March as the sampling period for the ABS was the first two weeks of the month, pre-dating social distancing measures. Total jobs gained increased by 5,900 and comprised of a 6,400 lift in part-time jobs and a small fall in full-time jobs. The unemployment rate edged up to 5.2%, with the participation rate steady at an elevated 66%. Plunges in the ANZ Job Ads and NAB Survey employment series point to a collapse in the labour market, with the RBA Governor warning that the unemployment rate could reach 10% by mid-year.

While consumer sentiment fell sharply in April, retail sales temporarily surged in March as consumers stocked up ahead of lock-down. After lifting 0.4% in February, preliminary estimates point to a record 8.2% monthly lift over March. High frequency consumer data from NAB point to very large and accelerating falls in spending over April.

The Consumer Price Index (CPI) for March rose by 0.3%, taking the yearly rate to 2.2%, above the bottom of the RBA’s target band. The average of the RBA’s statistical measures lifted by 0.5% for a 1.7% yearly rate. A large fall in the CPI is expected in the June quarter reflecting significant falls in fuel prices and the Government’s decision to provide temporary free childcare until the end of June.

In money markets, the RBA’s unconventional policy measures resulted in the interbank overnight cash rate ending the month 7bps lower at 13bps; the official RBA cash rate target remained at 0.25%. Three and six month bank bills ended the month 27bps and 37bps lower at 0.10% and 0.17%. Cash rate expectations remained consistent with RBA forward guidance for no change in the cash rate for around three years or until the economy returns to full employment.

Global credit markets had a strong month as sentiment showed continued improvement following the unprecedented, coordinated central bank activity and support globally. The severe liquidity-induced selling in March subsided, and credit spreads were broadly tighter across investment grade and high yield markets.

Australian credit spreads saw a disperse set of outcomes. Synthetic credit, like the iTraxx Australia Index tightened significantly by 56bps to end the month at 115bps, better reflecting the momentum in offshore markets. Floating rate notes from the main domestic banks benefitted strongly from balance sheet demand and an influx of liquidity from depositors, as well as RBA liquidity support, which saw spreads also rally about 45bps on average. Meanwhile, the lower volatility in Australian physical corporate bonds continued. While these bonds didn’t widen as much in March as offshore bonds, they also haven’t rallied as much. Spreads on the Bloomberg AusBond Composite 0+ Yr Index were unchanged during April.

We anticipate that Australian corporate bonds will eventually converge with global pricing, and this is typical of the Australian credit market which tends to exhibit lower volatility due to the higher quality of issuers and relative scarcity of securities.

In the US, primary market volumes broke monthly records and European issuance continued apace. The actions by the US Federal Reserve to underpin market liquidity has allowed the primary market to function, while in Australia there has been a hiatus of issuance which typically occurs during volatile conditions. Some domestic companies favoured the conditions in offshore markets as a way of accessing funding, with Transurban, Telstra, Toyota Finance Australia and APA Group issuing in euros. By contrast, the Australian primary market only saw issuance of AAA rated covered bonds by four of the major Canadian banks, and then Suncorp which issued $750m of new bonds into more than $2bn of demand.

Market outlook

World growth is expected to fall by 3% during the ‘Great 2020 Lock-down’ according to the latest projections from the IMF, far outpacing the 0.1% fall in the 2009 Global Financial Crisis. Assuming the pandemic fades in the second half of 2020 and that the US$8 trillion of global policy support to-date acts as a buffer, the IMF expect growth to rebound by 5.8% in 2021. They estimate the cumulative output loss over 2020 and 2021 to be around US$9 trillion. Risks to the global outlook remain tilted to the downside, especially if the pandemic has further waves, or it takes longer to find an effective vaccine. Given that all the monetary policy bullets have been fired, fiscal policy remains best placed to provide further support.

For the Australian economy, we continue to look for a ‘U’ shaped profile for growth over the period ahead. Higher frequency economic indicators show that the restrictions on population mobility will push the economy into a sharp and deep recession. Cumulative output losses of around 10% are in store, along with a mid-year spike in the unemployment rate to around 10%. In the absence of recent fiscal and monetary measures worth 16.4% of GDP, output and labour market outcomes would have been much weaker.

Time spent at the bottom of the ‘U’, or the trough phase, will be determined by the time it takes for population mobility restrictions to be lifted. On that front, Australia’s success in flattening the infection curve raises the prospect that the period of ‘controlled hibernation’ may be shorter than initial expectations for a six month lock-down. We look for the economy to trough in the September quarter before rebounding. For 2020, we expect the Australian economy to contract by 6% before growth rebounds by 6.5% over 2021. We estimate that economic activity will only get back to end of 2019 levels by the end of 2021.

Given such an outlook and the damage that lock-downs are doing to the economy’s potential growth rates, we look for a low rate regime to persist for many years. We took advantage of the rally in longer-dated yields earlier in April to take further profit on the duration positions that we had added during March’s spike in yields. We see limited scope for a sell-off in 10 year government bond yields at 0.90% given the nearer-term growth and inflation outlook. Furthermore, central banks will need to keep yields low via unconventional policy measures to create the fiscal space governments will need to support aggregate demand over the period ahead.

We continue to see value in spread sectors at current elevated levels given the outlook for an extended period of low yields on government securities and unprecedented levels of central bank support for both sovereign and non-sovereign debt markets.

We remain mindful that massive fiscal easing and the blurring between monetary and fiscal policy in some jurisdictions raises term risk. Stimulus and intervention that politicians may find difficult to unwind raises medium-term inflation risks, so we remain attracted to maintaining a core exposure to inflation-protected securities.

Views as at 30 April 2020.