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

Market review

Financial markets were buoyed by the prospect of economies re-opening, with improving risk appetite driving strong gains in equity markets. Improving sentiment flowed into credit markets and spread sectors, where investors sought to take advantage of the higher yields on offer. The Australian bond market, as measured by the Bloomberg AusBond Composite 0+Yr Index, ended May 0.29% higher.

The unemployment rate lifted to a less than expected 6.2%. Had the participation rate not fallen by 2.4 percentage points to 63.5%, the unemployment rate would have lifted to 9.6%.”

Australian government bond yields traded in relatively tight ranges, with central bank and Government policy communications having little impact on pricing. At the shorter end of the yield curve, three year government bond yields were anchored by the Reserve Bank of Australia’s (RBA) 0.25% yield curve control target and ended the month at 0.26%.

At the longer end of the curve, the 10-year government bond yield traded in a 15 basis point (bps) range. During periods of government debt issuance and recovering oil prices, yields tended to be higher. Deterioration in the US-China relationship over the latter part of May saw the 10-year government bond yield fall from 0.98% to end the month unchanged at 0.89%.

Economic readings had limited market impact, but the most recent partial indicators remain consistent with the implementation of social distancing measures leading to the biggest economic contraction since the Great Depression. March quarter retail sales, trade and capital expenditure data suggest that economic growth will fall by around 0.25% in the upcoming release of the March quarter national accounts. The largest falls in activity are expected to be concentrated in the June quarter.

In the April NAB Business Survey, business conditions fell precipitously to -34, marginally higher than the Survey lows experienced in the early 90’s recession. There were early signs that accommodative policy measures were having a positive impact, with consumer sentiment lifting from April’s 75.6 low to 88.1 in May.

The hit to the labour market from lock-down measures became more evident in April, where employment fell by a record 594,300 and hours worked plunged by 9.2%. The unemployment rate lifted to a less than expected 6.2%. Had the participation rate not fallen by 2.4 percentage points to 63.5%, the unemployment rate would have lifted to 9.6%. On the wages front, the trend for subdued gains continued, with the Wage Price Index lifting by 0.5% over the March quarter and 2.1% over a year ago.

Money market rates were steady, with the RBA leaving the official cash rate target at 0.25%; the interbank overnight cash rate ended the month unchanged at 14bps. Three and six month bank bills also ended the month largely unchanged at 9.5bps and 16.5bps. 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.

Improved risk sentiment flowed through to credit market performance, with physical credit spreads enjoying a 10bps rally. The iTraxx Index also ended May 13bps stronger at 102bps. Offshore credit markets remained on a positive footing with another strong month of issuance well received by investors. The US investment grade corporate market has seen US$1 trillion of new issuance already this year, almost equivalent to a full calendar year’s supply in five months.

In this more positive environment, the Australian primary market kicked into gear with the first non-financial corporate bond issuance by Woolworths receiving strong demand. A broad range of credit was on offer, from AAA segments like government agency, Airservices Australia, and secured covered bonds from Bank of Queensland, through to subordinated issuance from Macquarie Bank, which issued Tier 2 and ASX listed hybrids during May. The strong demand seen for new credit securities offering better levels of income also assisted the secondary market to perform and provide capital gains for investors.

Market outlook

We continue to look for a ‘U’ shaped profile for growth with activity falling sharply over April/May following the introduction of population mobility restrictions. Success in flattening the infection curve raises the prospect that we will see the low point in activity round May/June, especially after the Government announced an earlier than expected three step plan to ease restrictions and re-open the economy.

While an encouraging development, the RBA remain mindful of the risk that animal spirits may be slow to recover. Hysteresis effects could be large and lingering coming out of this shock to activity and the human psyche. A deferral of investment decisions, lift in precautionary behaviour and loss of human capital could interact to reinforce the secular trend to lower economic growth and neutral interest rates.

Both the US Federal Reserve (Fed) and RBA have responded to these developments by largely ruling out the prospect of negative interest rates, with the RBA particularly noting that the cost of such a regime outweighed the benefits. Instead, while they both saw scope for further forward guidance and yield curve control measures, the most powerful policy tool going forward was fiscal policy. The RBA has warned of the risks of removing fiscal support too early and that more fiscal easing maybe needed to restore confidence.

Given such an outlook and the damage that lock-downs are doing to the economy’s potential growth rate, we look for a low rate regime to persist for many years. We see scope for some flattening at the longer end of the yield curve given the size of output gaps and central banks’ desire to create fiscal space for governments by keeping yields low via unconventional policy measures.

We remain attracted to spread sectors but have shifted from accumulating holdings following the widening in spreads over March, to becoming more selective about the names and tenors we are adding. Despite ever-present solvency risks, we expect spread sectors to be shored up by 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.

That said, 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 31 May 2020.