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

Market review

Despite volatility caused by COVID-19 flare ups and mixed economic data, risk appetite remained resilient, supported by open-ended policy support. Equity markets were generally firmer, while credit markets continued to perform as investors searched for yield. Longer-dated yields edged lower as the growth outlook became more uncertain. The Australian bond market, as measured by the Bloomberg AusBond Composite 0+Yr Index, ended July 0.37% higher.

The re-introduction of lockdown measures in Victoria, which accounts for around a quarter of national output, will weaken the near-term growth profile.”

Yields at the shorter end of the Australian government yield curve remained anchored by Reserve Bank of Australia (RBA) forward guidance and yield curve control measures. The RBA Governor did note that some volatility caused by market supply indigestion would be tolerated and that a sustainably higher move in the three-year government bond yield over the 0.25% target level would be needed before the RBA intervened. The three-year government bond yield ended the month 2 basis points (bps) higher at 0.27%.

Further out along the yield curve, 10-year Australian government bond yields traded in relatively narrow ranges, before rallying later in the month as COVID-19 flare ups, dovish US Federal Reserve (Fed) commentary and a 9.5% fall in US Q2 GDP hosed down growth expectations. The 10-year government bond yield ended 5.5bps lower at 0.815%.

Economic readings pointed to a national recovery in activity over June and early July as earlier lockdown measures were relaxed. There were solid rebounds off very low levels in the June NAB Business Survey and signs of healing in the labour market. Jobs lifted by 210,800 in June and hours worked by 4%. Although the unemployment rate lifted to 7.4%, this is still well below the 10% estimates made several months ago by the RBA and Treasury.

However, the re-introduction of lockdown measures in Victoria, which accounts for around a quarter of national output, will weaken the near-term growth profile. Negative confidence effects were evident in the 6.1% fall in the July Westpac Consumer Sentiment Index.

The impact of policy measures was evident in the June quarter Consumer Price Index (CPI) which fell a massive 1.9% over the quarter and 0.3% over a year ago. Temporary free childcare detracted 1.1 percentage points (ppts), while lower fuel prices detracted 0.7ppts. Core inflation, as measured by the average of the RBA’s statistical measures, was flat over the quarter.

Against this backdrop, money market rates were relatively steady. The RBA left the official cash rate target at 0.25% and the interbank overnight cash rate ended the month 1bps lower at 13bps. Three-month bank bills ended the month largely unchanged at 10bps, while the six-month bank bill ended 1.5bps higher at 17.5bps. Cash rate expectations remained consistent with RBA forward guidance for no change in the cash rate until the labour market and inflation outlook improved.

Credit markets continued to recover following the COVID-19 shock that occurred in March, with the iTraxx Index ending the month 11bps tighter at 76bps. Despite the setbacks regarding the second lockdown in Victoria and the impact this will have on economic growth and the credit profiles of corporate Australia, credit investors generally looked through this weakness.

With company reporting season about to commence, primary markets were dominated by offshore banks or private domestic companies predominantly in the utilities and infrastructure sectors. Investors are expecting weak corporate earnings to be announced, but the focus will be on whether management can comment on the outlook for the remainder of the year and what their funding intentions are.

Market outlook

Australia’s near-term growth outlook has been set back by a surge in COVID-19 cases in Victoria, which despite an initial Greater Melbourne lockdown, shows no sign of slowing and appears to be spreading into other eastern states.

We suspect Treasury’s forecasts for the economy to fall by 3.75% over 2020 in the latest Economic and Fiscal Update may prove to be too optimistic. We look for growth to fall by up to 5% over 2020, with the economy contracting in the March, June and September quarters, with the largest falls in the June quarter.

Economic growth is expected to rebound from the December quarter with the Government’s decision to extend income support, albeit at a reduced rate until the end of March 2021, shoring up the outlook by fading the rate at which fiscal support is reduced. Stronger and wider lockdown measures will delay and flatten the rate of recovery and likely require more fiscal support.

While progress towards finding a vaccine continues, the nearer-term outlook remains highly uncertain. Fiscal policy remains best placed to target support to individuals and industries. While the RBA has indicated that it is content with the current level of monetary accommodation, an extension of forward guidance or yield curve control measures remain policy options to support fiscal measures if needed.

Cyclical and structural factors continue to point to a low rate regime that should persist for many years and see income producing assets bid. The two preconditions for an RBA rate rise remain a return towards full employment and inflation returning on a sustainable basis to the 2% to 3% target band. We see neither of these preconditions being met for several years given the amount of spare capacity in the economy.

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.

We remain mindful that massive fiscal easing and the blurring between monetary and fiscal policy in some jurisdictions raises term risk. Stimulus, interventions that politicians may find difficult to unwind and supply chain reconfigurations raise medium-term inflation risks. A lift in breakeven inflation rates has seen some of these risks starting to be priced, so we have trimmed some of our core exposure to inflation-protected securities.

Views as at 31 July 2020.