Market review

The rollercoaster in yields continued through November, reversing the October sell-off. A US led bond rally, on expectations of a slowing economy, supported broad based bond market gains. Against this backdrop, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, rose +2.97%.

Markets turned their eye to the next phase of the economic cycle, pricing a slowing and lower policy rates across the developed markets. This allowed for a broad bond market rally.

As the economic, and policy, cycle matures, uncertainty as to the next move remains high and can turn easily. November saw such a turn, moving to price a slowing US economy and taking broader markets with them. The Reserve Bank of Australia (RBA) continue to worry about the risks of sticky inflation and raised rates to curtail any reignition of domestic inflation. The cash rate increased 25 basis points (bps), to 4.35%, at their November meeting. Three-year government bond yields ended the month 39bps lower at 4.01%, while 10-year government bond yields were 51bps lower at 4.41%.

Against the current cash rate of 4.35%, three-month bank bills ended 2bps higher at 4.37%. Six-month bank bill yields ended 17bps lower at 4.58%.

The RBA have warned that they may have to raise rates again if domestic services inflation does not moderate. Inflation expectations remain a concern for them, but the good news is that these measures have fallen. Employment was strong, boosting incomes, but the forward indicators of the labour market have turned and point to an easing up of the tight labour market. Retail spending has also eased and is running at a low 1.2% year on year (yoy), despite strong population growth driving volumes. Meanwhile, the monthly Consumer Price Index (CPI) was lower than expected at an encouraging 4.9%yoy, from 5.6%.

US and European inflation have come in below expectations and point to a global inflation downdraft. The US economy remains mixed, but broad-based purchasing manager indices (PMIs), including for Australia, have weakened. Given this, the decline in bond yields reflected both a moderation in inflation as well as a drop in real yield.

Risk markets rallied in November as softer inflation and activity data raised hopes that the aggressive global rate rising cycle may be close to peaking. As is customary for this time of year, investors considered year-ahead investment outlooks against a backdrop of slowing growth, tightening financial conditions and a geopolitical back-drop showing little signs of calming. In credit markets, a theme of bifurcation continued gather pace. While consumer and corporate fundamentals remained relatively robust on average, weakness is accelerating in the lower to mid quality market segments. Returns on offer in low/no default risk Investment Grade bonds and upper echelons of securitised markets remained attractive on a risk-adjusted basis. Whereas in leveraged and sub-investment grade markets, credit spreads appear not to adequately reflect deteriorating fundamentals, rising defaults and upcoming maturity walls.

The domestic primary market was active as corporates looked to access a limited funding window ahead of the traditional year-end holiday lull. Notable non-financial corporate issuers included Coles Group Limited who issued $600m of 7.7- and 10-year fixed rate senior unsecured bonds. These BBB+ rated instruments were issued at yields of 5.8% and 6.2% respectively, and received strong demand from investors attracted to the strong risk adjusted returns on offer from a well-known consumer staple. In the financials space, NAB, Westpac, CBA and Suncorp-Metway issued across the capital structure. Most notable amongst these was Westpac who issued both BBB+ rated fixed rate Tier 2 subordinated debt callable in 10 years yielding 7.2%, and their latest floating rate Additional Tier 1 ASX listed hybrid (rated BBB-) at a margin of +310bps over the three-month BBSW. Sized at $1.5 billion and $1.75 billion respectively, these investment grade instruments likewise attracted strong demand.

Reflecting the risk rally, the Australian iTraxx Index ended 22bps tighter at 75bps, while the Australian fixed and floating credit indices returned +1.84% and +0.45% respectively.

Market outlook

Most G10 markets are now pricing for an easing policy cycle commencing mid-2024, while pricing for the RBA move is less equivocal. There is a small chance of a RBA hike priced for February, which also reflects our degree of near-term risk for the RBA. Our base case is for the RBA to remain on hold at current rates. Beyond mid-year is where the market pricing for Australia differs from major central banks. There is very little policy action priced across the year, and no real easing cycle. Our base case is for a mild easing cycle to commence in late Q3 2024.

The RBA continue to monitor the balance between the slowing household sector, the strong labour market, and high wages growth. The economy has peaked and there are increasing signs of slowing in the economy. This does need to be balanced against the stickiness of services inflation, and that will keep the RBA cautious until there is a clearer signal of downside risks and / or lower inflation.

We see the very near-term RBA pricing as reasonable, but the expectation of policy rates held at contractionary levels over a period of years as underestimating the cyclical risks. We currently see the Australian yield curve as under-valued at points in the curve. We remain on the lookout for tactical opportunities to add further duration.

In recognition of the increasingly complex global investment environment, our credit strategy remains skewed towards high-quality, investment grade issuers with resilient business models, solid earnings power and conservative balance sheets. We have been actively and selectively taking advantage of the attractive yields on offer in highly rated corporate bonds and structured credit, particularly in the primary markets where transactions have come with new issue concessions. While we believe that the cumulative impacts of tightening financial conditions will become evident, we are mindful of a healthy starting point of above full employment and remain open-minded to a wider range of potential economic outcomes that include scenarios less dire than ones revolving around deep recession.

Backed by fundamental research and experience, we also continue to identify pockets of opportunity where perceived risks have been overly discounted into the valuations of what would traditionally be considered stable and sustainable credits. In such instances, a strong case can be made for capital gains over-and-above already attractive cash yields, setting up for outstanding risk-adjusted returns for patient investors with a medium term investment horizon. We have judiciously begun to access such opportunities, while also preserving significant capacity to take advantage of opportunities arising through future market dislocations.

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