Market review

May was a tale of two halves, backed by the fortunes of inflation and central bank expectations. The Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, rose 0.39%.

The two-tone month for yields was indicative of the conflicting pressures and uncertainty surrounding the central bank outlook for the rest of the year. The RBA should commence easing in late 2024 with the risks balanced.

Bond markets rallied over the first half of May, giving most of it back through the second. This was due to continued evolution of central bank easing cycle expectations, and inflation outcomes. Australian three-year government bond yields ended the month one basis point (bp) higher at 4.05%, while 10-year government bond yields were 1bp lower at 4.41%. Against the current cash target rate of 4.35%, three-month bank bills ended 6bps lower at 4.35%. Six-month bank bill yields ended 10bps lower at 4.60%.

The two-tone month for yields was indicative of the conflicting pressures and uncertainty surrounding the central bank outlook for the rest of the year. Australia is caught up in the global trends, and mirrors many of the themes. The G10 central bank easing cycle is underway, with the Riksbank joining the Swiss in easing and the European Central Bank (ECB) making strong comments about a June easing. Early month inflation prints, including in the US, were manageable. This all went well, until a swath of stronger than expected purchasing manager indices (PMIs), pointing to stronger economic growth ahead in the larger economies. This triggered the lift in yields into month end. The push and pull between growth and inflation continues to muddy the outlook for central banks, making a comprehensive easing cycle harder for markets to see in the very near term.

This too remains the case for Australia. The Reserve Bank of Australia (RBA) kept interest rates unchanged in May, and while they continue to be data dependent, warned on inflation risks. Local economic growth indicators continue to soften but with inflation remaining persistent, the immediate environment is one of waiting and seeing. Consumer sentiment is very weak and raises questions about the ability for households to comprehensively rebound in H2. Meanwhile, current household spending remains moribund. The unemployment rate ticked higher, and the construction sector was weaker than expected. On the positive side, current capital expenditure is solid, and there is a lift in housing finance. The Federal Budget does point to some fiscal easing later in the year, which may be supportive. Overall, the RBA continues to note the difficult balancing act the current economic conditions provide. The bar appears high for further hikes, but they are able to delay easing until late in the year or beyond.

Global credit markets benefited from benign conditions primarily centred around soft-landing expectations in the US. Issuers took full advantage of the attractive funding environment to front-load primary issuance ahead of the Northern Hemisphere summer break and the peak of the US election cycle later in the year. Domestic primary markets took the same theme, and a range of financial and non-financial corporates issued bonds at attractive yields. The securitisation market was likewise highly active across the bank and non-bank sectors.

The Australian iTraxx Index ended 9bps tighter at 66bps, while the Australian fixed and floating credit indices returned +0.70% and +0.50% respectively.

Market outlook

The Australian economy is slowing gently, and while no recession is forecast, the pressure of higher interest rates is expected to continue to broaden out across sectors of the economy. While households should be able to stabilise through year end, we see softening of the investment outlook and continued below trend economic growth into 2025. Under these conditions, the labour market should weaken, and inflation move slowly back to target.

Our base case is for the RBA to remain on hold at current rates before commencing an easing cycle late 2024. We price a more modest than historically average easing cycle, of around 175bps, spread over an extended period. There are a myriad of risks to the base case at this stage, with the high case of no easing until 2025, and a slow cycle through to 2026, and the low case of a modestly earlier commencement, which finishes with slightly more easing over the whole cycle. Both are possible given the current set of uncertainties.

We see the near-term pricing of minimal easing through 2026, as underestimating the risks to the economy after a long period of policy tightness. We currently consider the Australian yield curve as under-valued at points in the curve. We hold a long duration position and look to add to it on any worsening of the economic outlook.

Our credit strategy remains skewed towards high-quality, investment grade issuers with resilient business models, solid earnings power and conservative balance sheets. Conversely, we are avoiding SME, lower quality and leveraged sectors, where default stress is increasing. While we acknowledge that credit spreads in general are tight, all-in yields particularly in low/no default-risk Investment Grade credit remain highly attractive. We continue to actively and selectively take advantage of these yields in highly-rated corporate bonds and structured credit, particularly in the primary markets where transactions have come with new issue concessions.

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