Market review

Bond markets worry about stubborn inflation pressures, moving to price a higher for longer rate environment. Against this backdrop, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, fell 2%.

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.

Sticky inflation in the US, and locally, pushed yields back to levels last seen in December. Australian three-year government bond yields ended the month 42 basis points (bps) higher at 4.04%, while 10-year government bond yields were 46bps higher at 4.42%. Against the current cash target rate of 4.35%, three-month bank bills ended 6bps higher at 4.41%. Six-month bank bill yields ended 20bps higher at 4.70%.

US economic data continues to surprise to the upside. Members of the US Federal Reserve (Fed) have signalled that they are willing to wait before easing, to be more certain about inflation subsiding to target. This has opened up a divergence with other major Central Banks, where inflation is slowing towards target, and markets are pricing mid-year easing. But, it was the US surprises which dominated the push to higher yields across the board, and moved possible Fed rate cuts to year end.

Australian quarterly consumer price index (CPI) came in higher than expected and shows that a move to the Reserve Bank of Australia’s (RBA) inflation target is being held back by sticky services prices. At 3.6%yoy, headline CPI is well off its peak and moving lower, but more is needed. Employment eased in March, although is coming from a stronger base. The RBA has outlined the broad range of factors in the labour market it now monitors to determine full employment. These are softening but slowly. Household spending has been volatile, March was weak and highlights the pressure individual households continued to be under through the first quarter. The housing market remains outside the rates cycle due to continued limited supply, and rising demand from population growth. There was no supply relief in the month’s data with building approvals and construction starts weak, as completions roll off. House price increases are not boosting consumers though, with sentiment remaining very poor. Meanwhile, business sentiment slowly eases back.

During the month, risk markets were driven by three powerful forces. These were a significant escalation in geopolitical risk in the Middle East, upside surprises to inflation pushing yields higher, and remarkably resilient earnings released by corporates during Northern Hemisphere first-quarter reporting season. Credit investors chose to focus on still reasonable growth, solid fundamentals and attractive all-in yields, creating a strong demand technical which held credit spreads in check. Looking forward, expectations are for bifurcation to increase with Investment Grade corporate credit expected to perform reasonably while highly leveraged, sub-investment grade and un-rated Issuers are forced to contend with a sustained high cost of capital environment with no relief forthcoming in the near term.

In the domestic credit market, the complex global investment backdrop had little impact on primary market activity levels, which remained high. Notable transactions included A rated mall REIT Vicinity Centres issuing $500m of 10-year senior unsecured fixed rate bonds at an attractive yield of 6.2%, while quality infrastructure issuers Sydney Airport (rated BBB+) and Adelaide Airport (rated BBB) issued $850m of 10-year and $200m of seven-year senior secured fixed rate bonds at yields of 5.9% and 5.7% respectively. Lastly, in a move that had been widely anticipated by credit investors, ratings agency Standard & Poor’s undertook ratings action on a swathe of Australian Banks. Of particular relevance was the elevation of the credit ratings of Tier 2 Subordinated Debt of the four Major Banks, from BBB+ to A-, making them even more attractive to global credit investors as a source of high quality, investment grade yield and spread.

The Australian iTraxx Index ended 12bps wider at 75bps as volatility picked up, while the Australian fixed and floating credit indices returned -0.91% and +0.48% 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. 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 hinting at a rate hike this year, and very limited cuts in 2025, 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.

In recognition of the complex macroeconomic and geopolitical environment, our credit strategy remains skewed towards high-quality, investment grade issuers with resilient business models, solid earnings power and conservative balance sheets. While acknowledging that credit spreads in general have tightened considerably, all-in yields particularly in low/no default-risk Investment Grade credit remain highly attractive. We have been actively and selectively taking 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. Further, 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 attractive risk-adjusted returns for patient investors with a medium term investment horizon. We continue to judiciously seek out, create and access such opportunities, while simultaneously preserving significant capacity to take advantage of opportunities arising through future market dislocations.

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