Australia Market Commentary
The Australian bond market (as measured by the Bloomberg AusBond Composite 0+ Yr Index) was up 0.94% over the month. The yield curve flattened as the spread between long-term and short-term bond yields narrowed. 3-year government bond yields ended the month down 12 basis points (bps) to 1.63% while 10-year government bond yields were down 14 bps to 2.10%. Short-term bank bill rates ended the month lower. The 1-month rate was down 17bps to 1.84%, the 3-month rate was down 20 bps to 1.87% while the 6-month rate was down 19 bps to 2.00%. The Australian dollar was one of the worst performing currencies, closing the month lower at USD 0.71.
The cash rate remains unchanged at 1.50%. The Reserve Bank of Australia (RBA) maintains its view that the Australian economy is performing well, although GDP growth had slowed unexpectedly in the September quarter. The labour market, conversely, continues to improve with unemployment having fallen to 5%. Underlying inflation remains low, but is above its trough. The RBA’s forecast for the Australian economy is for GDP growth to be around 3% for 2019 and 2% over 2020 and a small downward revision to the underlying inflation forecast for year-end means it is now expected to increase to 2%.
The latest domestic economic data releases were mixed in February. Residential building approvals for December continued their fall (–8.4%) against a market consensus of +2.0%. This sees the year-on-year slump to -22.5%. Employment rose in January to add 39,000 positions, with most of these positions being full-time (65,000 positions), whilst part-time employment fell by 26,000 positions. The unemployment rate remained steady at 5.0%. The NAB Business Conditions rebounded 4 points to +7 in January, while business confidence rose slightly to +4. Retail sales were down 0.4% in December, with November’s number being revised up to 0.5%.
Australia Market Outlook
Global growth has desynchronised and we remain cautious given ongoing geopolitical risks and shifting central bank policy settings. The US Federal Reserve turned more dovish during January, appearing to drop their bias to hiking rates. The US instigated trade war remains ongoing, however trade tensions with China have subsided to a degree.
The Australian economy continues to grow and has officially completed 26 years of uninterrupted expansion. However there are some risks on the horizon. Over the past six months the consumer has struggled despite a strong business and employment outlook. Corporate profits are robust and business confidence remains positive, however historically low retail sales and poor consumer confidence driven by very low wages growth moderates the outlook for growth. Furthermore, the weaker housing market is starting to bite with falling house prices, lower building approvals and lower mortgage approvals filtering through to the broader economy.
We expect the RBA will need to cut rates in 2019, as the decline in house prices will slowly feed through to the real economy. Given the soft inflation backdrop the RBA will likely have little justification to move cash rates higher in the near term. The RBA has recently changed its tone, with a speech from Governor Lowe in February indicating that the probabilities of either a rate cut or hike appear evenly balanced. Market participants are also starting to come around to this view, with some pushing back their expectations for rate hikes, while others are calling for cuts this year.
Credit Commentary
Credit market sentiment in February was mixed with more optimism about the US-China trade war being offset by ongoing confusion regarding Brexit and domestically, a results season that was soft, with more target misses than hits. Credit markets retained the positive momentum of January although spread contraction was lower than last month with the US tightening by 4bps and the European market by 6 bps. Australian spreads again lagged offshore markets, tightening by just 1 bp. Synthetic indices all rallied with the Australian iTraxx 9 bps tighter and, in offshore markets, the US CDX 6 bps and European iTraxx 8.5 bps tighter.
Company reporting was the major news during February. As mentioned above, reporting was slightly on the weaker side overall. The weakness was not significant and for most issuers, the company reporting had no significant credit implications. For AMP, however, weak results were coupled with the negative stories from the Financial Services Royal Commission and uncertainty regarding the sale of AMP Life, putting severe pressure on its ratings.
At the start of the month, the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry presented its final recommendations. The 76 recommendations targeted means of improving the conduct of financial institutions but stopped short of any changes that might fundamentally change the nature of the banks and hence had limited credit implications.
In other regulatory news, the Productivity Commission indicated in its draft report that regulation for airports is to remain at the status quo i.e. at a light level - a positive for the sector.
In rating news, Standard and Poor’s (S&P) downgraded Nissan Motor from A to A- with stable outlook and Moody’s upgraded Citigroup’s holding company and a number of its subsidiary operating companies by one notch. S&P also updated its speculative grade default expectations to reach 3.1% by December.
Corporate issuance for February was solid and more diverse than the major-bank dominated supply of January. Supply totalled AUD 6.89 billion of which AUD 2.05 billion was non-financials (General Motors Financial Motors, Virgin Australia and McDonald’s). The financial issuance was well-spread among issuers (NAB, BNP, Newcastle Permanent Building Society, Credit Union Australia and Liberty Financial). There was also substantial AUD 4 billion issuance in the securitised market, although out of this amount, one deal (Westpac’s WST 2019-1) formed the bulk of the supply at AUD 3 billion with Pepper and a refinance of a CBA Medallion tranche rounding out the supply.
Credit Outlook
Domestic credit spreads were stable over the month, remaining tighter than the post-financial-crisis wides of 2015. As such, there is room for further widening in an environment where global or economic uncertainty continues to apply pressure: however, underweighting credit at current spreads for any sustained period of time has become more expensive than at the beginning of last year.
Supply has begun to increase domestically after a slow start this year in terms of number of issuers. Domestic non-financial supply is often less abundant and is always uncertain given many Australian investment-grade issuers tend to be lowly geared and so require less debt. In addition, the bank loan market remains attractive for shorter maturities and offshore markets offer competitive pricing for sizable long-term debt issues. Many issuers have also taken advantage of low rates to refinance many of their maturities and the short-term corporate pipeline is thin.
Given the possibility of further weakness of spreads, caution needs to be applied especially when investing in lower-rated credits. Despite the differing performance in terms of ratings, high-yield spreads in the US still appear reasonably tight and in Europe are close to normal but vulnerable to further widening; as such, the extent of compensation for taking exposure to lower-rated credit is less compelling.
Domestic and offshore financials tend to be the most common issuers in the Australian market and can offer value. However, for offshore issuers the attraction is decreased aspects such as the increase in non-domestic issuing programmes and the complexity of the variations in treatment of TLAC (total loss-absorbing capital). Accordingly domestic major banks offer a simpler value proposition due to their liquidity and some of the smaller local approved deposit institutions (ADIs) provide a solid spread with conservative management. On the non-financial side, the lack of supply has resulted in many deals being expensive but stable sectors such as the utilities and quality REITS remain more attractive sectors. Securitised product remains another area of value given solid spreads and in many cases superior credit quality.
