Australian market commentary
The Australian bond market (as measured by the Bloomberg AusBond Composite 0+ Yr Index) returned 2.33% over the month. The yield curve flattened as 3-year government bond yields ended the month down 28 basis points (bps) to 0.62% while 10-year government bond yields were down 42 bps to 0.95%. Short-term bank bill rates ended the month lower. The 1-month rate was down 7 bps to 0.80%, the 3-month rate was down 4 bps to 0.88% while the 6-month rate was down 13 bps to 0.90%. The Australian dollar fell sharply, closing the month at USD 0.67.
The cash rate remains unchanged at the record low of 0.75% given the traditional absence of a January meeting by the Reserve Bank of Australia (RBA).
Domestic economic data releases were mixed in January. On the inflation front, the Consumer Price Index rose 0.7% during the fourth quarter, while the annual rate ticked up to 1.8%. Both results were marginally above consensus. Employment rose by 28,900 positions in December which also exceeded expectations. The unemployment rate edged lower from 5.2% to 5.1%. The NAB Survey of Business Conditions fell in December to +2.7 points and business confidence turned negative, falling to -1.9 from 0, the lowest level since July 2013. November retail sales were up 0.9%, beating market expectations. National CoreLogic dwelling prices continued to post gains, rising 1.0% in January.
Australian market outlook
Despite being only one month in, 2020 has had a rocky start, with positives such as the signing of the phase one trade deal between the US and China being overshadowed by rising geopolitical risks in Iran and then the growing fears regarding the impact of the coronavirus emanating out of China. There were signs in 2019 that global industrial production had bottomed, and fundamental data in China has shown improvement with both Chinese imports and new export orders ticking up recently. Given the uncertainties posed by the coronavirus, the improvements in Chinese data may be short-lived, however we remain hopeful regarding the overall global growth outlook given the willingness of central banks to maintain liquidity in times of crisis. In Europe, Brexit finally took place on 31 January, and Britain now enters an 11-month transition period where it will need to strike a trade deal with the European Union. Eyes will also be on the US this year, with the presidential election taking place in November.
Domestically, the Australian economy has been growing below-trend, with sustained low income growth impacting household consumption. Despite strong employment growth, unemployment has hovered around the low 5% mark in recent months as labour force participation has increased to a record level. Economic growth is expected to increase only gradually, supported by the record low level of interest rates and turnaround in the housing market.
The delivery of three 0.25% rate cuts in quick succession last year saw the RBA take action to support employment growth and reduce the spare capacity in the labour market. We were somewhat surprised to see the RBA continue with its third cut of 0.25% in October, as we thought that the RBA would wait to see if the prior two cuts where flowing through the economy. In spite of this we think that the RBA was warranted in providing additional support to the Australian economy amidst concerns that global trade was slowing. We expect rates to remain on hold for the remainder of the year given the employment situation remains favourable, inflation is expected to rise (impacted by rising house prices and food price inflation) and the positive housing outlook should lead to a flow-on effect on household consumption.
The credit markets in January were buoyed by the US trade deal before being pulled back by the news on the coronavirus and, domestically, sentiment from the bushfires. Market performance was mixed with physical markets rallying but synthetic markets selling off: the US CDX was 5 basis points (bps) wider, the European iTraxx widened 2 bps from end-of-year levels and, domestically, the Australian iTraxx closed 3 bps wider.
In Australia, competition in the supermarket sector eased slightly with the announcement that Kaufland was pulling back from entering Australia. Lendlease confirmed that John Holland has pulled out of the process to buy its services business. John Holland had been viewed as the frontrunner. Transurban released a statement that it had received a document from the joint venture of CIMIC’s CPB Contractors and John Holland seeking to terminate a subcontract for the West Gate Tunnel project on the basis of force majeure relating to contaminated soil. Standard & Poor’s (S&P) commented that they expected the termination notice to trigger commercial negotiations between the two parties and the Victorian government, with all parties likely to seek a commercial solution.
Suncorp updated its natural hazard exposures and reserve release expectations for 1H20. Suncorp estimated that 1H20 natural hazard costs would be AUD 109 million above its AUD 410 million natural hazard allowance with a further AUD 75–105 million in claims in 2H20 from early January bushfires, taking the total gross claims from the fires to AUD 220–250 million. Suncorp expects hailstorms and rain events on the east coast in January to add to gross claims, however the net cost for the three January events (fire, rain and hail) post reinsurance is expected to be limited to AUD 300 million. At FY19, Suncorp reported reserve releases of AUD 322 million but 1H20 will see releases drop to AUD 50–70 million, the lowest level in recent years. The group continues to expect releases to be above the long-term target, creating a further drag on earnings.
In US reporting, major US Banks, JP Morgan, Citigroup and Bank of America all reported strong results. Wells Fargo continued to lag with litigation and regulatory issues remaining a drag on the company. Goldman Sachs was also weakened by litigation over the 1MDB scandal but otherwise presented a reasonable result. Outside of the financials, GE rebounded from a multi-year slump, and Coca Cola Bottling Company was positive, while McDonalds Corporation and Paccar remained on course. In the telecommunications area, both AT&T and Verizon provided slightly disappointing results from an equity viewpoint, although the fact Verizon leverage has continued to decrease is a definite positive for the credit.
In Europe, Swedbank reported better than expected results but remains challenged as it works through the anti-money laundering litigation based on dealings with entities in Estonia. Deutsche Bank has mixed results as it continues to work through its transformation under new management and Santander reported results slighter above consensus.
In ratings news, S&P commented that Alimentation Couche-Tard Inc.'s (ACT) bid for Caltex Australia Ltd could weaken Caltex’s credit profile: ACT is rated BBB/Stable while Caltex is BBB+/Negative. Places for People Homes Ltd was upgraded to A3 from Baa1 by Moody’s. Barclays PLC was upgraded to Baa2 from Baa3 by Moody’s.
Domestic corporate supply started the year well at AUD 7.2 billion, including major bank issues from ANZ and National Australia Bank. There was one non-financial corporate issue, a twelve year deal from Dexus. January is typically a very quiet month for financials but this year saw three issues with a total of AUD 3.7 billion including a prime RMBS issue from Westpac and two auto finance deals from Pepper and Liberty.
Last year saw a substantial tightening in credit spreads. At current levels, in an environment where political or economic uncertainty continues to apply pressure, the risk of widening is increasing; however, underweighting credit at current spreads for any sustained period of time remains an expensive position. The allocation to credit can, however, be more weighted towards shorter dated credit which is less sensitive to spread widening.
Supply has been strong this past year particularly in terms of number of issuers. Although non-financial issuers have been increasing in number and size, issuance is still biased towards financials. 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. Given the possibility of further weakness of spreads, caution needs to be applied especially when investing in lower-rated or longer-dated credits. High-yield spreads offshore appear reasonably tight and are vulnerable to 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, caution must be applied due to the complexity of the variations in treatment of capital requirements with varying rules on TLAC (total loss-absorbing capacity). Accordingly, domestic major banks offer a simpler value proposition due to their liquidity while some of the smaller local 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.