April may only be a few months ago, but on the Reserve Bank of Australia’s (RBA) calendar it was a whole regime away. Four months ago the central bank was preaching ‘wait and watch’, but by July it had hiked by 50bps. To the surprise of many, the RBA hiked in May and June as inflation did not fall in line with its expectations. Of note was June’s hike which came despite softer inflation and weaker jobs growth reported in May. The RBA looked through this and pushed through another hike to hedge against inflation persistence.1
The aggressive rate hikes by RBA over the last quarter have softened the economic outlook for Australia. There was a severe hit in household consumption as shown by retail sales which were flat in April and only marginally better in May. The housing market remains at risk as the ability to continuously service household debt at high interest rates is challenged. Moreover, there is the risk to exports from a global slowdown. Commodity prices have been on a downward trend and global growth has been subdued. The anticipated strong recovery from China has not quite materialised.
There is a counterweight to these elevated risks. The recent recovery in housing prices is encouraging. The primary reason for this is strong net inward migration – which may just sustain the turnaround and have other positive economic impacts. Higher prices can also provide relief to debt stretched consumers. Inflation is also on a downward trajectory. The annual May inflation rate was 5.6% down from its 8.4% peak in December. With the RBA in ‘follow-the-data’ mode, the pause at its latest meeting in July aligned with the signs of a slowdown in inflation and growth. We think that the central bank is in the last phase of tightening given the weakening macroeconomic backdrop.
Our mid-year global outlook also indicates softening growth prospects. The slowing but sticky inflation has sustained the monetary tightening momentum, affecting both supply and demand side forces. The higher rates have stalled economic activity and eaten into consumers’ excess savings cushion.
Figure 1 – US Treasury Spread and US Recessions
Figure 1 plots the history of the US Treasury Spread against periods of US recessions. The current spread indicates a potential recession in the next 12-months. A recession means it will be hard for investors to find opportunities in risky assets. Locally, the Australian treasury spread (10-2Yr) has also turned negative for the first time since 2008. Although, it is worth noting that there was no recession that followed the 2008 inversion.
Even though our economic outlook is for sluggish growth we believe there are material investment opportunities such as fixed income.
For long term investors, the decadal high yields are the main proposition to the current fixed income opportunity. The chart below plots yield for the Australia Aggregate Bond Index against the subsequent 3-year return. There is a positive correlation between these two metrics. A high Yield-to-Worst has supported a subsequent high total return for the asset. The present Yield-to-Worst is at a decadal high.
Furthermore, the tight monetary regime and lending standards are expected to slow down inflation and allow central banks to pause the rate hiking cycle. We expect lower rates, steeper curves, and wider spreads in the next 12-18 months. This reiterates the case for booking current high fixed income coupons.
However, the investment journey for fixed income investors is likely to be associated with above average levels of volatility as central bank uncertainty is a feature of markets in the near term. To ensure defensive portfolios retain greater capital stability we advocate using a barbell strategy i.e. a combination of short and long durations positions. This strategy will help hedge against policy and economic uncertainty. Second, we recommend investment grade over high yield given the possibility of a hard landing remains. In a slowdown, default risk is material for lower-rated companies and high quality fixed income is more resilient in an economic downturn.
The current yield in Australian investment grade fixed income is 5.25% (AusBond Credit Index) and is higher than the current dividend yield of 4.5% (ASX 200)2– this is the first time this has happened since 2014. The value proposition to overweight equities at these levels is poor. A possible strategic allocation as we await better opportunities in equities could be investing in Floating Rate Notes (FRNs). These instruments have negligible duration due to coupons that adjust in line with interest rates. Additionally, they offer higher yields than cash deposits. Finally, the FRN index in Australia has a higher rating profile than the fixed investment grade index, which can help manage the credit risk in the portfolio. We take a deeper dive on the role FRNs can play in the current environment in our recently published paper “Is Cash King in Uncertain Times?”.
1Bloomberg Finance L.P., as of July 2023
2Bloomberg Finance L.P., as of July 2023
Issued by State Street Global Advisors, Australia, Limited (AFSL Number 238276, ABN 42 003 914 225) (“SSGA Australia”). Registered office: Level 14, 420 George Street, Sydney, NSW 2000, Australia · Telephone: +612 9240-7600 · Web: ssga.com.
This material is general information only and does not take into account your individual objectives, financial situation or needs and you should consider whether it is appropriate for you. Investing involves risk including the risk of loss of principal There is no representation or warranty as to the current accuracy of this material, and SSGA Australia shall have no liability for decisions based on such information.
All information is from SSGA unless otherwise noted and has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation r warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
Investing involves risk including the risk of loss of principal.
Equity securities may fluctuate in value and can decline significantly in response to the activities of individual companies and general market and economic conditions. Investing in foreign domiciled securities may involve risk of capital loss from unfavorable fluctuation in currency values, withholding taxes, from differences in generally accepted accounting principles or from economic or political instability in other nations.
Floating rate securities are often lower-quality debt securities and may involve greater risk of price changes and greater risk of default on interest and principal payments. The market for floating rate securities is largely unregulated and these assets usually do not trade on an organized exchange. As a result, floating rate bank loans can be relatively illiquid and hard to value. Diversification does not ensure a profit or guarantee against loss.
The value of the debt securities may increase or decrease as a result of the following: market fluctuations, increases in interest rates, inability of issuers to repay principal and interest or illiquidity in the debt securities markets; the risk of low rates of return due to reinvestment of securities during periods of falling interest rates or repayment by issuers with higher coupon or interest rates; and/or the risk of low income due to falling interest rates. To the extent that interest rates rise, certain underlying obligations may be paid off substantially slower than originally anticipated and the value of those securities may fall sharply. This may result in a reduction in income from debt securities income.
Bonds generally present less short-term risk and volatility than stocks but contain interest rate risk (as interest rates rise bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Government bonds and corporate bonds generally have more moderate short-term price fluctuations than stocks but provide lower potential long-term returns.
All the index performance results referred to are provided exclusively for comparison purposes only. It should not be assumed that they represent the performance of any particular investment.
BLOOMBERG and BLOOMBERG INDEXES are trademarks or service marks of Bloomberg Finance L.P. Bloomberg Finance L.P. and its affiliates (“collectively, “Bloomberg”) or Bloomberg’s licensors own all proprietary right in the BLOOMBERG INDEXES. Bloomberg does not approve or endorse this material and disclaim all liability for any loss or damage of any kind arising out of the use of all or any part of this material.
This document may contain certain statements deemed to be forward-looking statements. All statements, other than historical facts, contained within this document that address activities, events or developments that SSGA expects, believes or anticipates will or may occur in the future are forward-looking statements. These statements are based on certain assumptions and analyses made by SSGA in light of its experience and perception of historical trends, current conditions, expected future developments and other factors it believes are appropriate in the circumstances, many of which are detailed herein. Such statements are subject to a number of assumptions, risks, uncertainties, many of which are beyond SSGA’s control. Please note that any such statements are not guarantees of any future performance and that actual results or developments may differ materially from those projected in the forward-looking statements.
The views expressed in this material are the views of the Portfolio Strategist Team through the period ended 21 July 2023 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA Australia’s express written consent.
Expiry Date: 31/07/2024