We expect 2018 to be a stable year for Australian fixed income, with the performance of the domestic economy constraining the RBA’s ability to increase interest rates in the near-term. This is predominantly the result of weak wage growth and inflation running below the RBA’s target. The former is due to excess labour market slack and the latter is due to entrenched and widespread, albeit mild, deflation amongst consumer goods and services. Australian bonds will remain tied to fluctuations in US and Eurozone markets and sensitive to Chinese economic data, as well as iron ore prices.
In the Eurozone, we don’t expect any surprises from the ECB in the first part of the year as it has already committed to extending its asset purchase program, albeit at a reduced volume.
In the US, the Fed looks to be transitioning to a new Chair almost seamlessly and has already made much of the difficult tightening decisions under Chair Yellen, reducing the size of the balance sheet and its initial steps to tighten monetary policy.
China has also managed capital outflows and its economic slowdown in an effective manner. We think that a Chinese ‘hard landing’ is a tail risk, nothing more.
The Australian credit sector will closely track offshore moves in credit spreads, and will begin 2018 at the tightest level of valuations since the pre-GFC period. The recent uptick in synchronised global growth has positively impacted corporate earnings, while Trump’s tax plan carrot has been dangling in front of credit investors’ eyes for months. If successfully implemented, we think that there will be less issuance from US high grade corporates which could keep global credit spreads at relatively expensive levels. Australian credit remains attractive versus global peer offerings due to its higher average credit rating and lower duration, which will see the asset class outperform on a relative basis should outright yields rise aggressively.
RBA to start hiking in 2018
We expect the RBA to maintain a neutral bias until the second half of next year, when we expect moderate monetary tightening to commence. While employment has recovered strongly this year there is still slack in the labour market and inflationary pressures are muted while wage growth is very weak. The latter is weighing on consumption, and higher utilities bills and increased lending rates on interest only loans will not help the situation.
While the broader economy is making progress, the starting point means that there is no urgency for monetary policy to tighten. However, low interest rates can be partly blamed for high and rising household indebtedness and unless macro-prudential measures can discourage this trend, the RBA may wish to keep borrowers on alert to the possibility of gradually rising rates, at least through its regular commentary on monetary policy.
What to watch in 2018
The most important indicator for investors to monitor is inflation. In 2017, markets have enjoyed synchronised growth, modest central bank tightening and steady and low inflation. General financial conditions remain at very accommodative levels. Should inflation surprise on the upside, there is an increased risk that central banks will respond too quickly, causing another tantrum like the one we saw in 2013. This is not our expectation, but we do see reasons for US wage growth rising more rapidly in 2018.
Chinese capital flows remain another relevant risk indicator even though they have been very stable for many months. The success with which China manages its economy is intertwined with the management of US monetary policy and associated movements in the USD. If China begins losing FX reserves, risk appetite can quickly dry up.
Credit performance is linked to equity markets and broader risk asset sentiment. We are closely watching the amount of operating cash flow that corporates generate relative to revenue and EBITDA (earnings before interest, tax, depreciation and amortisation). There is some early evidence to suggest that revenues and earnings, which can be ‘massaged’ by management and creative accountants, are starting to disperse from actual cash flow generation at an aggregate level. Equities are typically valued based on earnings, so a lower quality of earnings may result in vulnerable valuations, which are at their highest levels since the glory days before the GFC. The Technology sector is particularly exposed to this theme, and has had a very solid run in 2017.
A dangerous consensus
When Donald Trump became President of the US in late 2016, there was a lot of market angst around his campaign messages and anti-globalisation, anti-trade rhetoric. Throughout the course of 2017, Trump appeared to tone down his aggressive stance on some of these issues and emerging markets ended up having a great year. It is too early to tell if this was because Trump is ultimately an economic pragmatist or if domestic and international distractions kept him from following through on his promises. Given the amount of so-called tourist money in emerging market debt, a renewed assault on global trading partners would be disconcerting for the asset class and broader market sentiment.
The safety net withdraws
Investors have become accustomed to the central bank ‘put’ after many years of liquidity injections into global markets. As a result, traditional risk assessment took a back seat as the search for yield intensified, and the rising tide lifted all boats, making it a good year for equity markets, emerging markets and credit markets. With central banks shifting gears in 2018, the large safety net of recent years is being slowly removed. We think rising idiosyncratic risk will be a feature of 2018, and investors are yet to properly discount this theme.
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Nick Bishop is the Head of Fixed Income in Australia and a member of both the Credit and Sector Allocation team and the Risk Oversight Group. He is also a CFA® charterholder.