Uncertainty Drives Opportunity for Australian Fixed Income in 2022

For most of 2021, central banks argued inflation was transitory and a result of economies reopening, pent up savings being spent, and a rapid return to spending in services sectors, that had to re-employ staff. Recently, due to constant adjustment to restrictions and the ongoing supply issues faced by many industries, inflationary pressures have lasted longer than expected.

In December, as the Federal Reserve achieved its key mandate of full employment Federal Reserve Governor Powell announced that it was time to retire the word ‘transitory; to describe how long inflation is expected to last. Since then there has been a noticeable pivot from central banks globally with the rhetoric becoming more hawkish, quantitative easing programs starting to wind down or stopping abruptly; and policy rate hike guidance being brought forward. This has caused elevated volatility across all asset classes not just fixed income.

The global economy and its supply chains have been finely tuned for efficiency as globalisation has occurred over the past few decades. The onset of the pandemic put an unprecedented strain on these systems which created bottlenecks and supply side driven inflation. While there are some signs of improvement, the inflationary supply constraints are taking some time to ease and have translated to remarkably high inflation which appears more persistent than most market participants expected. The US in particular is experiencing inflation not seen since the early 1980’s which has contributed to the pivot by the Federal Reserve in their rhetoric and the sharp rise in yields experienced year to date.  

In Australia, the inflation pressure is not as stark, with the annual core inflation rate, the RBA’s preferred measure, returning to just above the mid-range of its target band in the December quarter of between 2 and 3 percent. While acknowledging in a recent parliamentary committee meeting that a rate rise this year is “plausible”, Governor Lowe has insisted that the RBA won't move rates until it observes inflation sustainably within its target band. In combination with its requirement for full employment, the RBA expects that to achieve that level of inflation on a sustainable basis, wage growth of greater than 3 per cent will also need to be achieved.

Various factors, including the resumption of economic activity post-lockdown alongside the ongoing impacts of border closures restricting labour, and enterprise bargaining agreements that limit many industries ability to bargain for wage increases, means that the RBA may not achieve this objective until the latter part of 2022.

However, we are ever thoughtful about the secular headwinds that pre-dated the pandemic and expect that public debt levels which have grown across most developed countries, dependency ratios that have worsened as demographics changed, and the impact of technological advances on employment which have been accelerated, will start to reassert themselves. In the medium term, fiscal policy is also likely to be an impediment to growth, turning from stimulatory, to being a drag in the US and here in Australia.

Tightening Constraints & Cash Rate Levels

Our expectation is that cash rates in Australia will be between 0.50-0.75% by the end of this year and then move towards an official cash rate of between 1.5-2.0% at the end of 2023. These expectations are predicated upon a continued recovery in Australian economic growth, the absence of another COVID variant that challenges vaccination efficacy or an economic shock caused by geopolitical tensions.

We do not expect the RBA to tighten monetary policy as aggressively as market pricing suggests. This view is tied to the economic risks inherent in the heightened level of debt that exists today, not only at the government level, but also on the consumer balance sheet. Evidence of this latter risk is clearly visible in the rising level of house prices and therefore debt levels of carried consumers. This contributes to our expectation of a terminal cash rate of around 2.5% this cycle.

Opportunities from Active Management

As always, multiple forces are at play and current conditions only serve to strengthen the case for active management. Market pricing appears overly aggressive with the timing and magnitude of rates hikes priced in across the globe looking overdone. Volatility within Australian fixed income markets provide us with the opportunity to add value through active duration and yield curve management as well as sector and security selection.  

Attractive opportunities within high-grade corporate bonds continue to be uncovered via our fundamental research process. Many sectors have benefited from the RBA’s supportive policy stance as well as other government incentives. Selective exposure to issuers in these sectors offer attractive risk adjusted return potential within this strategy.

Overall, we believe that current yields are attractive for existing and prospective bond investors. Continued volatility is expected to provide ongoing opportunities to generate alpha through active management. We are excited about the opportunity set and continue to seek to harness attractive income and total return opportunities within our robust risk management framework, whilst creating the ballast required to protect riskier asset classes if it is required.