Amy Xie Patrick: Sticky inflation, oil shock, and how we’re positioning income portfolios

The Strait of Hormuz blockade wasn’t an isolated shock. Understanding what was already in motion is the key to reading what comes next, argues Pendal’s AMY XIE PATRICK

• Sticky inflation persists; central banks must stay hawkish
• Oil disruption, not conflict, drives market risks
• Find out about Pendal Dynamic Income Fund and Pendal Monthly Income Plus fund

STICKY and rising inflation was already a problem before the global economy encountered the most recent oil shock.

In the US, core Personal Consumption Expenditure — the Fed’s preferred measure of underlying inflation — has been stuck around 1% above the Fed’s 2% target since mid-2024.

Core PCE itself hasn’t been at 2% for five years.

In Australia, reflation was already underway, causing the RBA to initiate a new hiking cycle.

Markets are now pricing a peak cash rate of around 4.75%, roughly 40 basis points above the peak of the entire 2022-23 hiking cycle.

Demand has been running ahead of supply in both the US and Australia.

By the RBA’s own estimates, the output gap – the difference between how much the economy could produce without creating inflation and how much it is producing – is positive and accelerating in Australia.

Meanwhile, consumer demand in the US has remained resilient while a new cap-ex cycle is in full swing, led by AI and technology.

Higher oil prices never guarantee higher core inflation, but this robust demand backdrop gives businesses the pricing power to pass on higher costs to customers.

The job of central banks is to ensure that the inflation coming over the next few months doesn’t embed itself into persistent expectations.

Separate the conflict from the oil disruption

It’s easy to conflate the geopolitical conflict with the economic disruption, but they can – and likely will – diverge.

Ceasefire talks could extend indefinitely (just as the Ukraine conflict did), and at some point markets move on regardless.

What matters for economies is whether oil and energy supply chains normalise.

That could happen through alternative shipping routes or new sources of supply coming online, independent of diplomatic moves.

In a scenario where the conflict drags on but oil logistics recover, we can expect a higher-for-longer oil price.

At the same time, a severe demand-destruction scenario, where fuel shortages cause genuine economic contraction, becomes a much smaller tail risk.

That’s why at Pendal we are less focused on ceasefire odds and more on the following data:

1. Vessel flows: Limited, but not zero

While commercial traffic through the Strait of Hormuz is still down sharply since February, it has started to recover.

The Bloomberg graph below shows rolling 7-day transits rising at the end of April (compared to 758 on February 28).

2. Tanker indices: Elevated, but coming off the boil

The next graph below shows baltic dirty (crude oil) and clean (LNG) tanker indices.

Tanker indices are market price benchmarks for hiring oil and gas tankers. They act as a real‑time barometer of stress or recovery in the global energy supply chain.

This data suggests early signs that oil logistics are beginning to normalise from the peak of disruption.

Shortages will still be felt in parts of the world, but the probability of severe demand destruction is falling as supply chains adapt.

Our view: Inflation above recession

With demand resilient and the worst supply scenarios becoming less likely, we believe the dominant risk is inflation running higher for longer — not a growth collapse.

The positive output gap that existed before the shock means businesses can protect margins. Corporate profitability should therefore hold up reasonably well in the near term.

We expect the uncertainty of inflation data in coming weeks and months to drive episodes of bond-market volatility.

However, as long as corporate profitability and economic activity remain healthy, equity markets should be able to confidently weather this volatility.

Indeed, once tail risks become the central case, risky assets tend to stabilise and move on.

Fuel inventories are the key variable to watch for when the scales tip from inflation to growth concerns.

Inventories have also not changed meaningfully yet due to the lag between when oil leaves the Middle East to when it reaches Australia in the form of ready-to-use fuel.

In-bound shipments of fuel have also been supported by Asian refining nations running down their own excess reserves to capture higher margins.

However, those refining nations will turn towards protecting their own supplies over supernormal profits if the shortfall of global oil supply persists.

Portfolio positioning: Minimal duration, selective on credit, tactical on equities

The Pendal team has cut portfolio duration back to minimal levels.

With growth resilient and inflation elevated, duration doesn’t offer compelling risk-reward.

The market is pricing two more hikes from the RBA, and no policy change from the Fed.

We’d rather preserve flexibility and add duration when either inflation fears are more meaningfully priced into yields, or the data mix shifts enough to suggest that bond markets have already discounted the worst.

On credit, we made an active decision to de-risk in early March – not on a prediction of what would happen, but because the asymmetry was clear.

If markets normalised, we could replenish exposures from primary issuance, likely at more attractive levels than pre-war.

If conditions deteriorated sharply, the additional cash gave us the flexibility to either protect liquidity or selectively buy into forced selling.

As it turns out, credit markets have remained functional and primary activity has picked up. We’ve used that window to rebuild some exposures, but we’re being deliberate about it.

Australian credit markets have been well supported in recent weeks due to the higher all-in yield that corporate bonds now offer.

However, most of that rise in yields is due to risk-free rates reflecting inflation concerns, rather than credit spreads reflecting higher credit risks from corporate borrowers in a more uncertain macro environment.

It’s vital to treat the interest rate-setting and the credit exposure of the portfolio as two separate and intentional choices.

The two can behave very differently depending on the economic and market backdrop.

When adding corporate bonds to our portfolios, we want to ensure that we are being compensated specifically for taking on extra credit risk.

On equities, fundamentals remain reasonably supportive in the near-term.

Positive demand conditions, the ability to pass through costs, and the stabilising effect of tail risks being well-flagged all point in the same direction.

The key watch item remains the consumer tipping point.

If demand destruction comes from fuel shortages or the cost of living itself, the equity story changes. We’ll be watching the data carefully for early signs of that transition.

Find out about

Pendal Dynamic Income Fund

Learn more

Amy Xie Patrick,
Head of Income Strategies

Bottom line: Higher for now, with eyes on demand

As we can see, the oil shock met with pre-existing economic trends that were bond-bearish: sticky inflation above central bank targets and resilient economic growth.

This backdrop does not afford the RBA the luxury to “look through” the supply-side shock, and in line with market predictions has again raised interest rates by 25 basis points to 4.35%. 

While we want to see greater bond market discounting of inflation headwinds, we continue to monitor the ability of both businesses and consumers to deal with rising costs.

In the meantime, our income portfolios continue to access core income through Australian credit markets, as well as having the option to tactically engage in return boosters such as Australian equities as market sentiment recovers from recent volatility.

In a cycle where the inflation and growth mix can shift quickly, preserving the option – rather than the obligation – to add interest rate exposure is one of the most valuable tools that we have.