The Point

Tim Hext: The case for inflation-linked bonds

With the cost of living rising, are inflation-linked bonds a good option?

Returns from inflation-linked bonds are adjusted for inflation, allowing investors to protect real returns. They’re not popular in Australia, which is something of a mystery to our government bonds chief Tim Hext.

“We expect US inflation will fall soon and Australia will follow by mid-2023. Risk markets may take some encouragement from this, but inflation is likely to remain around 3-4%. 

In this environment investors need the defensiveness of bonds, which have restored their insurance credentials after this year’s hits, says Tim.

“My recommendation would be to buy inflation-linked bonds. The mainstream investment community seems to prefer standard, nominal bonds — as evidenced by the nominal-only benchmark proposed for bonds in the Your Future Your Super guidelines.

“In my view this is poor policy, overlooking the benefit that inflation-linked bonds provide for retirees or those near retirement.”

TIM HEXT: Mixed signals will remain into Christmas

After an extraordinary year, investors are hoping for clear air in 2023.

Will we get it?

Next year is when rate hikes fully kick in and the resilience of the real economy will be tested, says Pendal’s head of government bonds Tim Hext.

“Policy-makers are happy for the pain to continue until they see actual – not anticipated – inflation turns,” says Tim.

“Inflation is a lagging indicator – often by six to 12 months. But central banks view an inflation policy mistake as worse than a recession.

“Waiting for supply to solve the problem is proving too much. Demand destruction is required, even though it means people losing jobs and in some cases forced out of homes.”

That means clear air is unlikely until 2024 when a “normal” economy returns, says Tim.

TIM HEXT: Inflation will test Fed’s patience, but RBA has cards up its sleeve

US rates are headed for 4% or more after inflation remained high in August.

But the RBA may have more patience, says Pendal’s Tim Hext.

“We still expect goods deflation in the months ahead,” says Tim, who manages our government bond strategies.

“But US wage growth is spreading inflation wider into services. Services inflation is now the battleground.

“As always, Australian bonds will follow the US. But the RBA seems prepared to show a bit more patience due to factors such as wages and our floating-rate mortgage market.

“The RBA remain on course for 3% cash rates by year end (either 2.85% or 3.1%).

“Credit and equity markets were hit by the high inflation numbers, but for now look to be range-trading rather than breaking down.”

Consumers and business head in different directions

Consumer and business sentiment are heading in different directions according to the latest data.

What’s going on?

Early last year consumer confidence boomed as we escaped from lockdowns with money in our pockets, says Pendal’s Tim Hext.

“Sentiment hit an all-time high in April 2021. Weighed down by rising prices and rate hikes we’ve since plunged almost to the March 2020 low.

“For business, however, it’s hardly looked better. An NAB survey sees business conditions at 20, not far off the April 2021 high of 30 (it averages around 5).”

So far rate hikes have been manageable for consumers, but the next 1% this year will start to bite — heavily for some, says Tim.

Meanwhile tight supply of goods and services means businesses are able to pass on higher costs, maintaining margins and seeing conditions as strong.

“Of course, consumers and business can only be out of step for so long — and 2023 will see a reckoning.”

‘No pre-set path’: What the RBA statement means for investors

Did the RBA this week signal fewer rate hikes ahead? Probably not, says Pendal’s head of government bond strategies Tim Hext.

“We know we’re going to hit neutral this year. Another 1% can be expected, moving the cash rate to 2.85%.

“Whether it’s four lots of 25bp or 50bp at fewer meetings is only of interest to short-end traders. Hence the RBA’s line that it is ‘not on a pre-set path’.

“Sounds like an opportunity for everyone to interpret this with their own confirmation bias — which on Tuesday seemed to be fewer hikes, not more.

“I think that’s reading too much into it.

“As asset owners we must remember the ‘central bank put’ is now also a ‘central bank call’.

“If bonds, equities and credit spreads rally too much without a significant easing in inflation pressures, the RBA will lean against the easing of conditions.

“The rally of the past month suggests this is in danger of happening — so expect more hawkish speeches from officials, especially in the US.”

Fixed interest: why bonds look promising and how to take advantage

A re-assessment of fixed income securities and yields — and their defensive qualities — have recently made bonds attractive again, says Dale Pereira, who heads up client solutions at Pendal.

“Bond returns don’t predict the future — they reflect what’s happened,” says Dale.

“That’s where the opportunity lies: they may be showing negative returns now, but the future looks a lot brighter.”

Bonds typically lead equities in terms of market reaction, says Dale.

“From the end of 2021 and into the first half of 2022, bond yields moved in line with expectations of future rate rises — which in turn reflected inflation expectations.

“But markets often over-react when extrapolating good and bad news. And that’s probably the case now.

“The market has likely priced in too many rate rises. It’s priced in a good chance that central banks won’t be able to control inflation. (Though recently that pricing has started to dissipate, making yields less volatile.)

“This means the bond market is at a much better entry point for investors.”