Inflation will rise over the next five years as Australia transitions out of COVID, but investors shouldn’t be alarmed by the prospect of rising prices. Pendal’s Tim Hext explains why 

• Inflation to return to RBA target over next decade
• Rising prices no cause for investor concern
• On-demand webinar: The two big issues shaping Fixed Income 

FALLING underemployment driving higher wages will be the key driver of inflationary pressures over the next few years as the economy moves back towards capacity.

That’s the view of Pendal portfolio manager Tim Hext, who recently addressed a Pendal on-demand webinar on the outlook for fixed income. 

An underemployed person is as someone who is employed now, but would like additional hours (and is available for more work). 

Importantly, businesses are in a strong position to pass on wage rises as price increases, Hext says.

Unlike previous recessions, many households are exiting the Covid downturn with higher incomes, he says. 

A forecast underemployment rate of 6 per cent in 2023 – alongside an official unemployment rate at 4 per cent or lower – means a full employment economy. This points towards 3 to 4 per cent growth in wages. 

This means services inflation — which accounts for two-thirds of the consumer price index — is expected to rise to 3 to 4 per cent, while goods inflation will likely rise to 1 per cent. 

“And voila, the RBA is hitting their two-and-a-half target,” says Hext. 

“Crucially though, we are still going to have negative real interest rates. Cash rates will be below inflation and bond rates will also be below inflation. 

The implication for investors? 

“Whether you have 2 per cent, 2.5 per cent or 3 per cent inflation — it is low,” says Hext.  

“Provided inflation is seen as low and inflation expectations remain low, it is supportive for risk markets. 

“That’s why I’m alert to inflation but not alarmed.” 

Inflation – a history 

Hext says investors should look at the history of inflation in Australia in three distinct stages to better understand the outlook: pre-global financial crisis, post-GFC and the post-COVID era. 

Pre-GFC, the Reserve Bank of Australia consistently hit its inflation target in a two-decade period characterised by the emergence of China as an economic force, lifting commodity prices and keeping manufactured import prices low. 

After the GFC, Australia entered a second phase when inflation sank below the target. Partly, this was the end of the Chinese-driven mining investment boom and the GFC-inflicted damage to business investment. 

But a more powerful and unheralded driver was strict fiscal policy as governments tried to balance budgets and pay off the GFC debt. 

Hext calls that time the “three 1 per cents”.

“We had inflation 1 per cent below target, we had GDP 1 per cent below capacity and unemployment 1 per cent above full employment.

“And we seemed happy with that. “We were happy to go along in that sludge and fiscal policy was used hardly at all to try and address it.” 

We are entering a third phase

Now, Australia is entering a third phase triggered by the pandemic.  

“It is a huge reset and it is why we are entering stage three of inflation targeting which will last for at least 10 years. 

“We will see inflation a fair bit higher than we have seen in the last 10 years.” 

Hext says the most important reason for this is the return of fiscal dominance where governments are willing to run large deficits in the vicinity of 5 per cent GSP without concerns about high debt. 

“We are actually genuinely striving to run a full capacity economy,” he says. 

Another feature is the move towards a low carbon economy as governments take on the challenge of addressing climate change and start to shoulder the costs of reducing carbon for the long-term benefit of society. 

The transition to a sustainable economy will see shifts in energy sources from oil and gas to green and renewables, lifting costs. 

Over the past 34 years, Pete has held financial markets roles spanning portfolio management, advisory and treasury markets. He joined the company in 1994 and is responsible for managing our range of listed property securities funds. Specialising in the Property, Retail, Insurance and Infrastructure sectors, he has previously held roles with Midland Montagu Australia, Daiwa Securities and has served as the non-executive director of the Industry Superannuation Property Trust. Pete holds a Bachelor of Economics and a Bachelor of Law from the University of Sydney.

Here’s what’s driving Australian equities this week according to Pendal’s head of equities Crispin Murray. Reported by portfolio specialist Chris Adams.

FIVE ISSUES played on the minds of investors last week, leading to a weaker equity market:

• ASX earnings season: Last week’s results were more mixed than the previous week. But it was still a net positive. Management teams continue to indicate that lockdowns are not having as harsh an impact as many feared.
• Domestic Covid situation: A deterioration has led to greater restrictions and more risk to economic growth and earnings.
• Vaccines: New studies suggest vaccine effectiveness in preventing Covid fades relatively quickly, leading to calls for booster shots.
• US Fed: Signalled a more hawkish stance in regard to tapering Quantitative Easing.
• China: Beijing continues to reinforce the notion of “common prosperity,” seen by some as a risk of further market-unfriendly regulation.

The outcome was a 1.94% fall in the S&P300 last week. The S&P 500 was down 0.55%.

It feels like we are approaching a key juncture for equity markets.

The constructive case for equities is based on the view that we are near a nadir of sentiment regarding Delta cases and the sell-off in cyclicals. From here policy supports, signs of peaking cases, resilient economic momentum, earnings growth and liquidity will drive markets higher into year end.

The negative take is that markets are extended on the back of excess liquidity. Coupled with some early warning signals in the data, deteriorating market breadth, more speculative sectors rolling over, growth risks from Covid or inflation and policy tightening it could spell a softer period for equities.

We should have a better read on this by the end of September.

By then we will have a better idea of Delta cases in the US, strength in US employment as benefits roll off and the market’s reaction to tapering by the Fed.

In Australia, resources fell 10.7% last week, driven by lower commodity prices and exacerbated by BHP’s plan to consolidate its Australian and UK listings.

The rest of the market held up reasonably well.

Australia’s Covid situation

The rise in Melbourne cases is concerning. Extended restrictions will mean about 40% of the national economy is now locked down. The acceleration of cases in Melbourne will provide insight on whether lockdowns can achieve Delta variant elimination.

Either way, we are discovering lockdowns now need to be harder and longer to get the desired effects.

The focus on vaccinations is yielding results, particularly in NSW.

The seven-day moving average of daily vaccination rates is now running at 1% of the population and 1.4% for NSW. This is similar to peak rates in Israel and Canada.

In NSW 57% of people have had one dose and 30% two doses.

Assuming current vaccination rates persist, we should hit 70% of the population with one dose by early September and 80% three weeks later.

There is about a five-week lag to achieve the same proportions for two doses.

The debate now is about how far restrictions can be pared back once we reach these levels.

International Covid situation

National case numbers continue rise in the US. But there signs of stabilisation in States that were hit first.

The key question is whether we see evidence of US cases peaking in the next two weeks — as occurred in India and UK. Return to school is a risk to that outcome.

The US hospital system is under some strain. The daily rate in new hospitalisations continues to climb, albeit it at a slowing rate.

A number of southern States are now in a critical position in terms of ICU capacity. This is beginning to affect people’s behaviour and sentiment.

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Crispin Murray,
Head of Equities

Israel’s experience offers an important perspective for Australia. With a high degree of the population vaccinated, new cases were negligible in June. But as soon as they opened the borders — even with strict controls — the Delta strain took hold and new cases surged.

Hospitalisations have also risen dramatically in Israel, although not to the extent of previous waves (despite similar case numbers).

This highlights the challenges Australia faces in the next phase, especially since Delta is already established here.

Vaccine effectiveness

Israeli data continues to suggest that vaccine immunity to Covid wanes at about 20 per cent per month for Pfizer and 7-8% for Astra Zeneca.

Protection against severe infection seems to remains in place, however.

A booster program for over-60s appears to be working. But we don’t know whether the waning immunity issue will persist or if boosters will be necessary for younger people.

The key point is that ongoing management of Covid remains difficult — especially once restrictions are removed and borders are even partially re-opened.

Until we see a Delta-specific vaccine — or we can demonstrate boosters do not wane — we are set to see only limited re-openings, particularly in countries like Australia.

Economics and policy

US sentiment surveys show a marked shift in people’s behaviour in response to the growing Delta wave. Interest in restaurant dining, for example, has fallen 33.5% since July.

The US economy remains strong, however. The Atlanta Fed GDP predictor is still implying 6% annualised growth.

The Fed’s minutes were more hawkish than expected.

Concern over inflation may see Quantitative Easing tapering start in November with an aim of completion by mid-2022 (rather than late 2022). This would provide the Fed with an ability to raise rates by the end of 2022 if inflation warranted it.

There was little in the way of new economic data last week.

Markets

The high degree of uncertainty makes markets hard to call near-term.

The bull case is built on strong economic growth and earnings revisions, coupled with muted expectations. There is some technical support for this case, since the market has pulled back to a trend line that has been a buying opportunity eight times in 2021.

The more cautious view is that the market is not as healthy as it may appear.

Market breadth has deteriorated, though it remains high by historical standards. An equal-weighted version of the S&P 500 — removing the distortive effect of the largest stocks — actually rolled over in May.

There are some early warning signs in credit markets as BB spreads have widened, though this is small.

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We are also seeing the US dollar break higher, weighing on commodities and potentially reflecting some risk aversion.

Bond yields remain low. The question is whether this is the result of central bank buying, or a harbinger of disappointing growth as inflation throttles demand and stimulus effects wear off.

Over the next month we should get a better read on three factors that will guide us on which way the market breaks:

• Whether the US delta wave peaks, boosting consumer confidence
• How the US labour market performs as benefits roll off
• Whether the Fed will prioritise inflation risks or slowing growth

Australian equities

Earnings season is still going well, although there were a few more disappointments than the previous week.

Overall, the proportion of companies beating expectations is running above historical averages, although disappointments are in line.

Resources have performed best in terms of earnings. But similar to February, this hasn’t been reflected in stock moves since commodity price falls have dominated. Financials have so far done better than industrials.

Capital management is positive. About 41% of companies have beaten dividend expectations, versus a 27% historical average. There have been $12.7 billion worth of buy-backs announced, which is supportive for markets.

Earnings downgrades are lower than historical averages, but upgrades are running at average levels.

This reflects falling commodity prices and lockdowns.

About Crispin Murray and Pendal Focus Australian Share Fund

Crispin Murray is Pendal’s Head of Equities. He has more than 27 years of investment experience and leads one of the largest equities teams in Australia. Crispin’s Pendal Focus Australian Share Fund has beaten the benchmark in 12 years of its 16-year history (after fees), across a range of market conditions.

Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management. 

Find out more about Pendal Focus Australian Share Fund here.  

Contact a Pendal key account manager here.

Paul Wimborne has over 20 years’ experience in emerging markets strategies and funds management. He has held positions covering emerging markets with Insight Investment, Rothschild Asset Management and most recently, at Baring Asset Management with James Syme, where he was either lead or deputy manager for 14 emerging markets mandates with a peak FUM of over US$4 billion. Paul is an affiliate member of the CFA and holds a Bachelor of Science (Management and Chemical Sciences) with Honours from the University of Manchester Institute of Science and Technology in England.

NAB this week broke the Big Four banks bond drought. Tim Hext explains what it means for investors

WE WROTE last week about Covid and vaccination rates leading to a potential re-opening in late October and November. 

But at the end of this week markets still seemed lost in lockdown gloom as worsening daily headlines continued to drown out positive news about accelerating vaccination rates.

After a snap lockdown in New Zealand, we even saw Reserve Bank governor Adrian Orr change his mind at the last minute, deciding not to hike rates. 

Perhaps he thought it just wasn’t a good look — basing medium-term monetary policy on day-to-day news seems reactionary. 

But enough of that. Onto other issues.

NAB breaks Big Four banks bond drought

This week NAB returned to Senior AUD Term Funding Markets with a new 5-year bond issue. It was the first such deal by one of the Australian majors since January 2020. The deal was $2.75 billion at 41 over. 

Of course the drought was caused by the Term Funding Facility (TFF) — where the RBA gifted some $200 billion of 3-year money to banks at 0.1% to drive down term rates and mortgage rates.

It worked as a public policy driving down mortgage rates. Bank margins crept slightly higher, but most of the savings ended up in lower mortgage rates, supersizing the housing price boom to levels that are nothing short of startling. 

We’ll save the longer-term implications of that for another day.

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The extra money from the TFF of course ends up back at the RBA in the Exchange Settlement Account — earning zero since public money given to the private sector is surplus to the private sector. 

It does mean banks want fewer savers but look more aggressively for borrowers. 

Bank treasuries will need to manage the maturity of the TFF, which takes place largely in two blocks in September 2023 and June 2024. Banks will want to begin terming out their private sector debt to dates beyond this well in advance. 

This week’s NAB is the first of many to come. 

For now, pent-up demand for bank paper is experiencing strong support. But we expect spreads to drift wider over time. We see more value for now in the Tier 2 bank market.

Outlook for rates

For those term deposit holders and cash account holders there is little good news on the horizon. 

For the next 12 months at least, interest rates will be next to nothing. 

We see hope of RBA rises in 2023 and by then maybe even strong credit growth in the private sector. 

The bad news is interest rates will be below inflation for years to come, effectively sending the purchasing power of savers backwards. 

Oh well, maybe they own a house to more than offset it.

The Regnan Global Equity Impact Solutions Fund aims to generate positive and measurable impact, alongside a financial return by investing in companies using the United Nations Sustainable Development Goals (SDGs) as an investment lens.

Rajinder has over 17 years’ experience in Australian equities and manages our range of sustainability and ethical funds. He is also involved in the development and implementation of our Enhanced and Individually Managed Account strategies. Rajinder holds a Bachelor of Science (Mathematics) and Bachelor of Commerce (Finance) from the University of New South Wales and is a CFA Charterholder.

There are parallels between China’s crackdown on its education and tech industries and similar moves in the US. China investors can learn from this, says Pendal’s Samir Mehta

• July was challenging for investors in Asia and emerging markets
• But there are underlying principles to consider with China’s regulatory crackdown
• Well-managed and resilient businesses adapt and find means to thrive in any situation
• Find out about Pendal Asian Share Fund

CHINA’S recent diktat to private tutors effectively crippled the sector. Ordered to become “non-profit”, desist from raising capital, and shun foreign teachers, the sector became uninvestible overnight.

Several commentators were furious and accused the government of hurting foreign investors.

But was this behavior unique?

A blunt clampdown might be. But what about the underlying principle?

Take a look at the US to witness the state of finances for students and universities.

Over the past decade, one of the single biggest sleeves of debt that has spiralled out of control relates to student debt. There is clamor (mostly from the left) for writing that debt off.

Many politicians demand free education at community colleges. It just goes to buttress the point that in every human activity, there are multiple stakeholders.

In China, 92% of parents enroll their children in extracurricular classes and half of families spend more than 10,000 yuan ($1,500) each year on such classes, according to a survey reported by Chinese news source Caixin.

“The term often used to describe this situation in China’s education is ‘neijuan’ or involution, which literally means, ‘inside rolling’, a process of incessant competition from which no one benefits,” Caixin reports.

“Chinese parents feel intense pressure to provide the best resources to their children, who in turn must work extra hard to keep up in an educational rat race.”

On Zhihu, a Chinese social website for questions and answers (similar to Quora), almost all comments from parents are against the government’s new regulation of cram schools.

“This is like America’s Prohibition Act. You can ban alcohol, sure, but does that mean that people don’t want alcohol anymore?” posted one commentator.

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“Same with banning cram schools. If you close them, does that mean parents do not want to send their kids to these
schools? The demand is still there. It’s just becoming more costly.”

Another posted: “Only half the students graduating from Grade 9 are allowed to go to high schools. The other half have to go to vocational schools. There is a quota now. But what parents want their children to become blue-collar workers?

They’ll do everything possible to make sure their kids score well enough to be the top half.”

Unfortunately, the ban on these education companies does not solve a real problem for parents who want their children to get supplemental education.

In effect, those who can afford to pay will hire personal tutors while the State will pressure existing schools
to provide alternatives, which might be sub-par.

There are no perfect answers. Fair access to quality education at an affordable price are universal problems for almost every society.

Each society has their ways of dealing with pressures from stakeholders.

The one lesson I take away from this episode is that when one stakeholder ‘extracts’ disproportionate benefits, the backlash will be felt over time.

Contractors vs employees

Consider the admonition and regulations dished out by the Chinese authorities to food delivery firm Meituan Dianping on providing fair wages and benefits to its delivery riders.

A stock we own, it suffered a sharp sell-off on news of further tightening of regulations. The authorities had three choices when it came to imposing better pay conditions:

1. Low coverage proposal: classify all the workers under a contractual relationship instead of a labor relationship –
   meaning they are not staff of the company. Companies do not provide social benefits but shift the burden to the individual or the State.
   
2. High coverage proposal: classify all the workers under a labor relationship, meaning full coverage would be provided by the company. This would add significant costs to platforms such as Meituan which would potentially also be passed on to consumers.
   
3. Middle coverage proposal: Only a very small group of workers are classified under contractual or labor relationships.

The majority would be classified under some middle form of labour.

The only insurance that the platforms are required to provide for these workers is occupational injury insurance. The rest are up to the workers themselves to fund.

From what I gather, authorities have agreed upon the middle path, greatly reducing the uncertainty on compensation for labour.

Over time, this might still be subject to change if societal pressures force a rethink. As of now, the cost increase for the platforms will be only a few cents per order.

In my view, that burden is bearable – it will reduce profitability in the near term but not structurally damage
the business.

Markets ignore the bigger and more relevant case for continuing to own the stock. This service is crucial for society –
imagine life without the ability to order food during this pandemic.

Restaurants and delivery riders have fair demands but the platform delivers an essential service. Besides, after stringent regulatory requirements, in my opinion, no startups are likely to raise capital to challenge Meituan’s dominance.

During the worst of the sell down, I added to our holdings.

Contrast this to the US.

In January last year California passed a law Assembly Bill 5 which is supposed to make it harder for companies to hire workers as contractors.

As NPR reported at the time: “Supporters of Assembly Bill 5 say companies have been exploiting contract workers for years because they are not considered employees who get benefits like health coverage and workers’ compensation.

“The law touches many industries, from trucking to tech to certain medical professions. AB5 does include carve outs for professions such as dentists and attorneys.”

California voters later handed Uber and Lyft a big victory when they approved a measure allowing the ride-hailing companies to keep classifying their drivers as independent contractors.

If you are a steward of capital adhering to the principles of Environmental, Social and Governance factors, which of these outcomes is preferable?

China equities: What can go right?

July was challenging for investors in Asia and Emerging markets.

Thankfully, our fund was positioned to shield us from the worst of outcomes. The sell-off was furious and sometimes indiscriminate.

Some clients questioned “should we even bother investing in China?” To which my answer is a resounding yes.

We now have to ask the question – what can go right? If you reflect back to 2015 and 2018, we had sharp sell-offs across Chinese equities in both years.

Once we got past them, what mattered is what still matters today – liquidity, earnings progression and valuations.

In my view, the regulatory risks in China always existed; it’s just that we are now more attuned to them. That should not be an excuse for revulsion.

I am running screens to identify the businesses we can own over the next two to three years or longer.

The timing of recovery in stock prices is difficult to predict. Risks abound. Yet after this sell down and the growing distaste for Chinese equities, I am setting myself up to buy into stocks at much better valuations.

As always, time will tell.

About Samir Mehta and Pendal Asian Share Fund

Samir manages Penda’s Asian Share Fund, an actively managed portfolio of Asian shares excluding Japan and Australia. Samir is a senior fund manager at UK-based J O Hambro, which is part of Pendal Group.

Pendal Asian Share Fund aims to provide a return (before fees, costs and taxes) that exceeds the MSCI AC Asia ex Japan (Standard) Index (Net Dividends) in AUD over the medium-to-long term.

Find out about Pendal Asian Share Fund

About Pendal Group

Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management. 

Contact a Pendal key account manager.