Matt Sherwood is Perpetual’s Head of Investment Strategy, Multi Asset. In this role, Matt is responsible for monitoring, analysing and forecasting earnings growth, interest rates, currencies, economic growth and policy implications across major regions.

Matt joined Perpetual Asset Management Australia in 2005 and his viewpoints and analysis of international developments are frequently sought by policymakers, opinion leaders and investors in Australia and Asia. These include television news networks such as Reuters, CNN and Bloomberg in Asia and Sky News, SBS and the ABC in Australia. His opinions have appeared in many newspapers including the Wall Street Journal, Washington Post, the New York Times and Australian Financial Review.

Matt has previously been a panel member which discussed macro issues with the US Federal Reserve on a quarterly basis and has briefed the BIS on several occasions on balance sheet issues facing the global economy. His current research focus is on the global trade war and whether monetary policy can prevent a serious downdraft in growth and regional sharemarkets.

Matt is a published author of the book titled ‘Intelligent Investing’ and began his career as a Senior Economist at the Reserve Bank of Australia, where he gained significant experience in monetary policy formulation and undertook detailed research into the equity risk premium, currency markets and business investment.

Matt has a Bachelor of Business from the University of Newcastle and a Masters Degree in Economics (Finance and Econometrics) from the University of Sydney. Matthew has also held a lecturing position with Kaplan Education (formally FINSIA) between 1997 and 2010 and has also lectured MBA classes from Case Western Reserve University in the United States.

Here’s what’s driving Australian equities this week according to Pendal’s Jim Taylor. Reported by portfolio specialist Chris Adams.

KEY INDICIES consolidated gains last week in the face of surging Delta cases around the world. The S&P/ASX 300 was flat, while the S&P 500 shed 0.4%. 

Commodities were generally stronger with the notable exception of iron ore. Materials (+2.8%) were the leading sector on the ASX.  

The market is watching the spread of Delta, but so far remaining relatively sanguine. Ironically the rapid growth in Delta cases is creating a scenario where current policy settings may remain in place longer than expected. 

US reporting season has been strong and is providing near-term support to markets, as is the flurry in Merger and Acquisition activity in major developed markets. 

The outlook for China remains unclear. The government previously looked to moderate growth in specific sectors, but the overall slowing of growth may have reached a bottom. Implications of a change in government policy toward the biggest tech names is yet to be fully understood. 

Covid and vaccines 

New daily cases continue to plummet in the UK, while rising in France and the US.  

US regions with low vaccination rates are reporting the greatest rise in new cases. Critically, the link between vaccination and lower rates of hospitalisation appears to be holding. 

The curve just refuses to bend in NSW. Recent mobility data suggests we have only now got back to mobility levels last seen in April 2020. 

There are signals that the NSW government has pivoted from a policy of elimination to suppression.  The National Cabinet has adopted a new framework which makes lockdowns a first resort — and vaccination targets of 70-80% to move away from the lockdown strategy. 

India has experienced a 90% drop in daily confirmed cases over the past two months. A recent serum study indicated 67% of the population had Covid antibodies either from the vaccine or through infection. The number of tests has remained pretty constant at around 1.6 million for the past two months as daily case numbers have fallen. 

Israel has started a program of a third vaccination for people over 60. Some troubling data on the duration of the effectiveness of the vaccines continues to emerge, though questions remain about its accuracy given it’s not a controlled test. The current positivity rate in Israel is about 2.4% 

Economics 

The small amount of macro data out last week didn’t raise many headlines. 

The core personal consumption expenditure (PCE) deflator — a measure of inflation — was 3.5% year-on-year versus an expectation of 3.7%. The month-on-month reading was 0.4% versus 0.6% expected. This is still well above the Fed’s flexible 2% target, though its rate of change may be starting to slow. 

US headline private sector wages are growing at 3.5% year-on-year — the strongest rate for many years. Labour supply issues from the past few months are likely still affecting the data. Better indications of the extent to which the wage data will remain high should be forthcoming in the fourth quarter data (late January 2022). 

At roughly the halfway mark of the US and European earnings season, a record number of companies are beating consensus sales and EPS estimates.  

In the US, 88 per cent of S&P500 companies that have reported beat EPS estimates. EPS growth for these companies is running at +83% year-on-year — 18% ahead of consensus expectations. Revenue growth in the US is coming in at +23% year-on-year — 5% ahead of consensus expectations. 

The average positive surprise and the proportion beating expectations has been pretty broad-based across sectors, though the more cyclically exposed parts are leading the charge.  

This strength in earnings is important because it further eases the market’s valuation multiple and provides support even as concerns about the Delta variant mount.  

Markets 

Australian equities have so far held up despite the Sydney lockdown and lack of clarity regarding re-opening.  

The expectation of fiscal assistance to counter the economic impact is likely a key part of this.  

Last week resources (+2.5%) outperformed on signals of a more pro-growth tack from China and the prospect of huge dividends. We are still expecting to see positive adjustments to consensus expectations, which are lagging on recent commodity price increases.  

M&A continues to feature. Santos (STO, -2.1%) and Oil Search (OSH, -4.5%) appear to have agreed to terms for a merger. There was a bump up in the bid for Spark Infrastructure (SKI, +5.9%), which will now allow due diligence to take place. This week we saw a bid by Square for Afterpay (APT, -9.4% last week) valuing it at a 30% premium to recent trading.    

Crown (CWN, -14.1%) was the worst performer in the ASX 100 last week. This followed comments from the Victorian Royal Commission that it could take years for Crown to meet the conditions for its licence. The upcoming West Australian Royal Commission extended the reporting time frame to Q2 2022.    

A2 Milk (A2M, -13.6%) fell on concerns that Beijing’s efforts to alleviate the cost of raising children —  exemplified by turning the huge tuition business into not-for-profit with the stroke of a pen — may flow through to regulated pricing for infant formula.    

AGL (AGL, -9.5%) and Origin (ORG, -9.3%) saw earnings downgrades for 2022 in their energy markets business due to higher coal costs.    

Some of the growth names had a soft week following recent strength. In addition to APT’s fall, Seek (SEK) was down 4.4%, Fisher & Paykel Healthcare (FPH) fell 3.1% and Ansell (ANN) lost 4.6%. 

Solid quarterly production updates helped resources lead the pack. Lynas (LYC, +14.2%) was the best in the ASX 100. Oz Minerals (OZL, +9.3%), IGO (IGO, +5.3%), BHP (BHP, +4.3%) and Alumina (AWC, +3.1%) also fared well.  

Rio Tinto (RIO, +5.0%) was disappointing on the production front. Nevertheless, a slightly higher-than-expected dividend and a high payout ratio is emphasising the cash flow story.    

BlueScope Steel (BSL, +6.7%) upgraded earnings expectations for 2H FY21 on strength across the board in volumes and spreads. 

David Hudson is the Head of Asset Allocation within the Multi Asset team for Perpetual Asset Management Australia. In this role, David is part of the portfolio management team managing all multi asset funds. He is responsible for generating and implementing active asset allocation ideas and the strategic asset allocation of multi asset funds.

David is a proven portfolio manager with almost two decades experience in multi asset portfolio management including 14 years as the lead portfolio manager of diversified funds at BlackRock Investment Management. David has a strong fundamental background in macroeconomics and all asset classes.

David has also held positions as an equity strategist at Bankers Trust Investment Management; fixed income strategist and senior economist at Bankers Trust Investment Bank; and as a senior adviser to the Prime Minister. He started his career as an economist with the Commonwealth Department of Treasury in the early 1980s.

David has an Honours degree in Economics from Adelaide University.

Here’s our weekly Bond, Income and Defensive Strategies wrap from Pendal portfolio manager Tim Hext.

THE June Quarter CPI numbers were strong but largely as expected. Headline CPI was 0.8% for the quarter buy underlying was a more tepid 0.5%.

The number plays well into the Reserve Bank narrative that inflation is transitory — and helps it maintain a medium-term forecast of 2% annual inflation. Markets have spent the last month taking out rate hikes. If the RBA is right about inflation then rates are here for a long time to come.

But we are not in normal times and the task for statisticians is made difficult by numerous measurement issues.

How do you currently measure international flights or hotel accommodation? How do you measure rents when all kinds of deferrals are taking place?

The main impact comes from government subsidies. CPI is what consumers pay, not what a business charges. Of course normally they are the same thing but a myriad of subsidies means governments are footing part of the bill.

For example Homebuilder might mean a builder is charging $500,000 for a new home but the consumer is only paying $475,000. In fact new dwelling costs in the CPI (8.5% of the index) have been negative this year despite actual prices going up almost 4%. 

State governments have also been busy subsidising utility bills, restaurant meals, movie tickets and a host of other items.

On our subsidy-adjusted estimate, underlying CPI is now more like 0.7% or around the annual RBA 2.5% target.

Eventually these of course come off but it will be more of an early 2022 story. We remain of the view higher inflation is coming, but it will be services rather than goods leading the way.

Nothing to see from the Fed

Chairman Powell managed to turn the latest Federal Open Market Committee meeting into a non-event, retaining a watching brief on how they may respond to stronger data down the track.

There is nothing to see here for now.

A combination of China wobbles and rising Covid cases kept bond markets generally bid on the week.

Real rates are now at record lows, driven by the weight of money but also growth pessimism. This feeds back into positive news for equities (what isn’t these days) despite being potentially concerning news for the economy.

Asset owners can relax because central banks have your back, and their “put” seems to be a trailing level on the way up.

The chart below shows how the market sees inflation as transitory in the US, with real yields falling to record lows last seen in 2020.

Geoff Ryan is Portfolio Manager for Diversified Strategies at Perpetual Asset Management. In this role, he is responsible for the portfolio management of the diversified funds and tactical asset allocation.

Geoff joined Perpetual Asset Management Australia  in June 2018, having previously worked for five years as Investment Manager, Risk & Strategy for Commonwealth Superannuation Corporation where he developed and implemented the Fund’s dynamic asset allocation process.

Prior to this, he worked at Black Rock / Merrill Lynch, where he held various roles in the multi-asset division. Most recently he was Portfolio Manager, Balanced Funds and Portfolio Manager, Overlays as well as Strategist, Fundamental Global Macro Funds.

Geoff has a Bachelor of Economics (Honours).

A monthly insight from James Syme and Paul Wimborne (pictured), managers of Pendal’s Global Emerging Markets Opportunities Fund 

• Five important global macro indicators to monitor when assessing risk and opportunity in the higher-risk, more capital-flow sensitive emerging markets.
• Conditions that have led to capital inflows, stronger currencies and good returns to equity investors are still in place.
• Find out about Pendal Global Emerging Markets Opportunities Fund

IF YOU wanted to paint a negative view of the emerging market asset classes (equities, bonds and currencies), there would be several pieces of evidence in macro conditions to point to.

Traditionally, the northern hemisphere summer is seasonally difficult for risk assets.

Covid-19 case numbers are again moving in the wrong direction in some countries.

And the surprisingly hawkish June commentary from the Federal Reserve has seen a rapid shift in a number of financial market indicators that are not supportive of risk assets.

St. Louis Fed president Jim Bullard made these comments in June:

“FOMC was surprised on the upside over the last few months… recent data is very good news… by the time you get to the end of 2022, you’d already have two years of two-and-a-half to 3% inflation. To me, that would meet our new framework where we said we’re going to allow inflation to run above target for some time, and from there we could bring inflation down to 2% over the subsequent horizon.“

This saw a sharp upward move in shorter-term US bond yields as the markets priced in tapering and a US rate hike in 2023.

A June Financial Times opinion piece by former India Reserve Bank governor Duvvuri Subbarao was an important indicator of the current environment for emerging markets (particularly the higher risk ones).

In the article, Emerging markets are right to worry about capital flows, Subbarao discusses the impact of foreign capital flows on India and the central bank’s resulting policy dilemma:

“With extraordinarily loose money supply and low returns in the rich world, emerging markets inevitably become a destination of choice for investors looking for high yields…

“The RBI has been in the market almost continuously, buying dollars to prevent an unwarranted appreciation of the rupee. But buying dollars results in extra rupee liquidity which could go beyond the central bank’s comfort level.

“The RBI could of course mop up the extra liquidity by selling bonds. But such a move would cause interest rates to spike, resulting in the economy being swamped with “carry trade” dollars looking to make money on the yield differentials.”

Subbarao’s main concern is that, when inflows become outflows, India (and other, similar, emerging markets) will see a liquidity crunch and a hardlanding in the economy and financial markets.

We agree with his diagnosis of the mechanism, but not (yet) his concern.

Generally, the conditions in emerging markets that typically mark the top of the capital-flow cycle have not yet occurred: sustained increases in credit and money supply, high capacity utilisation, buoyant financial markets and in particular, weak current account balances.

Five indicators to monitor risk and opportunity

We think there are perhaps five important global macro indicators to monitor when assessing risk and opportunity in the higher-risk, more capital-flow sensitive emerging markets:

1. Capital flows into the bond markets of emerging economies

One event in the mind of many investors is the ‘Taper Tantrum’ in the second quarter of 2013.

When the Fed announced that it would, at some point in the future, reduce the volume of purchases of assets, it triggered a sharp rise in US yields and significant weakness in the currency and bond markets of many emerging countries as capital flowed out and back into US dollar assets.

The fear is that the Fed’s indication of future policy tightening will have a similar outcome.

We are much less concerned.

In particular, positioning in EM fixed income markets is more benign, in our opinion. The years leading up to the Taper Tantrum had seen significant capital flows into the riskier emerging markets, and had driven down bond yields relative to US yields. (This gap is the heart of the carry trade that attracts and keeps those flows into Emerging Markets).

We estimate that for the six main riskier emerging markets (Brazil, Mexico, South Africa, Turkey, India, Indonesia), net foreign capital flows into government bonds in the year before the Taper Tantrum were over US$100 billion.

Right now that number is less than a third of that.

Similarly, the average ten-year local currency bond spread over US ten-year bonds was, we estimate, 1.5% below its long-term average. Now it is 1% above the long-term average.

We would concede that US-denominated bonds look expensive relative to history, but these are now a small part of the funding mix for mainstream emerging market

2. Currencies in the riskier markets look reasonably valued

We have written at length this year about large moves in terms of trade and current account balances in some of these markets (particularly Brazil, Mexico, India and South Africa) and how we see those underpinning currency valuations.

We think a lot of weak hands were flushed out of riskier emerging markets in the middle of 2020. We do not see the same positioning in equity or bond markets that we had back then (or, indeed in 2007-08, the previous period of excessive optimism towards the asset class).

3. Commodity prices are a significant driver of inflationary concerns in the US

It remains our view that Chinese credit growth is contractionary at the margin — and the Chinese economy is slowing.

Chinese demand remains a major driver of global commodity prices. We have seen heat go out of some of the most dramatic commodity markets. For example the Chicago lumber future contract finished June below US$800 per lot after peaking in May at US$1686.

4. The Fed’s own long-term forecast for the peak US policy rate remains at only 2.5% (and, notably, is unchanged since before the pandemic).

If the peak of the hiking cycle is only 225bp above current levels, it is likely to have far less impact than, say, the 375bp that was expected in 2013.

5. Forecasts for both GDP growth and equity market earnings are still being revised up in our preferred emerging markets.

This is not a universal phenomenon. But these improving expectations are a powerful support for markets — not only equities, but also currencies and bonds — as better conditions attract capital inflows.

Countries to avoid

Following on from that last point, we believe investors should always be selective when investing in emerging markets.

There are two types of countries we think lack the economic fundamentals to be attractive at this time.

The first are the South-East Asian economies. In this region growth recoveries have been weak and the next move in policy rates is likely down, not up.

Malaysia’s commodity sectors have been more supportive of growth there (although we remain zero weight). But we see a lack of a compelling growth stories particularly in Indonesia, Thailand and the Philippines.

The second country we choose to avoid on economic grounds is Turkey.

Turkey has had a very significant credit boom in the last few years due to unorthodox fiscal and monetary policy.

With the current account deficit elevated, inflationary pressures mounting and a weakening currency, the pressure on the central bank to hike rates is a defensive one to prevent capital flight, rather than a reflection of strong growth.

Bob Farrell, the legendary head of research at Merrill Lynch, is famous for his “10 Market Rules to Remember”. His fourth rule says in part that “rapidly rising or falling markets usually go further than you think”.

In our time in emerging markets we’ve found this is very much the case for the emerging market capital flow cycle.

In good times currencies appreciate far more — and interest rates and bond yields fall much further — than predictions.

Between 2003 and 2008 Brazilian policy interest rates fell from 14.25% to 11.25%. At the same time the Real strengthened from BRL 3.60 to the dollar to BRL 1.60.

We believe the conditions that have led to capital inflows, stronger currencies and good returns to equity investors are still in place.

We do not agree that a repeat of 2013 is likely to happen soon.

We think there is plenty of scope for a positive capital flow/growth cycle to continue in emerging markets.

Markets usually go further than you think.

About Pendal Global Emerging Markets Opportunities Fund

James Syme and Paul Wimborne are senior portfolio managers and co-managers of Pendal’s Global Emerging Markets Opportunities Fund.

The fund aims to add value through a combination of country allocation and individual stock selection.

The country allocation process is based on analysis of a country’s economic growth, monetary policy, market liquidity, currency, governance/politics and equity market valuation.

The stock selection process focuses on buying quality growth stocks at attractive valuations.

Find out more about Pendal Global Emerging Markets Opportunities Fund here.
 
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 here.