There have been a few false starts in the turning point for the current economic cycle, but now it’s the real deal, says Pendal’s head of government bonds, TIM HEXT

• Focus is shifting from inflation to the labour market.
• Bond yields likely to keep falling
• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Browse Pendal’s fixed interest funds

CENTRAL banks never use language unintentionally and Federal Reserve chair Jerome Powell has made it very clear that rate cuts are coming, Hext says.

Powell recently used phrases like “the inflation battle is over”, Hext says, and while inflation is always important, it is less important than it was.

“The market will now be more forgiving. A slightly higher number on inflation, or a slightly lower number, won’t move the market as much,” he says.

“The focus now is squarely on employment and unemployment and Powell’s line that the Fed does not ‘seek or welcome further cooling in labour market conditions’ is particularly interesting. He is basically saying the US is at full employment, at a point where it is not inflationary.”

That is a key difference between the US and Australia, and a reason why the Reserve Bank has not indicated a bias towards easing monetary policy.

“It’s hard to put a number on it but the RBA believes full employment in Australia is probably around 4.4 per cent and currently the unemployment rate is 4.1 per cent.”

What does that mean for investors in government bonds?

“It is very difficult to pick the very top or very bottom in yields. What is easier is to look at the trend. Are rates going up or are they going down?” Hext asks.

“When the central bank starts hiking or cutting benchmark rates, the bond market has already moved. But that doesn’t mean the moves in bond yields have gone as far as they are going to go. The changes in benchmark rates continue the trend. They don’t end it.”

“When the Reserve Bank hiked rates in May 2022 the market had been selling off quite aggressively for six months and it continued to sell of afterwards. Right now, there’s been a decent rally for six months and that will continue,” Hext says.

“The point is the trend will keep going and there’s still time to benefit from that.”

In equities trading, price-to-earnings multiples and forward earnings expectations are widely used to determine the “fair value” of a stock. Is there an equivalent in bonds?

“There’s two key anchor points for bonds,” Hext explains.

“One is inflation, and that other is real interest rates. It is a bit definitional because inflation plus a real rate equals a nominal rate, but it tells investors if interest rates are protecting them against inflation.”

Hext says if the Reserve Bank is doing its job, inflation over the long term will be about 2.5 per cent, which provides a starting to point for risk-free government bonds.

To get a real return in excess of the risk-free rate, over the long term, an economy must become more productive, meaning more output per unit of input.

The Productivity Commission estimates that productivity should be around 1.2 per cent long term, meaning a risk-free bond yield of 3.7 per cent is about par.

Hext emphasises these are long run concepts and provide a guide only.

The yield on a ten-year government bond currently is around four per cent, suggesting bonds are fetching more than the long-term average, Hext says.

“If anyone asks what fair value is for a ten-year bond, then that’s as good a guess as any. It looked ridiculous when ten-year bonds were at one per cent and optimistic when they were at five per cent, but it is a long-term concept,” he says.

“It is the sort of analysis people need to undertake if they are, for example, considering a term deposit. Within 12 months you are not going to get a term deposit for a four in front of it, whereas in bond markets, which are liquid, you can buy a semi-government bond at closer to five per cent.”

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About Tim Hext and Pendal’s Income & Fixed Interest boutique

Tim Hext is a Pendal portfolio manager and head of government bond strategies in our Income and Fixed Interest team.

Tim has extensive experience in banking, financial markets and funding including senior positions with NSW Treasury Corporation (TCorp), Westpac Treasury, Commonwealth Bank of Australia, Deutsche Bank, Bain & Co and Swiss Bank Corporation.

Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.

Find out more about Pendal’s fixed interest strategies here

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About Pendal

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

In 2023, Pendal became part of Perpetual Limited (ASX:PPT), bringing together two of Australia’s most respected active asset management brands to create a global leader in multi-boutique asset management with autonomous, world-class investment capabilities and a growing leadership position in ESG.

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Here are the main factors driving the ASX this week according to investment analyst SONDAL BENSAN. Reported by investment specialist CHRIS ADAMS

• On demand: watch Crispin Murray’s Beyond the Numbers webinar
• Find out more about the Pendal Focus Australian Share Fund

A SOFT LANDING is increasingly accepted as the most likely outcome in the US, with inflation-related data in check and the labour market not showing any material incremental deterioration.

Last week, we went from the market pricing next-to-no chance of a 50-basis-point (bp) cut by the Fed following Wednesday’s CPI data, back to an almost 50% chance of a 50bp cut by week’s end.

This drove equities higher and gold to new highs. The S&P 500 rose 4.06%, the NASDAQ was up 5.98%, and Australia’s S&P/ASX 300 was up 1.48%.

The change seemed to come from what was viewed as a leading article in the Wall Street Journal: “The Fed’s Rate Cut Dilemma: Start Big or Small”.

It quoted Jon Faust, who served as senior adviser to Fed Chairman Jay Powell until earlier this year, who said it was a “close call” between whether the first move is 25bps or 50bps but that the number of cuts over the next few months is going to be more important.

Markets also got a boost from the AI thematic as NVIDIA CEO Jensen Huang made positive comments about trends toward densification and acceleration in data centres at the Goldman Sachs Communacopia and Technology Conference. NVIDIA was up about 16% for the week.

Oracle also had an investor presentation that provided bullish future guidance well above market expectations. Its stock was up 14% for the week.

US macro and policy

August Consumer Price Index (CPI) and Producer Price Index (PPI)

There was not a great deal of new information, or anything to derail the path of inflation falling back to 2%, in the August CPI or PPI released last week.

Core CPI rose 0.3%, slightly above consensus but driven by segments that will moderate:

• A 0.33% increase in the core services ex-rents index was primarily driven by a 3.9% rise in airline fares, reversing a five-month decline. The impact of pandemic-related travel restrictions and the surge in travel demand in summer 2021 and 2022 has distorted seasonal patterns.
• A 1.8% jump in accommodation prices contributed an additional 0.10 percentage points to the core services index increase. However, accommodation price growth is expected to average just 0.2% in the coming months, as households cut back on discretionary spending due to a worsening labour market.
• Primary rents increased by 0.37% in August, down from July’s 0.49% rise. However, it was still higher than expectations given that Zillow’s new rents index has averaged a 0.29% increase over the past two years. It is anticipated that primary rent increases will converge to 0.30% over the next six months.
• Auto insurance prices rose by 0.6%, an improvement compared to the previous six months’ average increase of 1.2%. The downward trend in vehicle prices suggests that auto insurance inflation could continue to decline.
• CPI for hospital services increased by 0.4%, which was better than anticipated following a sharp 1.0% decrease in July.

 

The market’s reaction was an increase in the implied probability of an initial 25bp rate cut from 66% to 83%.

Core PPI increased 0.3%, a modest overshoot of 0.2% consensus expectations.

Importantly, most of the components of the PPI that feed into the personal consumption expenditures (PCE) deflator – the Fed’s key measure of inflation – were lower than expected.

In particular, the unadjusted PPI for domestic air passenger transportation fell by 1.8%, which means that the seasonally adjusted PCE deflator for airline fares likely dropped by about 2%.

There is a debate that airline fares will fall further over the next few months, given the drop in oil prices. But US airlines have been making no money and have cut capacity into the fourth quarter, so oil prices will likely drop to the bottom line and fares could actually go up.

PPI for portfolio management charges, health insurance, and hospital services also rose less than expected. Auto insurance prices were unchanged, in contrast to the CPI equivalent, which has continued to rise rapidly.

Growth in wages – the key input cost for services firms – is continuing to slow in response to the recent fall in the openings-to-unemployment ratio, the drop in the quits rate, and the decline in inflation expectations.

Mortgage applications

US 30-year fixed mortgage rates came back a long way last week.

While still high in an absolute sense, lower rates are already having an impact on the appetite for households to borrow again and breathe some life into the housing market.

Applications for home purchase rose by 1.8% last week. The year-over-year growth rate has improved to -3.5% from -7.9% four weeks previously, and a low this year of -22.8% in early April.

Weekly jobless claims

There was nothing alarming here. Initial jobless claims increased to 230k from 228k, a bit above the consensus of 227k.

Let’s not forget the market panic when this number shot up to 240k in July. Since that aberration, it has been relatively steady at these current levels.

Forward indicators for jobless claims point to the number falling further based on layoff announcement data.

US election

The second US Presidential debate was largely a non-event. While the candidates remain neck-and-neck, post the debate the odds swung marginally toward Harris.

A Harris win is generally seen as a pro-market outcome given spending continues and we don’t have the negative growth and inflation impacts of tariffs from Trump. The election is 5 November, two days before the FOMC meeting.

Australia macro and policy

August CBA retail data confirmed some of the partial-month retail updates from corporates through reporting season.

Some of these numbers may have got a slight bump from the timing of Father’s Day this year and there is likely still some upside from tax cuts.

The conclusion remains that the consumer is holding up quite well in Australia. There still seems no real chance of the rate-cutting cycle beginning in Australia this year.

That said, the NAB Business Survey Index deteriorated for August, with retail conditions one of the big areas of weakness.

The Consumer Sentiment Survey for August was also soft. Compositionally, weaker perceptions of the economic outlook offset a marginal improvement in perceptions of personal finances. Perceptions around the labour market and house prices continued to soften.

The Melbourne Institute inflation gauge, which is a timelier measure of where inflation is headed, points to further easing in Australian inflation back to within the RBA target band.

China

As the S&P 500 retests its highs, Chinese equity markets are retesting their lows as both the property market and domestic demand remain problematic and as policymakers sit on their hands – most likely until after the outcome of the US election.

This underperformance is also being reflected in Australian companies that are leveraged to growth from China.

There are three broad issues in China:

1. High savings rates are leading to lower domestic demand, domestic deflation and a growing trade surplus in goods.
2. The housing problem remains after years of overbuilding. Housing starts and sales are tumbling.
3. Birth rates are low as people lack confidence to have babies, creating a demographic problem.

There is no easy solution, other than perhaps handing out cash and free homes to those willing to have a few children.

On Friday, Beijing approved a plan for the first hike in retirement ages since 1978, raising the age to 63 for men and 58 for women.

China’s export growth for August was stronger than expected at 8.7% year-on-year (YoY), versus 7.0% YoY in July.

Imports lagged and slowed from 7.2% YoY in July to 0.5% YoY in August.

For most of the post-pandemic period, exports and imports have been tightly correlated.

However, from the start of this year imports have consistently fallen short of export growth, supporting a prognosis of weak domestic demand.

Europe macro and policy

The European Central Bank (ECB) cut its deposit rate for a second time this year, by 25 bps to 3.5% as expected.

It also lowered its growth forecasts through 2026, with President Christine Lagarde saying the recovery is “facing some headwinds” and reiterating that the path for rates is not pre-determined.

Lithium

Lithium equities rebounded over the week following news that CATL (Contemporary Amperex Technology Co. Limited), a Chinese battery manufacturer and technology company, has suspended production of a lepidolite mine in China.

Lepidolite is a mineral from which lithium is extracted.

The announcement drove a short squeeze across the sector, with the suspension expected to take roughly 10% of China’s existing supply, or 3% of global 2025 supply, of lithium carbonate equivalent out of the market.

The suspension is driven by the sharp drop in pricing – with the CATL mine cash cost estimated at US$11k/t, or RMB89k, below where spot was trading.

The news also follows recent moves by Arcadium Lithium and Mineral Resources to defer growth projects and near-term supply.

Pricing has dropped below marginal cost, providing more support to pricing from here.

However, the market remains in surplus and new projects that were approved and/or funded over the past two years will continue to drive material supply growth near term, limiting expected price gains.

Markets

US equity sector performance was led by a rebound in materials (with gold stocks up about 9%), continued performance in tech and interest rate-sensitive sectors like homebuilders.

Energy stocks were the key laggards, even with a small reprieve in oil prices, as the oil price move was more from traders short covering as Hurricane Francine ripped through key oil-producing zones in the US Gulf of Mexico.

In Australia, Materials gained 5.69% and Real Estate 5.65%. Financials were weakest, down 0.76%.

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About Sondal Bensan and Pendal

Sondal is an investment analyst with more than 20 years’ experience covering the Retail, Telecom, Media and Transport sectors. He joined Westpac Investment Management in 1999 and has previously held roles with Commonwealth Bank and Bell Commodities.

Sondal holds a Bachelor of Commerce (Finance) and a Bachelor of Science (Maths and Statistics).

Pendal is a 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  

Contact a Pendal key account manager

Where next for Asia? As companies and countries across the continent adapt to China’s slowdown, opportunities are emerging. Portfolio managers ADA CHAN and SAMIR MEHTA explain

• Asia’s companies rapidly adapting
• If liquidity improves, Asia could be “well set for a decent run”
• Find out more about the Global Emerging Markets Opportunities Fund
• Find out more about the Asian Share Fund

ASIAN economies are shaking off China’s slowdown and showing signs of renewed vigour, sparked by a wave of tech innovation and a global trend to supply-chain diversification.

Renewed optimism for Asia is a reminder to avoid the trap of assuming temporary challenges are here to stay, says Pendal portfolio manager Samir Mehta. Companies tend to actively adapt and evolve during difficult times, he says.

Mehta and emerging markets portfolio manager Ada Chan were speaking in an Asia Reborn webinar which examined the drivers of the improving outlook for Asian equities.

“When a country goes through significant challenges, you don’t expect companies to remain static,” says Mehta.

“Headlines about tariffs and geopolitics are all we hear of. But each and every company we meet with is reacting in a very different manner, adjusting and getting more competitive to deal with these challenges.

“All the company meetings we do and the managers we meet make us reasonably confident that if liquidity conditions do get better — which is the potential in the next 12 to 18 months — Asia could be well set for a decent run in terms of economic activity and potentially even stock market performance.”

Mehta manages Pendal Asian Share Fund, an actively-managed portfolio of Asian shares.

Chan co-manages Pendal Global Emerging Markets Opportunities Fund which takes a top-down, country-driven approach to stock selection in emerging markets.

China: pockets of strength

Beijing’s crackdown on excesses in the real-estate sector sent Chinese credit growth tumbling to multi-year lows, says Chan.

“The property sector, which is a pillar of growth in China, has slowed down because the Chinese government was concerned about the balance sheet of property developers. Hence, we’ve seen this credit deterioration,” says Chan.

However, the overall decline masks a more nuanced story. As real-estate credit growth plummets, credit in China’s industrial sector is rising sharply.

“The government needs to take care of over-leverage — so spending is going into other industries.”

This reflects a deliberate policy choice.

Ada Chan, far right, a co-manager of Pendal Global Emerging Market Opportunities fund

“China is very government driven,” says Chan. “Even though the overall economy might be weak, there are pockets of strength, and we want to try to align with what Beijing wants.

“To sum it up in a simplistic way, the Chinese government wants people to spend domestically, and that’s one of the themes we have in our portfolio: domestic consumption and domestic travel.”

Taiwan and Korea: strong tech outlook

Taiwan and Korea are pivotal players in global technology and the big tech exporters are benefiting from the rapid adoption of artificial intelligence, says Chan.

“Within technology we want to position in the leading-edge technology.

“We think AI will be an important growth driver for many years. The timing might be uncertain, but if you own the leading-edge technology companies, we think you can play it through the cycle.”

Chan says her portfolio is underweight Taiwan and Korea overall, but with investment in those leading-edge technology firms.

Mehta says investors could also look beyond the leading firms to capture growth from a potential AI-inspired upgrade cycle for both corporate and personal technology devices over the next few years.

“That replacement cycle will require a lot of the expertise that Taiwanese manufacturing companies have, even below the leading-edge technologies.

“That’s where we have some of the stocks in our portfolio, reflecting that potential for growth.”

But he says in his view the potential for gains in Korea is somewhat clouded by an inheritance tax regime that discourages the big family-owned chaebol conglomerates from realising the full value of their businesses as they seek to hand down control to the next generations.

India: valuation concerns

In contrast to China, the Indian economy has performed very well in recent years, driving equity markets strongly higher.

Mehta says the outperformance is driven in a large part by a dramatic improvement in the country’s Incremental Capital Output Ratio — a measure of the efficiency of capital use in an economy.

“One of things investors are trying to understand is if there are any fundamental drivers that could justify some of the elevated valuations in India,” he says.

“ICOR is how much incremental capital investment is required in an economy to generate additional marginal $1 of GDP growth.

“For the period between 2005 to 2014, China and India were relatively similar. But since 2015, so much of the investment in the mainland Chinese economy went into unproductive assets, which has led to a stark deterioration in the ICOR in China.

“Whereas in India, which is a country that has perennially been starved of capital, when you had this growth come through, returns on capital employed for the economy as a whole, and therefore for companies that are listed on the stock exchange, have done exceedingly well.

“That partly, we think, explains the elevated valuations.”

Chan says the high valuations have led her to tilt towards businesses exposed to infrastructure spending and away from export-related businesses and those exposed to domestic consumption.

“We think the valuation is too rich. The economy is growing and economically strong, however with that kind of valuation, we are a bit concerned — it’s basically pricing for perfection.”

‘China plus one’ strategy

Indonesia’s decade-long ban on raw nickel exports has helped position its economy to capture a larger share of battery manufacturing for electric vehicles, says Chan.

This is driving a rapid improvement in the country’s trade balance and attracting attention from foreign investors.

But Mehta says what is less known is that a similar story is playing out throughout South-East Asia.

“Overall, I’d say ASEAN is in a much, much better position and all these countries are very well-suited to take advantage of the ‘China plus one’ strategy that is at the heart of geopolitics.”

Adopting a ‘China plus one’ business strategy means keeping a Chinese supply chain but adding parallel suppliers elsewhere to build redundancy.

“And it’s not just the multinationals,” says Mehta.

“In fact, some of the largest Chinese manufacturing enterprises also want to de-risk the tariffs that might come through — and so they’ve set up operations, not just in ASEAN, but in Mexico and other countries.”

Mehta highlights Thailand’s expertise in auto-manufacturing.

“Some of the leading companies out of China have taken one of the biggest parcels of land ever bought in an industrial estate in Thailand.

“A number of Chinese workers and management are moving into Thailand to run these operations. That requires a lot of services to be provided for them and their families and so there are opportunities that Thai businesses are taking advantage of.”

About Ada Chan and Samir Mehta

Ada Chan is a co-manager of Pendal’s Global Emerging Markets Opportunities Fund.

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

Samir Mehta manages Pendal Asian Share Fund, an actively managed portfolio of Asian shares excluding Japan and Australia.

Ada and Samir are senior fund managers at UK-based J O Hambro, which is part of Perpetual Group.
 
Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management.

Contact a Pendal key account manager here

Earnings season results indicate a positive outlook for the Australian economy. That’s good news for stocks, says Pendal’s head of equities CRISPIN MURRAY

• Earnings season indicates economy is resilient
• US rate cuts bolster outlook
• Find out about Pendal Focus Australian Share fund
• Register to watch Crispin’s Beyond the Numbers webinar

A DIMINISHING threat of recession in Australia and US rate cuts should support Australian stocks over the next 12 months, says Pendal’s head of equities, Crispin Murray.

Australian equities have performed strongly since March, driven by ratings increases and growing confidence in the economic outlook.

Strong spending from older Australians and a growing population should see Australia avoid recession, even as younger generations come under increasing cost of living pressures, says Murray.

“We think the economy is OK. Doesn’t mean it’s strong — there’s still going to be plenty of challenges — but we don’t believe we will see recession.

“That’s important, because that helps ensure that earnings in the equity market hold up and are supported,” he says.

Murray was speaking at the bi-annual Beyond The Numbers webinar after the August ASX earnings season.

US outlook positive

The outlook for the US economy is an important influence on markets, with concerns growing about the effect of cumulative interest rate rises, ongoing high fiscal deficits, and the uncertainty of the impending elections.

“But I think it is important to keep in mind that the US economy has held up better than pretty much everyone was expecting,” says Murray.

“We have a US Fed that feels they have done the job on inflation, and they have a clear easing bias.”

Murray says financial conditions in the US are easing — as measured by an index of credit spreads, mortgage rates, equity market moves, and currency — indicating the US has already entered a moderate easing cycle.

“The key message here is that even if the US economy turns out to be somewhat weaker, we will see more rate cuts. That will be supportive for equity markets, knowing there is this safety net in terms of much more aggressive easing, if required.”

China structural issues

China, another big influence on Australia’s fortunes, looks more problematic, says Murray.

“The issues in China are structural” as the economy deals with the unwinding of a multi-year property bubble, he says.

“The government has decided that they need to address that, and they continue to avoid stimulating the economy.

“But the trade-off is to what extent those structural issues begin to gather steam and China goes into even lower growth trajectory — or will government policy continue to be able to ensure that we get moderate growth.”

Murray says China has traditionally relied more on investment than consumption and the longer-term hope is that domestic demand becomes a more important driver of growth.

“We believe that this sort of sluggish growth will continue, but we do also believe that the government [wants] to underpin growth — that they will continue to come through with a series of policy measures that will help prop up growth.

“So, while we remain wary and cautious on China, we do not believe that it’s going to spiral further down.”

That would indicate upside for markets, where investors are pricing in further negative outcomes in China.

Positive market outlook

What does this mean for potential market outcomes?

Murray says the profit season reports showed earnings revisions remain resilient, particularly in industrials, offsetting declines in resource sectors.

Unlike in previous periods of economic weakness, such as the Global Financial Crisis and the pandemic, the monthly rate of earnings revisions for the next twelve months indicates no sign of material economic deterioration.

As a result, Murray says he anticipates positive returns for the ASX over the next 12 months.

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About Crispin Murray and the 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 a 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  

Contact a Pendal key account manager

Here are the main factors driving the ASX this week according to portfolio manager JIM TAYLOR. Reported by investment specialist Chris Adams

• The call on how big the Fed’s September cut will be is “finely balanced”
• Need to look elsewhere for data, which will shift markets and guide the Fed
• Find out about Pendal Focus Australian Share Fund
• On demand: Crispin Murray’s Beyond the Numbers webinar

SOME elements of the current investment landscape are finely balanced right now.

For example, the US election is anyone’s call at this juncture.

That’s pretty handy, because the market can ignore policies from both sides at the moment – it’s a bridge too far to price anything in.

The call on whether the Fed cuts by 25 or 50 basis point (bps) in September is also finely balanced.

Pricing has been seesawing between a 30% and 60% chance of a 50bps cut. The much-anticipated employment data out of the US last week wasn’t non-consensus enough to move the dial materially outside of these bands.

Comments from the Fed late in the week saw the market finish at the lower end of the 50bps cut probability band.

On the other hand, the toe-to-toe in Australia last week between RBA Governor Michele Bullock and Federal Treasurer Jim Chalmers wasn’t “finely balanced”.

The treasurer pointed fingers at the RBA, which retorted with comments that may not sit very well with the government this close to a federal election.

The S&P/ASX 300 fell 0.66%, while the S&P 500 was off 4.2%.

Resources were trounced (down 6.27%), with red ink across the commodity and equity screens. The outperformance of banks versus resources nearly added another 10% to an already incredibly lop-sided ~50% for the year to date.

Australian reporting season wrapped, with overall downgrades to FY24 earnings-per-share (EPS) of about 3%. Reporting season market volatility was in line with what we have experienced since Covid.

Margin pressure was probably the key call-out from reporting season. A more subdued sales environment means that continued cost pressures are manifesting in negative operating leverage, which is flowing through to pressure on earnings and dividends.

There is some CPI and PPI due this week but the infatuation with inflation has largely run its course, and without any real data on growth, the market may be a bit skittish as we head toward Fed decision time.

US macro and policy

The Fed

Emphasis on the focus shift from inflation to the labour market was evident in several comments from the Fed – probably the last as it moves into black-out mode before the next meeting:

San Francisco Fed President Mary Daly noted the need to cut rates to keep the labour market healthy, highlighting the risk from “a real rate of interest that’s rising into a slowing economy”.


FOMC Board member Christopher Waller said that Friday’s job report showed that the labour market has cooled, but that evidence doesn’t suggest that the economy is in recession or “necessarily headed for one”. He noted that front-loading rate cuts, or cutting in 0.50% increments, could be appropriate if determined “by new data”, suggesting he would need to see subsequent evidence of significant deterioration.


New York Fed President John Williams noted that balance in the labour market and good data on inflation “are telling us it’s time to dial down that restrictiveness” of monetary policy.


Atlanta Fed President Raphael Bostic sounded more cautious, saying that the Fed’s goals of stable prices and full employment are in balance but that he is “not quite prepared” to claim victory on inflation.

Economic data

The Institute for Supply Management (ISM) US manufacturing index shrank in August for the fifth consecutive month. At 47.2, it was higher than July’s 46.8 but lower than the 47.5 expected.

New orders – which are watched as an indicator for growth – fell from 47.4 to 44.6, which is an 18-month low. Production, at 44.8, is at a four-year low.

The bottom line is that the manufacturing sector is just not large enough to weigh too heavily on overall GDP, and so remains a small headwind to production and employment as it has been for a few years now. 

We need to look elsewhere for economic data, which will shift markets and guide the Fed. 

The ISM Services index rose from 57.0 in July to 57.3 in August and continues to suggest moderating inflation in underlying services over the next few months.

Employment

There was a raft of datapoints which generally underpinned the notion of a softer labour market:

• Friday’s August non-farm payrolls were keenly anticipated and rose 142k versus a consensus expectation of 165k. Net revisions to previous readings were down 86k.
• The unemployment rate fell from 4.3% in July to 4.2% in August, which was in line with expectations. The three-month average is now 0.54% above the trailing 12-month average, rising from 0.49% in July and leaving the Sahm Rule of recession still triggered.
• Average hourly earnings rose 0.4%, the biggest gain in seven months and ahead of 0.3% expectations, driven by the service sector. It is now running at 3.8% year-on-year, up from 3.6% in July, and while the Fed focuses more on the employment cost index (ECI) than average hourly earnings, this bears watching.
• Earlier in the week we saw the ADP Employment Report, which rose 99k in August versus 141k expected. July was revised down from 122k to 111k. Private job creation slowed for the fifth consecutive month and was the lowest since January 2021.
• The bulk of new jobs were in construction, education and health services, and financial activities. There were declines in manufacturing, information and professional/business services.
  • July job openings, measured by JOLTS, came in at 7.67m versus 8.10m expected, falling to the lowest level since January 2021. The number of vacancies per unemployed worker is now at 1.1x, the lowest level in three years and almost half the peak of 2.0x in early 2022.
• Finally, initial jobless claims came in at 227k versus the 230k expected and the previous week was revised up from 231k to 232k. Continuing claims were 1,838k versus the 1,868k expected and the previous week was revised down from 1,868k to 1,860k.

Australia macro and policy

Federal Treasurer Chalmers noted that while he and the RBA Governor have different responsibilities, they are both focused on getting “on top of this inflation challenge in our economy without making life harder for people or smashing an economy, which is already weak enough”.

In contrast, Governor Bullock observed that “if the economy evolves broadly as anticipated, the Board does not expect that it will be in a position to cut rates in the near term” and that “full employment is not served by letting inflation stay above target indefinitely”.

She noted that younger and lower-income households have been particularly affected by cost-of-living pressures given tighter budgets.

On the data front, GDP increased by 0.22% in Q2 2024, which was largely as expected, and decelerated by 0.30% to 0.97% year-on-year, which was the weakest in 32 years barring the pandemic. Furthermore:

• Domestic demand rose 0.20% for the quarter and 1.5% for the year. Private demand remained constant at 0.8% year-on-year while public demand rose 0.8% for the quarter to 3.5% for the year. Public demand as a proportion of the economy is now 28%, which is the highest ever level (again, barring the pandemic).
• Net exports (up 0.20%) and inventories (down 0.30%) largely offset each other.
• Household consumption fell 0.20% in the quarter and rose 0.50% for the year. This was the largest quarterly decline (ex-Covid) since the GFC, with the Australian Bureau of Statistics suggesting that the “Taylor Swift” effect of the March quarter may have contributed to the decline. The RBA was expecting 1.1% year-on-year growth. Transport fell 4.4% for the quarter, while hospitality (down 1.5%) and clothing (down 2.6%) were also weak. Gains came in household goods (4.0%), utilities (2.4%) and education (1.2%).

Elsewhere, CoreLogic noted that its rent index was unchanged in August for the second straight month.

• The national annual growth trend was 7.2%, the lowest rate since May 2021.
• Rent values in Sydney declined for a second consecutive month.

Australian reporting season wrap-up

Earnings misses (38% of the market) outnumbered beats (32%), with the ratio of 0.8x ratio of beats to misses well below the long-term average of 1.4x.

Disappointments were driven more by margin, as revenues were largely in line with expectations.

At an aggregate level, ASX 200 FY24 EPS Growth was down 4.6%, which was in line with consensus and a second straight year of falling profits for the index.

Sales growth for the average firm slowed to 6.4% from 8.9% in the prior comparable period, but stickier costs (particularly wages) continued to put pressure on profitability – with margins now back in line with long-run averages.

Dividends fell 1.9% but, at 3.6%, were notably higher than forecast thanks to rising payout ratios and a number of special dividends from retailers such as Woolworths, JB Hi-Fi and Super Retail Group.

At an index level, small caps fared worse – 45% of small caps missed expectations versus 31% of large caps, and earnings revision trends have been twice as negative.

• Outlook commentary was generally cautious, with earnings revision trends weaker than normal:
• ASX 200 FY25 EPS growth has been cut from 3.7% to 0.4%, putting in play a third-straight year of negative growth for the index.
• Across Industrial firms, FY25 EPS was cut by 3%, nearly twice the long-run average and now standing at 4.4% (7.0% ex-banks). While revenue forecasts were trimmed, the bigger driver of downgrades was margins given companies are continuing to struggle to pass on higher costs.
• Downgrades were broad-based, but larger in cyclical sectors such as steel, gold, media, energy and mining. Of the more defensive sectors, healthcare continued its recent run of negative earnings momentum.
• Banks was the only sector to see net upgrades, driven by better net interest margins, albeit to only flat earnings for FY25 and despite highlighting some concerns around deteriorating asset quality.
  Stock volatility in response to earnings was lower than the past two reporting seasons but remained elevated versus the pre-Covid era.

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About Jim Taylor and Pendal Focus Australian Share Fund

Drawing on more than 25 years of experience investing in top-performing Australian companies and a background in accounting, Jim manages our Long/Short Fund and co-manages our Imputation Fund. He is a Chartered Accountant with membership of the Australian Institute of Chartered Accountants.

Pendal Focus Australian Share Fund is managed by Crispin Murray. The fund has beaten its benchmark in 14 years of its 18-year history (after fees), across a range of market conditions. Find out more about Pendal Focus Australian Share 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

Late-cycle dynamics can be tricky to navigate. Here are five tactics Pendal’s head of income strategies AMY XIE PATRICK is considering for the path ahead

• Late-cycle dynamics can be vulnerable to shocks
• While growth slows, inflation remains a concern
• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Browse Pendal’s fixed interest funds

EQUITY markets seem to have recovered from their August gyrations for now.  

But investors are left wondering if those moves were a one-hit wonder or a warning shot of more to come.  

The key characteristic of this “late cycle” economy is that growth – while still positive – is slowing down.

This is broadly the case the world over, though some places like China never even lifted off during the good part of the cycle.  

Late-cycle dynamics are tricky to navigate, since they carry the risk of being caught wrong-footed in both directions.  

If we get concerned too early we can miss some impressive late-cycle market rallies. We’ll also miss out on good corporate bond coupons and decent equity dividends along the way.  

Get too greedy, though, and we can be caught in the down-draught with little to no ability to sidestep any of the pain.  

Knowing what to prioritise and staying focused on our investment goals can give us the agility and tenacity we need to navigate uncertain macro environments.  

This article covers the top five things that our team are prioritising for late-cycle trading in our income portfolios.  

1. Conviction in quality

Now is the time to kick the tyres of every corporate bond we own.  

As the economy slows, credit quality will disperse and generally deteriorate. 

Companies that can preserve strong cash positions and demonstrate resilient business models will do well. Those who have few levers to pull against the headwinds of slowing sales and narrowing margins won’t. 

Another feature of late-cycle dynamics is a system more vulnerable to shocks.  

Physical corporate bonds in Australia are usually the first to lose their trading liquidity at any sign of trouble. The most extreme example of this was during the early weeks of Covid, as Australian credit markets ground to a halt.  

Since fundamentals are deteriorating and liquidity events can happen without notice, the only way to prepare is to test our conviction of every issuer we own. Those who can’t pass that conviction test need to leave the portfolio. 

Our portfolios passed our conviction tests with flying colours.  

We have always had a through-the-cycle quality discipline with the assets we buy.

Sure, our tyre-kicking exercise left us with slightly scuffed shoes, but it also meant little need for additional action.  

2. Demand the right pay

It is more recent bond issues from the primary market that tend to fail our conviction test.  

Marginal and first-time issuers have been extending the maturities of new debt and offering to pay very skinny spreads to us investors. 

There are points in the cycle where investors must succumb to these sellers’ markets.  

When most portfolios have stayed on the sidelines for too long, cash levels are high, and bond issuance is measured and high quality, we have no choice but to accept what is on offer to keep our portfolios invested.  

The economic backdrop is usually benign in those times. Growth tends to be stable or accelerating, inflation won’t be in Google’s most-searched items, and global economic cycles will be in sync.  

That is not what the economic stage looks like today.  

While growth is slowing, inflation remains a lingering concern. And while the US economy grows at 2% per annum, Australia is seeing growth at its lowest level in two decades (outside of the pandemic).  

Even if strong issuers come to this market, investors need to be compensated for the likely volatility those businesses could experience economically, or the certain volatility their credit spreads would experience if recession were to hit.   

For inaugural issuers, investors need to be compensated for both of the above, as well as what can’t be known beforehand: how will this bond behave and what will its trading liquidity be like through a prolonged bout of market volatility?  

3. Liquidity is our flex

Notwithstanding the cyclical liquidity of physical corporate bonds in the Australian market, now is the time to make sure we have enough overall liquidity in our portfolios.  

Not only does this mean carrying plenty of cash buffers, it also means making sure that whatever exposures we’re taking in addition to credit is through the most liquid means possible.  

Liquidity allows for agility, and that is a prized asset in late-cycle markets.

The volatility in early August was a glimpse into how the market’s assessment of economic fundamentals can change on a dime.  

One minute, a soft-landing was the received wisdom. The next, the US economy was already in a recession. And a few minutes (or days) after that, a soft-landing was back on the table.  

Our portfolios were exposed to both defensive and risky levers throughout this volatility episode.  

Our implementation was through the most liquid means possible, so that we did not need to rely on the rather clunky and slow functioning of physical bond markets to enact our views.  

As rates market enthusiasm peaked, looking for emergency cuts from central banks, we quickly trimmed our interest rate positions to protect profits.

As equities and global credit indices passed through their lows, we were able to add some exposures for our portfolios so they could join in on the recovery – even though they didn’t participate in the fall.  

4. Good decision-making

This seems superfluous, since investors need to make decisions all the time. But a strong process for decision-making is something to be prioritised in uncertain times.  

The uncertainty that plagues late-cycle market dynamics tend to lead to binary outcomes. Recession, or no recession? Default rates surge or stay benign?  

There is no room for vague decision-making when these are the potential outcomes. Making half a bad decision causes portfolio managers to spend all of their energy dealing with the consequences of that decision.  

It’s important to be clear that a good decision isn’t defined by the outcome.  

Good decisions take into account as accurate and as objective an assessment of the relevant information. They are based on a rational assessment of the risks and rewards.  

Good decisions are made when we are honest about what we know, and what we don’t or can’t know. Good decisions involve taking risks and cutting losses.  

One way to ensure a strong decision-making process is to understand what the markers of success and failure will look like before taking on any exposures for the portfolio. That way, an action plan can be formed with the benefit of rationality.  

This removes the demand for cool-headed decisions to be made in the heat of the moment.

5. Look around the bend

If a recession were to happen, whether it be global or local, the worst thing would be to have held a portfolio of expensive and illiquid assets through a significant market drawdown.  

The second worst thing would be not to have acted on dislocated market opportunities for our portfolios.  

Recession isn’t a done deal – we just know that simply because the momentum for growth is now slowing, it necessarily raises the odds for a hard landing.  

A hard landing looks like accelerating unemployment, drawdowns in house prices and rising rates of debt default.  

In markets, it looks like large drawdowns in equity markets (think 25%+), significant widening of credit spreads (think US high-yield spreads above 1,000bps compared to 320bps currently), and a low in 10-year bond yields below 2.5%.  

The difference between a recession in the real world and how it plays out the markets is that the latter happens far more quickly. Most will remember the V-shaped move in equity markets through the rolling years of the Covid pandemic.  

If recession happens, it’ll be caused by the lagged effects of monetary policy tightening.  

The main reason for the long lags in this cycle has been the magnitude of cash stimulus during and after the pandemic. With cash in pockets, consumers had a lesser need to borrow and hence the economic sensitivity to interest rates was lower.  

Now that much of the excess cash has been spent, the next cycle can only start once the cost of borrowing falls materially. New leverage will be necessary to fuel consumption.  

Failing to look around the bend means waiting for economic activity to recover before adding risk to the portfolio. By then, the opportunity to buy the dip will have come and gone. 

Summary and performance

In summary, our active approach is geared towards prioritising five things to navigate late-cycle dynamics.  

Since growth is slowing, we are staying with only the highest-conviction exposures that we’re happy to hold even through a recession.  

We are demanding to be paid the right spreads for those exposures. And any exposures on top of that, we are prioritising liquidity since it arms us with the flexibility to act as things change.  

As always, we need to ensure that our decision-making processes stay solid. This means we won’t be blinded to future opportunities by any debris that may fall from near-term chaos. 

Total returns* of Pendal’s income strategies 

Fund name	Total return	RBA Cash Index	Active return
Dynamic Income Fund	9.0%	4.3%	4.7%
Monthly Income Plus Fund	8.9%	4.3%	4.6%

*Returns are net of fees, to end of August 2024 

What the latest GDP data tells us | Opportunities in small caps and Chinese equities | AI chip-maker takes a tumble

Active small-cap managers are delivering strong returns despite index underperformance. Pendal portfolio managers LEWIS EDGLEY and PATRICK TEODOROWSKI explain why

• Small caps could return to favour as conditions evolve
• Quality earnings the key
• Find out about the Pendal Smaller Companies Fund

IS IT time to invest in ASX-listed small caps?

It’s a question investors are asking ahead of potential global rate cuts which could bring a long period of small-cap underperformance to an end.

But while it’s tempting to focus on timing, the unique nature of small-cap indices means a careful stock-selection approach can outperform regardless of broader market conditions, argue Pendal’s Lewis Edgley and Patrick Teodorowski.

“As a whole, small caps have been a significant underperformer relative to large caps over the last two years and people are asking us ‘is now the right time to be investing?’ says Edgley.

“My answer is the underperformance problem isn’t just a two-year problem – it’s a two-decade problem.

“The Small Ordinaries index has generated a 5.5 per cent compound annual return for 20 years, versus the ASX 100’s 8.8 per cent.

“But the median small-cap manager has returned 9.7 per cent over the same time.

“That tells you what an active small-cap manager can do when they’re able to sift through the maze of good and bad investment opportunities that the Small Ordinaries provides.”

Edgley and Teodorowski co-manage Pendal Smaller Companies Fund, which invests in companies outside the top 100 listed on the Australian and New Zealand stock markets.

Together the pair have 25 years of experience with Pendal Smaller Companies Fund.

Unique opportunities and challenges

The Small Ordinaries index – which includes companies included in the ASX 300, but not in the ASX 100 — presents unique challenges for investors due to a wide array of industries and companies.

The index can often include faddish companies that enter the index with high expectations before underperforming as their popularity wanes.

It can include single-play resources companies that rally and fade as commodity prices fluctuate.

“We get themes that run and components of the index that get significantly exposed to that theme. Then as the theme runs its course, performance ends.

“But despite the fact that the benchmark has only delivered a 5.5 per cent a year over 20 years, by being dynamic and identifying the better-quality companies, we’ve been able to navigate that and find money-making ideas.”

Since inception in 1992, the Pendal Smaller Companies Fund has generated an after-fees return of 11.95 per cent. You can view the fund’s performance over other time frames here.

Rate cuts could spur performance

Small caps are historically correlated to changes in interest rates, argues Edgley.

“We have a blueprint for this in many cycles, whether it’s the GFC or Covid – declining interest rates are usually a tailwind for small caps relative to large caps.

“Over the last two or three years, small caps have essentially been driving with the handbrake on.

“We don’t know when rates are going to start coming off. But when they do, small caps should start to get a tailwind.”

What does that mean for timing?

“We think it actually doesn’t matter – our history shows there are ways of finding money-making opportunities regardless of what rates are doing.

“Small caps have historically traded at about an 8 or 9 per cent premium relative to large caps for the past 10 years – and they are at about that same premium today.

“Most people want to buy small caps when they are cheap. You could argue that as it stands, small caps aren’t cheap.

“In any case, our view is that buying the cheapest small caps generally isn’t the best way to make money.”

Earnings drive performance

“We don’t focus on the price-to-earnings ratio as the starting point – we focus on earnings and earnings quality,” says Teodorowski.

“Through the last two years of a challenging macro and market environment for small caps, we’ve been able to identify two groups of businesses: structural growth businesses that we were able to put more capital in at a better valuation; and businesses with more defensive earnings than the market thought, which have rebounded significantly.”

Edgley adds: “The reason we feel confident that we can continue to do this is due to the composition of our performance over time.

“The value we’ve created hasn’t just come through a very small number of big bets going well, it’s come through a broad combination of lots of things going well.

“That’s much easier to replicate going forward.

“If you can do lots of small things well over time, that can compound to a really great outcome.”

The latest GDP data shows a weak Australian economy, but the numbers should pick up from here, says Pendal’s head of government bonds TIM HEXT

• Commodity boom waning, households going backwards
• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Browse Pendal’s fixed interest funds

TODAY’S June quarter GDP numbers paint a reasonably bleak, but not unexpected, picture of the Australian economy.

Quarterly GDP was 0.2% for the third consecutive quarter, leaving annual growth at 1%. It was the weakest financial year – excluding the Covid hit of 2020/21 – since the recession of 1991/92.

We are avoiding a technical recession overall this time, but the consumer is going backwards – even with 2.5% population growth.

Remember, the main GDP you hear reported is a chain volume, not price measure.

I prefer looking at numbers on a state basis, split into consumption and investment. This gives a better picture of what is going on in the economy.

Source: ABS

Here are five key takeaways from today’s numbers:

1. Government spending remains strong despite government investment tapering off

Government expenditure contributed 0.3% to GDP, government investment 0.1%, while government spending rose by a strong 1.4%.

The main driver is social benefit programs for health services (largely the NDIS).

This also remains a major source of strength for employment and inflation, and is central to the current animated debate between Treasurer Chalmers and the RBA (though Governor Bullock has wisely toned down prior comments, leaving RBA proxies to continue it).

State governments are also major drivers of growth and inflation.

However, NSW has now seen government investment go negative (down 3.8%) as major projects like the Metro are completed. Victoria (up 5.4%) and South Australia (up 5.8%) clearly didn’t get the RBA memo asking for restraint.

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About Tim Hext and Pendal’s Income & Fixed Interest boutique

Tim Hext is a Pendal portfolio manager and head of government bond strategies in our Income and Fixed Interest team.

Tim has extensive experience in banking, financial markets and funding including senior positions with NSW Treasury Corporation (TCorp), Westpac Treasury, Commonwealth Bank of Australia, Deutsche Bank, Bain & Co and Swiss Bank Corporation.

Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.

Find out more about Pendal’s fixed interest strategies here

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About Pendal

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

In 2023, Pendal became part of Perpetual Limited (ASX:PPT), bringing together two of Australia’s most respected active asset management brands to create a global leader in multi-boutique asset management with autonomous, world-class investment capabilities and a growing leadership position in ESG.

Contact a Pendal key account manager