In their latest quarterly report, Tim Hext, Amy Xie Patrick, Terry Yuan and Murray Ackman explain the trends affecting Australian fixed income investors right now

• Download Pendal’s June quarter income and fixed interest report (PDF)
• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Browse Pendal’s fixed interest funds

Pendal’s income and fixed interest team has just published its quarterly deep dive into the themes driving Australian markets (PDF).

In the latest edition, head of government bond strategies Tim Hext explains how the RBA’s liquidity system affects investments – and why Australians need to honestly appraise the liquidity of their funds.

Head of income strategies Amy Xie Patrick explores which kind of income funds are best suited to the likely economic landing scenarios. (Hint: not one-dimensional funds)

Senior credit analyst Terry Yuan writes about a recent transformation in the credit bond issuance market which has led to a number of deals becoming heavily over subscribed.

An unprecedented shift from a buyer’s market to a seller’s market has led to significant changes in pricing dynamics, Terry says.

Lastly, senior ESG and impact analyst Murray Ackman has a quick guide to the key questions investors should ask about sustainable investing opportunities

About Pendal

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

The team won Lonsec’s Active Fixed Income Fund of the Year award in 2021 and Zenith’s Australian Fixed Interest award in 2020.

Find out more about Pendal’s fixed interest strategies here

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

• Find out about Pendal Focus Australian Share Fund
• On-demand: tune into Crispin Murray’s bi-annual Beyond the Numbers webinar

EQUITY and bond returns were strong last week, with the local market leading the charge.

The S&P/ASX 300 gained 1.97%, while the S&P 500 rose 1.36%.

Commodities had it tough, with the oil price falling through US$80 for the first time in four months.

This provides some comfort around the near-term direction for headline inflation, which flows through to interest rates, policy, the dollar, and the performance of mega-cap growth stocks.

The global central bank easing cycle was kicked further into gear, with the Bank of Canada and European Central Bank (ECB) both cutting rates.

With that said, the ECB cut felt hawkish, with President Lagarde at pains to suggest the scope and pace of the rate cutting cycle from here is far from certain.

Economic data has been plentiful but lacking in real substance ahead of the US CPI this week, though Friday’s blow-out US jobs data print – which drove US bond yields up 15 basis points (bps) – pointed to a resilient labour market which continues to be a unique feature of this cycle.

Another feature is the bifurcated spending patterns of young versus older consumers, which is making the central banks’ job of navigating policy a whole lot harder.

The market has been oscillating between “bad news is good news” and fears that major economies are beginning to show signs of consumer stress based on the maxim that “monetary changes have their effect only after a considerable lag and over a long period”.

It seems the market is okay with bad news provided that news is not too bad.

Australia macro and policy

Reserve Bank of Australia (RBA)

RBA Governor Bullock delivered testimony to the Senate, which struck a government-friendly tone.

She noted that that the RBA’s estimate of the non-accelerating inflation rate of unemployment (NAIRU) was currently 4.3%, only 20bps above the current unemployment rate of 4.1%.

This was caveated by significant uncertainties around the estimate.

The RBA expects new energy rebates to reduce headline inflation by about 50bps in the next financial year, but that it won’t have a material impact on underlying trimmed-mean inflation or boost consumer spending given the relatively small size.

Bullock also pointed out that the RBA thinks monetary policy is taking about 18 months to flow through, suggesting in “a general sense that there is about 50bps of policy tightening to come”.

Q1 GDP

Economic growth was subdued in the first quarter, rising 0.1% quarter-on-quarter and 1.1% year-on-year. It is running at 0.9% on a six-month annualised basis.

This reflects a broader slowdown in the economy as the 2023 softness in households – in response to higher taxes and interest rates crimping real incomes – has expanded to public and private investment.

Both declined in Q1 and saw a smaller contribution to annual growth.

Public investment does remain at high levels, despite falling for the second consecutive quarter.

State and Federal budgets suggest that the spending pipeline peaks in FY25, as some major transport projects also reach completion.

Dwelling investment fell 0.5% to be 3.4% lower year-on-year. This is expected to continue falling, with detached housing projects falling steeply as the Homebuilder Subsidy boost falls away.

Other data

The Fair Work Commission raised Award and Minimum wages by 3.75% from 1 July 2024, which was largely as expected and below the 5.8% increase in 2023.

Dwelling prices across the eight-city average rose 0.8% month-on-month in May, up from 0.5% in April, representing the largest monthly gain since October 2023.

According to CoreLogic, national rents rose 0.7% month-on-month in May, down from 0.8% in April, representing the lowest monthly gain since December.

The slowdown is probably attributable to lower net migration and the impact of affordability on rental patterns, they noted.

Retail volumes have fallen below the pre-Covid trendline, though price remains well above it.

Conditions in Victoria look particularly weak, with anecdotes that events such as the Australian Open, the Grand Prix and Taylor Swift concert have masked underlying softness.

There are suggestions that changes to state taxes are taking a toll on sentiment.

US macro and policy

Non-farm payrolls rose 272k in May, versus 180k consensus expectations and 175k in April.

The three-month moving average is running at 249k per month, only modestly down from 261k per month in the preceding three-month period.

There was a strong skew to the “experience” pasts of the economy, where spending remains strong – potentially supported by older cohorts – with leisure and hospitality adding 42k jobs versus 26K in the good-producing segment of the economy.

Government jobs also strengthened following a weak April.

Average hourly earnings rose 0.4% versus the 0.3% expected and 0.2% seen in April. It is running at 4.1% year-on-year, which is still too high for the Federal Reserve’s comfort.

Unemployment is running at 4.0% versus the 3.9% expected. This is the first time at 4% in two years.

April JOLTS job opening came in at 8.06 million versus the 8.35 million expected and the 8.25 million seen in March.

This means the job-opening-to-unemployed ratio is at 1.24 – the lowest since January 2020 and down from 2.0 when rates began rising in March 2022.

The Quits rate – seen as a lead indicator for wage pressures – held steady at 2.2% and continues to suggest the employment cost index (ECI) should moderate over the next six months.

The ISM Manufacturing Index fell from 49.2 in April to 48.7 in May, driven by weakness in the new orders sub-index, which suggests ongoing weakness in manufacturing.

The ISM Service Index hit 53.8, up from 49.4 in the previous month and ahead of consensus sat 51.0.

While strong, this index has been in a range and has not been a strong indicator of spending habits.

Central banks

The Bank of Canada became the first G7 central bank to cut rates, shifting down 25bps to 4.75%.

The Chair left the door open to further cuts, saying they are confident inflation is heading to the 2% target.

The ECB reduced rates from 4% to 3.75%, however, the accompanying commentary was clearly designed to discourage expectations of a near-term continuation of cuts.

The rate-setting committee “is not pre-committing to a particular rate path” and rates are “not close to neutral”, according to accompanying statements.

This was reinforced by April core inflation in the EU ticking up from 2.7% to 2.9%. ECB President Lagarde noted a “strong likelihood” of further cuts in the months ahead, but stressed that “the speed of travel and time it will take” are very uncertain.

Markets

We observe that there has been a significant increase in demand for upside exposure among professional investors in the past week.

The funding spreads – the cost to fund a levered long position in futures, swaps or options –jumped to 70bps, the highest level since January 2018.

Most sectors in the S&P/ASX 300 gained for the week, led by Financials (3.88) and Consumer Staples (3.40%).

Information Technology fell 0.67%, while Materials was off 0.50% on some weakness in the resource sub-sector.

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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

We have updated and reissued the Product Disclosure Statements (PDSs) for the following Pendal funds effective on and from Thursday, 6 June 2024: 

• Pendal Australian Equity Fund
• Pendal Australian Share Fund
• Pendal Focus Australian Share Fund
• Pendal Government Bond Fund
• Pendal Imputation Fund
• Pendal MidCap Fund
• Pendal Monthly Income Plus Fund
• Pendal Property Investment Fund
• Pendal Property Securities Fund
• Pendal Short Term Income Securities Fund
• Pendal Smaller Companies Fund

(the Funds).

The following is a summary of the key changes reflected in the PDS for each Fund.

Updates to significant risks disclosure

Each Fund’s investment strategy involves specific risks.

We have updated the significant risks disclosure applicable to each Fund to ensure that our disclosure continues to align with the nature and risk profile of each Fund and the current economic and operating environment.

Updates to ongoing annual fees and costs disclosure

The estimated ongoing annual fees and costs for the Funds have been updated to reflect financial year 2023 fees and costs. These include changes to estimated management costs, estimated performance fees (where applicable) and estimated transaction costs.

We now also disclose the maximum management fee and performance fee (where applicable) we are entitled to charge under each Fund’s Constitution.

Additional information on how to apply for direct investors

We have provided additional information for non-advised investors (investors without a financial adviser) investing directly in each Fund who may also be required to complete a series of questions as part of their online Application, to assist us in understanding whether they are likely to be within the target market for the Fund. 

Updates to our complaints handling process

We have provided additional details about our complaints handling process and the Australian Financial Complaints Authority.

We have updated and reissued the Product Disclosure Statement (PDS) for the Pendal Managed Cash Fund (the Fund) effective on and from Thursday, 6 June 2024.

The following is a summary of the key changes reflected in the PDS.

Updates to significant risks disclosure

The Fund’s investment strategy involves specific risks.

We have updated the significant risks disclosure applicable to the Fund to ensure that our disclosure continues to align with the nature and risk profile of the Fund and the current economic and operating environment.

Updates to the Fund’s description

The description of Pendal’s investment process for Australian cash and short-term securities has been updated to better reflect Pendal’s investment approach for the Fund.

Updates to the Fund’s risk level description

There has been no change to the Fund’s risk level of ‘Very low’.

We have, however, standardised the Fund’s risk level description in the PDS with the format used for other Pendal funds.

Updates to ongoing annual fees and costs disclosure

The estimated ongoing annual fees and costs for the Fund have been updated to reflect financial year 2023 fees and costs. These include changes to estimated management costs and estimated transaction costs.

We now also disclose the maximum management fee we are entitled to charge under the Fund’s Constitution.

Additional information on how to apply for direct investors

We provide additional information for non-advised investors (investors without a financial adviser) investing directly in the Fund who may also be required to complete a series of questions as part of their online Application, to assist us in understanding whether they are likely to be within the target market for the Fund.

Updates to our complaints handling process

We have provided additional details about our complaints handling process and the Australian Financial Complaints Authority.

Australia has joined other sovereign nations in issuing an inaugural Commonwealth green bond. Senior ESG and impact analyst MURRAY ACKMAN explains what it is and why Pendal invested in it

• Australia has joined 30 other sovereign issuers by issuing its own green bond
• Investors willing to pay a premium for the bond, market oversubscribed
• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Browse Pendal’s fixed interest funds

THE Commonwealth Government just issued its first green bond.

It has a June 2034 maturity with $7 billion issued.

The Green Treasury Bond also came with a “greenium” (meaning investors were willing to pay a premium to hold it) of around two basis points, which is roughly consistent with global peers.

Green bonds are meant to finance solutions for climate change and environmental challenges, but not all bonds are equal.

At Pendal — and at our specialist sustainable investing business Regnan — we’ve seen quite a few green-labelled bonds that don’t have any meaningful impact. Some are simply doing business as usual.

For governments, this is a particular risk.

At Pendal we are not interested in green bonds made up of already-completed projects that they were going to work on anyway, such as public transport or other infrastructure projects.

But we were very active in buying this bond – mainly across our sustainable funds, through which investors expect the majority of bonds to finance specific projects in the environmental or social space.

How did we judge this new bond? We asked a few questions:

• Does this green bond fund new things?

We want the first Commonwealth green bond to support new projects.

This is known as additionality – that is, funding something that would not have been funded but for this green bond.

Half the proceeds will go towards existing commitments and half will go towards new commitments.

In our view, this is quite reasonable and is better than some other green bonds from governments.

Ideally, we would like to see completely new projects, but we recognise that there are complications in doing this for a first issuance.

• Does it fund revolutionary projects?

Government has a different risk profile to the private sector and that gives it an opportunity to fund catalytic change — things that lead to a step change.

The list of projects funded include some that will help with the transition to a low-carbon economy – with the focus on renewable energy, clean transport, climate change adaptation, and a circular economy.

Electricity generation is the biggest source of emissions in Australia, so upgrading the grid to allow greater renewable energy connectivity will be essential in reducing emissions.

Electrification using renewable energy will significantly reduce emissions. The green bond includes investments in modernising the electricity grid and developing new transmission infrastructure through concessional financing.

This bond also funds projects that relate to this – from community batteries and electric vehicle charging infrastructure to loans for energy-saving home upgrades.

However, there are some sectors that cannot easily switch to electricity – for instance, industrial activity, which requires certain inputs for chemical reactions.

Taking a page from Joe Biden’s Inflation Reduction Act, which has made hydrogen use and production more viable, this bond will also help fund the development of regional hydrogen hubs.

We would like to see more catalytic change, but for the very first Commonwealth Green Bond, we are pleased with the scope of projects.

• Is clear reporting available?

The Commonwealth’s commitment is to distribute an annual impact report no later than 18 months after first issuance.

This will be reporting at a portfolio level rather than each bond line, which is fairly typical.

The government has also made the commitment to have independent verification of allocation and impact reporting.

This will assist in establishing annual reporting with independent verification as industry standard.

We are hopeful that this bond will demonstrate what the minimum requirements are for clear and transparent reporting for green bonds in Australia.

What else do we know about this bond?

A green bond should be a reflection of an issuer’s philosophy — not an apology for their actions.

Prior to issuing, the government announced funding to progress leadership on climate action in Government operations, which includes financing to support all Commonwealth entities in publicly reporting on their climate risks, opportunities and management.

This bond is consistent with recent government action to respond to climate change as well as engage in environmental repair through this bond.

The government has put in a lot of effort to make sure it got its inaugural green bond right.

The market has agreed, being nearly three times oversubscribed.

We anticipate that there will not be a new green bond for at least a year or two, so we believe it should perform well in the secondary market.

It provides integrity to the Australian green bond market and will provide a clear example of expectations for the market in future.

We have updated and reissued the Product Disclosure Statement (PDS) for the Pendal Fixed Interest Fund (the Fund) effective on and from Thursday, 6 June 2024.

The following is a summary of the key changes reflected in the PDS.

Updates to significant risks disclosure

The Fund’s investment strategy involves specific risks.

We have updated the significant risks disclosure applicable to the Fund to ensure that our disclosure continues to align with the nature and risk profile of the Fund and the current economic and operating environment.

Updates to asset classes and asset allocation ranges disclosure

There has been no change to the way the Fund is invested.

We have, however, removed the reference to ‘currency’ from the Fund’s asset classes and asset allocation ranges description to more accurately reflect the fact that ‘currency’ is not an asset class. 

Updates to ongoing annual fees and costs disclosure

The estimated ongoing annual fees and costs for the Fund have been updated to reflect financial year 2023 fees and costs. These include changes to estimated management costs and estimated transaction costs.

We now also disclose the maximum management fee we are entitled to charge under the Fund’s Constitution.

Additional information on how to apply for direct investors

We have provided additional information for non-advised investors (investors without a financial adviser) investing directly in the Fund who may also be required to complete a series of questions as part of their online Application, to assist us in understanding whether they are likely to be within the target market for the Fund.

Updates to our complaints handling process

We have provided additional details about our complaints handling process and the Australian Financial Complaints Authority.

Here are the main factors driving the ASX this week, according to Pendal’s head of equities CRISPIN MURRAY. Reported by portfolio specialist Chris Adams

• Equities quiet, may see period of consolidation
• The Fed unlikely to cut rates in June/July
• Find out about Pendal Focus Australian Share fund
• Watch Crispin’s most recent Beyond the Numbers webinar

EQUITY markets have been quiet and were down marginally last week.

Combined with a lack of follow-through on the Nvidia result and weakness in US software, this suggests we may see a period of consolidation.

The S&P 500 fell 0.49% while the S&P/ASX 300 was off 0.34%.

In the US, Personal Consumption Expenditure (PCE) inflation data was marginally lower than expected, which kept the chance of a pre-election rate cut alive.

Economic growth data was a touch softer than expected, but this week’s employment data should provide a clearer picture.

Australian inflation data was worse than expected and – despite softer retail sales – the prospect of rate cuts seems remote.

BHP’s attempt to take over Anglo American has ended for now. UK rules mean it can’t try again for another six months.

US inflation outlook

April’s PCE data was incrementally positive for the inflation outlook, but the Fed remains in “wait and hope” mode.

It is unlikely to cut rates in June or July.

The PCE – the Fed’s preferred measure of inflation – was in line with expectations, with Headline up 0.26% and Core up 0.25% month-on-month (or 2.8% year-on-year), versus a 0.3% run-rate in the last two months.

The market read this as marginally positive as the “super core” data – which adjusts for some of the imputed service components – fell from 0.3% month-on-month in March to 0.17%, which is consistent with 2% inflation.

But it is too soon to be bullish on inflation, as the trend remains too high – with three-month and six-month annualised growth at 3.5% and 3.2%, respectively.

The year-on-year reading is in the high 2% range, and in the past few months the outlook for inflation at the end of 2024 has also shifted there from the sub-2.5% range.

As a result, the Fed remains on hold – waiting for three months of data that indicates inflation is fading again.

We note that the base effect of slowing inflation in the second quarter of 2023 will also work against readings in the second half of 2024.

Digging into the details, core services inflation is moderating again but is still above the trend of late 2023, suggesting it sticks in the 3% range.

Meanwhile, goods deflation has now ended.

The bull case here is that retail margins, which are materially higher than pre-Covid, will be driven lower by competition in a softer economy, which could help bring inflation down.

The upshot of all this for markets is that we are unlikely to see rate cuts in either June or July. The question is, then, whether the Fed will cut ahead of the Presidential election.

The market is currently implying a 4% chance of a cut in June, 17% in July, and 63% in September.

US economic growth

Here, the incremental news was softer, though it remains on trend for somewhere around 2% in 2024.

Headline first-quarter GDP was revised down from 1.6% to 1.3% (as expected) – driven mainly by lower consumption growth and lower net exports and inventory accumulation, while investment was stronger.

However, the drag from inventory and exports overstates economic softness.

Final sales to private domestic purchasers is a better indicator, which rose 2.8% versus 3.1% in the initial estimate.

Data on personal consumption was also softer, with consumer spending up 0.2% in April following 0.7% growth in March.

Personal incomes rose 0.3% and the savings rate was steady at 3.6%.

Real consumer spending – adjusted for inflation – was weaker than expected (-0.1% in April), continuing the signal of a slightly weaker consumer.

Services remains the strongest component, but this is fading. Spending on goods is down 1% on a three-month annualised basis.

This has seen second-quarter GDP forecasts reduced, though this is only the first month of the quarter.

The Atlanta Fed GDPNow estimate has shifted from the 3% range into the high 2% range. Market consensus is at 2%.

Anecdotally, in some sectors, US corporates are still constructive.

Booking.com and Airbnb are saying leisure travel demand is solid, while Uber is seeing no “trade-down” activity in restaurant delivery. Demand for digital advertising is also holding up.

The conclusion at this point is that US economic growth is decelerating at a moderate pace, but still heading for about 2% in 2024.

News of Trump’s conviction has led to a small shift back towards Biden in the betting odds, with the Real Clear Politics Betting Average showing Biden at about 39% and Trump at about 48%.

Europe

The European Central Bank (ECB) is expected to cut rates for the first time in this cycle this week.

The markets are pricing two-to-three rate cuts by the year’s end.

However, growth data, wages and inflation have been stronger than expected in last couple of months, so ECB President Lagarde may be cautious in the press conference and not commit to cut rates again in September.

Australia

The April Consumer Price Index (CPI) rose 0.73% month-on-month, taking it to 3.6% year-on-year, versus 3.4% as expected.

Core CPI rose 0.24% to 3.8% year-on-year.

This pushes out expectations around rate cuts. Inflation is falling, but it remains too high for the RBA’s comfort.

The food, clothing and health components drove the upside surprise.

Construction costs have accelerated in the past few months.

High construction costs are a structural issue for Australian inflation, as it leads to a lack of supply of housing, retail space, distribution centres and other physical capacity.

Subsidies are helping ease some pressure, with the electricity component down 1.9% month-on-month and rent inflation slowing due to higher Commonwealth rent assistance.

Elsewhere, retail sales for April were softer than expected at 0.1% month-on-month and 1.3% year-on-year.

The read-through is messy due to the timing of Easter and school holidays, but the trend is flat-lining and has been reliant on population growth, which is now slowing.

On the positive side, there has been a pick-up in credit growth on the back of rising house prices.

This suggests that the stabilisation in interest rates is feeding through, and policy may no longer be as restrictive as it was.

The takeaway is that Australian inflation looks stickier than most countries and is being held up by structural problems. Even though the consumer is softening, rates look set to stay on hold for some time.

Markets

Markets appear to be consolidating and there are signs of deteriorating breadth.

Despite the S&P 500 being up about 11% calendar-year-to-date, 45% of stocks are down.

Higher bond yields are weighing on equities and ten-year bond yields are rising towards key resistance levels.

Positioning is getting more extended. Cash levels in US equity mutual funds are as low as we have seen in decades, though hedge fund exposure has room to rise further.

At this point, we see markets in something of a holding pattern and we believe liquidity can continue to support them through the September quarter.

The Magnificent Seven have become the “Fab Five” of Amazon, Apple, Microsoft, Google and Nvidia.

Indicators suggest that mutual and hedge fund managers are still underweight these stocks in aggregate, so there is still potential for them to squeeze higher.

When the 27% year-to-date index return of these stocks is removed, the roughly 6% or more return from the rest of the S&P 500 looks closer to a roughly 3% return from the S&P/ASX 300.

The AI thematic helping drive the Fab Five is also seeing bifurcation in the tech sector.

This can be seen in the divergence between the iShares Semiconductor ETF and the Global X Cloud Computing ETF, which have traded largely in tandem in 2022 and 2023.

However, the AI theme has seen semiconductors materially outperform since early 2024 – a trend which has accelerated in the last two weeks.

In this vein, the US Software sector was down 5.4% on Thursday, which was biggest day of underperformance in more than 10 years.

This was on the back of a quarterly result for Salesforce.com, which was in line with expectations but saw softer revenue guidance – leading the stock to drop about 20%.

The key debate is whether slowing revenue is company-specific or a broader macro issue.

We have seen this divergence in an Australian context in the performance of Goodman Group (GMG), which has also decoupled from a previously close correlation with a fellow industrial property company in the US, Prologis.

GMG has outperformed massively since Q3 2023 on the back of GMG’s pivot towards data centres.

Australian market

The S&P/ASX 300 rose 0.85% in May.

The thematic winners included aluminium/alumina names like Alumina and South32, as prices caught up with copper, as well as AI-related names such as Goodman Group and NextDC.

Other good performers such as Aristocrat Leisure, Xero, Technology One, Bendigo & Adelaide Bank, and AGL were driven by stock-related news.

Thematic losers were discretionary retailers such as Super Retail, Bapcor and Nick Scali as anecdotes of softer trading came out.

Some caution around the outlook for corporate travel saw Corporate Travel Management and Flight Centre softer.

The market was relatively quiet in the last week, with limited rotation. A weaker iron ore price saw some of the miners underperform.

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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

How Nvidia is impacting the global economy | Aussies relaxed about inflation outlook | Three charts that show the advantage of an active approach to fixed income

Despite a narrative around re-emerging inflation, Australian investors are remarkably relaxed about the outlook. Here Pendal’s head of government bond strategies TIM HEXT explains the latest inflation data

• April CPI came in higher than expected
• Australian market relaxed about inflation outlook
• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Browse Pendal’s fixed interest funds

APRIL’S inflation numbers point to a 3.6% increase in the annual Consumer Price Index.

That’s slightly higher than March (3.5%) and more than the 3.4% the market was hoping for.

Excluding volatile items (food and energy) the CPI was steady at 4.1%.

It bears repeating that the monthly CPI number does not measure all items.

Sixty per cent of items are collected every month, while 30% are collected once a quarter (with roughly 10% in each of the three months), and 10% are collected annually. 

Forecasters are still having to constantly refine their models and learn something new every release.

The ABS is constantly improving that collection and is hoping to release a comprehensive monthly number later next year.

What’s up and down in monthly price moves?

International travel led the way, up 10.6% after sharp falls earlier in the year.

Fruit prices were up 7.3%, fuel prices were up 2.2%, and medical and hospital services were up 2.7%.

Surprisingly, clothes and footwear were up 4% on average – a rare and large rise in goods prices.

What was encouraging, though, was some rent relief – inflation “only” rose 0.5%, which is the lowest increase in a long time.

Electricity and gas prices fell slightly and will obviously collapse as subsidies hit in Q3.

The narrative has been that goods prices (about a third of CPI) should only grow 1-2%, allowing services (the other two-thirds of CPI) to be 3-4% and still get near the inflation target.

However, overriding these concerns are the impacts of upcoming government subsidies.

Electricity subsidies should deduct 0.5% from CPI in Q3 and the RBA will need to reduce its end-of-year (2024) inflation forecast from 3.8% to 3.3%.

Lower oil prices in May should see the monthly CPI start falling again and end the year closer to 3%.

Implied 10-year inflation levels, based off inflation swaps, remain reasonably well anchored at 2.77%.

Over the past 12 months, this level has largely been treading water – between 2.70% and 2.90%.

The market is backing the RBA to do its job.

Implications for investors

Three-year yields in Australia have backed up above 4% once more following this inflation number.

We view this as an opportunity to add duration, as our medium-term view on inflation is positive.

US inflation numbers come out on Friday and should show lower rental outcomes feeding through to lower outcomes.

As mentioned before, the CPI track in Australia should improve into the third quarter.

We will dig around and see if the goods inflation story in this number is temporary or a sign of emerging pressures.

The Pendal Australian equities team’s insights are very useful in this regard.

Unless our concerns ramp up, we will be happy to be long duration into the winter months.

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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

Here are the main factors driving the ASX this week according to Aussie equities analyst and PM ELISE MCKAY. Reported by portfolio specialist Chris Adams

• Nvidia delivers blow-out 1Q result
• Pendal Australian equities portfolios positioned to benefit
• Find out about Pendal Focus Australian Share fund

THE global economy appears to have left last decade’s monetary policy era well behind and embraced a far more exciting fiscal policy era.

Kicked off by Covid spending, and quickly bolstered by the energy transition and defence focus, we now see further momentum in a sovereign artificial intelligence race and the generative AI build-out.

This was highlighted by last week’s blow-out Nvidia first-quarter result.

The stock gained 15% over the week, suggesting that investors continue to underestimate the speed, scale and scope of the AI revolution.

Nvidia is perhaps more than just another stock. At present it appears to be a key driver of markets – touching almost every aspect of the global economy.

Its influence is felt everywhere – from the geopolitical need for sovereign AI and the productivity and capex boom affecting economic growth, to increased demand for commodities to help power data centres, and the wealth effect of rising stock markets, which helps consumption.

Our portfolios are positioned to benefit.

In the large-cap portfolios, we have NextDC (NXT) and Goodman Group (GMG), which benefit from increased demand for data centres.

In our midcap fund, we hold NXT and Megaport (MP1), which is exposed to networking, as well as newly listed copper stock Capstone (CSC).

The small-caps team own another data centre play Macquarie Technology Group (MAQ), along with copper miners Sandfire (SFR) and CSC.

In this week’s note we check the pulse of the global consumer – with the European consumer strengthening, the Australian consumer under pressure, and a bifurcation occurring between US consumers who own shares (like higher-income households) and those at the lower end.

On the inflation front, a bounce in May’s Flash S&P Global Composite Purchasing Manager’s Index (PMI) plus more hawkish Federal Reserve speak and minutes resulted in US 10-year Treasury bond yields moving up five basis points (bps) to 4.47%.

Goldman Sachs was prompted to push out its first rate-cut assumption from July to September 2024.

But the PMI sub-components data, plus unemployment claims, were consistent with the narrative that employment and inflation measures are on track to weaken over the coming months.

Confidence remains high that the next move will be down.

The market is now only pricing a 10% chance of the Fed cutting rates in July, while this rises to 50% by the September meeting.

Though last week was very busy in Australia, with a mini-reporting season seeing the likes of Xero (XRO), Technology One (TNE), James Hardie (JHX) and ALS (ALQ) all delivering results, this week looks a little quieter.

The S&P/ASX 300 fell 1.11%, while the S&P 500 returned 0.05% last week.

The US market is closed Monday for the Memorial Day long weekend and then we get personal income and spending data on Friday.

Economics and policy

The Fed

The May FOMC meeting minutes were released and were relatively hawkish. In addition, we had almost 20 statements from various Fed members.

The broad takeaway is that there is no sense of urgency to cut, and it looks as if like the fastest route to a cut would come through an unexpected deterioration in the labour market, rather than inflation alone.

Unemployment claims

The four-week average weekly unemployment claims inched up to 220k, off the lows of 201k earlier this year.

While we haven’t seen a meaningful increase in claims, the slowing rate of hiring (the first step taken by businesses in response to rising borrowing costs and reduced demand) would suggest claims will eventually follow.

S&P Global PMIs

The flash S&P Global Composite PMI survey rose to 54.4 in May – up from 51.3 in April and well above consensus expectations of 51.2.

The market responded negatively, with US 2-year bond yields rising 7bps on the day.

It is worth noting that this index has been a poor indicator of growth in GDP since the COVID pandemic.

More importantly, the sub-components data was consistent with the narrative that employment and inflation data are on track to weaken over the coming months, supporting potential US rate cuts later this year.

Expectations of the first cut have now been pushed back to September.

On the negative side, the composite employment index recovered half of the unexpectedly soft April decline.

However, it remains soft at 49.9 – suggesting equally as many firms are reducing employment as there are those increasing it.

This is consistent with materially weaker jobs growth and signals that businesses expect demand growth to soften.

The output prices indices for both Services and Manufacturing supported the global disinflation story:

• While the services output price index ticked up from 53.7 to 54.0, it suggests that CPI services ex. rents will soon be rising at a 2.5% three-month annualised rate, down from 7.1% in April.
• The manufacturing output price index moderated from 54.9 to 54.5 and also suggested manufacturers built up inventories of finished goods in May, which may prompt price cuts to free up cash flow and be positive for disinflation.

The Nvidia (NVDA) result

Another “beat and raise” print for Nvidia, which reported 1Q24 revenue of $26 billion – beating consensus expectations by 6%.

Earnings per share (EPS) of $5.59 were in line with expectations.

Guidance for 2Q24 is revenue of $28 billion and EPS of $6.30, which are 8% and 3% ahead of consensus expectations, respectively.

A 10:1 stock split was also music to the ears of retail investors.

Incredibly, data centre revenue growth accelerated again from 409% year-on-year in 4Q23 to 427% year-on-year in 1Q24.

The velocity of demand for graphics processing units (GPUs) continues to grow, with demand expected to outstrip supply until at least 2025.

This is not just from the larger cloud service providers (the “hyperscalers”) – individual corporates (“enterprise”) are now the largest incremental buyers in aggregate.

In addition, sovereigns are now coming in and buying to build their own secure infrastructure stacks.

For example, Japan is making a US$740 million investment in a project led by telco KKDI, Skura Internet and Softbank to build up Japan’s AI infrastructure.

NVDA also talked about supplying 100 “AI Factories” – data centres operated independently of the hyperscalers, which may also provide opportunities for companies such as NextDC (NXT).

Amazingly, NVDA now has 81% share of wallet for data centre processors and continues to gain on its peers (Intel and Advanced Micro Devices, or AMD).

It is estimated that there are 15-20k generative AI-related start-up companies.

We are still in the experimental phase of what this new ecosystem will mean for the economy.

Long-term, the AI revolution is expected to drive significant productivity gains, however, the more immediate concern is the inflationary impact the boom in share prices may have on consumer spending.

This was reflected in the FOMC meeting minutes, with at least two participants hawkishly noting that “financial conditions appeared favourable for wealthier households, which account for a large portion of aggregate consumption, with hefty wealth gains resulting from recent equity and house price increases”.

NVDA stock closed up 9% on the day and added about US$275 billion in market cap (equivalent in size to Salesforce, Netflix, and AMD).

To put this in perspective, NVDA made a cyclical low in October 2022 – trading at 25x next-12-month (NTM) price/earnings (P/E) with a US$280 billion market cap.

Since then, earnings have grown roughly ten times and the stock is now trading at 31x NTM P/E with a US$2.5 trillion market cap.

This is supportive for shareholders more broadly; the boom in the US tech sector alone has added about 10% of GDP to US household net worth this year.

According to Fidelity, the number of millionaires in the 401(k)-retirement savings scheme has hit a new record, with 485k in 1Q24 – up 15% for the quarter and 43% for the year.

Fidelity has more than 23 million plan participants with an average balance $126k, which is up 16% year-on-year.

So the rich are getting richer and that’s supportive for the companies skewed at the higher end of the consumer market, as the beneficiaries of such gains are likely to spend a bit more.

We note that households own 39% of the $73 trillion US market in cash equities – that rises to 65% inclusive of mutual funds and ETFs.

The UK

Core CPI inflation came in at 3.9% year-on-year in April, which was down from 4.2% in March but above consensus expectations of 3.6%.

Disappointingly, services inflation only declined by 10bps from 6% to 5.9%, which was well ahead of consensus and Bank of England (BOE) expectations of 5.4%-5.5%.

This has pushed out expectations for a cut from June (with a 10% probability now) to August.

Further, the BOE will not being updating on policy or giving any speeches until after the UK election on 4 July.

Wage pressures remain firm in the UK, with the three-month average private sector regular pay growing at 5.9% year-on-year.

Several leading indicators, such as the Indeed wage tracker and HMRC pay data, are pointing to a potential increase from here.

Europe

The flash S&P Eurozone Composite PMI rose from 51.7 in April to 52.3 in May – its highest reading for twelve months.

This suggests that output across the combined manufacturing and services sector has continued to grow.

This is supportive for Eurozone GDP growth, which should be bolstered further by the expectation that the European Central Bank (ECB) will cut rates in June.

Further optimism came from output prices, which rose at the slowest rate in six months and are rising at a level that is consistent with inflation meeting the ECB’s 2% target.

The data was particularly constructive for Germany, where output rose for a second month running and the pace of growth strengthened and hit a twelve-month high.

Germany has been under pressure for some time, suffering from a range of cyclical problems (like the gas crisis, higher rates, weaker Chinese demand) and structural issues (like its reliance on China imports, the auto industry shift to EVs, and unfavourable demographics).

Real GDP has been flat since 2019, compared with 5% growth for the rest of the Euro area and 9% growth in the US.

A cyclical upswing is underway – with lower inflation boosting real household incomes, which should support consumption growth in coming months.

Combined with lower inflation dynamics allowing the ECB to ease, growth in Germany should pick up over the next twelve months, leaving behind two years of stagnation.

Europe, and Germany in particular, should benefit from the huge wave of liquid natural gas (LNG) supply coming online over the next couple of years. This should result in lower energy prices and act as a tailwind for consumers and the energy-intensive manufacturing industry.

Global consumer pulse-check

This change in Europe is starting to come through in consumption measures.

The Euro area Goldman Sachs Consumer Health Indicator has improved, from the 30th percentile in early 2023 to the 60th percentile more recently.

The US is also around the 60th percentile on the same measure.

It is downbeat in the UK, where it has ranged between the 30th and 40th percentile for 2023 and into 2024.

Australia is also around the 40th percentile.

More broadly, Australian consumer sentiment has continued to decline despite a supportive budget, according to the Westpac Monthly Survey.

The decline was driven by softer perception of personal financials and an increase in unemployment expectations – signalling a softer outlook for the labour market.

Within Australia, those under 40 years old are facing the greatest pressure.

Analysis from CBA on consumer card transactions in 1Q24 showed that cuts to real discretionary and essential spending are skewed to younger cohorts – particularly the average 25–29-year category.

On the other hand, those at or heading into retirement seem well-placed to enjoy it – with a strong propensity to spend.

This is particularly favourable for those consumer companies most exposed to older age cohorts, such as Flight Centre (FLT).

Meanwhile in the US, overall spending remains healthy but bifurcated, with companies increasingly calling out a weaker lower-end consumer.

These consumers are also most exposed to a weakening labour market, with each 1% increase in the overall unemployment rate lowering spending by 1.2% for households in the bottom income quintile but only 0.4% in the top-income quintile.

Of Australian-listed companies, Block (SQ2) is exposed to the lower-end US consumer through its Cash App offering.

Markets

While the NASDAQ had a decent week (up 1.4%) off the back of an exceptional NVDA quarterly, the rest of the market was pretty soggy.

Looking at US large caps, winners are taking more of the spoils – with the largest ten companies now accounting for 26% of S&P 500 earnings, yet 35% of market cap.

While large caps are reporting positive earnings, this is not the case for small caps.

It was interesting to note that the number of companies mentioning AI during quarterly earnings calls has jumped from about 10% in 2022 to 41% in the most recent quarter.

The breadth of sectors that are considered AI beneficiaries has expanded from semiconductors into AI infrastructure plays, such as copper and power.

In particular, utilities have been in focus as a potential AI beneficiary given the substantial energy requirements to power data centres.

Global data centre power demand is expected to more than double by 2030.

This has been reflected in mutual fund positioning, with the smallest underweight to utilities in ten years.

More broadly, hedge and mutual fund positioning has rotated towards cyclicals – with increases across consumer discretionary, financials and energy as investor confidence about economic growth has strengthened.

Copper

Copper dropped 5.5%, giving back some of its 23% year-to-date gains and coming off all-time highs of $5.12/lb reached during the week.

This has been an interesting market, with differences emerging between the two most liquid markets for the metal: the Chicago Metal Exchange (CME) which is largely investor driven, and the London Metal Exchange (LME) which is largely a physically based market.

Pricing between the two is usually within a 2%-3% range, but huge demand from investors has overwhelmed the physical market – pushing the spread by more than 10%.

This huge dislocation has led to risk mitigation as the medium-term speculative positioning is at odds with a lack of physical tightness in the market today.

In fact, the physical market is trading in contango, with spot demand less than current supply.

However, traders are widely expecting that a supply deficit will start building from 2H24 and that long-term structural drivers, such as decarbonisation and AI-related demand, are very supportive for a tight market.

Previously, the ASX had only one sizeable copper player – Sandfire (SFR) – but that has recently been joined by the Australian listing of Capstone (CSC).

Gold

Gold also fell on the week, down 3.3% (but still up 13% in 2024) despite real yields going higher.

Usually, they would trade inversely, reflecting lower demand for inflation-proof assets.

However, this relationship hasn’t held with new buyers emerging from central banks and the Chinese retail market.

Global central bank purchases have increased three times since Russia invaded Ukraine.

Emerging market central banks (like China, Poland, Turkey, India and Qatar) have been big net buyers.

There is further room for this momentum to continue, with only 6% of emerging market official reserves being held in gold versus 12% in developed markets.

About 20% of all gold mined throughout history is sitting in central bank reserves.

Incremental retail demand out of Japan (reflecting the devaluation of the yen) and China (showing movement of wealth out of property) has also been supportive.

While the Chinese government’s recent moves to support the property market are helpful, we don’t think they are yet at a level to disrupt this trend.

Despite the bullishness in gold, the miners have lagged.

This reflects a combination of positioning – and the possibility that western investors are trained to sell gold miners on the move higher in real rates – as well as hiccups in operational performance.

Australia

Within Australia, Tech (+2.45%) performed off the back of some strong results from Xero (XRO, +8.41%) and Technology One (TNE, +12.18%) while Utilities (+2.35%), Energy (+1.19%) and Industrials (+0.80%) were also in the green. Consumer Discretionary (-4.24%) and Communication Services (-3.73%) were the worst sectors, with Wesfarmers (WES, -6.68%) and Telstra (TLS, -5.99%) weighing on the market.

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About Elise McKay and Pendal Australian share funds

Elise is an investment analyst and portfolio manager with Pendal’s Australian equities team. Elise previously worked as an investment analyst for US fund manager Cartica where she covered a variety of emerging market companies.

She has also worked in investment banking and corporate finance at JP Morgan and Ernst & Young.

Pendal Horizon Sustainable Australian Share Fund is a concentrated portfolio aligned with the transition to a more sustainable, future economy.

Pendal Focus Australian Share Fund is a high-conviction equity fund with a 16-year track record of strong performance in a range of market conditions. The Fund is rated at the highest level by Lonsec, Morningstar and Zenith.

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

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