Pendal’s head of income strategies AMY XIE PATRICK argued in favour of an active approach to fixed income at this year’s Lonsec Symposium

• Pendal employs AI to analyse “central bank speak”
• Active management matters the most when markets are volatile
• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Browse Pendal’s fixed interest funds

I RECENTLY had the pleasure of participating in a fixed income panel at the Lonsec Symposium.

It was the most engaging panel session I’ve attended in a long time – and if nothing else, it tells me that this asset class has become a hot topic.

In case you weren’t able to attend, here’s a summary of my main observations from the Symposium.

1. What’s better than a rate-cutting cycle for bonds?

In 2022, the Pendal Income and Fixed Interest team embarked on an exercise to see how bonds and equities performed in different parts of the rate cycle.

The motivation?

Being in the middle of the steepest hiking cycle I’d ever witnessed in my career. I wanted to see just how ugly it could get for bonds.

To do this, we needed to look at data going back as far as the 1970s and the era of hyperinflation.

The results gave us a surprise beyond our original curiosity.

Of course, bonds do well when central banks are slashing interest rates, but it turns out that what’s even better for bonds is when central banks come to the end of hikes.

Opinions are divided about whether cuts will come this year, how many and how soon. On the margin, some debate whether another one or two hikes might be necessary.

This first chart cuts through all that noise – what it tells us is that as long as the conviction has shifted away from hikes, then good times lie ahead for bonds.

2. So, is this the post-hike pause?

Yes, I think so. But having an objective way to discern how policymakers are leaning is key.

At Pendal, we employ the AI power of large language models to help us decipher “central bank speak” – be it from their statements, minutes or general speeches.

This thinking is not novel, but our methods are unique.

When you do nothing to the raw language coming out of central bankers’ mouths, generative AI tools have a hard time delivering useful results for investors; ten attempts may well lead to ten different answers.

By design, language models prioritise syntax (language) over logic. Our methods look for ways to clean the raw language to make it as straightforward as possible.

The crucial test for whether our measures are useful is the presence of a relationship to local policy rates and yields.

When Pendal’s hawkishness scores peak, policy rates and front-end yields usually peak as well.

What these charts show is that both the RBA and the Federal Reserve have passed their peak hawkishness. Peak policy rates and yields won’t be far away, if not already behind us.

This is most likely the post-hike pause where bonds do their best work.

3. Don’t just close your eyes and buy

Yes, bonds are back. Yes, the time is now. But the road for fixed income has been bumpy.

Active management matters the most when markets are volatile.

As the above chart shows, when volatility spikes, the dispersion between active managers’ performance in fixed income really stretches out.

What you can’t see from the chart is that first-quartile managers during the calmer times are rarely able to keep their positions in more volatile times. This makes sense because you need different active tools in different volatility regimes.

Volatility today is about as low as it has ever been in the last three decades.

Now is the time to ensure that not only is your fixed interest exposure allocated to an active manager, but that the managers you choose have what it takes to weather the next spike in volatility.

Here are the main factors driving the ASX this week according to Pendal investment analyst ANTHONY MORAN. Reported by portfolio specialist Chris Adams

• Economic data points to a slowing US economy
• Australia’s Budget is increasingly stimulatory
• Find out about Pendal Focus Australian Share fund

IT WAS a bullish few days for assets last week as the US monthly consumer price index broke its run of hawkish surprises.

Instead, the inflation print delivered in line with expectations, validating a recent decline in bond yields and the US Dollar Index.

We also saw a continuation in the run of softer, but not disastrous, economic news – reinforcing the narrative’s switch back from “no landing” to “soft landing”.

In response, US equity markets hit fresh highs; the S&P500 gained 1.60%, the S&P/ASX 300 rose 0.98%, while commodities and bonds also moved higher over the week.

As a result of recent data, the market is now pricing 45 basis points (bps) of rate cuts in the US this year – with an 85% chance of a first cut by September.

At the same time, the Atlanta Fed GDPNow tracker estimates that the US economy will grow 3.6% in Q2 2024.

On balance, this combination is positive for markets and – given the slower pace of change in the data – may support this environment through the Northern summer.

However, Federal Reserve Chairman Jay Powell noted that while he expects inflation to come down, his confidence is not as high as it had been and that it may take longer than expected for restrictive policy to help bring inflation down to target.

So, bond yields overshot in mid-April, but it is hard to see them moving much lower from here in the short term given the large pullback from peak.

We also need to keep a close watch on company earnings for any sign of impact from a slowing economy.

US macro

Inflation

The monthly US CPI provided the week’s marquee data point.

The upshot is that the print was reassuring, but it needs to ease further to allow rate cuts.

The backdrop was concerning as the April core Producer Price Index (PPI) had come in at 0.5% month-on-month versus the 0.2% expected.

However, the market’s reaction was muted given that:

1. March was revised down from 0.2% to -0.1%, leaving year-on-year core at 2.37%, which was in-line with consensus
2. There was slower growth in components of the PPI that fed into the core Personal Consumption Expenditures (PCE) deflator – the Federal Reserve’s preferred measure of inflation – such as insurance and airfares.

The University of Michigan’s monthly survey of inflation expectations data had also seen an uptick in one-year-forward expectations from 3.2% to 3.5%.

However, core CPI came in at 0.29% month-on-month in April, which was in line with consensus.

Importantly, it slowed from March – breaking the sequence of upside surprises that has been causing market anxiety this year.

The market also liked seeing year-on-year core CPI slowing to 3.6% – the lowest reading since April 2021. This helped take the risk of a rate hike off the table and gave some support for rate cuts this year.

Digging into the data, we can see that the deflationary impulse from Goods remains but is shrinking.

Core Goods inflation was down 0.11% month-on-month, but up 0.4% once used cars and trucks were excluded.

The big change was a healthy deceleration in core Services (excluding rent/owners-equivalent-rent or OER) from 0.65% month-on-month in March to 0.42% in April.

This is the lowest reading since December, but still well above target.

Rent/OER continued to trend lower.

Looking forward, on the positive side, gasoline pricing may have peaked and insurance repricing has largely occurred, possibly reducing their upwards pressure on inflation.

On the downside, rent growth appears to have stopped slowing.

Shelter cost is particularly important; if it is stripped out, CPI has been largely in line with the Fed’s target since June last year.

The concern is that this has flattened out and the deflationary impulse from rent will start to ease off.

There are some encouraging signs in the housing market, which may flow into rental availability: single family housing inventory is increasing and the year-on-year price growth in housing appears to be slower.

As a result, the Fed may want to keep rates on hold until a loosening housing market is more entrenched.

Economic data

Other data pointed to a slowing economy, but not one falling off a cliff.

This reinforced the notion of a soft landing and so, in this case, bad news was good news.

US retail sales were flat during the month, with higher gasoline spending draining consumer wallets. We note this follows a couple of strong months of spending, so cannot yet call it a trend. 

Softer retail sales were perhaps not a surprise, given real average hourly earnings fell 0.2% month-on-month in April.

Initial jobless claims are increasing but, again, it is too early to call this a convincing trend – particularly as it is not showing up in continuing jobless claims data yet.

The NAHB Index (a measure of homebuilder sentiment) fell to 45 in May, but this is likely to reflect the recent rise in mortgage rates, which has since unwound.

Industrial production is going sideways and manufacturing output fell 0.3% month-on-month. Both the Philadelphia Fed and Empire Manufacturing surveys were also softer.

China

Recent data suggests that the Chinese property market is not healing.

Macquarie Macro Strategy research suggests that existing home prices in 70 major cities fell 6.8% year-on-year in April – the fastest decline on record.

A sharp fall in mortgage interest rates is not supporting the market.

Beijing announced a number of supportive measures, including:

• removal of mortgage floor rate 
• lowering of minimum downpayment requirements
• directives for local governments to acquire homes at “reasonable” prices and turn them into affordable housing.

There is some market debate about this.

It is incrementally positive on the policy side, but there is also concern that the actual size of this stimulus will not be enough to make a material difference.

What we can see is further evidence of a twin-track economy emerging, with industrial production strong but consumption weak.

Industrial production grew ahead of expectations at 6.7% in April – with Autos (up 15%), semiconductors (up 32%) and solar panels (up 11%) all strong, while steel, cement and coal were all weaker.

On the other hand, fixed asset investment (FAI) grew 3.6% and retail sales grew 2.3% year-on-year, both weaker than expected.

So exports – and possibly inventory builds – are currently underpinning Chinese growth.

For example, Chinese exports of autos grew 34% year-on-year in the period January to April, driven by electric vehicles (EVs).

The issue is that the Biden Administration has just announced a 100% tariff on imported EVs, as well as increased tariffs on semiconductors, batteries and solar cells.

This only affects 4% of Chinese exports to the US, but it does set a protectionist precedent for other countries; the EU is also reportedly looking to introduce protective tariffs in some areas.

This potential threat to exports – and possible implication for the resource sector – needs to be watched closely given the current state of the Chinese economy. 

Australia

Our key takeaway from the Federal Budget is that it was increasingly stimulatory.

The $300 per household energy subsidy, rental subsidies and additional spending all adds up to healthy stimulus for households, coming in on top of the Stage 3 tax cuts in July. 

But might this stimulus be needed?

Unemployment surprised, with a jump from 3.9% to 4.1% in April.

There was a big jump in part-time employment (up 44.6k new jobs) while full-time employment fell 6.1k roles.

The key issue was the participation rate, which was up 0.1% to 66.7%, while the number of hours worked remained flat.

Employment is now growing slower than the population (ex-children and non-residents).

The government is looking to cut net migration, from 528k in FY23 to 395k in FY24 (upgraded from 375k) and then to 260k in FY25. That would take some pressure off housing, which should be deflationary.

The question is – will it be enough?

Commodities

Copper was up 7.7% for the week.

The catalyst may have been the combination of China property support measures, a weaker US Dollar, and trade measures which hinder movement of Russian and Chinese physical copper to US.

But short-dated contracts traded at a record high to longer-dated futures, indicating a physical shortage due to shorts being squeezed.

Short copper positions are at record highs, as are long positions.

One thing to note is that Chinese copper indices are depressed and inventories are at record highs.

There are many potential moving parts here, but it is a disconnection from normal copper markets which needs to be watched, given China consumes about 55% of the world’s copper.

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About Anthony Moran

Anthony Moran is an analyst with over 15 years of experience covering a range of Australian and international sectors. His sector coverage has included Australian Industrials and Energy, Building Materials, Capital Goods, Engineering & Construction, Transport, Telcos, REITs, Utilities and Infrastructure.

He has previously worked as an equity analyst for AllianceBernstein and Macquarie Group, spending a further two years as a management consultant at Port Jackson Partners and two years as an institutional research sales executive with Deutsche Bank.

Anthony is a CFA Charterholder and holds bachelor’s degrees in Commerce and Law from the University of Sydney.

Find out more about Pendal Focus Australian Share Fund  

Contact a Pendal key account manager

The allure of higher interest rates and certainty of returns from term deposits is strong, but the income advantage of bonds over term deposits remains clear, writes head of income strategies AMY XIE PATRICK

• Higher interest rates in 2023 made term deposits seem attractive
• Active income strategies have a role to play
• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Browse Pendal’s fixed interest funds

THE RESERVE BANK held the Overnight Cash Rate steady at 4.35% on May 7 for the fourth consecutive meeting.

At first look, this makes 12-month term deposits seem attractive.

The 2022 “everything sell-off” still haunts many investors, while the allure of higher interest rates and certainty of returns is hard to turn down.

At the margin, however, investors we speak to are starting to wonder whether there is more to life than term deposits — even in a higher interest rate environment.

Our answer? Yes!

Term deposit returns in 2023

Since 2022 was such a volatile and disappointing year for both defensive and risky assets, many investors found it better for their peace of mind to leave their capital in cash products at the start of 2023.

After all, one of the reasons bonds and equities had sold off together in 2022 was because inflation had been a problem and so interest rates had been raised across the globe.

In Australia, the RBA raised the Overnight Cash Rate from 0.1% to 3.1% in the space of six months.
This meant that at the start of 2023, 12-month term deposit rates on offer with the major banks exceeded 3.5%.

Since the economic backdrop looked far from straightforward, one-year return rates of between 3.5%–4% looked pretty attractive to lock in.

Indeed, last year was eventful and volatile.

US regional banks threatened to bring another credit crunch into the global financial system. Chinese property developers continued to be in dire straits with no sign of rescue from Beijing. Inflation continued to be a concern despite passing its peak. And at one point in the year, it seemed like the rise in bond yields was about to bring a repeat of 2022.

Yet, what we see below was the final scorecard of asset class performance in 2023, including 12-month Australian term deposits.

What Figure 1 highlights is that while the decision to turn to term deposits made complete sense following the market chaos of 2022, it is one you then have to stick with for the whole year – even as you see opportunities unfold again.

In short, locking in certainty isn’t a bad thing in certain environments, but it’s good to understand that this would also lock out opportunity along the way.

In today’s environment, what else should investors consider instead of term deposits?

It might be helpful to separate the market environment into four simple regimes, as depicted in Figure 2.

These regimes can be either high or low in volatility, as well as high or low in the interest rate backdrop.

The top-left quadrant of the diagram was a lot like the post-GFC period, where interest rates were low and headed ever lower. Most of that period was benign in terms of market volatility, minus a few short and sharp events.

Term deposits were unattractive in that regime and most investors went searching for yield in riskier assets.

In such a regime, high-quality (investment-grade) floating rate corporate bonds are likely to do a better job at generating income than term deposits.

Not only does a low-volatility backdrop support asset classes such as credit, but a floating rate bond will also not be hurt by interest rate rises should the RBA start to tighten monetary policy.

The bottom-left quadrant of the diagram is like the Covid crisis of 2020, even though it was relatively short-lived. Interest rates were low at the start of the pandemic, but they were slashed further as global central banks tried to provide economic stimulus.

Government bonds were useful to own back then, even if it seemed pointless to own them before the volatility hit since the interest they carried was so low. It seems that no matter how low interest rates get, government bonds still rally when the economy comes under stress.

Term deposits were also not a bad option if capital preservation was all that was required, but they could not have delivered the capital gains that government bonds did during that troubled period.

In the bottom-right quadrant, we see a period of both high interest rates and high volatility. This is a lot like 2022, where being in cash or term deposits would have at least saved you from the drawdowns in other major asset classes.

However, high volatility can set in because of concerns about growth as well, which would prompt central banks to cut interest rates in a hurry. Here again, term deposits cannot offer that upside.

The last quadrant is on the top-right and is probably closest to where we are right now. Interest rates are high, but volatility is low.

Term deposits are easily beaten by fixed-rate corporate bonds in such an environment because not only will yields be higher, but the fixed-rate nature of those bonds will also help to deliver capital gains should rates and yields fall from here.

Figure 3 is a stylised illustration* of how a 12-month rolling term deposit, a five-year floating rate corporate bond, and a five-year fixed rate corporate bond are all likely to perform in a gentle RBA easing cycle.

For simplicity, let’s assume that each of these investments are taken on in a passive way.

For the bonds, the investor holds them to maturity and for the term deposit, they are simply rolled at the end of every year into a new 12-month deposit.

The income advantage of bonds over term deposits is clear.

Even at today’s higher interest rates, the higher yield from corporate bonds (the credit spread) helps bonds generate a better income stream for investors.

At lower interest rates, only the fixed-rate five-year bond can continue to deliver a consistent income stream.

By years two or three, that income stream will look very generous compared to market interest rates that will be on offer.

What is an “active income strategy”?

In each of the four quadrants illustrated in Figure 2, active income strategies have a role to play. Let’s first define what an active income strategy is.

In the first instance, the role of any income strategy is to deliver income. Therefore, the “income engine” of these strategies needs to be made up of assets that pay regular income.

You might think of shares that pay a dividend, but those dividends are at the discretion of the company which is not contractually obliged to pay dividends (or any set level of dividends).

That’s why Pendal’s income strategies like to rely on corporate bonds for their income engine.

Here, we mean high-quality corporate bonds with defined coupons. Hybrids don’t count because once again, they have a provision that allows issuers to skip coupon payments should certain conditions arise.

The income engine itself ought to be actively managed – a high-volatility regime calls for a more cautious approach to taking on more corporate exposures and vice versa.

But other levers are needed on top of that.

When yields are low and volatility is high, government bond exposures are beneficial, but only up to a point. As the reflationary episode after the pandemic showed, you don’t want to overstay your welcome in government bonds when yields are super low.

Equally, higher yields are not a shoo-in for government bonds either, as the last two years have shown.

Active portfolio management to help time when and how much government bond exposure to take should be a key feature of active income strategies. After all, government bond exposures serve different purposes for income funds (as seen in the different quadrants of Figure 2).

In some cases, it is to provide diversification and defensiveness to the credit risk in the portfolio. In other cases, it is to help boost income returns on top of what the income engine is able to generate.

Lastly, we believe an active income strategy should offer investors a compelling way to chase returns when there is more upside on offer.

Rather than adding on more credit exposures to the portfolio, which will have negative quality and liquidity consequences down the road, active income strategies ought to be able to stay liquid while participating in more of the upside.

That liquidity is not only beneficial to investors who may want constant access to their capital, but also beneficial to the agile positioning of the portfolio.

An income strategy that pursues additional exposures only by piling on more corporate bonds will find it hard to dial that back if the market takes a sudden turn for the worse.

That’s not a big problem if it’s only a short-term hiccup, but it could be difficult to resolve should a longer-term bear market set in.

On the other hand, an active income strategy that pursues the addition of exposures through only liquid means will be able to switch off that exposure very quickly and efficiently should there be an unexpected shock.

If it turns out to be only a short-term hiccup, the liquidity of those exposures permits a quick restoring of exposures. If it’s something more fundamentally negative, then those timely risk-reductions would have been hugely beneficial for preserving capital for investors.

Conclusions

Higher interest rates in 2023 made term deposits seem attractive. But despite a volatile year for markets, term deposit returns looked disappointing versus bonds and equities.

Term deposits are great for capital preservation, but by locking in your rate of return, you may also be locking out a lot of upside opportunity.

It may be helpful to consider active income strategies as an alternative to term deposits.

Their income engines comprise corporate bonds offering a compelling yield advantage to term deposits, even if interest rates stay where they are for a long time.

The other active levers within Pendal’s income strategies are also designed to mitigate risk and improve returns regardless of the market backdrop.

Best of all, unlike term deposits, investors won’t be locked in if better opportunities present themselves along the way.

The case for investing Thailand | How the federal Budget will affect inflation | A simple way to explain ESG investing

The Australian government has unveiled its Budget. TIM HEXT, Pendal’s head of government bond strategies, looks beyond the noise at what it really means

• The government has unveiled its latest Budget
• As the dust settles, yields are sharply unchanged 
• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Browse Pendal’s fixed interest funds

WHEN you’ve watched enough federal Budgets (this was my 35th in markets), you start to see familiar patterns across commentaries.

Every vested interest or ideological bent comes out bleating about the Budget being irresponsible or reckless, that there’s too much spending or not enough major reform.

What worries me more is when people view the government as no more than a large corporation and when they speak of the budget like a profit and loss statement.

Looking through the noise and self-interest is what really matters for bond markets in the year ahead.

I have narrowed it down to three impacts.

Inflation

There are a number of direct measures that reduce inflation, one of which is electricity subsidies.

Every household gets $300 off their electricity bill, by way of quarterly $75 payments directly off the bill. Businesses receive $325.

The average household bill is $2,000 a year, so that’s 15% off.

Electricity is 2.4% of the CPI basket, so this equates to 0.36% off inflation in direct impact. The government is quoting 0.5% overall impact.

Queensland has already announced a $1,000 subsidy while Western Australia has announced a $400 subsidy, again not means tested.

It will be interesting to see what upcoming state budgets keep rolling existing subsidies (no impact to inflation), let them roll off (inflationary) or, like Queensland, increase them (deflationary).

If we assume modest subsidies coming up from other states, then the electricity impact on lower CPI could be 0.8% or even higher.

Other measures in rental assistance and cheaper medicines are slightly deflationary.

Overall, federal Treasury is forecasting inflation of 2.75% in 2024/25, which is below the current Reserve Bank (RBA) forecast of 3.2%.

We expect an upcoming downward revision of the RBA forecast of 3.8% CPI for 2024, which looked too high anyway. This could also see its 2024/25 forecast moderated lower, though still near 3%.

Tax cuts and spending

Against the direct impact of the Budget on lower inflation, markets ask the question of whether the extra money in people’s pockets may cause higher inflation if and when it is spent.

There is around $20 billion of new spending measures (the Stage 3 tax cuts have been locked in since 2019) in this Budget, with the majority in the next two years.

The Budget will return to deficit, with a forecast of $28.3 billion for 2024/25 and $42.8 billion in 2025/26.

While still low by international standards, the main question is whether or not deficits are appropriate at this point of the cycle.
It must also be noted that it also is based on the usual conservative commodity price forecasts.

For example, an iron ore price of US$60 is assumed, despite a current price nearer US$110 and a five-year average of US$120.

This opens up potential upside surprises as we have seen in the past few years.

This has really excited Budget hawks and has some calling for higher rates as all this money is supposedly spent, stoking inflation.

The question I would ask is whether or not this money is being injected into an economy at full capacity.

On this, my view is that we are sufficiently past the pandemic that supply chains can handle the modest rise in consumer spending without stoking inflation.

Consumers will be spending more in the year ahead. Tax cuts, subsidies and lower inflation should finally see some growth in real incomes – however, this is from a base of real incomes having for the past few years.

Bond issuance

We will see an update on the 2024/25 program from the AOFM shortly.

Given high refinancing (two benchmark maturities totalling $83 billion) the borrowing task is expected to be around $90 billion, as the RBA has borrowed much more than needed this year.

It is important to remember that when determining yields, bond demand and supply dynamics are largely outweighed by economics.

As a bond manager, I only view supply and demand as a short-term impact around supply events.

Ignore the booming debt rhetoric from some commentators and self-styled bond vigilantes – Australian debt will remain AAA for at least the medium term, and with the RBA moving to an “ample liquidity” framework, demand for bonds will remain robust.

So, what does this mean for bonds?

Well, the market always votes straight away, and has already made a half-hearted attempt to run with the higher spending higher inflation narrative.

However, as the dust settles (to quote the cliché), yields are “sharply unchanged”.

I think the RBA will see the Budget for what it is – a mixed bag of measures that will leave it hopeful of further inflation relief but wary of whether the 2%-3% band can be achieved and then sustained.

I would also make the observation that the “Future Made in Australia” spending is an overdue response to the global game-changing US Inflation Reduction Act.

By comparison, our government’s measures are modest for now, but can be expected to increase in the future.

We are in a very different world to the last decade and governments must respond.

For now, a more detailed breakdown of the domestic economy is below.

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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 Pendal’s head of equities CRISPIN MURRAY. Reported by portfolio specialist Chris Adams

• Equities continued moving higher last week
• Australian inflation remains key to market performance
• Find out about Pendal Focus Australian Share fund
• Watch Crispin’s most recent Beyond the Numbers webinar

EQUITY markets continued moving higher last week, triggered by the drop in bond yields.

Macro news flow, while limited, supported the signal that US growth is slowing at the margin. This is good for markets, as it brings rate cuts back into play.

The S&P 500 gained 1.89%.

The ASX 300 was up 1.78%, supported by bank results, which noted that the economy is holding up and margin pressures are abating.

A series of updates from other companies generally painted a picture of a solid economy, particularly on the industrials side – with upgrades from AUB Group (AUB) and AGL (AGL), good results from Orica (ORI) and Goodman (GMG), and an absence of material downgrades at the annual Macquarie conference.

The one area of potential weakness is in consumer discretionary stocks, which have underperformed the market.

We’ve also seen a significant shift in government energy policy ahead of this week’s Federal Budget.

The Federal Government is now embracing gas as a transition fuel and recognising the risk of a shortfall in gas supply from 2028, unless more development occurs or import facilities are built.

US economy

Credit

The senior loan officer opinion survey (SLOOS) – a quarterly update on the credit environment – suggested banks are still in credit-tightening mode, but the extent of that is flattening to slightly diminishing.

The US Federal Reserve pays attention to the SLOOS.

This result is consistent with its perception that policy is still somewhat restrictive but not deteriorating. Given the economy has been able to grow despite tighter standards, it suggests nothing should change.

Employment

Following softer payrolls data, we saw a spike in jobless claims last week.

However, half of this came from New York, suggesting it was a not a signal of broad-based deterioration.

Consumer expectations

The University of Michigan’s survey on consumer sentiment deteriorated while inflation expectations rose, which is at face value a negative signal.

The issue is that surveys in general have not given great signals.

For example, consumer sentiment fell in late 2023 despite a strong economy. There is a view that the heightened political tensions in the US may be having an impact on the measure.

Inflation expectations have been volatile, but they are important as it points to more persistent wage pressures. On a more positive note, the Conference Board surveys for CEO Confidence are improving, mirroring the better-than-expected economy and earnings.

US market update

Around 85% of the US market has reported quarterly earnings.

In summary, it has been a good season, with EPS up 6% year-on-year, versus 3% expected when results started.

This has been driven by margin improvement rather than revenue growth, which highlights both the issue of industry structure, and that economic resilience enables more pricing power.

The other observation is that the better earnings tended to be concentrated in the larger stocks rather than the median.

The rally in bond yields has put a floor under the market’s recent correction, and it seems likely we’ll see a test of the prior high.

Volatility has eased off, which is supportive, and we have seen key sectors like the banks already back at their highs.

There is an interesting signal in European equity markets – these have performed well recently, reflecting a more benign inflation outlook than the US and greater scope for rates to fall.

This is also reflected in European bond markets, where yields are rolling over.

The relevance for Australia is that our inflation performance is key to how well the market does. This week’s Budget will be important to see the level of restraint in fiscal spend, which can impact rates.

Australian equities

The combination of results for March-end reporting companies and the Macquarie conference meant there was a lot of stock news.

Banks saw earnings fall but signalled that they were not seeing any signs of economic deterioration, with asset quality good, a steady pipeline of business loans and margins stabilising.

Orica (ORI) offered a good example of an industrial company managing sluggish volumes with more value-added products, helping improve margins.

Consumer trends are divergent.

Some retailers are seeing a slight slowing of sales; combined with cost growth, this triggered market concerns on margins.

However, Qantas (QAN) is seeing no slowdown in travel demand, with some small improvement in the corporate travel market. The upshot is we remain of the view that the market can continue to move higher, with individual stock stories – rather than macro factors – re-emerging as the key driver of performance.

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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  

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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

• Environment may signal equities pushing higher
• Find out about Pendal Focus Australian Share fund
• Watch Crispin’s most recent Beyond the Numbers webinar

WE saw a reversal in recent trends last week.

After rising 47bps in April, US 10-year government bond yields fell 16bp last week, triggering a continued bounce in equities.

The S&P 500 gained 0.56% and the NASDAQ lifted 1.44%.

This followed dovish comments from US Federal Reserve chair Jerome Powell after US interest rates were left unchanged.

Powell clearly indicated rate hikes were not on the agenda and the Fed did not expect a recent jump in inflation to be sustained.

A subsequently softer payroll report and moderating average hourly earnings data lent credibility to his comments.

The fall in bonds yields was reinforced by a 7.3% drop in Brent crude oil on higher weekly inventories.

The key question is whether this is the beginning of a larger reversal in bond yields as inflation momentum begins to wane.

We suspect this will happen, though we anticipate a relatively moderate bonds rally given resilience in economic growth and recognition of structural factors supporting inflation. 

Trends also reversed in currency markets (with a potential near-term top in the US dollar/Japanese yen trade) and Chinese equities (where internet stocks have made strong gains this month).

Such an environment may signal the equity market is going to push higher.

US earnings have been supportive. Apple was the latest tech name to surprise on earnings and capital management.

In Australia the S&P/ASX 300 rose 0.74%, supported by tech and banks stocks. National Australia Bank’s half-yearly results were largely as expected and the CEO struck a positive tone.

In contrast, Woolworths delivered another disappointing sales update, indicating they were seeing consumers “trade down”.

US inflation and policy outlook

The Fed left rates on hold, as expected.

The focus was on Powell’s press conference and the potential for rates to rise after recent disappointing inflation data.

The market was pricing a 30 per cent chance of a hike by year’s end.

Powell firmly knocked this back.

He acknowledged a set-back on the path to 2 per cent inflation and the need for rates to stay on hold for longer.

But he also noted policy was already restrictive and the question was therefore how long rates should be kept at current settings.

Powell noted the criteria which could allow rates to fall – such as unexpected easing of the labour market – rather than the factors that could lead to a rate rise.

This was likely a deliberate signal on where the Fed is focused.

He also indicated that the Fed expected inflation to move back down this year, noting recent pressure was tied more to lagging factors built into the inflation-measuring process (eg healthcare and rents) as well as confidence in a supply response to support disinflation.

Our conclusion remains that while the Fed retains its current “hold” bias, there is a skew towards looking for reasons to cut rather than reasons to raise rates.

The market’s implied expectations of a rate hike this year have fallen back below 10 per cent.

Liquidity a key factor

Market liquidity has been a key factor driving the equity rally from November 2023.

After the FOMC meeting, the Fed announced a relatively dovish slowdown in Quantitative Tightening (QT) from US$60 billion per month in US Treasury bonds to US$25 billion, effective from June.

This is important as it supports the liquidity environment for markets – and extends that support well into the northern summer. 

Elsewhere, the US Treasury announced its projected financing requirements for the September quarter. This is watched carefully since it also affects market liquidity.

Last year more financing was shifted to the short end of the yield curve, which supported liquidity and helped turn markets around.

This time the plan is a moderate reduction in the Treasury General Account (ie their cash on hand) from US$940 billion to US$850 billion. This is not as aggressive as some looked for, but still partly offsets bond issuance.

The mix of issuance remains largely unchanged, retaining the relative skew to the short end of the curve.

The reverse repo market can also serve as a source of further funding for Treasury issuance in coming months.

US economic outlook

The economy continues to hold up well, but there are signs employment growth is slowing.

US employment

April non-farm payrolls rose 175k, well below a three-month average of 269k and 240k consensus expectations. There were also net revisions of -22k for February and March.

The government sector drove the downside surprise, adding just 8k jobs versus a 60k average over the past six months.

The private sector held up at 153k new jobs, with healthcare and social assistance representing half the rise.

The forward signals are mixed. The NFIB small business survey indicates a material slowdown over the next few months, while jobless claims data is more benign.

The average US work week fell marginally to 33.7 hours — another sign the labour market could be weakening.

Average hourly earnings also softened from 4.1% year-on-year in March to 3.9% in April. There was weakness in leisure, hospitality, construction and government.

This reinforces the signal that wage growth is slowing towards a level consistent with low inflation in the low 2 per cent range.

A household survey saw unemployment rise from 3.83% to 3.86% – not quite as large as some were expecting.

We have crossed a threshold for the “Sahm Rule” – which indicates that a 0.5% increase in unemployment signals a recession will follow.

We have some reservations about this rule and do not read too much into it.

The outlook for lower wages was supported by the latest Job Openings and Labor Turnover Survey from the US Bureau of Labor Statistics.

Notably, the favoured “Quits” rate – a decent lead indicator on wages – continued to move lower. Its current level is consistent with 4.5% unemployment based on historic data.

While we note there are still structural factors underpinning inflation, this is all supportive of easing inflationary pressure in the near term.

US service sector activity

There was some focus on the US services sector after an April ISM survey showed a fall of two points to 49.4 – its lowest point since the pandemic.

The data suggested the worst of all combinations: business activity down materially and new orders also lower, while pricing expectations were higher.

We note this is a volatile series, where weather can play a part. But it does provide a warning shot, particularly in the context of a series of consumer facing companies such as McDonalds and Starbucks signalling weaker demand.

The April S&P Global US Services PMI remains above 50 – and the ISM had been running above it for some time.

We may be seeing a convergence of these series, rather than a material change in trend.

Markets

US earnings season

First-quarter US earnings have been positive, partly reflecting a low bar of only 3 per cent expected earnings growth.

The response to beats is also much more muted than normal, suggesting the market was positioned for good news.

Apple provided a boost to both the tech sector and overall market, with earnings coming in better than many had feared.

There is also a shift in sentiment towards the potential impact of AI – from concerns that it posed a risk to Apple’s outlook, to speculation it may drive a handset upgrade cycle.

Looking across the tech sector, several trends have been supportive:

1. Demand is strengthening and prices are increasing, supporting revenue growth
2. Capital returns picking up; Alphabet and Meta both announced their first dividends in 2024, alongside share buy-backs
3. Rising profitability; margins are up in 80% of internet companies as a result of greater focus on costs
4. The AI cycle; AI use cases are increasing the focus on cutting costs and improving services.

Market signals

There has been some notable price action, likely tied to the reversal in bond yields.

Technology stocks and gold miners represent two ends of the thematic spectrum.

The former’s surge in outperformance from October to February (measured by the Technology Select Sector SPDR Fund versus the VanEck Gold Miners ETFs) reversed entirely in March and April —  but now may have turned higher again.

This may be supportive for equities given tech’s weight in global indices.

There are a couple of other reversals to watch, which are potentially positive signals for the market:

1. The USD/JPY currency cross rate, which has seen a material reversal off sentiment extremes.
   This may be a catalyst for the US dollar trade-weighted index to start easing. This is positive for markets as it supports liquidity.
2. A potential shift in sentiment towards Chinese equities. This may be seen in the KraneShares CSI China Internet sector ETF, which has been in extended bear market. There has been a material break higher in recent weeks — on short-term time frames at least. This reflects changing sentiment on the Chinese market combined with very low exposure to it. Allocation to China in active global equity funds is at it record lows — and in the first decile of historical allocation by one measure.

What does this all mean?

We think it means markets are probably supported at current levels and we could see rotation back to higher beta sectors — those stocks with rate exposure such as telcos and REITs, as well as China consumer-related names.

Australian market

National Australia Bank (NAB) delivered the first bank result — which seemed good enough to sustain the sector’s premium valuation rating — with a surprisingly positive message from the new CEO.

Consumer anecdotes were softer, notably from Bapcor (BAP), Ampol (ALD) and Woolworths (WOW).

Gold stocks rolled over reflecting the bond reversal, while lithium names ran higher on a clean-out of IGO’s (IGO) inventory by its Chinese partner.

High-quality growth names began to run again (eg Goodman (GMG), Xero (XRO), Pro Medicus (PME)), reflecting more positive sentiment on rates.

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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  

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Pendal named in Fund Manager of the Year Awards | ASX small caps back in favour | Two EMs set to benefit from lower rates | 10 investor themes for 2024

Aussie small caps are once again outperforming large caps. Pendal portfolio managers LEWIS EDGLEY and PATRICK TEODOROWSKI explain why

• ASX small caps are back in favour with investors
• Earnings holding up better than expected
• Find out about Pendal Smaller Companies Fund

AUSSIE small caps are once again outperforming their large-cap counterparts after a period of underperformance in recent years.

Conditions have turned in favour of ASX-listed small caps in recent months and Pendal portfolio managers Lewis Edgley and Patrick Teodorowski believe that trend will continue.

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. (Teodorowski has been with the fund for 14 years and Edgley for 11.)

In this article, the pair explain why small caps underperformed, how conditions have changed and what they’re doing to take advantage.

Why small caps under-performed in recent years

Small caps underperformed large caps in 2022 and 2023 as higher rates and recession fears pushed investors towards larger, more established companies.

When markets first anticipated a rapid post-pandemic rate-rise cycle, that precipitated a significant underperformance of small caps, relative to large caps, says Edgley.

Many companies in the large cap index — such as banks and insurers — were natural beneficiaries of a rising interest rate environment.

“In the small-cap universe, the composition was quite different,” Edgely says. “For example, we’ve got a large proportion of real estate trusts where rising rates hurt their valuations.”

“We’ve also got a high degree of economically-sensitive businesses.

“When you have a fear of recession these businesses are typically sold off. That happens in advance of any earnings impact as sentiment weighs on those types of businesses.”

At the start of that period small caps had a significant premium compared to large caps, which also exacerbated their relative underperformance.

How conditions changed in favour of smalls

This year, as recession fears dissipated and inflation began moderating, investors regained interest in smaller companies.

“We’ve had the US Fed on hold and the Australian RBA on hold, and in that environment the market starts to anticipate things improving and a shift to the other side of the interest rate cycle, which is rate cuts,” Teodorowski says.

“We’ve also subsequently seen earnings hold up significantly better than investors feared.

“We’ve seen a re-rating of companies that were most likely to feel the pain of higher interest rates.

“More fundamentally, over the past two earnings seasons we’ve seen greater resilience out of the more cyclical companies within our index.

“They’ve been able to manage their earnings far better than the market expected.”

Materially lower valuations and a low Australian dollar has prompted more merger and acquisition activity in the last six months, says Teodorowski.

An expected flurry of “new and bigger Initial Public Offerings” should also see increased demand and investment opportunities.

What sets Pendal’s small caps team apart

“We believe a few things set us apart as quality small-cap investors,” says Edgley.

“The key driver is the breadth and depth of the team.

“We’re a team of five. That would be one of the largest, dedicated small cap teams in the market.

“We’re also supported by the broader Pendal Aussie equities team. So in total there’s 19 of us.“

A larger team allows Pendal to cover a lot of ground — which is very important in small-cap investing, Edgley says.

“The small-cap universe is very diverse by sector. There are always new moving parts. The refresh within the universe is significant.

“With sectoral responsibility across all areas we’re able to make active decisions in certain sectors, and we think we’re able to make the best investment decisions.”

Active management important

“The process has always revolved around going out and wearing out boot leather,” says Teodorowki.

“We do a lot of direct meetings with the management of companies. We meet with other industry participants, whether customers or competitors.

“That’s always been a big part of the process in coming up with a view on a business.

“Another big part of our process is peer review. Lewis and I are not only portfolio managers, we’re analysts.

“When any idea gets brought to the team, we all sit around as a group and debate the merits of that investment as a team.

“The five people in the team are very experienced. This brings a different lens into analysing the business. It normally raises additional questions and drives deeper research into the investment idea.”

Says Edgley: “It’s very much style-agnostic, bottom-up idea generation. “We take a pragmatic view of the opportunities in front of us and converting those opportunities.

Here are the main factors driving the ASX this week according to Pendal portfolio manager JULIA FORREST. Reported by portfolio specialist Chris Adams.

• Underlying inflation in Australia remained well above the RBA’s target in Q1
• The GDP print in the US suggested ongoing economic strength
• Find out about Pendal Focus Australian Share fund

LAST week was a big one for macro data.

In the US, headline Q1 2024 Gross Domestic Product (GDP) growth came in relatively soft at 1.6%, versus 3.4% in the prior quarter and the 2.5% expected.

At the same time, the Q1 Core Personal Consumption Expenditure (PCE) deflator – a measure of inflation – accelerated to 3.7% annualised, versus 2% in Q4 2023 and the 3.4% expected.

As a result, US bond yields continued their climb, with ten-year Treasury yields ending up five basis points (bps) for the week at 4.67% and the market increasingly implying a first rate cut by the Fed in December. 

Chicago Federal Reserve President Austan Goolsbee said that the Federal Open Market Committee needs to “recalibrate” its stance – noting that “progress on inflation has stalled” in 2024 and that after three months, this signal “cannot be dismissed”.

While it was a bumpy week for data, there was an underlying tone of resilience, with the market finding comfort in US Q1 earnings.

The Nasdaq and SP500 ended up by having their best week since November, returning 4.23% and 2.68%, respectively.

AI optimism lifted Alphabet (+10%) across the US$2 trillion market cap threshold, while Nvidia (+6%) and Microsoft (+2%) also gained.

The S&P/ASX 300 was up 0.12%.

The Australian Q1 2024 consumer price index (CPI) came in at 3.6% year-on-year versus the 3.5% expected, slowing from 4.1% in the previous quarter.

The “trimmed mean” measure preferred by the RBA rose 1.0%, again above forecasts of a 0.8% gain.

Following the data release, the Aussie Dollar jumped 0.7% to $0.6530 versus the US Dollar before settling at $0.6517, while yields on the 2-year (up 31bps) and 10-year government bonds (up 27bps) moved higher to trade at 4.18% and 4.52%, respectively.

The two things that the RBA focusses on – employment and inflation – are both above target, with the recent unemployment rate 20bp below the RBA’s forecast (3.9% vs 4.1%) and the trimmed mean inflation now 20bp above (1.01% vs 0.8%).

US macro

Headline GDP growth of 1.6% for the first quarter was softer than the 2.5% expected and the 2.7% forecast by the Atlanta GDPNow measure.

However, the breakdown was quite constructive, as final domestic demand remained solid (up 2.8%) for the quarter – with robust contributions from consumer spending, business fixed investment and residential investment.

The drag came from net exports (down 0.86%), driven by strong import growth apparently related to technology (computers, parts, semiconductors and telecommunications equipment).

In sum, the GDP print suggested ongoing economic strength in the US.

The Atlanta Fed GDPNow estimate for Q2 GDP growth is near 4%, which further fortifies upside risks to the inflation outlook.

The annualised Q1 Core CPI growth of 3.7% was the strongest quarter since the early 1990s, excluding the immediate post-pandemic period.

Core services ex-housing is the key driver, growing at a three-month-on-three-month annualised rate of 5.2%.

This is largely driven in turn by wage growth, where there are some possible early signs of cooling in measures of labour market hiring plans, the quits rate, and the Atlanta Fed wage growth tracker.

However, the US macro backdrop remains strong, with the ISM Manufacturing index showing a big uptick in 2024 and – importantly for markets – earnings fears as reflected in 12-month forward earnings-per-share estimates seeming to have passed.

The combination of sticky inflation and economic resilience raises the question of whether the neutral rate is as low as the Fed and market previously thought and, by extension, whether policy settings are as restrictive as assumed.

Financial conditions are now looser by the Chicago Fed’s own metric than at the beginning of 2022, when rates were effectively at zero and the Fed was still officially saying that inflation was transitory.

The Fed significantly eased financial conditions late last year via its “dovish pivot”, which reduced the global cost of both equity and debt capital.

Fiscal policy is working against the Fed’s rate settings.

The economy is resilient, unemployment is at 3.8% (too low to reduce inflation), and wage growth is strong (albeit slowing).

However, the US fiscal deficit is -6.2% and it is unusual for large deficits in boom times – normally it is the result of recession.

We are a little over six months out from the US Presidential Election and a balanced budget is probably the farthest thing from the mind of either candidate.

As such, the Fed is likely to continue to lean against the continued fiscal dominance.

The problem for the stock market is that rates seem too high to allow equities to push through to higher levels, but not high enough to create the kind of economic slowdown that forces the Fed to ease.

Australia macro

The Q1 3.6% twelve-month growth in Australian CPI slowed from 4.1% in Q4 2023, but by less than the 3.5% expected.

Nearly half of Australia’s CPI basket rose at an annualised rate of more than 3% in the March quarter.

The trimmed mean measure rose 1.0% in Q1, versus the 0.8% seen in Q4 2023 and expected again. The twelve-month rate dropped from 4.2% to 4.0%.

Several components appear to be sticky, notably in domestic market services lifted by rents, insurance and education costs.

Rental prices rose 2.1% for the quarter, in line with low vacancy rates across the capital cities. Rents continue to increase at the fastest rate in 15 years.

On any measure, underlying inflation in Australia remained well above the RBA’s target in Q1.

There are some signs that the labour market is beginning to soften, but wage rates remain too high to be consistent with the RBA’s targets.

Monetary policy is working its way through the system, lifting debt service costs and reducing household disposable income.

However, the Stage 3 tax cuts are likely to see an uptick in retail spending from July, with a possible additional $23 billion in spending capacity in FY24/25.

If 75% of this is spent, this could see a 4.1% lift in retail sales.

Europe/UK macro

The Euro area Composite Purchasing Managers’ Index (PMI) came in at 51.4 versus the 50.7 expected, while the Services PMI was at 52.9 versus the 51.8 expected.

The UK Composite PMI was at 54.0 versus the 52.6 expected. Recent data has been solid and picking up, suggesting that economic activity – having initially been shocked by a shift from zero rates – is now adjusting.

US earnings season

With the US market near its most concentrated in history, earnings for the “Magnificent 7” were crucial to markets.

Three of the four that reported were well received (Tesla, Microsoft, Alphabet), with only Meta disappointing – here’s more:

• Alphabet beat expectations for revenue, operating income and EPS. It also announced its first ever dividend and an additional US$70 billion buyback.
• Microsoft beat consensus EPS expectations and highlighted the growth of its cloud computing business and its efforts to bring AI technology to clients.
• Tesla missed on revenue ($21.3 billion versus expectations for $22.3 billion) and earnings estimates for Q1, noting that “vehicle volume growth rate may be notably lower” in 2024 than in 2023. However, investors were upbeat on the company’s strategy going forward, with a focus on “accelerating” the rollout of new, cheaper models. There are some interesting potential parallels between EVs and today’s enthusiasm for AI. Three years ago, EVs – and Tesla in particular – were expected to take over the world. However, competition has been intense in the sector (especially from China) and demand disappointing in some regions.
• Meta saw lighter revenues and higher expenses and capex as it looks to spend more on AI. 2Q24 revenue guidance was below consensus. There is a concern being that advertising revenue is slowing due to geopolitical events.

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