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

• Find out about Pendal Focus Australian Share fund
• Pendal’s Crispin Murray reviews the lessons from 2023 and outlook for 2024

THERE was nothing to de-rail the market’s bullishness last week, after the US Federal Reserve signalled its inflation mission had been accomplished.

The reaction was very positive with the S&P 500 up 2.5%, now 25% higher year-to-date.

US yields also fell by 30 basis points (bps) and have now ended up where they started at the beginning of the year.

Market price action is positive, with breadth widening and momentum indicators breaking higher and indicating the pathway to moderate growth and falling rates (ie a soft landing) is in sight.

Near-term consolidation will likely occur in the short term before another move higher into the start of 2024, which bodes well for risk assets.

In addition, last week we saw mildly positive inflation data on a net basis, with US economic data supportive of no imminent recession.

In Europe, the ECB and BoE both took a more cautious stance on the prospect of rate cuts – with the former struggling with weak economic data and the latter more understandable given England’s inflation.

China’s policy meetings were mildly disappointing. There were no strong policy signals, but the background message appears to be that fiscal stimulus would continue to be used to prop up growth.

The S&P/ASX 300 was up 3.5% for the week. The Australian economy continued to signal that things were better than sentiment suggested with a strong employment report.

This was reflected in a break higher in the Australian dollar to more than 67 cents.

Economics and policy

Inflation data came in as expected and continues to trend downward on a net basis.

In November, US CPI was higher at 0.1% month-on-month and 3.1% year-on-year.

Core CPI was firmer at 0.28% month-on-month and 4% year-on year.

There was a bit for the bulls and bears – with core goods seeing material disinflation despite a strong auto inflation component, which should unwind.

The service component was not quite as favourable, with rent growth remaining higher than expected. This is somewhat discounted, as more real-time measures of rents are now flat year-on-year.

Core services ex-OER (Owner’s Equivalent Rent) and rent also saw a small re-acceleration over a three-month period.

Medical services and health insurance were the main drivers in this underlying core services pick-up, but it should be noted that these services are known to lag the most – suggesting that inflation is not, in fact, rebuilding.

This will make the next PCE print (the Fed’s preferred measure for inflation) important, as we are seeing a divergence here from the CPI.

We also saw weaker PPI data in the US, and Michigan inflation expectations also fell back down.

In other US economic news retail sales bounced back, up 0.3% versus expectations, though negative revisions reduced part of this.

The underlying trend looks to be around 2.5% growth, which is consistent with the outlook for a soft landing. This means the overall inflation trend is still supportive for the Fed to shift its policy signal, with the headline target of 2% now plausible.

The Fed

In its meeting, the Fed clearly shifted its policy bias.

The market was initially wary that Chairman Jerome Powell would seek to settle things down given a fall in financial conditions since he spoke, and a warning from Fed member Christopher Waller.

But we got a set of dovish signals:

• The dot-plots signalled a move from two to three expected cuts in 2024
• Powell noted there had been discussions on how long to keep rates on hold before cutting. This was expected to be a topic for a more detailed discussion going forward
• Powell noted good progress on inflation, including core and core services
• He also talked about the risk of over-tightening. This was an important shift, relating to the central bank’s desire to avoid having to cut rates too far this cycle
• When pushed about the current easing of financial conditions, Powell did not use the opportunity to diffuse the reaction.

All up, the meeting was taken as a green light for markets.

The following day, Fed member John Williams of New York did try to diffuse the message – particularly given the move to March cuts by the market. But it was met with little reaction since the market believed the data would support a cut then.

The market is now expecting six rate cuts in 2024.

There is a concern from some that the Fed has been too dovish, which may prevent a proper slowdown – resulting in a resurgence of inflation. 

European Central Bank

President Christine Lagarde took a more cautious stance than Powell, repeating her message of no cuts in the first half of the calendar year, but her message was largely ignored given the perceived weakness across Europe.

She said the ECB had not discussed the timing of cuts, though the market has been pricing in 150 bps of rate cuts in 2024.

China

November data looked better year-on-year.

For example, retail sales were up about 10%, though they have been weak sequentially.

The outlook remains consistent. GDP growth is steady in the low fives for 2023 and the market expects this slowing between 4.5% and 4.8% in 2024.

Last week, the December Politburo meeting and the Central Economic Work Conference took place, where key economic targets are set (but not announced until March).

Signals were for policy support focused on fiscal policy, though there were no major initiatives which was seen as slightly disappointing.

Australia

Employment data was much stronger than expected (up 61,500) despite a marginal rise in unemployment (to 3.9%) given the continued rise in labour supply.

Total hours worked were flat, which implies average hours worked was lower.

This indicates that businesses are looking to save costs by lowering hours rather than layoffs – possibly due to the difficulty of rehiring in the past.

Forward indicators on unemployment still indicate it should be set to rise further, though these signals have so far not been validated.

Markets

The Fed cutting rates is not necessarily a green light for equity markets, as in the end, the economy gets the final say.

If a recession were to occur, the de-rating of earnings would overwhelm the benefits that the lower rates would bring.

This is why GDP growth next year is key.

We are also seeing some interesting shifts in market internals on the back of this. Notably, mega-caps have done their dash and market breadth is rising.

This can be tracked in the relative performance of the Russell 2000 vs the S&P 500.

For small-caps, this is a particularly positive signal for them to outperform.

Another interesting disconnect is that the market has a very different perspective on the economy than some of the traditional leading indicators of growth, shown by the rotation away from defensives to cyclicals. 

This makes early 2024 interesting, as the cyclicals would be sensitive to any weak growth.

In Australia, the ASX saw a broad-based rally with only utilities underperforming.

Rate-sensitive sectors such as REITs and tech led the market.

Energy was supported by the bounce in oil and the continued fallout of the potential STO-WDS merger.

Lithium stocks also had a strong bounce back given how oversold they have become.

Lastly, this environment looks to be positive for the AUD, which continues to look good technically.

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About Crispin Murray and Pendal Focus Australian Share Fund

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

Pendal is 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

What did investors learn in 2023? What are the main issues facing us in 2024? Here’s an overview from Pendal’s head of equities CRISPIN MURRAY

• Find out about Pendal Focus Australian Share fund
• Fixed income: Pendal’s 2024 outlook for bonds, credit and cash

2023 year in review

EACH year Pendal’s head of equities Crispin Murray outlines the major factors that will affect investors in the coming 12 months.

Here Crispin reviews the big issues of 2023 and how they played out.

Further down he outlines the major factors for 2024.

1. Inflation persistence and tightening of financial conditions

Inflation fell faster than hoped in 2023 and key exogenous factors such as oil broke the right way.

Core inflation looks set to fall below 3% by the end of 2023 — and is within striking distance of the RBA’s 2% target.

This has been achieved without the need for a more severe economic slowdown.

2. Scale of US versus domestic economic slowdown

Wages – one of the lead indicators of underlying inflation – fell in 2023 without the need for materially higher unemployment.

This was because job openings shrank quickly and participation rates increased.

One hypothesis is that those holding back from labour markets stepped back in as excess savings were deployed alongside higher immigration.

Meanwhile job openings shifted down as firms worked through post-pandemic shortages.

3. Earnings leverage to downturn

No downturn meant no leverage came through. US earnings per share (excluding energy) is forecast to rise 4%, while the 2024 forecast is around 5%.

4. Did markets price in an economic downturn?

This proved to be important. Sentiment and positioning were very negative at the start of the year.

Therefore, the impact of the economy growing with inflation falling was exaggerated. US markets are up some 25 per cent year-to-date.

5. China’s economic performance as it exits zero-Covid

This disappointed after a promising first quarter. A lack of recovery in the property sector continued to impact consumer confidence.

Contrarily, this probably helped global equities. With stimulus helping steel and iron markets, oil demand was not squeezed too much and contributed to a more benign inflation outcome.

6. Could the RBA engineer a soft landing in Australia?

Australia saw stronger-than-expected growth in 2023. The mortgage cliff has – to date – been navigated through higher immigration, an ability to work more hours, higher wages, more excess savings, and supportive fiscal policy.

Inflation remains a bigger issue in Australia than the US and Europe, so the RBA cannot yet declare victory.

Key questions for 2024

Let’s now look forward. Here are the questions to consider in 2024:

1. Where is the strength in the US economy?

Will the monetary-tightening lags eventually flow through and trigger a much-anticipated recession?

Or will the easing of financial conditions, combined with rising real wages and more fiscal support, help drive growth?

Consensus GDP is 0.7% growth while the Fed is indicating 1.4%. A US recession will knock earnings estimates and be negative for markets.

2. What happens to inflation?

Markets are focused on the challenge of the last mile – ie getting from 3% to 2% inflation.

The Fed acknowledges this may be tough, but to date it hasn’t been the case. The quicker this progresses, the more rate cuts we should get in the US. In turn, this is likely to drive PEs higher.

There is also a counter thesis. In this scenario the Fed repeats the mistakes of the Burns Fed, reading too much into shorter-term lower inflation, only to see inflation re-accelerate as growth holds up.

This would likely force the Fed to shift back towards a more hawkish stance – a clear negative for markets.

3. How will the US election (and others) impact markets?

The 2024 US presidential election is already billed as the most unpredictable and important for decades.

There remain questions as to whether Biden or Trump end up running, or whether a credible independent could impact the outcome.

There is a scenario where no one achieves the required majority in the electoral college.

With so many unknowns there is one conclusion we can draw. The Biden administration will throw everything at ensuring the economic backdrop will be as favourable as possible.

This may extend to the Fed itself and become part of their shift in stance.

We also have elections in Taiwan (Jan 13), UK (May), EU (June 6), India (April), Indonesia (Feb) and Russia (March).

4. What will US rates do?

This is tied to the first three issues. The market has now priced in up to six cuts. Has this gone too far?

5. Will the Chinese economy continue to muddle through?

Will the balance of negative structural issues offset by policy continue to deliver moderate growth with no material surprises? Or will we see structural issues alleviate or deepen?

6. In Australia, can inflation be muted, allowing the RBA to cut rates?

Will the increasing impacts of higher rates begin to squeeze the economy enough to lower inflation?

Or will inflation persist, forcing the RBA into further hikes, running the risk of a faster slowdown?

7. Is the market position becoming too positive?

We are in a very different place when it comes to sentiment and positioning compared to a year ago.

We are more vulnerable to a deterioration in the current benign outlook. But we still have room to rise if the rate cycle plays out as the market now expects.

The issue we resonate with the most is the shift in the Fed’s mindset to underpin the economy rather than build inflation credibility.

Combined with a preparedness to keep using fiscal policy to support growth, this means liquidity and growth are less of a headwind, supporting the market and favouring higher-beta names.

The risk is positioning, which suggest a lot of good news is priced in – making us vulnerable to any inflation surprises.

So, as ever, the market remains unpredictable. This creates opportunity and highlights the importance of thematic positioning.

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About Crispin Murray and Pendal Focus Australian Share Fund

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

Pendal is 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

Effective 1 December 2023, Pendal will not accept applications from direct non-advised investors (an investor without a financial adviser) in the Pendal Geared Imputation Fund (Fund).

The Fund invests in a geared portfolio of shares and securities. Gearing means borrowing to invest and therefore magnifies both potential investment gains and losses. This means that returns are higher during a rising market and losses are greater during a falling market (in each case less the interest paid on the borrowings (compared to a similar investment that is not geared).

Due to the additional risk associated with the Fund’s geared investment strategy, compared to a conventional Australian share fund, the Pendal Geared Imputation Fund will only accept applications from direct investors who have received personal financial product advice.

If you wish to invest in the Fund, please seek personal advice from a financial adviser and include the confirmation of advice with your Application Form, alternatively the Adviser can complete the relevant Adviser section on the Application Form. 

Effective 15 December 2023, Pendal will only accept applications from direct non-advised investors (an investor without a financial adviser) in the Pendal MicroCap Opportunities Fund (Fund) if you are assessed as likely to be in within the target market for the Fund.

Due to the nature of micro cap companies there is some additional risk in investing in the Pendal MicroCap Opportunities Fund, compared to a conventional Australian share fund. Because of the additional risk, Pendal only accepts applications from direct non-advised investors who are likely to be in the target market of the Fund.

If you wish to invest in the Fund, please contact Client Services by emailing ServiceTeam@pendalgroup.com and an issuer representative will call you back as soon as possible.

The issuer representative will ask a series of questions to assess whether you are likely to be in the target market of the Fund. Based upon the responses to your questions, if you are assessed as likely to be in target market of the Fund we will issue you with an application form for the Fund, so you can proceed with your investment. If you are assessed as unlikely to be in target market of the Fund we will be unable to issue you with an application form for the Fund.

Alternatively, you may wish to contact your financial adviser to discuss your personal circumstances.

Positioning for a hard landing | 2024 outlook for bonds, credit, cash | Caution on home bias | Opportunities among M&A deals

The Pendal Multi-Asset team have completed their annual Strategic Asset Allocation review. As an outcome of the review, effective from 20 December 2023, a portion of the Fund’s international share exposure will be hedged to the Australian dollar. Currently the Fund’s international share exposure is generally not hedged to the Australian dollar.

ASX investors have seen a flurry of corporate transactions and associated equity raisings in recent months. Here Pendal equities analyst ANTHONY MORAN explains the opportunities

• Negative reaction to M&A can uncover opportunities
• Orora and Treasury Wine recent examples.
• Find out about Pendal Focus Australian Share fund

NEWSPAPER headlines have been full of merger and acquisition activity and associated capital raisings in recent months.

Chemist Warehouse-Sigma Healthcare. Brookfield-Origin. Newcrest-Newmont. Allkem-Livent. Woodside-Santos.

The activity is likely to continue in 2024, especially in the resources space.

Investors haven’t always been impressed with recent deals – but that doesn’t mean there isn’t opportunity, says Anthony Moran, an analyst with Pendal’s Aussie equities team.

Negative reactions and sell-offs following M&A deals can provide opportunities for investors, says Moran.

“Any deal that is large enough to be raising equity tend to be shareholder destructive in the short term,” he says.

“The market tends to over-react to the downside and that’s understandable because the market doesn’t like diluting the positive investment case for a company.

“M&A introduces a whole new element of uncertainty. There are going to be risks around the businesses being bought, and investors have to learn about them,” he says.

“Also, Australia’s track record of large M&A is extremely weak. It’s just a safer bet that a deal won’t go too well, almost regardless of the details.”

Opportunities from negative reactions

The negative reaction to M&A can provide potential investment opportunities, Anthony explains.

“Market over-reactions around M&A are exacerbated at the moment with fears that the economic cycle is rolling over.”

Investors are concerned that companies are buying businesses that may have puffed up earnings or been trading on a cyclical peak, he says.

“They are worried that the acquiring company has not done enough due diligence and that gives them a reason to sell off the acquiring stock.

“But if you can do the work on the acquired businesses and start to get an understanding and more informed perspective on the probability of the success of a deal, then the sell-off could be quite an attractive investment opportunity.”

Take a long-term view of M&A

Amcor’s purchase of US-based flexible packaging company Bemis in 2019 worked well with significant cost synergies extracted and an improved top line.

But initially, after the deal was announced, Amcor was sold off.

A similar example was Boral’s 2016 purchase of US-based fly ash producer Headwaters.

Following the announcement of the deal Boral was initially sold-off – then bid up as investors got excited by the potential growth prospects of the Headwaters business.

Ultimately there were few natural synergies between the businesses and as the underlying low quality of the Headwaters business became apparent, Boral underperformed over several years.

It recent months, two ASX-listed companies — both held in Pendal equities funds — have acquired businesses and are now trading on historically low multiples.

“Packaging group Orora (ASX: ORA) bought a France-based specialty premium glass manufacturer that supplies high-end glass bottles for luxury spirits and is a global leader,” Anthony says.

“But investors are worried that post COVID, the growth in luxury spirits, in particular, is rolling over.  

There are concerns Orora paid too much, the industry is going to become more competitive and the ESG burden of decarbonising returns will hurt returns,” he says.

Treasury Wine Estate (ASX: TWE) bought a US luxury wine company that has grown quickly in recent years.

Investors are concerned that the growth in earnings will not be sustainable, and that US consumer demand will wane.”

Anthony says that while it is much too early to tell whether the Orora and Treasury purchases are good deals, the kneejerk reaction from markets, selling off the companies, provides an opportunity for investors.

“Take the time to do the work on the underlying assets purchased. Talk to other industry participants and find out how these businesses are positioned, what’s sustaining their returns and what the outlook is.

“And bear in mind that doing the deals haven’t changed the underlying assets in the rest of the businesses.

“The de-rating has hit both the acquisition business and the legacy businesses. That means the legacy businesses have gotten cheaper.”

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About Anthony Moran

Anthony Moran is an analyst with more than 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

What lessons can fixed-income investors take from 2023 into 2024? Pendal’s head of income strategies AMY XIE PATRICK summarises the outlook with fellow PMs TIM HEXT, GEORGE BISHAY and STEVE CAMPBELL

• Pendal’s 2024 outlook for bonds, credit and cash
• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Find out about Pendal fixed interest capabilities

I LOVE this time of year. Not only is there plenty of holiday cheer, there is also time to survey the landscape as we head into a new year.

Five key observations that stand out to me from 2023:

• Recession never arrived, though it was widely expected at the start of the year
• Inflation came off without a significant rise in unemployment
• Riskier assets saw healthy returns while bonds had another challenging year
• US 10-year real yields pushed past 2%
• Small and regional US banks have not solved their fundamental problems.

Interestingly in October, when the real yield on 10-year US treasuries tested 2.5%, the bond sell-off halted.

Perhaps the market was saying: “sure, growth is strong now, but the party won’t last forever”.

How we fared in 2023

Pendal’s fixed income team reassessed the situation when we saw the economic data wasn’t weakening.

We identified that, in Australia, the fixed-rate mortgage cliff was a red herring.

George Bishay, our head of credit and sustainable strategies, moved away from a more conservative stance and started to re-risk his credit portfolios.

From banks to utilities, industrials to infrastructure, George has been cherry-picking his way through the primary market since things calmed after the US banking crisis.

“As long as inflation can continue to come down, bond market volatility can be contained,” says George.

“As long as bonds are no longer aggressively selling off, I’m happy to be tactically raising my credit exposures.”

Tim Hext, Pendal’s head of government bond strategies, recognised that just because inflation had peaked, it didn’t mean the fight was over.

While keeping duration positions small during the year, volatility threw up many opportunities in the physical bond space that he was able to take advantage of.

“You can’t ignore the fact that they’ve continued to pump out fiscal stimulus in the US,” says Tim.

“Australian bond markets have been passengers in the US-led sell-off.

“However patient the RBA wants to be, CGLs (Commonwealth Government Loans) couldn’t fight the strong tide of US Treasuries.”

Steve Campbell, our head of cash strategies, has had similar views, but was able to position a little differently in his portfolios.

“The cash funds were predominantly longer than the benchmark over 2023, despite the Reserve Bank continuing to tighten monetary policy,” Steve says.

“The additional yield and the steepness of the curve helped protect the cash funds’ performance from the move higher in yields over the period.”

As Pendal’s head of income strategies, I have the privilege of all this expertise around me.

The income funds benefited from the wisdom of my peers, positioning at first defensively and then risking up on credit.

Positioning long enough in duration earlier in the year in time for the Silicon Valley Bank crisis, then pulling back in to weather the bond storm.

In more defensive moments, Steve made sure extra cash in the income funds kept up with or beat offerings on term deposits – with the added advantage of liquidity.

I’ve enjoyed having that liquidity at my disposal this year. The income funds can take on exposures in Australian equities and emerging markets.

Although both those asset classes generated positive returns this year, there was plenty of volatility along the way.

Thanks to liquidity provided by Steve, the high yield he has offered on cash and our active asset allocation process, the income funds have been able to take advantage of this environment.

Where to from here?

Here’s a quick 2024 outlook on bonds, credit and cash from our income and fixed interest portfolio managers.

Bonds

Bonds have had three challenging years in a row – will there be a fourth? I ask Tim Hext.

That’s very unlikely, he argues.

“My framework for 2024 is for falling inflation and yields. Though as always, I’ll be flexible within the framework, since it likely won’t be a straight line down.”

That’s a good point to remember, I believe. It’s been a while since we’ve had straight-forward, unequivocal bond rallies.

“If the US Fed cuts rates as expected, markets will price in cuts here,” says Tim. “Though the RBA will likely be slow to react, since they rely on the lagging indicator of inflation to set policy.

“I’m watching the new RBA monetary policy board and how that works.

“Also, don’t forget stage-three tax cuts come in July.”

And the line I like the most from Tim: “Even if policy is on hold here for most of 2024, markets will not be standing still.”

This paints a backdrop against which our active investment process can shine.

Credit

Would rate cuts mean bad news for riskier assets like credit?

“Not necessarily,” says George Bishay.

“Like the past year, if the market can feel that inflation can be contained and the growth picture holds up, that’s basically a Goldilocks scenario and equities should do fine.”

Where Australian credit goes is largely led by where US equities have gone before, George often reminds our team.

If the Goldilocks picture can continue, George will be happy to hold on to the risk he now has. But he’s also ready to act if that isn’t the case.

“That’s why I’ve been very discerning in the type of risk I’ve been adding over the year,” George says.

“You can’t ignore the tail risks out there. As the US banking crisis showed us earlier in the year, sentiment can sour very quickly.

“I’ve kept to top-quality issuers, stayed in senior positions in capital structures and always had an eye on liquidity when I’ve been adding risk this year.”

Thanks to George’s nimble approach, I’m not worried about the income funds’ ability to pull credit risk in at the right time.

Cash

Will cash still be in vogue if a new cutting cycle starts in 2024? I ask Steve Campbell.

“Let’s not confuse the RBA with the Fed,” Steve reminds me.

“I expect fourth-quarter inflation to be lower than the RBA’s forecast. That should mean the Reserve Bank is done hiking.

“But any talk of a new RBA rate-cutting cycle is premature. Inflation is still too high and the labour market is still too tight.

“I expect the cash rate to remain unchanged over 2024, though with bouts of volatility.

“Significant global monetary policy tightening since early 2022 and related spill-overs will become more obvious in the coming year as economic growth slows further.”

Because of the uncertain environment ahead, Steve argues that “highly liquid cash strategies rather than term deposits are a better way for investors to capitalise on any bouts of volatility.”

If things go south and bonds still can’t protect you, it’s critical to have a deeply experienced cash manager by your side.

If Steve is right about bouts of volatility, our active and tactical return booster levers – which buy equities or emerging markets – should continue to get a work-out in 2024.

But if he is also right about a further slowing of economic growth, I expect tactical forays into riskier exposures in the income funds will become less frequent.

Recession odds for 2024

The consensus on US recession stands in stark contrast to this time last year.

Economies have been far more resilient than markets anticipated – and markets in turn have adjusted their expectations.

Soft-landing is now the narrative.

Worryingly, fundamentals have deteriorated as the lagged effects of monetary policy tightening play through.

There doesn’t need to be another Silicon Valley Bank-like shock to send the US economy into recession in the second half of next year.

In fact, I’d put the odds at about two-thirds.

It just takes the continuation of the same economic trends we’ve witnessed in recent months.

Slack is coming back into labour markets. Fewer people are quitting, fewer employers are saying it’s hard to find workers.

Lending standards have tightened, meaning credit growth will keep contracting and default rates will keep climbing.

Delinquency rates in consumer loans have risen for seven quarters straight (not months).

The concentrated exposure of smaller US banks to the commercial real estate sector is an unresolved tail risk.

Nothing in that list is dramatic, but the collective force is more likely than not to bring on a recession in 2024.

For much of 2023, the narrative was about too much supply and not enough demand for US government bonds.

If a recession hits next year, demand for safe-haven assets will overwhelm supply, even if the fiscal taps remain on.

Equity markets tend to peak about six months ahead of a recession.

The next few months is a chance to get your house in order.

Consider rotating back into fixed income and cash – and look for good active management.

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

• Find out about Pendal Focus Australian Share Fund

THE constructive narrative was unchanged by last week’s US data.

November’s non-farm payrolls and average hourly earnings data — along with surveys of inflation expectations and Job Openings and Labor Turnover (JOLTS) — all told a story of modest slowdown. There was no significant evidence that consumers or businesses were walking off a cliff.

The short end of the US Treasury curve sold off – perhaps reflecting a realisation that the market was a touch over-optimistic on the potential pace of monetary easing.

Ten-year US yields were relatively flat for the week, while yields rose at both the long and short end of the Australian curve.

Oil remained under the pump, with Brent crude down 3.9% for the week and 20.4% lower over the quarter to date. This is starting to translate into some relief at the fuel pumps for consumers. 

Gold pulled back from its highs (down 3.8%) while iron ore rose 3%, and its resilience is likely to persist into Q1 2024.

US equity markets delivered their sixth straight week of positive returns – the best run since November 2019 – though returns were relatively modest in the context of what we have seen over the last couple of months.

The S&P 500 gained 0.24% while the S&P/ASX 300 was up 1.69%.

This week, we have the Fed Open Monetary Committee meeting (December 12-13) as well as the November US CPI report.

On the latter, consensus is looking for a 0.05% month-on-month rise in headline inflation but a steep step-up to 0.3% month-on-month in core inflation.

US macro and policy

October JOLTS came in at 8.73 million versus September’s 9.35 million and consensus expectations of 9.3 million. 

It paints a picture of broad-based slowing in the labour market, but not the plunge some feared given the scale of rate increases. For every employed person, there are now an estimated 1.3 jobs available (down from 1.5).

The largest declines in job openings come from private sectors such as education (down 238,000) and financial services (down 217,000).

The Quits rate remained at 2.3%. (The three-month moving average in the private sector is running at 2.6% and falling).

This has historically provided a strong six-month lead on the direction of private-sector wages and salaries in the US Employment and Cost Index. It suggests growth in the latter should continue to soften.  

November payrolls rose 199,000, which was a touch above consensus of 185,000. This helped by an end to the auto worker strike.

The unemployment rate fell 0.2% to 3.7% versus consensus of 3.9%. This rise was driven more by an increasing workforce rather than more unemployed people.

Average hourly earnings rose 0.4% versus consensus at 0.3%. The three-month annualised rate of 3.4% versus 4% previously seems to be heading in the right direction. 

With commodities, goods and rent inflation all seemingly under control, wages remain one of last areas to address.

The US Federal Reserve is focusing on wages growth, which is the main driver of core non-rent PCE services inflation. Because of low productivity growth in many services, wage growth can quickly change price inflation.

Wage growth between 3% and 3.5% should be enough to see core non-rent PCE services inflation at 2.5% and overall medium-term core PCE inflation at 2%.

Lower petrol prices and higher stock markets played an important role in the December Michigan consumer sentiment index hitting 69.4 – up from 61.3 in November and ahead of consensus of 62.

In the same survey, one-year inflation expectations fell 1.4% percentage points to 3.1%, which is the largest single drop in a month since Covid.

Meanwhile, expectations over the five to ten-year timeframe also fell from 3.2% to 2.8%. 

This is all good news for the Fed, which closely watches consumer inflation expectations.

RBA leaves rates on hold

As expected, there was no Christmas Grinch from the RBA – with rates unchanged at 4.35%, as expected. 

However, the forward-guidance of data-dependency and the evolving assessment of risks was maintained.

On the labour market, the statement noted that “wages growth is not expected to increase much further and remains consistent with the inflation target, provided productivity growth picks up. Conditions in the labour market also continued to ease gradually, although they remain tight”.

We see some risk to this view. Recent data suggests there may be further persistence in wage growth in contrast to other economies.

The Board will next meet in February, after monthly and quarterly CPI data (due on January 10 and 31 respectively) and labour market updates.

Comments from the RBA’s head of financial stability Andrea Brischetto last week were consistent with the feedback we’ve received from banks: the cohort of borrowers that are under severe financial stress is unexpectedly very small given the magnitude of the rate rises we have seen.

Brischetto’s observations included:

• around 95% of variable-rate owner-occupier borrowers still have spare income after meeting their mortgage payments and essential expenses
• around 5% find their income insufficient to cover their mortgage payments and essential expenses, however, many of these mortgagees do have savings in their mortgage offset and redraw accounts
• this leaves less than 2% of all variable-rate owner-occupier borrowers who have both an income shortfall and low savings buffers, and so could fall into severe financial stress within six months assuming interest rates remain around current levels.

This suggests an aggregate level of the economy is getting through the great variable-rate reset without falling off “the mortgage cliff.”

The RBA and government’s conduct of monetary policy statement included a key change towards a shift to greater emphasis on the midpoint of the 2-3% inflation target, less emphasis on financial stability, and a requirement of the RBA to provide a more detailed assessment of full employment.

It also outlined changes to improve communications and accountability, such as publishing unattributed votes after each meeting and requiring external Board members to give public speeches.

Australian macro

Third-quarter GDP growth was softer than expected at 0.2% and 2.1% over 12 months.

Due to the increasing cost of living, consumption is growing at its slowest yearly rate since Q1 2021 while the savings ratio dropped to its lowest point since Q4 2007.

There were positive drivers from government expenditure (up 0.2%), investment (up 0.2%) and inventory growth (up 0.4%), which helped offset a drag from net exports (down 0.6%).

Productivity improved, rising 0.9% after a 1.6% fall in Q2. This was in a response to hours worked falling 0.7% (a level that is down 2.1% year-on-year).

Unit labour cost growth slowed to 1.2% for the quarter and is up 6.4% year-on-year, down from 7.4% in Q2.

While high, it is heading in the right direction.

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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

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