Here Pendal’s head of government bond strategies TIM HEXT points out what to pay attention to in the RBA’s latest monetary policy statement

• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Browse Pendal’s fixed interest funds

WHEN the Reserve Bank releases its quarterly monetary policy statement I look for two things.

Firstly, what are the forecasts?

There’s usually new information there, though often the preceding monetary policy decision mentions them earlier.

The second thing I look for are the two blue breakout boxes usually featured in the statement.

“Box A” and “Box B” are typically special interest topics – importantly, topics of special interest to the RBA.

They offer an insight into what topics our central bankers are discussing and investigating internally.

Sometimes there are clues as to what may follow.

In the latest statement released on Friday, Box A contains a rather technical article titled The Bond-Overnight Index Swap Spread and Asset Scarcity in Government Bond Markets.

Box B’sarticle is Insights from Liaison, which summarises discussions with 230 Australian businesses, industry bodies, government agencies and community organisations between May and August.

The first would appear to be of interest to very few, outside of bond geeks like me.  

Clearly though, the RBA is looking at the pros and cons of quantitative tightening, which should be of interest to investors. More on this another time.

The business liaison box is significant. The RBA has often referred to this extensive program, but has only recently started sharing specific data.  

Box B reveals a growing view that businesses are seeing an easing in both demand and costs, consistent with an increasingly neutral RBA.

Of particular interest is the graph below:

This graph shows an easing of expectation for wage rises in the year ahead.

Perhaps this is not surprising as actual inflation falls to 4%.

But the most popular indicator of wages, the Wage Price Index, is not forecast to peak until the end of this year at slightly above 4%.

This liaison shows the RBA will likely stare down commentators who talk about higher wages meaning further rate hikes.

Overall, the RBA’s August monetary policy statement should be reassuring for Australian bond investors.

However, a recent US fiscal surge seems to be weighing on US bonds and therefore curbing gains here.

But let’s save that topic for next time.

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

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

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

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

Find out more about Pendal’s fixed interest strategies here

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About Pendal

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

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

Contact a Pendal key account manager

Here are the main factors driving the ASX this week, according to investment analyst JACK GABB. Reported by portfolio specialist Chris Adams

• Find out about Pendal Focus Australian Share fund

THE biggest down day for the S&P 500 since May set the mood last week, triggered in part by credit rating agency Fitch downgrading the US to AA+.

Stronger-than-expected employment data, higher upcoming US debt issuance and further gains in Japanese yields added fuel to the flames.

Treasuries and equities sold off, with stock-bond correlation the highest it’s been since the 1990s. 

The US 10-year yield rose 8bps and the yield curve steepened. The S&P 500 ended the week down 2.26% despite 79% of companies beating consensus estimates in the first week of reporting season.

In Australia, the RBA held rates steady. This surprised most economists but was largely in line with the market, which was pricing in a 30 per cent chance of a hike.

In contrast, the Bank of England raised rates another 25bps to 5.25% and signalled rates were likely to stay higher for longer.

Australia equities fell (S&P/ASX 300 -1.17%), but less than most overseas markets.

Overall, data for the week was generally consistent with slowing inflation, despite continued earnings and jobs strength.

Central banks remain concerned around the stickiness of services inflation, but expectations for further hikes continue to fall.

Arguably, the key debate around central banks is how long rates stay elevated.

Oil is also worth watching. Brent crude is now up 15% and West Texas Intermediate (WTI) is ahead 17% for the quarter to date.

This is driven by a record drop in US stockpiles and a decision by Saudi Arabia and Russia to extend production cuts.

Gasoline is the sixth-biggest component of US CPI.   

US economics and policy

The data last week was generally consistent with slowing inflation and a soft landing. Two Fed members pointed to the labour market coming into better balance.

Despite uncertainty about a potential lagged impact of rate hikes and whether a recession can be avoided, expectations for further hikes continue to come down.

The market is pricing the probability of another Fed hike by November at just 18%, versus 32% in Australia.

Still, at least one Fed member still sees the need for further hikes. Governor Michelle Bowman said “additional rate increases will likely be needed to get inflation on a path down to the FOMC’s 2% target”.

Labour market data remains solid.

Non-farm payrolls came in at 187k new jobs, versus 200k expected, and the prior two months were revised down 49k. 

Employment data has shown increasing signs of cooling this year, though 200k jobs per month is still strong by historical standards.

On the other hand, wages rose more than expected with average earnings +4.4% year-on-year versus 4.2% expected.

Along with a low unemployment rate (3.5% vs 3.6% expected), this suggests the labour market remains tight and inconsistent with a 2% inflation target.

We will get two more inflation prints (the first this Thursday) before the next Fed meeting in September.

Consensus is forecasting headline CPI at 3.3% versus 3% prior. Excluding food and energy, the forecast is 4.8%, unchanged from prior.

Assuming no surprise — and the CPI prints confirm the June trend, hike expectations likely remain low.

Soft landing odds rising, bears capitulating

The bears have continued to capitulate, with Bank of America the first of the major US banks to officially reverse its recession call.

Bears now forecast US GDP growth of 0.7% in 2024 — 0.7 percentage points higher than was previously assumed.

However, inflation expectations have been revised to 2.8% in 2024 (+0.4 points) and 2.2% in 2025 (+0.1 points).

Unemployment is seen peaking at 4.3% in Q1 2025 versus the prior expectation of a peak at 4.7% in Q4 2024.

Soft landings are uncommon, with only three in the eleven recessions since World War II.

Concern remains over the lagged impact of rate hikes. While the US yield curve has steepened materially (and Australia is now back in positive territory), it has now been inverted for 13 months.

Ultimately, interest rates are coming down — the important factor will be why.

If it’s in response to a recession, the precedent for equities is not positive based on historical patterns.

US earnings season

Some 422 S&P 500 companies had reported Q2 earnings by the end of last week — with 79% beating analyst expectations.

This is more a function of low expectations rather than stellar corporate performance.

Based on Goldman Sachs data:

• 55% of companies have beaten consensus estimates by at least one standard deviation, versus historical average of 48%.
• Only 12% of companies have missed consensus estimates by at least one standard deviation, versus historical average of 13%. 
• EPS growth has been tracking at -6% versus -9% expected.

A few noteworthy results:

• Apple (-7.1%) — Now well below its historic $3 trillion market cap after reporting a third straight quarter of declining sales and guiding to a similar performance in Q4
• Amazon (+5.6%) — Q2 beat and guidance across retail and AWS (cloud) was strong
• Uber (-6.1%) — Reported its first-ever operating profit, but shares declined on slower growth
• PayPal (-15.2%) — Declined on lower transaction take rates and margins
• Caterpillar (+6.1%) — reported a big earnings beat, but noted Chinese demand was worse than was forecast only three months ago
• Starbucks (-0.6%) — Better margins offset lower comparable sales
• Expedia (-14.1%) — Q2 gross bookings missed expectations
• Booking (+1.7%) — Revenue and profits beat. FY booking growth guidance raised to >20% from low-teens
• Atlassian (+14.1%) — Reported better guidance. Cloud revenue growth seen +25-27% YoY

UK and Europe

The BoE hiked 25bps, as expected.

Rates are now seen as “restrictive” — though not necessarily “sufficiently restrictive” with markets pricing in another 50bps before the year’s end.

Doing less than that would likely require a big negative surprise in wages, employment and services inflation.

Commentary was perceived as more realistic on inflation than past optimism.

The statement and the press conference both sent a strong signal that the monetary policy committee had a preference for rate smoothing, ie maintaining higher rates for longer rather than pushing for higher peaks. 

In Europe, the ECB reported that underlying inflation had probably peaked.

Recent easing has been driven by non-energy industrial goods, while a decline in services also appears to have started.

China

Incremental policy announcements continue in the wake of the recent Politburo meeting.

There is still scarce detail, but three announcements caught our eye:

• China’s state planner released a policy document focused on removing government restrictions on consumption and improving infrastructure.
• The People’s Bank of China announced it would “guide” commercial banks to adjust mortgages interest rates lower, step up its monetary support for the economy and help banks control liability costs.
• Local governments are under pressure to use up this year’s quota of special-purchase bonds by the end of September. The question remains whether they will be allowed to pull forward 2024 issuance into this year, which could have a meaningful impact on spending.

Beijing has stopped short of providing major monetary or fiscal stimulus and uncertainty remains whether the measures will be enough.

The challenge was highlighted again last week with data showing continued weakness in manufacturing and property sectors.

• Manufacturing PMI remained below 50 in July, though slightly better at 49.3 versus 49 in June.
• New home sales among the 100 biggest real estate developers fell 33% year-on-year in July, down 33.5% month-on-month

Still, the Politburo has acknowledged the problem and Chinese stocks were the best performers last week.

Australia economics and policy

The RBA held rates at 4.1%, in-line with market expectations but contrary to most economists who had forecast a 25bp hike.

The commentary was on the dovish side, omitting a previous statement that “the path to deliver 2-3% target while the economy still grows is a narrow one”.

However growth expectations moderated.

GDP is now seen at a trough of 0.9% this year, down from 1.2% previously. GDP is expected to be 1.6% in 2024. 

CPI is forecast to decline to around 3.25% at the end of 2024, returning to the 2-3% target in late 2025, suggesting interest rates may remain elevated for longer.

Further easing in goods inflation is expected to drive the decline.

Key risks include services inflation, which remains strong amid rising labour costs. Rent inflation has also increased.

Energy prices are forecast to add significantly to inflationary pressures in coming years with electricity prices forecast to add 0.25% to headline inflation in FY24.

The RBA continues to see a “high degree of uncertainty around the speed and extent of the decline in inflation expected in the period ahead”. 

Four key domestic uncertainties were detailed:

• The outlook for China remains uncertain
• The outlook for household consumption is subject to competing forces
• Inflation could be more persistent than expected
• Goods prices could decline significantly

Consensus is pricing one more hike, then a steep drop-off in rates in 2024.

Australian Equities

Nearly all sectors ended in the red last week, led by utilities, real estate and financials.

This echoed similar moves in the US. Energy and consumer discretionary were the best sectors.

Energy was comfortably the strongest so far this quarter in Australia and the US on the oil price rebound.   

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About Jack Gabb and Pendal Focus Australian Share Fund

Jack is an investment analyst with Pendal’s Australian equities team. He has more than 14 years of industry experience across European, Canadian and Australian markets.

Prior to joining Pendal, Jack worked at Bank of America Merrill Lynch where he co-led the firm’s research coverage of Australian mining companies.

Pendal’s Focus Australian Share Fund has an 18-year track record across varying market conditions. It features our highest conviction ideas and drives alpha from stock insight over style or thematic exposures.

The fund is led by Pendal’s head of equities, Crispin Murray. Crispin has more than 27 years of investment experience and leads one of the largest equities teams in Australia.

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.

Find out more about Pendal Focus Australian Share Fund  

Contact a Pendal key account manager

 

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What’s next for rates | Questions to ask in earnings season | No stimulus, but there are still China opportunities | How AI could be a victim of its own success

Full-year reporting season is underway for 2023. Here Pendal investment analyst ELISE MCKAY explains the questions investors should be asking

• Earnings season about more than revenue and margins
• Look for macro impacts, pricing power and AI
• Find out about Pendal Focus Australian Share fund

AUSSIE equities earnings season kicks off this week.

What should investors be looking for in full-year results?

Look beyond revenue and profit margins to how companies are managing the macro-environment, says Pendal investment analyst Elise McKay.

“Have companies maintained the ability to pass through higher prices? What’s happening to wages? Are further cost reduction programs announced?”

“On the revenue side we are looking for the ability of companies to continue to pass through cost inflation, in a slowing economic environment,” McKay says.

“We are also looking for any forward demand indicators – any key performance indicators that will show how the business might perform in future years.

“What will drive revenue? For example, at [milk and infant formula group] A2, what is the birth rate in China doing?

Look at labour

“A key theme over the past 12 months has been availability of labour. We will be looking closely at headcount trends and wage inflation,” McKay says.

“The recent Fair Work Commission decision to lift wages 5.75 per cent highlights the wage inflation issue that we have in the economy.

“We’ve had a number of businesses across the tech sector announce headcount reductions and it will be interesting to see what sectors and companies follow in their footsteps to address their cost bases.

“And then more broadly, how will higher interest rates impact on earnings per share.”

Macro-environment is key

Similar to the June quarterly earnings season on Wall Street, the macro-environment will play an important role, McKay says.

“On Wall Street, up until 28 July, 48 per cent of companies had reported with a better than average result, 55 per cent were ahead of expectations and only 13 per cent missed.

“Yet despite this, the average ‘beat’ has only resulted in the stock going up 28 basis points, versus the average of one per cent.

“So even though companies are delivering better earnings, their share prices aren’t going up on the news.

“The recent market outperformance has been driven by the macro environment, not the earnings. We are still very much in a macro-driven market.”

Keep an eye on AI

McKay says another theme on Wall Street has been artificial intelligence, and she will be watching closely to see how local companies respond.

“You presume locally most companies are thinking about it. It would be a massive red flag if they’re not. You want to understand how companies are thinking about AI as both an opportunity and a threat.”

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About Elise McKay and Pendal Australian share funds

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

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

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

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

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

Contact a Pendal key account manager here

Despite higher-than-expected monthly data, the outlook for inflation should be mildly friendly over the next few months, says Pendal’s TIM HEXT

• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Browse Pendal’s fixed interest funds

THE RBA will be encouraged things are moving in the right direction on the inflation front.

The June quarter inflation numbers came in this week at 0.8% for the quarter, or 6% annual.

Underlying inflation (the trimmed mean where they remove the highest and lowest 15%) came in at 0.9%, or 5.9%. 

These outcomes were both 0.2% lower than expected.

The RBA is now forecasting 4.5% by year end. Given we are at 2.2% for the first six months of 2023 this seems a little high if anything.

We forecast 4.2% by year end, unchanged from before.

We last saw a 0.8% result in Q3 2021, just before the very large numbers kicked in.

However this may prove to be a low point for the quarterly number this year as utility prices kick in again in Q3 and Q4.

We expect 1.1% in Q3 and 0.9% in Q4 as goods prices moderate but services remain elevated.  

The high and lows of these numbers

Let’s start with the items that are accelerating.

Rents are finally kicking in, up 2.5% for the quarter and 7.3% for the year. They are finally catching up with other rental indicators and should remain at 2.5% a quarter for a while yet.

Insurance was up 5.3% for the quarter – no surprise for anyone who has received a payment notice recently.

International travel was up 6.5% in the quarter, again of little surprise.

On the high, but moderating side was new home dwellings.

They rose by 1% in the quarter, though that’s a long way down from the peak. The supply side issues in building seem to be finally working their way through.

On the low side, five of the 11 categories actually saw prices slightly fall.

Most of these were due to government subsidies, highlighting the impact both federal and state governments are having on dampening inflation.

Health, education, electricity and gas were impacted by government subsidies, highlighting the impact governments are having on dampening inflation. Q3 and Q4 will see utilities rebound sharply.

More genuine were falls in motor vehicles, telecommunications and domestic holiday travel as supply constraints ease.  

Goods versus Services

Services inflation is finally higher than goods.

The ABS provided us with this graph below, which highlights services inflation above 6% — not seen since GST started in 2000.

Given the strong link to wages this highlights the RBA point that wage growth above 4% with no productivity is not consistent with target inflation.

The RBA

Despite strong employment data this number should continue to provide the RBA headroom to stay on hold.

August will be Dr Lowe’s second last meeting in charge and having moved 4% in a little over 12 months there is room for further patience.

It will be interesting to see if the inflation forecasts are lowered again, although they lowered them in May and hiked anyway so perhaps it doesn’t matter too much.

Three-year swap is now around 4.25%, and the market has one more hike priced in.

I suspect the RBA will keep one more hike up its sleeve and if unemployment has not risen by October they may execute.

This would be Michele Bullock’s first meeting in charge where she may choose to stamp her mark as an inflation-fighting governor.

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

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

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

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

Find out more about Pendal’s fixed interest strategies here

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About Pendal

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

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

Contact a Pendal key account manager

How to invest in Hollywood | China’s latest signal explained | Why it’s worth digging into infrastructure | Domestic demand drives emerging markets

Economic weakness in China is affecting emerging markets commodity exporters. That means the key to success is looking instead for domestic growth stories, argues Pendal’s JAMES SYME

• China’s weakness affects EM exports
• Focus instead on domestic growth
• Find out about Pendal Global Emerging Markets Opportunities fund
• Watch a recent Emerging Markets overview webinar with James Syme

EMERGING markets investors often focus on commodity-intensive countries – many of which rely on China as one of the world’s top importers.

That may not be an attractive angle right now due to China’s weaker economy.

But it doesn’t mean there isn’t opportunity in the EM space, says Pendal PM James Syme.

Look instead for domestic growth stories that do not depend on exporting to China, argues Syme, who co-manages Pendal Global Emerging Markets Opportunities Fund.

“It’s been very good for the portfolio having the overweight positions in Mexico and Brazil — but we’re cautious on metals, cautious on China, and cautious on Latin American commodity stocks,” says Syme.

Why domestic demand matters in emerging markets

Emerging markets naturally go through business cycles where growth leads to inflation and pressure on the trade balance, which eventually leads to higher interest rates and a downturn, says Syme.

“Then eventually at some point inflation is very low, there’s loads of capacity in the economy, and the economy naturally grows. That’s the cycle that happening now in emerging markets.

“It tends to be boosted by what happens with global financial conditions and the US dollar. One of the big patterns we see at the moment is that after a decade of a strong US dollar, we may now be seeing a weaker dollar.

“That really opens the way for strong domestic growth booms in some of these emerging markets.”

Opportunity in Latin America

Some of the markets best-placed to benefit from this change are found in Latin America, argues Syme.

Brazil and Mexico should see significant interest rate cuts over the second half of 2023 and into 2024, further stimulating what is already quite robust domestic demand, he says.

“We’re very positive on Brazil and Mexico. They’re two of the largest overweights in the portfolio.”

Typically, Latin American GDP growth and equity market returns are highly correlated with commodity prices — especially metals.

Latin America is a large producer of oil, with Brazil, Colombia and Mexico all being major producers. It is also a big exporter of soft commodities which are filling supply gaps created by the Russia-Ukraine conflict.

But it is the metals part of the commodity cycle that tends to correlate with growth most strongly, says Syme.

“We’re very positive on the outlook for the domestic economies of Brazil and Mexico, but this is not because we’ve got a particularly positive view on metals.

“Although there are some significant supply constraints, particularly around copper, the world’s largest demand source for industrial metals continues to be China, the Chinese economy looks very weak and within the Chinese economy, it’s the most commodity intensive sectors that look the weakest.

“So, we have no copper, we have no Latin American gold miners, we have no Latin American iron ore miners. Generally, our exposure to the commodity complex in Latin America is very low.”

Instead, emerging markets portfolios need to be positioned to capture the beneficiaries of domestic growth, says Syme.

Leading opportunities include banks and financial stocks, alcohol producers and brewers, domestic airlines, fast food and building materials like cement, he says.

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About Pendal Global Emerging Markets Opportunities Fund

James Syme, Paul Wimborne and Ada Chan are co-managers of Pendal’s Global Emerging Markets Opportunities Fund.

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

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

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

Find out more about Pendal Global Emerging Markets Opportunities Fund here
 
Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management.

Contact a Pendal key account manager here

A new signal from China caused excitement among investors this week. AMY XIE PATRICK explains what it means

• Take caution with China’s latest property signal
• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Browse Pendal’s fixed interest funds

THE latest message from China’s top decision-making body caused a stir this week when investors noted softer language on property.

For the first time since 2016, President Xi Jinping’s signature slogan that “houses are for living, not for speculation” was missing from a note that followed the Politburo’s July meeting.

That caused excitement in the market about the potential for a meaningful stimulus push via the property sector.

China’s property industry accounts for up to 20 per cent of GDP once related sectors are added.

But the market is getting ahead of itself.

The line has likely been dropped because it’s simply no longer needed.

Buyers are no longer speculating. They are actively selling in an attempt to exit the property game altogether.

In fact, one of our investment themes here in Pendal’s Income and Fixed Interest team, is that there will be no silver bullet from China to turn around its economy.

Deleveraging leads to fire sales

Beijing’s attempts to de-leverage property developers effectively shut them out from official channels of funding in 2020.

The unofficial channel relied on off-the-plan pre-payments from buyers – but relying on this channel alone is a bit like a Ponzi scheme.

Developers need to keep selling properties they promise to build in the future, to secure the funds to finish what they’ve already pre-sold.

As defaults among Chinese property developers started to snowball last year, buyers soon came to the realisation that they may never get delivery of properties they’d made down payments on.

To cut their losses, owners of partially completed apartments started to list them at discounts on the secondary market.

Indicators suggest property prices are now falling as fast as they did during the initial outbreak of the pandemic, with no relief in sight.

Breaking bad

It is impossible to understate the extent of this shock to the Chinese psyche.

The economic model has had property at its core for the best part of a generation.

Every crisis has been met with property sector stimulus. This spurred consumer spending on all things related to buying a new home.

It gave local governments revenue from selling plots of land.

It spurred borrowing from Chinese households to get on the property ladder because as far as they knew, Chinese house prices only ever went up.

Confidence in the property sector has now been shaken to the core.

It forces Chinese households to recognise the real state of their balance sheets. At the margin, income will be directed towards balance sheet repair rather than new consumption.

I have some sympathy with commentary that draws parallels between Japan’s bubble bursting in the late ’80s.

In the long run, this is a good story for China.

It allows the economy to break away from its addiction to building endless apartments and move on to find healthier alternatives. What those alternatives might be is yet to be determined.

Economic debris

The bad news right now is that the debris from the current property carnage is clogging up China’s economic engine.

Policy response has so far been limited.

Interest rates and reserve ratios have been cut. But what use is making the price of borrowing cheaper in a system where there is no appetite to borrow because of shattered confidence?

Clearing this debris requires either allowing developers to borrow again or someone to absorb losses.

The former is unlikely given the pain endured to come this far down the deleveraging path. The latter is unpalatable given the sheer extent of losses that potentially exist.

As an example, Chinese property developer Evergrande recently wrote down US$52 billion of losses on the value of its assets – and faces a $44bn funding gap for completing its construction pipeline.

If that funding gap can’t be bridged, further write-downs will follow.

The extent of unrealised losses sitting within this sector may simply be too big for the private sector to bear.

But the state also faces a moral hazard dilemma if it tries to share the burden.

Against this backdrop, it is easier to understand why stimulus efforts have been so lacklustre to date.

What it means for markets and investors

Chinese asset prices have largely priced in a soggy growth story from here.

The rest of the world has had the luxury of ignoring China’s woes because strong consumption supported by excess savings has more than offset China’s drag.

What happens when those savings run out has most certainly not been priced into global asset prices.

The Politburo meeting also highlights a renewed focus on currency.

Beijing dislikes extreme moves over a short period of time. But in the absence of a property-driven growth engine, Beijing probably doesn’t mind a weaker currency.

Since domestic demand is hard to lift, a weaker yuan should at least help to channel some international demand in China’s direction.

Here are some broad-brush implications for positioning:

• Lean against yuan strength. Volatility can be smoothed but the trend can’t be stopped. A cheaper currency would help Chinese growth at the margin by lifting exports.

• Avoid betting on lower Chinese yields. Slashing interest rates won’t work to stimulate the economy when no one wants to borrow. Near term, the Chinese rates market may have priced peak pessimism.

• Maintain a long duration bias in global duration. When excess savings run out, China’s drag will become more evident on global growth.

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

• Find out about Pendal Focus Australian Share fund

EQUITY and bond markets trod water last week after well-received inflation data – and ahead of more US quarterly earnings reports, plus meetings at the Fed, European Central Bank and Bank of Japan this week.

The S&P 600 gained 0.7% while the S&P/ASX 300 was up 0.13%.

In US equities we saw a rotation from tech to banks.

There was some wariness of tech stocks ahead of results, given their big recent runs. Bank results are so far better than many feared. This rotation provided breadth to the market.

Positive surprises on inflation and economic resilience – combined with the AI thematic – have driven markets in 2023.

We now appear to be entering a phase of consolidation, rather than a major correction.

The improvement in market breadth is a constructive signal, as is an economy with little tangible sign of deterioration.

In Australia, strong employment data is a reminder of domestic economic resilience. It is hard to see how inflation falls sufficiently in this environment – but the market is waiting for this week’s inflation data before worrying too much about rates again.

Key market issues

At the start of the year we outlined six issues we thought most important for markets going into 2023.

It’s worth revisiting now to see how they’ve transpired.

In short, the key issues have evolved, but there haven’t been any definitive developments.

It’s worth noting the miracle of a soft-landing is now a real possibility – something no-one really believed six months ago.

Since then we’ve also added two new issues to keep tabs on:

• Artificial Intelligence: To what extent is AI a material driver of long-term earnings and will it continue to fuel a re-rating of tech?
  
• The US-dollar index (DXY): It’s off 2.4% since the start of 2023, which has supported markets and commodities. But is this the beginning of a more material move or a period of consolidation?

Here’s a look-back at the original six issues:

1. The persistence of inflation – which will determine how tight financial conditions should be

Inflation has proven more persistent than expected for much of 2023, though in recent weeks it’s started to surprise on the downside.

Importantly, this recent change has begun without the economy showing material signs of weakness.

Despite the rise in two-year bond yields – US government bonds are up 42bps in 2023 and Australian yields up 61bps – 10-year bond yields have remained flat (down 4bps in the US and Australia so far this year).

Lower commodity and input prices along with improved supply chains have eased inflationary pressures.

The key area of contention remains services inflation, which is tied to wage growth and productivity.

Wages are trending lower.

Forward indicators such as the Indeed Wage Tracker are slowing materially, down from about 9% annual growth in late 2021 to 4.8% by June.

The Atlanta Fed wage tracker has seen the gap between overall wage growth and wage growth for job switchers narrow materially, as the latter has decelerated faster.

This suggests the worker shortage is dissipating.

The remaining concern is the continued strength of the labour market, which may make the Fed question whether wages will fall back as far as they need to.

Weak productivity is another reason to be wary of how quickly services inflation falls back.

The upshot is that there is still more to do.

Wages need to reduce to 3% or below to be consistent with 2% inflation. The latter is heading in the right direction and offering hope.

2. The scale of the economic slowdown in the US and other developed markets

The economy has clearly held up better than most expected.

The market was pricing a 65% chance of recession at the start of the year. We remain at the same level some seven months later.

Higher rates have not wreaked havoc as many feared. The debate has shifted to how long the potential lags in effect may be.

Bulls point to “total financial conditions” – a measure of changes in key indicators such as mortgage rates, credit spreads, equity markets and currency moves – having already tightened to a peak. Lead sectors such as housing are turning the corner and an inventory de-stocking phase is now slowing.

Combined with the better inflation data, confidence is building of a soft landing.

Bears continue to point to yield curves and other lead indicators as signs the economy will roll over.

The Fed has now released its own “total financial conditions” index (alongside others from the likes of Goldman Sachs, Bloomberg and regional Federal reserves).

The Fed’s index – which measures the expected impact on growth – shows total conditions as more restrictive than indicated by other indices, suggesting we may see a weaker economy by the year’s end.

That said, even the Fed’s measure of total financial condition tightening has peaked – and the expected impact on growth is waning.

The March banking crisis was seen as evidence of how tightening can affect the economy in unpredictable ways.

But it’s increasingly looking like the “all-in” policy response from the Fed and US Treasury has successfully stemmed second-order consequences. 

The question remains: will we defy the “laws of economics” this cycle and avoid a recession?

The accumulated stimulus from the pandmic – combined with green investment, re-shoring and a deflationary China – may help pull off a soft-landing miracle. But there is still no clarity emerging.

3. The leverage of earnings to that downturn

With no sign of recession, there is no insight on the degree of operating leverage.

Earnings have proven more resilient than many expected, particularly in tech.

4. Whether markets have already priced in the downturn

In hindsight a lot of bad news was priced in at the start of the year.

Markets have done much better than expected, squeezing higher on cautious positioning and resilient outlooks for the economy and earnings.

The S&P 500 is up 19.24%, the NASDAQ 34.69% and the S&P/ASX 300 a more subdued 6.03%.

The bulk of this move is valuation re-rating. The S&P 500 has gone from 16.8x P/E to 19.6x.

This suggests less pessimism – but also less buffer in the case of an economic downturn.

5. How China’s economy performs as it exits Covid-zero

China has been a material disappointment.

Q1 saw a strong re-opening bounce, but it faded far more quickly than expected.

Housing has been weak. At best, it can be expected to stabilise.

Exports have suffered on slowing global growth – particularly in goods – although there are some signs of stabilisation.

Consumers remain cautious and this is more likely to be structural factors at play.

Q2 weakness was exacerbated by inventory de-stocking, so there should be some improvement in Q3 even without stimulus.

July’s Politburo meeting is usually focused on the economy. But the mail we are getting is not to expect too much.

The growth rate, while slower than expected, is still consistent with Beijing’s target. It is also unclear how effective stimulus would be.

So any measures are more likely to be specific industry-orientated actions, rather than a “big bang” type of stimulus.

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

Australia’s relative appeal has deteriorated.

When it looked like the rest of the world was facing a recession, our immigration-driven resilience was a relative positive.

Now with the rest of the world seemingly more likely to pull off the soft landing, the Australian economy is seeing more stubborn inflation due to higher population growth, combined with rising wage growth and weak productivity.

At the same time the much-anticipated mortgage cliff has not yet had a meaningful impact.

The latest employment data reinforced the strength in the economy.

The politicisation of the rate-setting process and an RBA flip-flopping between inflation hawkishness and social concerns also runs the risk of undermining confidence in policy making and de-anchoring inflation expectations.

So the risks here have risen.

Central bank policy

The Fed, ECB and BOJ meet this week. To summarise:

• The Fed is widely expected to hike for the last time, with rates up 25bp to a 5.25% to 5.5% range. They will probably look to maintain the expectation of one more hike, but may signal that it won’t be in September. The reason for this is they will not want the market bringing forward the first rate cut which is now priced for March 2024.
• The ECB is also expected to hike, but again, this could be the last. The Dutch central bank noted there was no certainty of hikes beyond July. Awareness of the monetary lag could also lead to a less hawkish message.
• The key issue for the Bank of Japan is whether to move the targeted cap on government bond yields from 50bp to 75bp. If they do, we could see a continued rise in yields and a stronger yen. If nothing changes we may see a re-test of the calendar year to date highs.

Markets

US earnings season kicked off with a focus on banks – where results were not as bad as feared.

One of the key issues was margins, which did deteriorate but not as much as expected. Big banks retain strong liquidity and haven’t chased deposits, which seems to have helped.

The other concern was around exposure to commercial real estate, particularly office.

The positive news here was that reserves against this exposure had stepped up from 3-4% to 8-9% – but without a hit to capital, providing more of a buffer.

Heading into the main phase of earnings, revisions have been at the weaker end of the historic range. Clearly if this persists it will add to the argument for market consolidation, or even a pull-back, given the recent run. 

It is also worth noting how low stock correlations have been in 2023.

They are now probably as low as they go, which would indicate macro factors may begin to re-emerge.

 

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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

The unemployment rate remains low. Pendal assistant PM ANNA HONG explains what that means for rates and bonds

• Why bonds, why now? Find out more from Pendal’s income and fixed interest team

TODAY’S jobs data shows the headline unemployment rate stuck around 3.5% and the participation rate falling by only 0.1%.

The good news is, we’ve got jobs.

But does it mean more rate hikes are on the cards?

Yes and no.

The unemployment rate is a slow-moving indicator, reflecting what has already happened rather than what will happen.

People tighten their belts, which results in a slowdown in economic activity way before we lose our jobs.

This can be observed through spending habits, retail sales and the inflation trend which clearly shows disinflation flowing through in the Australia CPI number.

Australia’s CPI peaked at 7.8% in December 2022 and continued to slow down to 5.6% in May.

That’s despite our unemployment rate tracking sideways at 3.5% since reaching a low of 3.4% in October 2022.

Furthermore, high net migration has already materially reduced the number job openings in Australia.

Job advertisements in NSW, VIC and ACT have weakened, especially in the segments such as hospitality, tourism and retail which are most sensitive to the inflow of foreign workers.

What does this mean for bond investors?

It’s not yet time to raise the “mission accomplished” flag, but we are closer to the end of the rate hiking cycle.

There may be one or two more rate hikes, though much of the market pricing already reflects than.

This is especially evident in Australian three-year and ten-year government bonds price moves after the release of the unemployment data – it moved in about a 0.06% range.

Is there a risk of over-hiking by the central banks? Yes.

In that scenario, something will break and we favour duration protection at around 4% yield to deliver capital gains for the portfolio.

What if we get a soft-landing?

That means that the RBA can chart a path back down towards neutral, which should give long bonds a nice capital kick.

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About Anna Hong and Pendal’s Income and Fixed Interest team

Anna Hong is an assistant portfolio manager with Pendal’s Income and Fixed Interest team.

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

With the goal of building the most defensive line of funds in Australia, the team oversees some $20 billion invested across income, composite, pure alpha, global and Australian government strategies.

Find out more about Pendal’s fixed interest strategies here

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About Pendal Group

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