The RBA’s path back to neutral cash rates this year is on track. The bigger story for long bonds is the US path to potential recession, writes our head of government bonds Tim Hext

UNTIL next year we remain stuck with quarterly Consumer Price Index numbers, meaning they carry huge importance.

(The ABS is planning a monthly CPI indicator — but for now the quarterly data is more important than ever.)

Wednesday’s June quarter CPI numbers landed almost on expectation, bucking the recent global trend of upside surprises.

That doesn’t mean the number wasn’t high — rather it was already factored in, even generating relief that it wasn’t worse.

Headline CPI for Q2 was 1.8%, meaning 6.1% annual.

Underlying inflation (the average rate after trimming away the highest and lowest 15%) was 1.5% or 4.9% annual.

Under the hood there was decent dispersion.

Food prices were up 1.45% — but given the stories and input prices this was a low result. We expected above 2%.

Commodity prices have eased in the past month so the worst of food price inflation — perhaps some vegetables excepted — may not eventuate for now.

Housing inflation remains buoyant  (2.5% q/q)  due to the cost of building new homes. Rents remain benign despite mounting signs they are moving higher.

A rare sighting of inflation in clothing and footwear (up 3.5% q/q) and furnishings (up 2.5% q/q) plays into the theme of higher goods prices.

Service prices to rise

We expect goods price inflation to be peaking, but service inflation to pick up in the year ahead.

Services remain contained for now. Health and education costs tend to be seasonal but overall are running closer to 3% than 6% annually.

Labour costs are moving higher. Skilled migration is picking up but it won’t be enough to stop cost-push inflation.

The move lower in goods prices may lead to some short-term easing of concerns overall, but we remain wary of current market pricing.

Expected inflation levels are back below 2.5% beyond 2023.

Inflation bonds are cheap and investors should consider picking them up around these levels as insurance for a decade of higher inflation.

What it means for investors

The monetary policy implications of this CPI number are not large.

The RBA will be happy its current path and pace back to neutral cash rates this year (2.5% to 3%) seems about right.

The market is still expecting more (3.25% to 3.5%) than the RBA thinks it will have to deliver this year, so there is the chance for a small rally in rates.

The bigger story for long bonds remains the US path to potential recession.

We get a Fed rates update and US GDP number shortly, so on we move.

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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 our head of equities Crispin Murray. Reported by portfolio specialist Chris Adams.

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THE market is seeing signs of inflation easing, the economy slowing and policy having an effect.

As a result, concerns over the extreme tail risk of substantial central bank overtightening may be receding.

It remains a challenging environment. The key questions around where inflation settles, the path of rate hikes and the economic impact are still unanswered.

Energy remains a wildcard. But at this point there is a reduced probability of some of the most negative projected scenarios.

The market bounce continued last week.

The S&P 500 gained 2.6% and the S&P/ASX 300 3.6%. This was despite more bad news on economic growth and the European Central Bank (ECB) striking a more aggressive stance than expected with a 50bp rate hike.

At this point bad news is seen as good news. Weaker growth is seen as helping drive inflation lower, bringing forward an expected peak in rates and bond yields.

US 10-year government bond yields are now 66bps lower than the June high, which is helping support the equity market. The S&P 500 is up about 8% from its lows. We are also seeing a rotation back to longer-duration sectors.

Oil prices, bond yields and the US dollar all remain tightly correlated and a key driver of markets. Recent falls in yields and oil and a pause in US dollar gains are all helpful for equities.

Early US corporate earnings signals are supportive. It was interesting to see Netflix bounce about 25 per cent despite weaker subscription numbers.   

Where to next for markets?

It is too early to call whether we have seen a bottom or if this is another bear market rally.

Technical measures of market breadth and volumes are not indicating a sustainable turn in sentiment.

Seasonally, August and September are typically soft months for equities.

That said, a market moving higher on bad news suggests some stale positioning and the squeeze could continue.

Bear markets don’t tend to end until policy direction shifts. It would also be unusual to see markets bottom before the extent of any earnings recession is known.

The challenge is that bear market rallies and squeezes can be large.

The average NASDAQ bear market rally since 1985 has been 30% — and the NASDAQ is only up 11% from its recent low.

The S&P/ASX 300 is now down 7.2% for the year to date. Technology is off 27%, consumer discretionary is down 17.6% and REITs has lost 16.8%. This leaves plenty of scope for these sectors to squeeze higher during reporting season.

This week will bring a lot of new information including a Fed meeting, the US Q2 GDP print and a raft of US earnings results.

Macro and policy outlook

Europe

The ECB raised rates 50bps — the first hike in 11 years — in response to a worse-than-expected inflation print of 8.6% year-on-year. The market was not expecting such a big move, only ascribing a 25% chance.

The market’s reaction was positive.

This could be partly because the ECB stated there was no change to the ultimate expected terminal rate. There was also likely some relief that the bank was catching up to the reality of dealing with inflation.

Given the likely slump in the European economy, there is a view the ECB has only a small window politically to raise rates — and therefore they are better to front load.

The ECB also provided the latest “tool” to manage the “fragmentation” risk of bond spreads blowing out in the periphery and creating the next Euro crisis.

The Transmission Protection Instrument (TPI) represents a form of Quantitative Easing in an era of rate tightening and Quantitative Tightening. The purpose is to prevent the upcoming recession from putting pressure on the Euro.

It is said to have no budget limit on the purchases or periphery bonds (refers to being “proportionate”) or any need to negotiate some economic reform package.

There is no stated threshold for use, which will be determined by the European Council. It will also likely relate to circumstances beyond the country’s control, so the current Italian political crisis is unlikely to trigger its use.

As with most European tools, this is deliberately vague. We suspect the market will want to test this at some point.

United States

It is almost unanimously expected that the Federal Reserve will hike rates 75bps this week. Speculation about a 100bp hike has dwindled along with the latest inflation expectations data.

The Fed is maintaining a hawkish tone.

We suspect they would rather wait for more firm evidence of slowing inflation over next two months – remembering they do not meet in August – than ease up too early and risk another embarrassing U-turn.

The curve of expected future policy rates shifted down 15bps last week. It now has rates peaking at the end of 2022, rather than the previous end of Q1 2023.

This is a big shift from where we were a month ago. It is likely the economy will need to be a lot weaker for this to happen.

Elsewhere there were limited data releases last week.

Regional Fed manufacturing indices were soft. But the Flash US Manufacturing PMI was better than expected at 52.3 vs 52.7 in June.

Interestingly the Services PMI was weak at 47 vs 52.7 in June, with the pricing component notably lower.

Overall, it painted a constructive picture of inflation easing.

Energy markets

Gas resumed flowing through the Nordstream pipeline from Russia to Europe after maintenance, calming some fears.

It is running at 40% capacity. This enables Germany to build enough reserves for winter – but only just. It remains vulnerable to any change in the Russian approach.

We now have the perverse situation where the West has imposed sanctions to constrain Russia’s ability to sell oil, but is desperately hoping Moscow keeps supplying gas.

Germany suffered the ignominy of asking the rest of Europe to reduce gas consumption 15%. Greece and Spain refused. The latter drew on Germany’s own Euro crisis era rhetoric noting that “unlike other countries, we haven’t been living above our means in terms of energy”.

Oil and gas will be key to determining whether sentiment around inflation continues to improve.

The growing consensus is that weak global growth will see oil prices fall below US$90, relieving pressure on headline inflation and consumer inflationary expectations.

This would allow softer Fed rhetoric perhaps as early as September.

 

The alternate view is that supply constraints, an end to strategic petroleum reserve (SPR) releases and Chinese re-opening could drive energy prices higher even as the global economy slows.

This would leave central banks facing an impossible choice.

China

Chinese equities have rallied since May on the easing of Covid restrictions.

However sentiment has turned more negative.

This is partly driven by the mortgage strike in relation to unfinished homes and also by the lack of any meaningful stimulus. Measures enacted recently really only serve to offset the negative impact from housing weakness.

At this point, it appears growth with be sluggish for the next few months. It is hard to see China as a big driver of any improvement in sentiment towards global growth in the near term.

The US dollar continues to drag the Chinese Yuan (CNY) higher, affecting its ability to compete with Korea and Japan. There is a risk we may see another step down in the CNY, which would likely be negative for commodities.

Australian market

Last week’s broad ASX rally was led by tech (+7.3%), financials (+4.5%) and small caps (+5.8%).

Small cap resources had a good bounce (+6.9%) after a sharp fall in recent weeks (about -33% since April).

This is symptomatic of being oversold and the market chasing beta into the bounce, rather than a shift in fundamentals.

We are seeing small signs of rotation from consumer defensives to discretionary. This was helped by an upgrade from JB Hi-Fi (JBH, +10.1%).

This will be something to watch in reporting season. We note Nine Entertainment (NEC) as a good example of stock that has been heavily de-rated without any sign of earnings softening.

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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 an independent, 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

A positive story for bonds; Inflation-driven sustainability opportunities; Investing amid inflation; Defining a neutral cash rate 

Bonds are back. Here Pendal’s head of income strategies AMY XIE PATRICK explains why

• Ten-year bond rates close to 4 per cent
• Benchmark returns for other asset classes higher
• Negative correlation between bonds and risk assets has re-emerged

INVESTORS have struggled to earn good returns from fixed income assets in recent years.

But yields on government bonds have risen over the past year — and the negative correlation between bonds and risk assets has re-emerged.

That reflects the narrative around a recession in the United States, Europe and possibly even Australia, says Pendal’s head of income strategies Amy Xie Patrick.

“The bond story of recent years has been flipped on its head,” says Xie Patrick.

“Buying 10-year government bonds in Australia can get you nearly 4 per cent. At the height of the pandemic, it was 50 basis points.

“Now the credit risk-free rate is 4 per cent, which raises the bar for other asset classes.”

Those other assets might be riskier fixed income instruments including junk bonds and private sector debt, or other asset classes such as equities and alternatives.

When government bonds yields have risen so much, so quickly, the economics of all other investments change.

“You can get credit-risk free, 10-year yields in Australia for 10 per cent. That sounds pretty good,” Xie Patrick says.

Investors should consider buying high-quality sovereigns, such as United States or Australian bonds, which are free from credit risk, says Xie Patrick.

Changing attitude to bonds

Investors have been hesitant to include bonds in portfolios in recent years — but that’s changing, says Xie Patrick.

“For the last three years equity yields were much higher than bond yields. Investors were better off sitting in equities and collecting the dividend.”

But fears of a recession have changed all that. Xie Patrick points out that it isn’t central banks around the world that will trigger a recession. Rather, it’s tumbling consumer sentiment that reflects inflation.

“You’re filling up your petrol tank and the cost at the bowser just keeps going up. Grocery bills are so much higher and feeding a family is becoming expensive. None of that is good for consumer sentiment,” she says.

Private sector sentiment is critical to economic growth because confidence leads to higher spending. The most recent Westpac-Melbourne Institute of consumer confidence in Australia (PDF) – the long-time benchmark – this month fell to its lowest level since the beginning of the pandemic.

In the US, the benchmark measure from the University of Michigan has hit a record low.

No quick turn-around

Consumer sentiment isn’t going to improve quickly, Xie Patrick says.

“High levels of inflation tends to lead consumer sentiment by six to 12 months, so even if inflation has peaked, we’ve still got six to 12 months of poor consumer sentiment. That’s not great.”

This adds to the argument why bonds are back.

One lingering question for investors is whether four per cent is a good return, given inflation is currently higher than that.

“To put that value into perspective, inflation markets infer that over ten years inflation will be, on average, around two-and-a-half per cent, which is the Reserve Bank’s inflation target,” Xie Patrick says. “Ten-year bonds are yielding a nominal rate of four per cent.”

“By owning a 10-year Australian bond, you are taking effectively no credit risk, keeping up with the two-and-a-half per cent long-term rate of inflation and then getting another one-and-a-half per cent.

“You’re getting paid to own something without credit risk and keep up with inflation.

“The value proposition for bonds is really back.”

The Reserve Bank considers a neutral rate around 2.5% and a bit. But how much is the bit? TIM HEXT has some answers

IT’S BEEN clear for a number of months that the Reserve Bank wants rates back to neutral sooner than later.

Quite simply nothing about high inflation and low unemployment cries out for expansionary rates.

Governor Phil Lowe has implied he would like to see neutral rates by year-end — and he considers neutral around 2.5% or slightly higher.

I was therefore quite excited to see the RBA has been working on “what is neutral” and whether it’s changed since the pandemic.

They referenced this work in this week’s RBA minutes, but the contents will have to wait for public release at a later date (we hope).

The concept of a neutral cash rate is very fluid to begin with.

The best notion is a rate that reflects long-term inflation expectations plus any adjustment for productivity.

That is, you should expect your cash returns through the long-term cycle to keep pace with inflation and (assuming positive productivity) deliver some small extra return.

This leads to the notion of 2.5% (the RBA target) plus a bit.

The size of that “bit” becomes crucial — and for that we need a view on productivity.

There are many reasons and views on why the last decade has seen poor productivity growth (less than 1%) and cash rates have been at or lower than inflation.

The neutral rate was roughly the inflation rate as evidenced by cash rates stuck at 1.5% from 2016 to 2019 — just below inflation at the time.

Have we experienced, as with many things, a Covid reset that changes this outlook for productivity?

That question will be answered in time, but there are some positive signs.

Firstly, business lending is strong. Private sector credit is nearing double-digit growth (currently 9%) for the first time since the mining investment boom more than 15 years ago.

And it’s not just housing driving it. Labour shortages are playing into the idea of replenishing capital stock and using existing labour more efficiently.

Secondly, Covid-driven supply shortages have seen businesses and households rethink efficiencies, whether reducing commuting or streamlining processes.

Against this, of course, are the challenges of reduced globalisation and sustainable energy. Both of these, though necessary to meet other challenges, introduce potentially less productivity at least in the medium term.

As investors, a return to positive real yields should be seen as an encouraging sign that demand for money is picking up again.

Businesses see productive uses for borrowing. While higher cash rates in response may reduce longer-term valuations for assets, it is not a sign of imminent recession as some risk markets are now pricing.

Investors should welcome news that a risk-free asset can not only keep pace medium term with their cost of living, but also earn a return above that — something not seen for a decade.

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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

What is the neutral cash rate in Australia? The debate rages on. Pendal assistant portfolio manager ANNA HONG explains

Today’s RBA minutes provide insights into the central bank’s decision making in its last policy meeting on July 5.

The minutes clearly lay out the uncertainty around price risks due to the continued war in Ukraine and China’s Covid-zero policy.

One thing is certain however. There will be another rate hike in August — most probably 50 basis points and a chance it could be higher.

The Reserve Bank expects inflation to peak late in 2022. We are merely a few weeks into the second half.

This means the RBA believes the inflation problem will worsen in the months ahead.

With only one blunt instrument in the monetary toolkit, there is no other option but to raise rates again in August.

How much? The case is much stronger for a rate hike of 50bps or more.

Why? The Australian June Labour report obliterated any lingering doubts that we are in in full employment.

Employment gains almost tripled expectations, leading to an unemployment rate of 3.5% — even accounting for the improvement in participation rate.

There is now one unemployed person per job vacancy in Australia. In other words, filling all our job vacancies will require every single unemployed person.

The economy is running red hot and the tightest labour market in almost 50 years is driving consumption demand on an upward trajectory.

The only way to cool off is to slam the brakes hard.

With other central banks raising the hawkishness stakes by hiking rates 0.75% to 1% in each board meeting, it will come as no surprise if the RBA raises cash rates by more than 50bps.

Despite earlier “guidance” indicating the most likely rate hike scenarios are 25bps and 50bps, Dr Lowe may once again have to correct himself.

The RBA governor is well practised on backflips — most notably Yield Curve Control and no rate rises til 2024.

Not surprisingly short rates drifted higher this week.

Longer rates are caught between expectations of higher cash rates and the damage to the economy and potential recession those higher rates may cause.

For now, 10-year Australian government bonds are holding around 3.5% but are vulnerable to drifting back towards 4%, where they were only a month ago.

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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. In 2020 the team won the Australian Fixed Interest category in the Zenith awards.

With the goal of building the most defensive line of funds in Australia, the team oversees A$22 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

Here are the main factors driving the ASX this week according to Pendal investment analyst ANTHONY MORAN

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INFLATION continues to be hotter than expected, as last week’s monthly US Consumer Price Index print shows.

Core CPI grew 5.9% year-on-year. It was down from 6% in May, but the market was expecting it to decelerate to 5.7%.

Meanwhile headline CPI (which includes energy and food) stayed high at 9.1%.

Despite this, the market’s reaction was relatively muted. The S&P500 fell 0.9% last week, following a solid rebound on Friday. US 10-year bond yields fell 16bps, with the inversion tightening from -3bps to -21bps.

This suggests the narrative of central bank over-tightening — followed by recession and the need for rate cuts in CY23 — remains in control.

In this context, the market is focusing on the current recession in US manufacturing and sees CPI as a lagging indicator.

The role of the consumer will be critical in determining the scale of a slowdown and needs to be watched carefully.

Locally, the S&P/ASX 300 fell 1.1% last week.

US inflation

We are seeing broad-ranging price declines in a number of areas, suggesting flat or negative month-on-month CPI figures in the next couple of months.

Some key factors:

1. Commodity prices are generally weaker due to a combination of disappointing Chinese economic data, slowing global manufacturing and a stronger US dollar. Action in the oil futures market suggests a deteriorating outlook for oil fundamentals, bringing it closer to an already negative view in financial markets. Weakness in oil prices is now flowing through to gasoline.
2. Global supply chain indices are showing material declines.
3. The outlook for food inflation is improving as soft commodity prices continue to decline. Corn, wheat and milk prices are all down materially from their highs. Better harvests and some easing of Ukrainian supply constraints are helping here.
4. In the US, used car and house prices are also finally rolling over, though they remain at historical highs.
5. Wage/price spiral concerns are easing at the margin. The labour market remains tight, but weekly jobless claims are now rising, taking some pressure out of the market. There are no signs of wage pressures growing in measures such as private sector average weekly earnings.
6. A third of CPI comes from shelter and “rent of primary residence” which accelerated from 5.2% in May to 5.8% in June. There are indications that growth in asking rents has peaked, which points to a slow-down in the rent component of CPI as well.

Gas remains the outlier to easing commodities. European gas prices are rising on Russian supply curtailment. Hot weather is seeing the same in the US.

However in aggregate these movements in price indices are starting to feed through to inflation expectations. Long-run inflation expectations fell to 2.8% in July (down from 3.3% in June) according to the latest University of Michigan survey.

US breakeven inflation rates have also fallen markedly over the past month. The two-year breakeven rate has fallen from about 4.5% to about 3%, for example.

The US consumer: not going down without a fight?

Compared to the end of June the expected peak in the Fed funds rate has been brought forward from Apr 23 to Feb 23, but the peak rate is at a higher level.

This reflects a view that the economy will deteriorate faster and deeper than previously thought — and that short term inflation remains too high.

There is a recession in global manufacturing driven by the effects of higher interest rates, energy prices and US dollar, combined with the roll-off of stimulus and normalisation of spending patterns post-Covid.

New orders are dropping and earnings are being revised down. This is not a positive for markets.

But it’s important to note we still don’t know the degree to which ongoing strength in US consumption can offset the manufacturing downturn.

We note:

1. Consumer confidence remains stronger than expected. The University of Michigan June survey had the index at 51.1 in June, versus 50 in May and 49.8 expected. Retail sales numbers for June grew 1% month-on-month, versus +0.9% expected.
2. Quarterly commentary from the big US banks, while wary on the longer-term, noted that current conditions remain positive. JPMorgan Chase CEO Jamie Dimon said: “Consumers are in good shape. Jobs are plentiful. They’re spending 10% more than last year. Businesses, you talk to them, they are in good shape… We’ve never seen business credit better — ever — like in our lifetimes”. Citi CEO Jane Fraser said: “Little of the data I see tells me the US is on the cusp of a recession”. Bank CFOs are saying consumer spending remains resilient, with a mix shift to travel and entertainment. They are seeing low levels of credit losses.
3. Jobless claims are deteriorating, but not at a scary rate.

The upshot is that the consumer may be more resilient than expected due to strong initial savings balances, a still-tight employment market, good wages growth and a softening in short-term inflationary pressures.

The question is whether this relative strength in the consumer will partly offset the recession in global manufacturing, leading to an overall economic outcome that is better than currently feared.

The current consensus view is that resilience in consumer spending is simply a head-fake and a summer splurge, with the hangover coming in 2H22.

This needs to be watched closely. We could be facing a scenario where the savings buffer for consumers is sufficient to see them through the peak in inflation and we see a slowdown, but not a material consumer recession.

We note markets are already very bearish. The ratio of consensus US upgrades to downgrades and changes in target prices has not reached the lows of previous market downturns. But it is in a very pessimistic range by historical standards.

Measures of shorting are already at the low points of previous cycles. The S&P 500 P/E has retraced to the Covid low point and is close to pricing in a recession.

This means it does not take much to beat very depressed expectations.

Energy crisis ongoing

There are a number of ongoing market concerns, including the fact that Covid remains disruptive and the outlook for manufacturing is deteriorating.

The energy situation remains the wildcard and could deteriorate further.

US gas prices are up on hotter weather. European prices have risen in response to tighter supply due to scheduled maintenance on the Nordstream pipeline. The latter will be closely watched — it is due to reopen this week. The risk is it becomes a geopolitical bargaining tool.

Higher energy prices are seeing Europe enter a recession much deeper than expected in other regions. The bearish European economic outlook was reflected in the very brief EUR-USD parity party this week.

Meanwhile, winter is coming.

Germany needs to be at 80% gas storage level by October to be ready for colder weather. Current storage levels are 64.7%. They need to add 0.19% a day to get there.

This was not a problem prior to Nordstream maintenance, but there will be serious issues if it doesn’t come back online in a timely fashion.

China macro weaker

China continues to struggle with impact of the zero-Covid strategy, adding to current market concerns.

Beijing has announced new financial stimulus measures. Packages put in place last year are seeing some benefit in infrastructure investment.

But the real estate sector remains a mess.

New home sales and starts are down dramatically. This is a large proportion of the Chinese economy. It is feeding through to broader economic softness, with weakness in steel production and prices. It is also an additional drag on global commodity prices.

Retail sales recovery post the partial reopening has also disappointed.

The silver lining for Australia is that Beijing is looking to resume Australian coal imports to avoid its own energy crisis.

Markets

Metals & Mining (-6.6%) led the S&P/ASX 300 lower last week, driven by weaker global industrial data and a stronger USD.

Staples (+1.3%) and Healthcare (+3.4%) were pockets of strength, benefiting from a pull-back in bond yields and an uncertain economic outlook. The rest of the market was flattish.

As it has been for a while, the market is grappling with uncertainty over how bad the upcoming recession will be. It was quiet week on news flow as we move towards reporting season.

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About Crispin Murray’s Pendal Focus Australian Share Fund

Pendal’s head of equities Crispin Murray 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 an independent, global investment management business focused on delivering superior investment returns for our clients through active management. 

Find out more about Pendal Focus Australian Share Fund  

Contact a Pendal key account manager

Here are the main factors driving the ASX this week according to Pendal investment analyst ELISE MCKAY

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Find out about Pendal Horizon Sustainable Australian Share Fund

THE markets endured another volatile week as we entered the second half of 2022.

Overall they were positive: the S&P 500 and S&P/ASX 300 gained 2% each and the NASDAQ lifted 4.6%.

Macro themes continued to lead sentiment — everything that worked in the first half of the year not working now and vice versa.

We saw growth outperform and commodities underperform last week as the case for peak inflation/near-term recession strengthened. This is supportive of long-duration plays.

Bond markets remain confused. Different yield curves are giving positive and negative signals as to the odds of a recession.

When averaged, however, the yield curve remains in positive territory.

We saw a 20bps increase to US 10-year bonds, bringing them up to 3.08%. Note the market is now pricing around 75bps of cuts in 2023.

The Atlanta Fed’s GDPNow tracker suggests the US is already in a technical recession, though this is challenged by positive payroll data.

Wages appear to be cooling off across many sectors which suggests Covid disruptions and re-openings have been the primary driver in the past, rather than linkages to structural inflation.

Looking forward, the next US CPI report on July 13 will be a key test for the market.

If it’s hotter than expected the thesis around peak inflation will be tested. Yields will likely increase and long-duration growth will once again underperform.

Economics and policy

The case for peak inflation continues to build with commodity prices softening, inventory de-stocking, supply chains recovering and labour market conditions easing.

Commodity prices rolled off again this week on the back of a strong USD.

There was a slight bounce at the end of the week after reports China would provide a US$220 billion stimulus package.

Retail gasoline prices were off peak levels and futures suggest prices will further decline over the next six weeks.

Anecdotal feedback implies retail inventory levels remain elevated. But it’s still unclear if this signals consumer weakening or a shift of spending towards services and travel.

June BAML credit card data supports the former with real spending declining for a second consecutive month. Spending on travel and restaurants fell for the first time since the Omicron peak.

Supply chain pressures continue to ease with the Global Supply Chain Pressure Index declining consistently.

The index is still however largely positive (2.41) meaning it is still elevated compared to pre-Covid levels.

We saw confusing data in the manufacturing industry with the ISM Services index increasing while the ISM Manufacturing index for new component orders slipped to a two-year low.

Global container trade volumes tracked negatively in May. Though on an annual basis volumes are flat versus long-term average growth of 3%.

On the employment front layoffs are still rising. June was a particularly tough month for the tech sector. We have seen general hiring freezes across sectors.

Zooming out, jobs data is holding up better than expected, with 70% of industries seeing job gains.

Unemployment is at 3.6%, average weekly hours are back to pre-Covid averages, and the three-month annualised average hourly earnings is up 4.3%.

Bonds

There is a lot of uncertainty in the bond market about the timing of a potential recession.

Usually the spread between the US 10-year and the Fed Fund rate moves in tandem with that of the 10yr – 2yr. But there has been a divergence on recent timing.

We saw the 10yr – 2yr spread invert on a daily basis last week, while the 10yr Fed Fund rate spread remained in positive territory.

This contradiction suggests the elevated volatility is likely to continue for some time.

It is worth noting we typically need to see the 10yr – 2yr inversion averaged over a month to suggest a future recession.

Markets

Confusing macro data leads to a somewhat confused market.

Despite bond yields rising, technology was the best performing sector last week.

Commodities fell with Brent crude oil down 4.1%, iron ore off 1.5% and gold losing 3.2%.

Reflecting on the first half of 2022, the US 60/40 “world retirement portfolio” had its second-worst start to the year since 1900, returning -17%. Once this result is reflected in retail investor’s report cards there could be structural outflows in the near term.

This would likely dampen the market’s positive start to 2H22 and affect broader performance.

In Australia performance was positive last week despite resources retreating.

The RBA’s 50bps rate hike was in line with expectations and had minimal impact  on the ASX. In fact, there was a slight rally in long-duration growth, suggesting some relief in expectations.

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About Crispin Murray’s Pendal Focus Australian Share Fund

Pendal’s head of equities Crispin Murray 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 an independent, 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 does the RBA’s latest interest rate hike mean for investors? Pendal assistant portfolio manager ANNA HONG explains

TODAY’S RBA rate hike of 50 basis points is no surprise – it’s coming off a low base.

The delay in lifting rates at the start of the year means we have a lot of ground to cover, just get back to neutral.

This month’s hike – which takes Australia’s official cash rate to 1.35% — is about tackling actual inflation.

Further hikes in coming months will be about tackling inflation expectations which are just as important to get under control.

This time last year we might have thought inflation was something that happened to others, but not here in Australia.

It’s now apparent that we are not different – just delayed. The delay has some upside though, since other developed economies can provide some guidance of what’s in store:

	New Zealand	US	Canada	UK	Australia
Policy rates	2%	1.75%	1.5%	1.25%	1.35%

How high can this go?

Guidance aside, what everyone wants to know is: “How high can this go?”

Australians have more say in the answer than we may realise.

While tackling inflation is now the number one priority, the RBA has no desire to send us into recession just for the sake of it.

That’s why the central bank is doing this delicate dance of 0.5% hike-and-see instead of breaking the economy with a one-off 2%-3% sledgehammer hit.

The Reserve Bank is trying for a soft landing. To achieve that, a few things need to dovetail for demand and supply to reach stable prices:

• A pick-up in the global supply chain: This inflation cycle is supply induced. The faster the supply chain issues ease, the more the inflationary pressures will ease.

• Evolution of household spending: Consumption growth is dragging prices higher while supply bottlenecks make it hard to keep up. Australian households can slow rate hikes by reducing consumption. That would allow time for supply to catch up without the RBA hiking rates by an ever-increasing amount. Recent NAB data shows we are already starting to adapt and evolve.

• Prevent a wage-price spiral: If workers are fully compensated for the increased cost of living, no personal consumption belt-tightening will be required. A merry-go-round of ever-increasing money chasing limited goods and services will lead to sustained higher inflation requiring more hikes. Counterintuitively, accepting a real wage cut will lead to long-term gains for the greater good.

No pain, no gain. It is unpleasant to cut consumption, and no one wants a cut in real wages.

But a protracted rate hike cycle will send the Australian economy into a recession, which is no good for anyone. We have a say in how high RBA’s Cash Rate Target will be. It’s time to exercise that power.

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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. In 2020 the team won the Australian Fixed Interest category in the Zenith awards.

With the goal of building the most defensive line of funds in Australia, the team oversees A$22 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

Here are the main factors driving the ASX this week according to Pendal investment analyst Sondal Bensan

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Find out about Pendal Horizon Sustainable Australian Share Fund

THE Australian market outperformed peers again last week as fears of a 2023 US recession started to increase.

We saw large drawdowns early in the week but they were partially recovered by Friday. The S&P/ASX 300 ended down 0.46% while the S&P 500 retreated 2.2% and the Nasdaq fell 4.13%.

Positive returns late in the week were driven by China finally beginning to reopen along with theories on peak inflation — which gathered momentum and resulted in a fall in bond yields globally. Despite this, recession fears remain.

Speculation about a smaller-than-expected 50bps rate rise at the Fed’s upcoming July meeting influenced sentiment — following weeks of a consensus view at 75bps.

A smaller rise could prove calming for markets. But it is still very much an outside chance considering recent rhetoric from the Fed.

China

After months under a zero-covid policy Shanghai is officially moving out of lockdown. China is also reducing quarantine for inbound travellers to ten days — which is seen as a small positive step.

China believes the spread of the virus will have far greater consequences than the lockdowns themselves, so there is caution on any change of course.

Unlike Australia, there has been no unemployment safety net for China’s workers. This will be the greatest challenge to overcome in restoring confidence.

China has talked up monetary support for the economy with 300 billion yuan ($A 65.6 billion) in extra funding for infrastructure projects, though nothing else has been confirmed.

Beijing is still optimistically targeting an annual GDP growth of 5.5%, so it’s expected further funding will be provided.

As we’ve seen around the world, activity accelerates rapidly after exiting lockdown — and we saw that in the latest Chinese PMI data.

The likelihood that China will shift from a zero-covid policy to living with covid remains very low even as the rest of the world moves forward.

One reason is that vaccination rates among the elderly are still comparatively quite low. Unlike Australia, China has not committed to a policy on Covid-linked vaccination rates so we are unlikely to see vaccinations increase quickly.

Full vaccinations among Chinese nationals aged 60 and over have risen to 64.8% (up 8.3 percentage points) over the past two months.

If the rate continued steadily at 0.6 points per week it would hit 90% in April 2023. But in recent weeks vaccination rates have slowed, which could further delay a complete reopening.

We will likely see in China a continuation of the stop/start mentality which lowers confidence and makes it incredibly difficult for economic growth and unemployment to be restored.

On top of a global growth slowdown and strengthening US dollar, this likely means means headwinds for commodity prices.

The good news for markets with China’s reopening is easing of supply chain pressures which will create some relief from rising inflation.

Inflation

Inflation — and inflation expectations — remain a key driver of markets.

There are no short-term signs confirming inflation has peaked, but there is an emerging sentiment it may top out sooner rather than later.

Fed rhetoric may have been too strong, since the market is starting to consider the prospect of rate cuts in 2023.

Calls around peak inflation are not left of field given the current magnitude and base effects.

The economy was expected to return to normality after a post-covid, bubble year. But it’s important that the speed and magnitude of rate rises does not break the economy before then.

The pace at which inflation subsides will be key. We’ve seen signs of this already.

There have been significant falls in many hard and soft commodities as well as swelling inventories which can absorb some inflation within corporate margins as demand fades.

However, for inflation to come under control, demand must fall and supply constraints must ease.

Covid created a world of free money to support consumption, but at the same time it severely restricted the world’s ability to produce and transport goods. Add in the turmoil in energy and commodity markets spurred from Russia’s invasion of Ukraine, and we have the ultimate recipe for inflation.

Consumer confidence in the US continues to slide to a near decade low as inflation concerns weigh heavily on households.

Despite 3.5% unemployment in the US, the number of job vacancies is about twice that. This indicates that right now consumer confidence is not too bad at the aggregate level, though it is likely to worsen.

Rapidly falling consumer confidence will be a problem for markets and must be watched closely.

There are theories that household savings generated throughout the pandemic will act as a buffer for consumption. Using Australia as an example, household savings average around 11% compared to the 5% from the pre-pandemic days.

It is possible that a collapse in confidence within an inflationary and rising rate environment that most societies haven’t seen before will result in the savings rate rising before it helps to buffer inflation.

This would lead to a much faster fall in demand/consumption than many might expect.

On a more positive note, the supply side continues to improve — helped recently by China’s reopening. This is a positive indicator for inflation peaking.

The other factor giving hope for a near-term inflation peak is the rapid reversal in many commodities from their previous high. Notable examples include sell-offs across the board in soft commodities as well as iron ore.

While weakening commodity prices are good news for inflation easing, we must remember most of the inflation to date has come from food, energy and other core goods. Services inflation has yet to filter through. How wages evolve will be also key.

There are headlines around the world about wages chasing inflation — with step ups of 4-6% under consideration.

Some companies such as Qantas and Nine are offering tactical cash bonuses to stave off a permanent wage increase. This will not be the norm as wage pressures increase by the week.

Bonds

Bond yields fell as market pessimism drove the market last week. US and Australia 10-years fell 23bps and 12bps respectively.

The US 30-year mortgage rate has also retraced back to 5.61%.

This week’s RBA announcement should be largely uneventful. A 50bps increase is expected to bring the cash rate up to 135bps.

Australian Markets

The markets are becoming quite narrow considering the broad themes discussed above.

Last week the markets performed better than expected as recession fears grew and bond yields retraced.

Utilities (2.6%), Consumer Staples (0.68%) and Financials (0.36%) saw gains throughout the week. In contrast, Resources (-1.58%), Tech (-2.35%) and REITS (-1.8%) fell.

Stocks

Resources suffered another rough week. Evolution (EVN, -29.59%), Northern Star (NST, -14.77%) and Newcrest (NCM, -12.02%) were the biggest detractors.

Evolution saw downgrades largely based on increased costs. Costs for gold miners have historically been highly correlated to oil, with knock-on effects from the squeeze on diesel refining. On top of that the labour disruption impacting many industrial companies is now affecting Evolution.

Companies deemed less sensitive to economic weaknesses such as Computershare (CPU, +5.07%) continued to eke out gains. Some non-REIT bond sensitives such as Transurban (TCL, +3.74%) and APA (APA, 3.30%) also saw positive performance.

Elsewhere we saw Metcash (MTS, +2.42%) report well ahead of the market at all levels including EBIT at $472m and NPAT at $300m. With strong sales momentum Metcash continues to grow revenue at the fastest clip in all segments versus peers. It remains a key position for many of our portfolios.

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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 an independent, 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