How to identify a good stock, sustainable opportunities in mining, return to China, how Aussies are adapting to inflation, a new approach to engagement

State government debt is becoming increasingly higher in yield against Commonwealth debt. Pendal’s Tim HEXT explains what that means for investors

AUSTRALIA is slowly re-emerging as a federation of states after the disunity of the past few years.

Governments such as Queensland and WA are running big ad campaigns to lure tourists back — barely months after they were threatening jail for interstate interlopers.

Though we are again a single nation, the financial status of the states has diverged in the post-pandemic world.

The recent round of State budgets revealed a number of things:

1. Total State debt will net increase by $67 billion in FY22-23.  Commonwealth debt will likely net increase by $40 billion. Both have downside risks but the Commonwealth more so. There is now twice as much Commonwealth debt as semi-government debt outstanding and usually their programs are at least double. This will be the first time in over a decade that State issuance exceeds Commonwealth.
2. WA (and to a lesser extent Queensland) are at or near a budget surplus courtesy of booming commodity prices and royalties. S&P this week upgraded WA to AAA, joining the ACT as the only AAA state or territory.
3. NSW and Victoria are now the laggard states on debt — unlike most of the past decade. NSW will be borrowing about $24 billion of new money, Victoria $16 billion and Queensland only $8 billion. WA is flat.

NSW has an election next March… Hence a State budget that continued to act like NSW is an economy with excess capacity needing help from the government. Or as The Australian Financial Review described it — a “gobsmacking spendathon.”

NSW is the only State reporting more borrowing not less since the mid-year update, despite a better than forecast economy. Vouchers and handouts seem to be here to stay — not just as emergency measures.

NSW, and to a lesser extent Victoria, may cause the RBA to go harder than previously thought.

We are yet to see where the new federal government lands with its budget, but the whole point of rate hikes is to reduce demand in a supply-constrained economy.

State budgets are leaning the other way, adding to demand and therefore increasing inflation pressures.  And unlike the federal government, the States cannot print money to finance it all.

This all leads to the fact that State government debt is becoming increasingly higher in yield against Commonwealth debt. 

As a fund manager we don’t worry about getting our money back from States. After all, the federal government has shown on numerous occasions it effectively stands behind the credit.

But we do have to worry about how that debt performs.

For now, the supply and demand dynamics suggest State debt will continue to underperform.

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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 Pendal investment analyst Oliver Renton. Reported by portfolio specialist Chris Adams.

Find out about Pendal Focus Australian Share Fund
Find out about Pendal Horizon Sustainable Australian Share Fund

WE SAW some relief for equity markets last week following a tough period. The S&P 500 gained 6.5%, the NASDAQ added 7.5% and the S&P/ASX 300 put on 1.6%.

There was a notable rotation in performance on the ASX. The year’s bottom-three sectors — information technology, real estate and consumer discretionary — were the best performers for the week, up 7.9%, 6.9% and 5.5% respectively.

Resources — which had been a lone bright spot in the market — fell 5.6%.

US Fed rhetoric continues to emphasise commitment to the fight against inflation. Increasingly, investors are trying to work out what this means for commodity demand. This helps explain market moves over the week.

We also saw this in volatility among commodity markets. Brent crude fell 2.6%, iron ore was down 5.4% and copper lost 6.4%.

Economics and policy

US

Fed sound bites indicate it will raise hard and fast, with seemingly very little prospect for a soft landing. 

Several members of the Fed’s Open Market Committee signaled that another 75bps move was very much on the cards next month. Fed governor Christopher Waller noted “the central bank is ‘all in’ on re-establishing price stability”.

Chair Jay Powell noted the Fed was “acutely focused” on returning inflation to 2 per cent and commitment to reining in inflation was “unconditional.” He warned a recession was “certainly a possibility” and it would be “very challenging” to achieve a soft landing.

In this vein, Philadelphia Fed president Patrick Harker noted the US could very well see a couple of quarters of negative growth.

The rate trajectory is well understood, but the market is still grappling with the possible implications. This is driving much of the volatility in markets.

China

President Xi noted last week that Beijing would “strengthen macro-policy adjustment and adopt more effective measures to strive to meet the social and economic development targets for 2022 and minimise the impacts of Covid-19”.

China should be a net positive contributor to the global economy in the second half of 2022, compared to the first half. That said, there is skepticism over the strength of the outlook given competing policy constraints.

Australia

RBA governor Phil Lowe noted the path of rate hikes currently implied by market pricing was too aggressive and not likely. But here, too, markets remain sceptical and are looking for evidence that the RBA has a handle on inflation. 

Markets

There is a lot of bearishness priced into current markets. At this point the S&P 500 is sitting at the third-worst, first-half return since 1928 (after 1932 and 1940).

Historically, the worst first halves have resulted in a positive second half — though usually not enough to return a positive full year. It remains to be seen if we follow that historical path this time around.

We are also mindful of bear market bounces.

Selling the rally has been a consensus trade in recent times. For example the ARK Innovation ETF — a proxy for the long-duration growth names — has undergone more than 15 rallies of 10 per cent or more over the past 15 months, but it’s still down some 70% from its highs.

Similarly, the NASDAQ had 19 rallies of more than 10% in the three years of the tech crash from 2000 to 2003.

Nevertheless this market has had a lot thrown at it in a historical context. So, too, in bonds, where the total return of a 10-year US treasury bond over the past year has been among the worst ever — albeit with a strong base effect.

We have also seen a large and sharp drawdown in high-yield bonds in a historical context.

At this point the relative forward P/E of defensives is at a historically extreme premium to cyclicals.

That said, current operating conditions remain fine. When we start to see earnings downgrades come through this may shift the “E” in the cyclical P/E — so they no longer look as cheap versus defensives.

Pessimism is showing up all over the place.

• The pace of rising US bond yields has exceeded even the 1994 experience.
• The US homebuilder index has fallen about 40 per cent. Historically moves of this scale have usually — but not always — been followed by decent rebound. In this instance, the scale of mortgage-rate increases continues to pose a material risk.
• Sentiment indicators around commodities are near extreme bearish levels in a historical context. The copper price continues to come under pressure over demand concerns.

There is a lot of chatter about private equity activity in the current environment.

With this backdrop and in this type of market it can be dangerous to get too bearish on certain stocks and sectors. Private equity has lots of liquidity and public market valuations are relatively cheap.

For example, we have seen a recent bid for Ramsay Health Care (RHC). The infrastructure space has also been very active.

Finally, it is worth noting Covid is not going away.

Combined with this season’s flu, Covid is leading to ongoing societal disruption. This is showing up as a real cost to businesses where working from home is not an option — such as supermarkets, hospitals and airlines.

The duration of this impost remains to be seen.

Energy

Energy came under pressure last week. 

With the Fed talking tough, people are questioning how oil can escape the maelstrom. Energy is a key component of inflation, which needs to be brought under control.

From a fundamental point of view demand remains stubbornly inelastic, while supply constraints remain an issue.

It is also worth remembering the oil price is not particularly extended from a historical point of view. This is all mitigation against the risk of a material fall in the oil price.

We also remember how strangely oil traded during the GFC. It literally peaked 12 months after the market peaked.

Oil, though, is also very macro-driven and is part of a broader trade expressing concern over the pace of US tightening. Thematic trades can prove to go way deeper and last way longer than the fundamentals justify.

All that said, it would probably take a recession to materially affect oil demand and prices enough to start helping tame inflation.

It is also important to note that refined oil product prices locally continue to rise even as crude has fallen, due to high regional refining margins.

This, in turn, could be driven by China which has spare capacity but may be holding it back.

Russian production remains stronger than many expected and is finding a home in China and India.

Sanctions are about to get tighter, but it seems people find ways of working around these impediments. The upshot is that the effect of trying to remove Russian volumes is not contributing as much to the price as some think.

Oil and refining is becoming very political in the US. There is not much the Biden administration can do about refining because the additional capacity doesn’t exist and has a long lead time. Meanwhile utilisation of existing capacity is already very high. If the US government sought to ban exports then regional refining spreads would go higher again.

Stocks

The rotation back to growth saw Block (SQ2, +21.6%), REA (REA, +19.7%), Xero (XRO, +11.7%) and Next DC (NXT, +10.6%) among last week’s market leaders.

Resources fared worst, led by Whitehaven (WHC, -9.6%), Evolution (EVN, -8.4%) and Santos (STO, -7.3%)

Elsewhere an update from Qantas (QAN, +2.1%) reiterated guidance but flagged some one-off costs, which equates to an upgrade for the underlying operations. Demand remains strong. Capacity has been trimmed to 110% of pre-Covid levels in response to higher fuel costs. Importantly net debt continues to improve, down $500 million since April to $4 billion.

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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

Time to rebalance, the case for AREITs, how to invest in solving homelessness, a global equities sector to watch

Are bonds a buy? Our head of government bonds Tim Hext offers his view in Pendal’s weekly Income & Fixed Interest snaphot

RATE HIKE expectations turned up another notch last week after a higher-than-expected US CPI and a 75bp lift from the US Fed.

Three-year bonds in Australia rose from 3.12% to 3.62% — another 50bp move. 

To put this in perspective that was more than the entire market range in 2018.

By the end of last week terminal cash rates were priced at 4.25% in mid-2023 and 3.8% by the end of this year.

This is well ahead of even a hawkish RBA’s expectations. Comments from Phil Lowe suggested they were too high even with the expectation of inflation hitting 7% late this year. This saw a small rally today (Tuesday).

Clearly the near-term mission of the RBA is to get back to a neutral 2.5% cash rate over the coming months.

Very little will stop them.

However, the broader debate is just how resilient the household sector — and to a lesser extent the business sector — is to these higher rates.

The RBA quotes higher savings as an important buffer. But it will not be the median household in trouble when mortgage rates hit 5-6%. Mortgage stress will fall on young families with a high propensity to spend — families without any savings buffer.

Bonds a buy?

The question of whether bonds are a buy at 4% is being increasingly asked.

Let’s break it down into inflation and real yields. 

For all the panic and commentary on inflation this last week, market expectations of longer-term inflation have not moved.

In fact a 10-year inflation swap is still at 2.5% — a vote of confidence that the RBA will hit its inflation target across the decade.

The rising nominal yields were all driven by rising real yields. This is not consistent with the view building increasingly in risk markets of a US recession in 2023.

In Australia 10-year real yields are now around 1.65%. This is your risk-free return above inflation… That is, you are protected for inflation plus you get an extra 1.65% and no credit risk.

Sounds quite compelling and real yields are at levels not seen since 2014.

Real yields are supposed to represent the productive capacity of the economy to generate more return from existing resources, meaning borrowers are happy to pay a return above inflation.

Maybe there is a surge in productivity building. There have been some encouraging signs in business investment recently, though higher rates may temper that.

The other factor that drives real yields is simply the level of cash rates versus inflation, or the real cash rate.

These are still sharply negative, though on future expectations markets are looking for Fed Funds around 3.5% in a year and forward inflation expectations suggest an inflation rate at a similar level.

In Australia it is harder to see a cash rate well above inflation for at least the next two years, though they may also eventually converge around 3.5% in early 2024.

This all makes real rates look like good medium-term value.

If you buy the market’s medium-term view that inflation will come back into the RBA band, it means bonds above 4% are cheap.

Given moves like the last week of trading this may be hard. But for asset allocators and portfolios underweight bonds it does suggest it’s time to get back to neutral.

If you buy into the whole recession view then clearly it is time to go overweight. But for us, momentum is still problematic in the short term.

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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.

Find out about Crispin’s Pendal Focus Australian Share Fund
Find out about Crispin’s sustainable Pendal Horizon Fund

Markets continue to see sharp falls.

A series of hawkish actions from central banks provided the catalyst last week, signalling their desire to raise rates more quickly. Some are interpreting the latest moves as signs of panic.

The Fed hiked 75bp. Their “dot plot” of expected hikes signals another 75bp in July, 50bp in Sep and then two 25bp moves to end year at 3.4%. Three months ago, this figure was 1.9%.

Elsewhere the Swiss National Bank delivered a surprise 50bp hike — their first in 15 years. The Bank of England increased rates 25bp and signalled they may add another 50bp in August.

There have been some decisive shifts in the way the market is behaving. Looking across asset classes:

• Equities were weak across the board last week: S&P 500 -5.8% (-22.3% CYTD), NASDAQ -4.8% (-30.7% CYTD), Euro STOXX 50 -4.5% (-18.9% CYTD) and the ASX 300 -6.6% (-11.7% CYTD)
• US 10-year bond yields rose to 3.5% — their highest level in 11 years — before falling late in the week to 3.23%
• Credit spreads — particularly sub-investment grade — widened
• Commodities sold off: iron ore -14.3%, copper -4.4%
• Crypto crashed. BTC was -28.1% for the week

The market is now fearing a recession. This is leading to two trends:

1. We are seeing positions liquidated, ie selling becomes more indiscriminate as correlations rise towards 1
2. Value is underperforming (led by energy and materials) for the first real time this year on the basis of cyclical risk. This is why we are now seeing the ASX underperform other markets

The core issue is whether the US ends up in recession. Investor surveys suggest an 80% probability. CEOs are suggesting 70%.

The market is concerned that the Fed has been cornered — it can see the risk of recession is rising, but needs to restore inflation credibility and raise rates quickly to at least get to neutral. We are all paying the price of central banks getting policy so wrong in 2021.

The Fed’s emphasis on spot inflation is concerning. This approach is flawed because it is driven largely by fuel and food factors where Fed action has little influence.

Chair Powell referenced the University of Michigan survey on inflation expectations, which is known to be correlated to fuel pump prices.

The combination of this backward-looking focus and the size and pace of rate increases means there is a high probability of over-tightening and a recession.

Under this scenario the S&P 500 is likely to fall through the 3500 support level at least to 3200, consistent with pre-pandemic levels.

The ASX is better protected in this scenario given lower valuations in a historical context, support from a weaker Australian dollar and index composition.

Central bank policy

It was a busy week for central bank watchers:

• Monday – The Wall Street Journal ran a story that the Fed planned to hike 75bps
• Tuesday – The European Central Bank announced an emergency meeting to address the issue of fragmentation amid concern about Italian bond spreads widening too far
• Wednesday – The Fed hiked 75bp and signalled rate would peak at 3.8% (the market is pricing in 4%).
• Thursday – The Swiss National Bank unexpectedly hiked 50bp and removed its currency intervention. The BOE hiked 25bp and signalled they may need to go 50bp in August regardless of the economic state.

There was only one dissenter against the Fed move. Ester George of the Kansas Fed argued for a 50bp hike given the uncertainty a 75bps hike could cause.

The remaining members of the Federal Open Market Committee justified the 75bp hike on the basis of a higher CPI print and the University of Michigan inflation expectations gauge.

They now expect rates to be a “moderately restrictive” 3.4% by the end of 2022, up from 1.9% in March. The ultimate peak rates are seen as 3.8%, previously 2.8%.

In their economic projections the end CY23 PCE inflation forecast rose 10bp to 2.7%. It is expected to be 2.3% (below the 2.5% target) by the end of 2024 and 2.3% at the end of 2024. Unemployment is expected to rise to 4.1% by the end of 2024.

It is worth bearing in mind the Sahm rule — that a 0.5% rise in unemployment signals a recession.

In an effort to soften the message Powell said in his press conference that the Fed would be flexible in implementing policy. But containing inflation is the priority.

As much as the Fed says it does not have to lead to recession, all logic suggests it will if the rate hiking path continues as signalled.

The central banks of the US and Australia continue to emphasise that the economy remains in good position to withstand rate hikes.

While this sounds reassuring, it’s also a problem since policy makers need to create slack in the economy to ensure the second-order effects of inflation don’t flow through. This implies even tighter monetary policy.

Australia

There were two important developments last week.

First, the RBA indicated their modelling (using current commodity prices) has inflation at more than 7% by the year’s end.

Second, we saw an increase of about 4.7% in the minimum wage and low-end award rates.

These show Australia faces similar challenges to the US with high inflation triggering second-order inflationary pressures in areas such as wages.

The RBA hopes that easing commodity prices — combined with companies being prepared to absorb cost pressures through lower margins — will stop an inflationary loop. For that to occur the economy needs to be weaker. By definition that would lead to earnings weakness.

The hope for Australia is that lower inflationary pressure, a looser job market and more exposure to variable rates means sufficient cooling can occur without rates needing to rise to the 4% level the market is predicting. But this would require a material slowdown in growth.

Our sense is the RBA is three months behind the Fed in gauging what they need to do.

Europe

The ECB held an emergency meeting to signal they were working on a mechanism to backstop the peripheral bond spreads.

Italian spreads did fall. But the important point was that through controlling the spread they would enable policy rates to be pushed higher without creating another periphery crisis. So this is a negative signal for tightening.

Switzerland

The rate increase here is more technical in nature since it does not apply to local borrowers. It is believed to be a signal that they want to stop further weakness in the Swiss franc to help contain inflation.

This may lead the Swiss central bank to liquidate offshore investments, where they have holdings in German Bunds and US equities. 

Japan

The Bank of Japan continues to dig in and remain committed to yield curve control. This is putting a lot of pressure on the Yen, which is heading back to its lows and approaching levels last seen in 1998.

We could see a major crack in terms of FX markets given the divergence between Japan and other regions. This adds to overall uncertainty.

US economy

It is increasingly hard to see how the US avoids a recession from here.

First the lagged effect of inflationary pressures means we are unlikely to see much relief on this front given fuel, food and shelter components are still rising. This gives the Fed little room to back off hikes.

Second, the lead indicators of activity are deteriorating:

• The “rule of ten” (which looks at the historical correlation of mortgages rates plus petrol prices on consumer spending) has a good track record of predicting slowdowns and recessions. It is now above the crucial “ten” mark.
• Housing looks like it is about to roll over as affordability deteriorates at an unprecedented rate. The only thing propping it up for now is low inventories. Falling house prices flows through into other areas of consumption.
• Consumption has benefitted from a material tailwind of credit growth and home equity withdrawal, which is likely to slow down. Even if this stabilises at current levels it removes an impulse to consumer spending.

Putting these factors together, you can see why the Atlanta Fed GDP tracker is deteriorating and is well below market consensus on growth.

This is also coming through at a global level with GDP growth forecasts for 2022 and 2023 rolling over.

This is an important issue for commodities.

Copper is a key indicator to watch. It has weakened recently and while it hasn’t broken through technical support measures, it is sitting on them.

 

This economic risk has implications for the market.

The market is discounting a material drop in earnings while they continue to hold up. Since 1987 we have only seen this disconnection twice (in 2002 and 2011) where markets overstated risk.

However in 2000, 2008 and 2020 earnings caught up with the market. Therein lies the risk if the US and global economy go into a recession.

Valuations in markets other than the US — including Australia — are lower and provide some protection. But we remain wary of how the market performs as downgrades come through.

While the risk is material, this bearish scenario is not a certainty. Factors which could see a better outcome include:

• Inflation momentum slows more quickly than expected. There are signs of hope with higher inventory at US retailers and evidence of discounting appearing. The fall in the oil price is a very important lead if sustained.
• Labour markets loosen up sooner. We have seen announcements from the tech sector on layoffs, but collectively this is not sufficient. On the supply side perhaps inflation and the crypto bust help drive participation higher.
• Supply chains begin to ease up as China re-opens and demand softens.

Should these factors start to play out we may see the Fed swerve again and be less aggressive on rates.

It’s unclear if this would be enough to avoid a recession. But in the market’s eyes it would at least signal the depth of the downturn could be lower.

Markets

The medium-term outlook is still bearish but there are signs the US market is tactically oversold — as you would expect after such a big move.

• We saw the first sign of an extreme in sentiment in this bear market with the 10-day average of advancing volumes falling to its first percentile (ie the number of stocks falling on short-term basis is at extreme levels)
• Another flag was Monday’s 46:1 decline / advance ratio in the market. On Thursday it was 17:1. Both are among the worst ratios for years
• We saw a spike in flows into short-dated treasuries
• Investor sentiment is pretty bleak

However we are not seeing signals to suggest the market is forming a bottom.

Put/call ratios are not at extremes. The number of stocks putting in a 52-week low is still expanding.

One signal to watch is the divergence between stocks and the market. Note the top was formed well after the average stock had rolled over. A similar outcome is likely at the bottom.

The other flag which is likely to mark the low in this cycle is the passing of time.

This market looks closer in nature to 2000 and 2008 where the market had to consolidate near its lows for a number of months before sentiment improved – unlike the sharp policy-driven bounce of 2020.

It is also worth noting that energy stocks could see a decent correction following a period of strong relative performance.

We’d likely see this as an opportunity, given supply issues remain severe with no sign of resolution.

Australian equities

There were few places to hide last week. The 20 largest stocks were as weak as the smaller caps.

Mining and energy underperformed. The gold miners held up well, as did some interest-rate sensitives among the financials and the defensive telco space.

Miners, industrials and tech were all hit hard. Most of the selling was largely indiscriminate. We are in a relatively quiet period for corporate news so expect the macro factors to dominate for now.

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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

What’s next for inflation, global equities sectors to watch, industries to consider, indicators to keep an eye on

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 Crispin’s Pendal Focus Australian Share Fund
Find out about Crispin’s sustainable Pendal Horizon Fund

HIGHER-than-expected US inflation data, combined with a hawkish tone from European and Australian central banks, have helped push equity markets down through the May lows.

US bonds have sold off, with a “bear flattening” of the curve as 2-year yields rose 41bps and 10-year yields rose 22bps (at Friday’s close). Risk aversion saw the US dollar and gold hold up, while equities fell.

The S&P 500 was off 5% last week, the NASDAQ lost 5.6% and the Euro STOXX 50 was down 4.9%. For the year-to-date the S&P 500 is -17.6%, the NASDAQ -27.3% and the Euro STOXX 50 -18.5%.

A record low in the University of Michigan Consumer Sentiment index (which goes back to 1978) and evidence that consumer longer-term inflation expectations are on the rise add to the sense of foreboding.

The market increasingly fears high interest rates and a recession.

The RBA’s 50bp rate hike triggered recession fears domestically. This prompted some shorting of domestic banks by international investors and saw the Australian market sell off even before Friday’s move.

The banks sector fell 10.6% last week. The S&P/ASX fell 4.3% and is down 5.5% in so far in 2022. 

The US Fed meets this week and the market is pricing an 80% chance of a 75bp hike.

The rationale is they need to “get in front of the curve” and restore confidence that inflation will be subdued.

There is a growing view the Fed has to choose between allowing inflation to stay high or triggering a recession. This translates to either rating or earnings risk for equities.

The combination of rates up, oil up and US dollar up is not good for equity markets.

Our view is the risk/reward trade-off remains skewed to the downside for now.

Economics and policy

The May CPI print was only 0.1% worse than expected. However the underlying components were considered more negative.

Some key points to note:

• Headline inflation rose to 8.6% year-on-year — a new high for this cycle and up from 8.3% last month. Energy accounted for was 0.3% of the 1% month-on-month increase. Gas prices are up a further 10% this month. 
• The Median CPI across all categories was +0.58% m-o-m. This was the highest-ever print, as was the y-o-y median. This reflects the breadth of pricing pressure. 
• Core CPI rose 0.63% m-o-m versus 0.5% expected. It’s running at 6% y-o-y, down from 6.2% last month.
• Core goods inflation picked up m-o-m, goods CPI +0.7% m-o-m versus +0.2% last month. New and used auto prices picked up as car manufacturing remained constrained.
• Core services inflation rose 0.6% m-o-m. Airfares remained strong, up 12.6% m-o-m.
• Shelter (50% of services inflation) did not decelerate as expected, rising 0.6% m-o-m.

One key issue is that goods inflation is not coming off quickly enough to offset the rise of services inflation.

The rent component was expected to decelerate, but did not. Some private measures of rent indicate this will continue to rise. This needs to be watched since it comprises 40% of core CPI.

The problem for policy makers is that inflation expectations are beginning to step up.

This puts more pressure on the Fed to break the wage-price feedback loop by slowing the economy and creating slack in the labour market. The Atlanta wage tracker is staying flat at 6.5% and hasn’t yet shown signs of falling back.

The University of Michigan Consumer Sentiment index weighed on markets, falling to levels not seen since the early 1980s. The disconnect here is that people are still spending despite a low confidence level.

There appears to be an emerging divergence between lower and higher income consumers. The former are hit harder by inflation and the removal of stimulus payments.

This is evident in feedback from consumer stocks, where luxury and premium products are continuing to see good demand.

Europe

The European Central Bank met and sent a clear hawkish shift in their outlook. They noted CPI was now expected to be above the target range through 2024, despite lowering the outlook for economic growth. They also signalled the risk to CPI expectations was to the upside.

The signal is for rates to increase 25bps in July. The market is now expecting 50bp in September and possibly another 50bp in October, with rates peaking at 1.75%.

This means the market is now seeing 125bps tightening this year, versus 50bps only four weeks ago.

It is worth bearing in mind that inflation isn’t expected to peak before September, at around 9.3%.

Using the old rule of thumb that rates need to reach the inflation level, there still seems risk to the upside.

The market’s other issue was the lack of any specific mechanism to avoid the “fragmentation risk” of widening spreads from Eurozone “periphery” economies.

This is already occurring with Italian 10-year yields now at 3.98% versus Germany at 1.58% — a spread of 240bp. This is a 100bp widening from the start of the year when German bonds were -0.18% and Italian 1.19%.

The ECB believes it has the tools to prevent this becoming a problem. But lack of detail opens the door to the market testing the level at which the ECB will act.

Markets

The rally over the last fortnight lacked conviction, with low breadth compared to previous market returns.

We are now breaking through the May lows in US equities. The near-term outlook is not constructive given:

• US bond yields have risen to cycle highs on the tail of a break-out in German bonds
• The most bombed-out tech names are rolling over again
• Mega-cap tech look to be rolling over; these have propped the overall index up
• The US dollar index is testing new highs
• Oil price – the source of a lot of problems – refuses to soften given supply issues

The risk-off signal is also apparent in speculative tech and also in cryptocurrencies, where Bitcoin is falling on liquidity concerns.

Tightening cycles often trigger some form of financial shock, which can create a capitulation in the market. This often marks the low.

In this context, there are specific areas we are watching for signs of further strain:

1. Peripheral bond spreads in Europe (indicates pressure on the Euro as ECB forced to raise rates into downturn)
2. Credit spreads (indicates evidence of recession risk)
3. US$/Yen and Japanese bond yields (indicates evidence market losing confidence in yield curve control)
4. CNY/USD (reflecting pressure on Chinese economy from higher energy and food prices)
5. Crypto, first real test of how liquid this is in a bear market
6. Performance of banks versus market

Technically, if the S&P breaks through the May low the next resistance is at 3500.

Beyond that, the pre-Covid level was 3250.

If we get into this territory it would represent a material tightening of total financial conditions which may see a moderation in the market’s view of how far the Fed needs to tighten.  

Australia

The RBA rose 50bps rather than the expected 25-40bp.  Like many other central banks the Reserve seems to realise the need to get back to neutral quickly. Rate expectations have now risen for the balance of the year. This has weighed on the ASX, with banks hit on economic concerns and REITs over the increase in funding costs.

 

After a multi-year cease fire, global long/short funds chose to put the short back on Australian banks, on the premise the economy is going to slow and that housing will follow.

We have been here before and it has historically been a losing trade.

The rationale, from an international perspective, is grounded in the fact that Australian house prices have more than doubled the growth rate of the US over the past 30 years.

There are explanations for this, including the impact of immigration and lack of supply.

But the simple narrative for now is that Australian mortgage rates are set to rise from around 2% to potentially over 5%. In the near term that means risk for housing and the banks.

This saw Westpac (WBC) -13.1% last week, Commonwealth Bank (CBA) -10.9%, National Australia Bank (NAB) -10.3% and ANZ (ANZ) -7.7%. Year-to-date the banking sector has now performed in line with the market.

Discretionary retail is the other sector particularly vulnerable to the rise in mortgage rates.

This is translating through to underperformance in JB Hi-Fi (JBH, -10%), Wesfarmers (WES, -7.4%) and certain small caps.

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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  

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How rates and inflation are impacting investors, the path to a soft landing or recession, time to consider high-yield bonds and why second-order effects matter

As bond yields rise investors can expect “some very good opportunities”, says Bill Bellamy, Director of Income Strategies at Pendal’s US-based investment manager TSW

• Bond yields high enough to consider investing
• Fundamental analysis is critical the further out the yield curve
• Find out about Pendal’s income and fixed interest funds

THE jump in bond yields this year has been stark, particularly in the high-yield end of the market.

US double-B rated bonds, for example, yielded 3.2 per cent at the start of the year and are now around 6 per cent.

But is that enough to make bond markets investable, given inflation rates globally are running at multi-decade highs?

Is it enough to look at high-yield investments, given the risk-reward trade off?

“Fixed income is, in our view, certainly much more investable today than it’s been for a while,” says Bill Bellamy, Director of Income Strategies at Pendal Group’s US-based investment manager TSW (Thompson, Siegel and Walmsley LLC).

“But we’re probably not totally done with this corrective phase and there is still room to go with yields. As they rise, there are going to be some very good opportunities.”

“Because the market has priced in a lot of the US Federal Reserve tightening that we think is coming, it’s time to take a look at fixed income markets once again,” Bellamy says.

Investing in fixed income involves interest rate risk, duration risk, industry risk and security specific risk.

But its main role in a portfolio is to provide ballast for stability.

“Investors want the ballast,” Bellamy says. “And investors can scale into the market as yields move higher.

“You may not pick the bottom, but you’ll get a better yield than what we’ve seen for some time.”

Returns don’t have to be spectacular because that’s not what investors use fixed income for — or as Bellamy puts it: “we’re trying to hit singles and doubles, not triples and home runs.”

While the philosophy across fixed income markets is the same, as investors move out the yield curve and go beyond investment grade to high-yield double B rated bonds, or single B or triple C, it becomes more of an individual credit picker’s market. It is an area of expertise for Bellamy.

Income cushion

High-yield bonds offer an income cushion that investment grade bonds and Treasuries do not, he says. The main risk in high yield is default risk.

“In high yield bonds, you need to do fundamental analysis of the underlying credits ultimately going into a portfolio.

“You need to know what the ultimate risk is in the event of a problem at corporate level. You need to know anything that could impair your ability to get your money back,” Bellamy explains.

That groundwork understanding the ultimate asset of a high-yield bond isn’t just a safety check. It also unveils mis-priced assets.

“Is the market efficient in that respect? We don’t think so,” Bellamy says. “We believe the ratings agencies leave a lot of opportunities in the high yield market especially as you go out the risk spectrum.

“That’s particularly so when an issuer might have one or two issues outstanding. That’s really where you can uncover some opportunities from an investment perspective.”

“When investing in fixed income, we believe that income wins over time. We try to outyield the indices in the most efficient way possible.

“We are a big believer in getting paid for the risks we are taking.”