Understand debt, disruption and demographics and you’ll understand why it could be a good time to buy bonds. Pendal’s ANNA HONG explains
AUSTRALIAN 10-year bonds yields are at a four-year high.
Where will they go from here?
To answer that we need to ask another question: what level of interest rates can the Australian economy withstand?
We think a neutral cash rate of 1.5% to 2% is bearable. But 3% will be an overshoot that strains the Australian economy.
Under those conditions, the Australian Government 10-year bond yield becomes interesting at current levels around 2.75%.
Why? Because the global trajectory of three key factors — debt, disruption and demographics — hasn’t changed despite recent events, especially in developed economies.
Demographics
Even though headline population growth is positive, it’s largely driven by net migration which has been impacted by Covid.
Australia’s fertility rate is below the replacement rate and life expectancy is on the rise. This means we have an ageing population. Adding higher interest rates to that mix will significantly impact GDP growth.
Disruption
Technology has transformed every facet of our lives and it’s not about to stop.
With continued technological progress we can expect goods prices to move downwards as we reap the rewards of manufacturing and logistical efficiencies. (Once the current supply-shock eases of course.)
This means that while inflation is a now-problem, it will not be a long-run issue which central banks need to tackle with never-ending rate hikes.
Debt
Finally, consider the debt overhang.
As a nation we continue to indulge in our favourite activity – buying property.
The Australian household debt picture is nuanced, however.
We’re one of the most indebted nations in the world, but we’re also rather good at things like pre-payment, so we can get ahead of the debt mountain.
This pragmatism will lead to many households tweaking spending decisions as interest rates rise. At a time when disposable income has already been hit by oil prices, the RBA will be cautious about adding further strain.
The dynamics of Debt, Disruption, Demographics means that the most probable outcome is a neutral cash rate of around 2%.
Rates higher than that will lead to curtailing of GDP growth, straining the Australian economy.
This may be welcomed in restraining inflation in the near-term but not in the medium-term.
Portfolio Implications
With current Australian Government (ACGB) 10-year bond yields at 2.75%, aggressive rate hikes are almost fully priced in.
Cash sitting on the sidelines will find value here as the Reserve Bank continues to delay rate hikes.
Economists’ consensus has the first hike occurring in August — therefore investors may need to wait until late 2023 for cash returns to exceed 1.5%.
The risk versus reward makes this an attractive option for balanced portfolios.
Bonds are still a defensive instrument, given forward uncertainties, especially in the geopolitical space.
Investors will need them in their portfolios.
Any investor currently underweight bonds should be looking to get back to neutral. We think the next three-to-six months may bring levels which are attractive for investors looking to go overweight bonds.
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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
About Pendal Group
Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.
Get ready as China edges away from Covid-zero, what rate expectations mean for bond buying, the likely path for ASX stocks and which global equities sectors look good
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 S&P 500 gained 6.2% last week, recouping half of its year-to-date decline.
This was most likely a combination of:
- Lower commodity prices offering hope that the disruption from the Ukraine conflict may be less than feared
- The Fed’s comments post rate hike prompting greater confidence that it can balance policy tightening without triggering recession
- Signs the Covid outbreak in China may be contained
- Policy signals from Beijing which were supportive of equity markets
The Australian market was less leveraged to this bounce, but still gained 3.3% (S&P/ASX 300). It is now down only 0.8% for the calendar year to date.
Bond markets were not as optimistic as yields continued to rise. US 10-year government bonds rose 16bps to 2.15% and the 10y–2y yield curve flattened further to 21bps.
We still see the recent bounce as a counter-trend rally.
Policy makers are treading a difficult path to resolve inflation without sending the economy into a downturn. This is driving uncertainty which we expect will weigh on markets in the near term.
This is exacerbated by the removal of liquidity.
In this vein, the Fed’s rate hike this week has not tightened the overall Goldman Sachs Financial Conditions Index, given the offsetting effect of stronger equity markets.
To put this in context, conditions have only tightened half as much as in the previous cycles of 2015 and 2018 — yet we are at a far looser starting point and inflation is a much bigger problem.
To resolve the inflation problem financial conditions need to tighten further, which is likely to act as a cap for the market.
US monetary policy
The Fed raised rates 25bp last week as expected. It was an 8-1 vote with one dissenter wanting 50bp. The overall message was seen as hawkish, with strong rhetoric on inflation.
It is worth noting the signals from changes in the Fed’s median forecasts from the meeting:
- Core inflation (ex food and energy) is currently running at 5.2% and is expected to end CY22 at 4.1%. This is up from a 2.7% expectation in December 2021. It is expected to be 2.6% at the end of CY2023, up from 2.3% in December.
- The US GDP growth forecast for CY2022 was cut from 4.0 to 2.8. The market is currently expecting sub 2% growth.
- The Federal Open Market Committee moved from expecting three to four hikes in CY22 to seven. The Fed Funds rate is expected to be 1.9% at the end of CY22, versus 0.9% in December. The market was expecting a signal of six hikes.
- Rates are expected to peak at 2.8% in 2023. The December expectation was a peak of 2.1%, in 2024
Year-end inflation expectations have effectively risen 1.4% since December, yet expected rates are up only 1%. So real rates will still be -2.2% at year-end, versus an implied -1.8% in December 2021.
Chair Jerome Powell said the Fed would devise a plan for quantitative tightening at their next meeting (May 3-4), to be implemented shortly thereafter. They have previously signalled this will equate to a 25bp rise in rates.
It is also worth noting that the Fed’s balance sheet has continue to expand even in the last week, as Quantitative Easing has only just come to an end.
Powell’s messaging was hawkish and conveyed a resolve to beat inflation akin to Mario Draghi’s ‘whatever it takes’ speech.
He noted the Fed was “acutely aware of responsibility to bring inflation down” and that real rates could be marginally positive by the end of CY23.
This provided some reassurance to markets.
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Despite the Fed’s current view that rates will peak at 2.8%, the market is implying a 2.3% peak in 2023. This highlights how the market is still shaped by the post-GFC policy experience.
However there is an inconsistency in the Fed’s messaging. Its own forecasts indicate inflation will fall with no rise in unemployment (which remains at 3.5%).
The Fed does not see rates needing to rise above 3% this cycle — ie no need to go above “neutral”. This is despite inflation running far hotter and labour markets tighter than in previous hiking cycles.
To reconcile this inconsistency we need to believe the supply side resolves the problem and dampens inflation and that the corporate sector will be able to resist efforts by labour to recoup the erosion of real wages.
The equity market appears to believe this — as reflected in its bounce.
In our view the Fed really has no idea what rates will need to rise to.
The current plan is to get back to neutral — just more quickly than previously expected. At that point the Fed will have a better idea of how sensitive the economy is to rising rates.
There is a wide range of potential outcomes.
There were nine hikes in the 2015-2018 cycle and 17 between 2004-2006.
We can gain a different perspective on US rates through application of the Taylor rule. This looks at the GDP deflator and slack in the economy to assess where interest rates should be.
Even adjusting for one-off factors driving inflation the implied interest rate is 5%. This is effectively double where the market expects rates to peak.
There are many reasons why this may not play out. But it highlights potential uncertainty on the path for rates in this environment.
European policy
The Bank of England also raised rates last week. But it sent a far more dovish signal, indicating the economy will not be able to absorb the number of rate increases currently priced in.
The only way rates will rise that much is if we see a substantial fiscal stimulus in the upcoming budget.
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European Central Bank president Christine Lagarde changed the previous week’s more hawkish message. There is now greater emphasis on watching the economy data before acting.
The market is ascribing a 50% chance of recession in Europe by the end of the year, reflecting the already slowing data.
China
Chinese equities were extraordinarily volatile last week — technology particularly so. This is worth watching since it’s been a lead for the rest of the tech sector.
Chinese tech had fallen 80% from its peak — akin to the NASDAQ bust of the early 2000s.
The sector fell almost 30% in the previous week before bouncing 50% last week and gaining about 30% in a day.
The catalyst was a statement from the head of the Financial Stability Committee which addressed five of the key issues weighing on the market.
In nutshell it emphasised:
- Stabilisation of the property market
- Ensuring new loans would continue to be issued
- Concerns over ADR de-listing would be addressed, with the US and China in dialogue to resolve accounting issues
- Commitment to make regulations on the technology sector more transparent
- Efforts to resolve HK regulatory issues
Concerns over Covid diminished somewhat as case numbers appeared to be brought under control.
Commodities
We saw substantial volatility in commodity prices last week. Oil dropped from US$113 a barrel to US$98 before rebounding to US$108.
Price volatility is being driven primarily by:
- Chinese lockdowns reducing demand by 0.5m barrels-per day (bpd).
- Signs that more Russian oil is finding its way into global markets via back channels. It is now estimated that 1.5m bpd is not finding its way into markets, rather than the previous 2.5m estimate.
- The huge spike in volatility has triggered more margin calls, which has led to some position liquidation
Volatility will continue to be high, but we expect prices to trend higher again due to the low level of spare inventory, the ongoing threat of further sanctions and the risk of an unexpected act threatening supply.
US economy
The data remains supportive, but it’s worth watching some softening (from a high base) in the trucking survey which is a decent lead indicator. There is also a slowdown in sales from European-facing companies.
Housing signals remain positive. Prices are up 15% year-on-year. The supply of houses on market remains at historical lows — and well below the levels seen running into the GFC.
There are also positive signals from US airline carriers. Air traffic is rising above previous expectations, though the market remains wary of the effect of oil prices.
Markets
While equity markets have bounced, we have doubts this can be sustained for the reasons above.
In our view the bounce lacks the conviction seen in March 2020 and Dec 2018, suggesting markets may still fall back.
From a technical perspective the breadth of the market rebound was reasonable, but not compelling. Also, the put/call ratio in option markets, as an indicator of fear, never rose to extreme levels.
Markets are running into technical resistance levels. This will be another thing to watch.
The Australian market was driven by technology, financials and healthcare last week. The headline return was decent given the decline in the resource sector and energy being flat for the week.
Rising yields and fewer concerns on some form of global financial shock helped the financials. Stock moves were mainly driven by a reversal — ie the names that had performed the worst bounced back the most.
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.
The US Federal Reserve has raised interest rates for the first time since 2018. Pendal’s head of government bond strategies TIM HEXT explains what it means
THE US Federal Reserve raised rates by 0.25% this morning, as expected.
However the Fed’s forecast for future rates were also raised, slightly catching the markets by surprise.
It was viewed as a ‘hawkish hike’, as we expected. You cannot begin a hiking cycle downplaying its impact – you need overall conditions to tighten.
A couple of interesting points.
The Fed is forecasting (via their dot plots) rates to be 1.9% by the end of this year – this means seven hikes in the next seven meetings.
They then expect 2.8% by the end of 2023. But by the end of 2024 they expect 2.4%. Neutral rates are generally considered to be around 2%, although that too is dynamic.
The Fed expects inflation to be 4.3% at year end and then 2.7% in 2023 and 2.3% in 2024.
This will be achieved through not only tighter policy but base effects (high numbers from a year ago drop out of year-on-year numbers) and of course reopening of supply chains.
We think these estimates are reasonable, though we agree with the Fed that surprises may be more to the upside. Markets believe inflation will average 2.8% for the next ten years, so are less convinced.
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In the Q&A with Chair Powell there was a lot of criticism about the rapid change of course.
As recently as November the message was that the Fed could be patient as inflation pressures were largely transitory. I am paraphrasing, but Powell’s response was that the situation was rapidly evolving.
As we mentioned numerous times recently it seems the inflation impact of events in the Ukraine has outweighed the risk-off or growth impact in the Fed’s mind.
Where does this leave the RBA?
As recently as this week the RBA minutes from the March meeting were maintaining the line, or as some would say fiction, that “while inflation had picked up, members agreed it was too early to conclude that it was sustainably within the target band.”
Sounds like the Fed in November.
The Q1 CPI in Australia will be released on April 27. Headline is likely to be 1.4% or 4.3% Y/Y.
We think the RBA rhetoric will change in May to be that “inflation appears to be sustainably within the 2-3% band” paving the way for a June hike.
They will likely go 0.4% first off taking the official cash rate to 0.5%. We would then expect hikes in August and November (after the next two CPIs) to finish the year at 1% cash.
There is a chance the RBA tries to cling on a little longer and the first hike is August, but either way rates finish the year at 1%.
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In the medium term it is interesting that curves are now flat in the US — that is, five year rates in the US are now flat to the 10-year rate at around 2.15%.
This suggests markets believe the Fed in that rates will peak in 2023 before levelling out of even coming back down.
This normally happens later in a hiking cycle but in these days of high transparency markets are far more forward looking.
Implications for Investment Markets
Equities seem to have taken the Fed actions in their stride, maybe also encouraged by the oil price tapering.
Economies remain strong and earnings healthy, although no doubt talk of slowdowns will build with the rate hikes. The Fed did downgrade their GDP forecast for 2022.
Australian 10-year bonds are now around or just above 2.5%.
As mentioned before this is not necessarily cheap but I am prepared to say bonds are no longer expensive and that balanced portfolios should be reducing underweights.
Bonds are still a defensive instrument and if the hiking cycle eventually produces a recession, as seven out of the last 10 hiking cycles in the US have, investors will need them in their portfolios.
Finally, cash is back and is short-priced odds to be the top-performing asset class in 2022 (ignoring some commodities).
While mortgage holders will suffer from higher rates, for every $3 of debt there is $2 of domestic savings (the other $1 borrowed from offshore).
Cash rates will remain below inflation for a long time yet, eating away at purchasing power, but there may at least be some relief for savers.
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
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.
Why Australia’s a good place to invest right now, how the stagflation story could play out, what happens if Russia defaults
Bonds are going digital, but they’re not going away. Pendal’s head of government bond strategies TIM HEXT explains why
AS A financial markets under-graduate 30 years ago I was sent off to see the plumbing of markets — how trades were recorded and settled.
I spent a few weeks wearing out my new leather soles walking around town with the couriers, getting stamps on physical bonds, writing bank cheques and heading up to the registry office to lodge them.
It was all very manual. (Many bonds were still bearer bonds, so you didn’t want to lose them!)
By the turn of the century technology enabled everything to be stamped and lodged electronically, meaning our rather old couriers could finally retire.
But bonds fundamentally never changed.
A bond is basically a loan that can be easily traded in secondary markets. It enables investors and savers to bring forward or defer their investment and spending decisions.
The technology behind them will continue to become more efficient.
Which leads us to…
Blockchain and bonds
Blockchain is basically a secure and decentralised (or distributed) ledger which records payments or ownership of property, equities or bonds.
It basically eliminates the need for a centralised registry. Custodians may initially continue to offer their services managing the blockchain on behalf of clients — but ultimately they may not be required.
Settlements can be instant, reducing counterparty and operational risk.
The terminology will change. Digital bonds can now be called “tokenised securities”. Paper-based contracts become “smart contracts”. Payments from the traditional banking system will need “on-chain payments solutions”.
Eventually all bonds will be digital — likely within the next decade.
But they will not disappear.
Why bonds will remain and governments won’t surrender their currencies
What is a government’s greatest power? To set laws and enforce them.
I would argue a federal government’s most important law is control of its currency — and more importantly the ability to create currency.
If you think about why the Australian Dollar (AUD) exists — why we don’t just transact in US dollars for example — it’s because the government makes us pay taxes and demands they be paid in AUD.
This creates a fundamental demand for AUD which underpins its acceptance for payments and savings by all Australians.
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The government can then create as many AUD as it wants to pay for goods and services.
The only limitation to this is inflation — putting too much currency in the system for the available resources.
The government therefore usually drains the currency back out of the system via taxes or government borrowing.
However they don’t have to, as recent effective monetisation by the RBA has shown.
If a government was to surrender control of the printing presses — via a monetary union like the Euro or via fixing to another currency or commodity such as gold — its actions become captive to forces outside its control.
Some purists may see this as a good thing, imposing the invisible hand of the market on the government.
History suggests otherwise.
Governments would become pro-cyclical and make inevitable private sector boom/bust cycles worse, as seen in the early days of the Great Depression. (For a recent example just ask the citizens of Greece.)
Can a central bank maintain control of a currency if it’s digital?
The answer of course is yes — provided the digital currency is still issued by them.
I doubt the government will be accepting taxes in US dollars any time soon and certainly not in crypto.
Central Bank Digital Currency (CBDC)
Currency is largely already digital. Some of us still keep banknotes handy but in the age of tap-and-go it is largely digital.
A Central Bank Digital Currency (or CBDC) would be a new form of digital currency — but importantly still issued by the central bank.
Unlike cryptocurrency, which has no backing, CBDC would essentially remain a liability of the central bank.
The unit of account is still the currency (so for the RBA still AUD), still legal tender and exchangeable for non-digital currency.
For small retail transactions there seems few immediate benefits. Banks have largely moved to live transfers between accounts, effectively making the payments system instant.
In the US Fed official Christopher Waller recently gave a talk “CBDC – A Solution in Search of a Problem”.
However the RBA could still issue retail CBDC if it was seen as supporting competition and efficiency in the retail sector.
Governments would probably like to get rid of cash — but that is a separate issue.
However, for wholesale transactions a CBDC could be very useful, effectively being part of the blockchain for tokenised assets.
Maybe you might accept Bitcoin when settling your house sale in a blockchain, but I know I would prefer the certainly of an AUD digital currency.
I would also want to know there was still a trusted party ensuring it all ran smoothly.
The Future
The Australian dollar and bond markets are not disappearing.
It is not in the collective interest of citizens to remove these powers from the government. Although far from perfect, the government is the only institution (at least in a democracy) which fundamentally protects the wider interest of society.
Some cryptocurrencies like Bitcoin will no doubt remain a store of wealth. Some like Ethereum, which supports smart contracts and efficient payment systems, will thrive.
The private sector will keep looking into the development of Stablecoins to help transactions, although they are likely to become more regulated around the assets that back them.
However an effective CBDC, backed by blockchain technology for speed and efficiency, could become the dominant digital currency, at least locally.
It wouldn’t be a cryptocurrency as such, given the Central Bank would likely control the ledger rather than a distributed ledger, for control and privacy. And cross-border transactions would still need intermediaries.
Digitalisation would also help finance become more decentralised over time as the use of intermediaries become less important.
It may take time for trust to develop, but in decades ahead it would likely all be second nature.
However, the need to borrow and lend money is as old as time itself — and the need for efficiency in buying and selling loans packaged as bonds will also remain.
The need to be able to assess credit may be helped by innovation but diversification remains an important investment concept.
Would you rather own a slice of a large pool of assets or just one randomly chosen asset?
For example buying a Westpac bond outsources the credit work that financing one individual loan or mortgage would entail.
Add liquidity and credit quality and it means government bonds are not going anywhere.
Though how we trade and settle bonds hopefully will evolve.
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
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.
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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WE continue to face the combined challenges of geopolitical risk, Covid, inflation and rising rates.
This is creating an intractable policy dilemma — the need to raise rates at a time when risk premiums are elevated, coupled with the risk that a commodity shock will lead to an economic downturn.
We didn’t see any sign of this dilemma easing last week.
The conflict in Ukraine intensified, US inflation data was no softer than expected, the Fed’s tightening bias persisted, the ECB was more hawkish than expected and China was facing another Covid outbreak, potentially causing disruptions to growth and supply chains.
As a result equity markets were mixed. The S&P500 fell 1.6% and the S&P/ASX 300 was down 0.4%. European equities bounced 3.7% (Eurostoxx 50) after previous sharp falls.
The market is struggling to build on any bounce despite the S&P 500 being off 12.4% from its early-January peak.
Our key observations are:
- The near-term market is likely to remain weak, but we don’t expect stagflation and the start of a bear market
- We see Australia as a relative safe haven given the economy is in good shape and skews to commodity and financial stocks
- The environment we are in today is different to the post GFC era — what worked in the last six years won’t work going forward. We see corporate cash flow and consistency as critical. We do not expect high growth, speculative and profitless tech to resume market leadership
- Current drawdowns tend to be indiscriminate, thereby creating significant stock opportunities.
Commodity markets
Oil and wheat prices peaked early last week and then fell back, despite growing signs of self-sanctioning.
One key debate is whether Russian oil will be locked out of global markets or find its way in via alternative channels.
At this point there is an expectation that some of that oil will find a home. But this will extend trade routes and it’s unlikely all will be placed.
At this point there are about 2.5 million fewer barrels per day (bpd) in global markets, compared to before the invasion. There are a number of potential sources of new supply to replace this:
- Saudi, the UAE and Kuwait: These countries have about 2.1 million bpd spare capacity, which would probably require a couple of months to come on line. Doing so would signal the end of the OPEC+ arrangement with Russia. Saudi is unlikely to make any moves until it sees the outcome of potentials deals with Iran and Venezuela.
- Iran: There is chatter the US and Iran may be nearing an agreement. But there is uncertainty over how many incremental new bpd would eventuate – and how long it will take.
- Venezuela: Easing sanctions on Caracas may provide scope for an additional 0.5 million bpd over time.
- US Strategic Petroleum Reserve releases: There is uncertainty in outcome here since this mechanism remains untested.
- US production: This will be a lot harder to ramp up due to shortages of equipment and people. For example, there is a lack of truckers due to the demand driven by online retail fulfilment. There are also capacity constraints in fracking as the Permian Basin, the most productive region, has already recovered to peak production.
There is also a persistent risk that Russia may itself disrupt supply, given its importance as a bargaining tool.
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The US is working with the likes of Saudi, Venezuela and Iran to bring other barrels back into the market to alleviate inflations.
Any success there will mitigate some of the pricing pressure. But we suspect we will be looking at US$100+ oil for at least a few months.
Economics
The market is starting to factor in the risk to economic growth. For example, Goldman Sachs cut its expected US GDP growth in Q2 2022 from 2% to 1.75% compared to Q4 2021.
This is driven by the impact on income and spending as a result of higher food and fuel prices.
Financial conditions continue to tighten as the US dollar and bond yields rise and equities fall. This adds to the headwind to growth in Q2 onwards by 0.3-0.4% of US GDP
We do not believe this will translate into a recession due to:
- The strength of the labour market
- Pent-up demand where supply constraints have been limiting growth, eg autos
- Strong housing, which means consumer net worth continues to rise
- Strong loan growth and still negative real rates
- Good household balance sheets
In combination this should enable growth to continue, providing earnings support for the market in time.
US inflation
The good news is that the US CPI data was in line with expectations for the first time in eight months, rising 0.8% month-on-month and 7.9% year-on-year in February.
The not-so-good news is it’s the highest rate in 40 years.
Digging into the numbers we see food, energy and auto are driving almost two-thirds of the year-on-year figure.
These should unwind over time. But there is also a broadening of the number of components where prices are rising.
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For example, the proportion of CPI components with deflation has fallen from more than 25% at the start of 2021, to about 5% today. This breadth issue is a concern for policy makers.
Rent is one component seeing a strong rise. This is likely to continue, slowing the normalisation of overall inflation.
We had been seeing shipping freight rates start to fall as supply chain issues improved. However this has stalled as shipping needs to be re-routed as a result of the sanctions on Russia and growing Covid issues in China.
On wages, the Atlanta wage tracker rose from 5.1% to 5.8% annual wages growth, countering the more positive signal that came with last week’s household employment survey
So the challenge for the Fed is that a number of key drivers of future inflation are signalling that the problem is not resolving itself.
This explains its hawkish stance, despite the wider geopolitical concerns.
Policy
The European Central Bank signalled that rate rises could come sooner than the market is currently pricing – potentially as early as July, though September is looking more likely.
The key point is they are signalling a greater preparedness to tolerate weaker growth to fight inflation.
If there is a risk of stagflation it is centred on Europe, given its greater sensitivity to energy prices and higher exposure to Ukraine and Russia.
There is talk now of a fiscal policy response to this threat, which could allow monetary policy to focus on inflation.
Covid
We are watching two issues here.
First, an emerging new variant looks to blend some characteristics of Delta and Omicron. At this point it’s not expected to be any more transmissible that Omicron, so may not supersede the latter’s dominance.
Second, we are watching rising cases in China – particularly in north-east provinces – and a potential headwind for economy activity.
Markets
We saw a snap-back in European equities — the German index made its seventh-biggest single-day jump.
But history indicates such volatility is more often than not seen in a downward trend.
From a technical perspective we still haven’t seen enough breadth of selling to indicate a low has been reached.
Bonds sold off despite concerns over growth — a very different reaction to what we have been used to in recent years.
The number of rate increases priced in by the market have marginally increased for the US, so the need to fight inflation is seen to take precedence over growth concerns.
Bonds remains a good signal on what’s happening in the economy.
History indicates 10-year yields peak towards the middle or end of a rate cycle — rather than near the start. This suggests further to go on bond yields. If this is not the case it would indicate more economic risk in US.
The other signal to watch is 2-year yields, which have not yet peaked. A peak in 2-year yields is a reasonable proxy for potential recession risk.
There is also a debate around whether commodities are peaking in terms of relative performance. While they have run hard, the relative move has been minor compared to past commodity cycles in the early 2000s or 1970s.
These moves can be sustained over longer periods than we have seen so far.
The final signal worth noting is a continued decline in the Chinese tech index.
This was the first part of the growth universe to roll over in February 2021 and is now down 75% from its high. Recent pressure relates to the risk of forced de-listings from the US.
It suggests the more speculative end of the growth cohort is still yet to find a bottom.
Australia
In Australia it was a pretty quiet week overall. Resources corrected from their recent run, while rising bond yields saw a rally in banks. Elsewhere the defensive rotation continued, with technology down and consumer staples up.
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.
Australia is as good a place as investors can be in this tough environment, says Pendal’s head of equities CRISPIN MURRAY
A UNIQUE collision of global challenges is clouding the outlook for equities in the near term, but Australia remains well-positioned to outperform, says Pendal’s head of equities Crispin Murray.
Four major challenges are hitting markets simultaneously, says Murray: the crisis triggered by Russia’s invasion of Ukraine, impending interest rate rises, the pandemic and the re-emergence of inflationary pressures (though Australia doesn’t face the same inflation challenges as other parts of the world).
“It’s not a great short-term message — we think markets are going to continue to struggle,” says Murray, speaking to investment professionals this week in his bi-annual Beyond the Numbers webinar.
Watch a replay of Crispin’s webinar here (registration required):
“There are however, two silver linings,” he says.
“The first one is that Australia is perhaps the most defensive market in the environment we’re in.
“And the second one is that when you see this sort of drawdown in financial markets, there tends to be an indiscriminate nature to those sell offs and they often lay the foundations for some of the best investment opportunities that we will be able to take advantage of over the next few years.”
Reliance on Russian commodities
Russia’s unprovoked invasion of Ukraine has first and foremost led to a terrible humanitarian disaster.
But it has also exposed the West’s reliance on Russia’s commodity exports and demonstrated that while Russia may be a mid-sized economy, it plays an outsized role in the global economy due to its commodity exports, says Murray.
Europe’s oil and gas purchases from Russia are in the order of 1 billion euros a day.
But government sanctions over the invasion are only part of the story of the global economy’s reaction.
Instead, widespread self-sanctioning is seeing companies avoiding trading with their Russian counterparts for fear of being seen to support the invasion.
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“What the Western governments were thinking would be minimal disruptions to these key commodities is turning into major disruptions,” says Murray. Estimates are that half of Russia’s 5 million barrels a day of oil exports is failing to find its way to market.
The result is a commodity price melt-up — prices are soaring.
This leads to the second big pressure point for markets in inflation.
Recent spikes in inflation have been driven by short term issues like COVID-related supply chain disruption, a tightening labour supply driving real wages higher and commodity capacity constraints, says Murray.
But now longer-term issues are taking over as the core inflation drivers, including rebuilding supply chains, declining working age populations, the investment required to build a clean energy economy and China’s shift away from exports to a domestic self-sustaining economy.
“The challenge we’ve see over the last few months is that a lot of these inflationary pressures are becoming self-reinforcing,” says Murray.
“History will look back and judge policy decisions in 2021 as some of the worst that we’ve seen in many decades.
“The reason is that we had a supply shock brought about by the pandemic and the policy response was to continue to stimulate demand and that’s led to this inevitable inflationary pressure.”
Murray says it’s important to remember that inflation can choke itself off: “Prices of goods go up high enough, chokes off demand, people don’t have the spending power, economy slows and inflation goes away.”
But inflation can become sustained if it is underpinned by rising wages.
“We’re at effectively full employment in the US, and that’s leading to higher wages.”
Outlook for rates
The question of how far interest rates will need to rise to combat inflation is key to the outlook for markets.
Murray says there are two schools of thought for how rates will play out.
One school believes rates will not need to be lifted as much as the market fears, due to deflationary forces and excess debt.
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That would lead to markets briefly correcting before rotating back quickly to long duration growth stocks, he says.
The second school of thought is that rates will need to rise and stay higher for a sustained period of time, similar to the period pre-GFC when the economy ran strong for years before slowing.
“If that is the model we’re looking at, then interest rates will have to go up materially more perhaps than the markets are thinking,” says Murray.
“This is the key debate from a macro point of view that we need to track,” he says.
Ironically, in the past, policymakers would likely respond to a geopolitical crisis by easing monetary policy, but that is highly unlikely this time.
“So, this is why near term we’ve got this irreconcilable conflict between these conflicting goals for policymakers.”
Where Australia fits
So, where does Australia fit in all this?
Surprisingly well, says Murray.
“Australia is as good a place as you’re going to be in this tough environment,” he says.
Partly this is because of the old-world make-up of the Australian stock market, dominated by finance, mining and energy companies.
But also, Australian companies are performing quite well.
Murray says Australian equity markets are declining despite improved earnings as a de-rating of prices due to higher interest rates and rising risk aversion is outweighing a good underlying earnings performance.
“So, what we’re seeing in markets so far is a reduction in the valuations rather than any earnings effect — if that remains the case, that would suggest that this is a correction within a longer term bull market, rather than the beginnings of a bear market.”
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.
Expect to see a lot more mentions of stagflation this year. TIM HEXT explains what it means for investors
WE’VE talked a lot recently about the easy days of central banking ending.
Russia’s invasion of Ukraine has sent this into overdrive.
Stagflation — a stagnating economy combined with rising prices — is a central bank’s worst nightmare. Should they risk sending the economy into recession to tackle inflation?
It is a scenario they haven’t had to face for about 40 years.
Inflation has reared its head since then, but it was always demand led. Slowing the economy was seen as responsible and investors were generally doing well.
Last week US Fed chair Jerome Powell was asked by Senator Richard Shelby if he was “prepared to do what it takes without any reservation” to tackle inflation.
Senator Shelby referenced former Fed chair Paul Volcker who aggressively tackled stagflation in the early 1980s — just before the US moved into a recession.
It was clearly a dig at Powell’s so far muted response to rising inflation.
If taken at face value US rates may need to go far higher than the current 2% factored in by markets.
In Australia, Governor Philip Lowe is still living in 2020, claiming inflation is not yet clearly sustainable within the 2-3% band.
He is sort-of correct — just the wrong way around.
It looks like inflation will be sustainably above 3% this year and next, potentially hitting 5% on an annual basis. No doubt he will be forced to change the narrative soon.
Stagflation will get a lot more mentions this year.
Powell said a clear “yes”.
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We will have to dust off the textbooks, having not lived or at least invested through it.
Suffice to say it is bad news for most of us, seeing not only our investments but also our spending power go backwards.
Another complicating factor for super funds is that stronger commodities may end up meaning a stronger AUD.
Since more than a third of assets sit offshore unhedged, super funds normally rely on risk-off moves driving a weaker AUD, somewhat reducing the negative performance.
A stronger AUD but weaker risk markets will increase the drag on asset returns.
As long as wages don’t lock in with inflation shocks — creating the vicious circle we saw in the 1970s — supply will eventually return to commodity and goods markets.
It just may not be a 2022 story — or even 2023.
Meanwhile will rate hikes assure another downturn as the cycle lives on?
A Pendal statement on Russia’s invasion of Ukraine
During these tragic times, Pendal’s sympathy lies with the people of Ukraine in their struggle to maintain their freedom.
As responsible investors, Pendal Group and its affiliates J O Hambro Capital Management, TSW and Regnan have taken decisive steps to reduce our already minimal exposure to Russian securities.
We are limiting direct risk in client portfolios and taking decisive steps to comply with evolving sanctions and restrictions. We will refrain from investing in Russian and Belarusian securities for the foreseeable future.
The situation is evolving rapidly and we continue to monitor the emerging risks, which may take an unexpected form as the consequences ripple through the financial and economic systems.
As active managers, our purpose is to navigate our clients through a world in flux to protect their interests during uncertain times.
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
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.
Be wary about holding growth assets right now — and consider some rotation to bonds says Pendal’s OLIVER GE
RUSSIA’S unprovoked invasion of Ukraine continues to attract sanctions aimed at limiting the terrible human toll in that part of the world.
The financial implications of those sanctions are of course reverberating far and wide in markets around the globe — and few investors would argue against such action.
But what does it mean in terms of asset allocation? Especially if the sanctions cause Russia to default?
“There is an increasing chance that Russia might default and that has implications for Europe,” says Oliver Ge, a portfolio analyst with Pendal’s Income and Fixed Interest team.
“That in turn hurts the United States and the rest of the global economy.”
“The average investor might take a cursory glance at what’s happening in Ukraine, but I’d argue it’s going to have major ramifications.”
“Russia has about $US640 billion of reserves of which $US400 billion is frozen in central banks around the world. On conservative estimates, it costs about $US1 billion a day to run the war so the impact to Russian coffers is material.”
“Even though energy products haven’t been sanctioned, many global buyers are staying away from Russian energy. If the war is protracted and the sanctions remain in place, pressure on the Russian economy will build.”
“It is also going to be a very challenging environment for neighbouring countries in Europe — not only through the energy channel and its effect on business margins but also through second-order effects via the banking sector in the form of bad debts.
“This will take time to fully play out but we are already seeing the cracks form.”
Financial impact in Australia
“At the start of the year, the consensus forecast for Aussie equities was for growth of about 5 per cent. Not a huge amount but a nice little bump. And that’s driven by the fact that we are in recovery mode.
“That hasn’t happened, predominantly because of Russia’s invasion of Ukraine. It doesn’t matter how much direct exposure our big companies have to Russia — once markets become concerned the effects spread around the world.
“The message to advisers is that if you were told at the start of the year that you’d get 5 to 7 per cent growth, that’s not going to play out in the current state of affairs.”
“So, you should be very wary about holding growth assets and potentially think about some rotation to bonds. Bonds will keep paying,” he says.
“It shouldn’t be a massive rotation, but investors should be more mindful around the expectations of growth assets.”
A Pendal statement on Russia’s invasion of Ukraine
During these tragic times, Pendal’s sympathy lies with the people of Ukraine in their struggle to maintain their freedom.
As responsible investors, Pendal Group and its affiliates J O Hambro Capital Management, TSW and Regnan have taken decisive steps to reduce our already minimal exposure to Russian securities.
We are limiting direct risk in client portfolios and taking decisive steps to comply with evolving sanctions and restrictions. We will refrain from investing in Russian and Belarusian securities for the foreseeable future.
The situation is evolving rapidly and we continue to monitor the emerging risks, which may take an unexpected form as the consequences ripple through the financial and economic systems.
As active managers, our purpose is to navigate our clients through a world in flux to protect their interests during uncertain times.
Find out about
Pendal’s Income and Fixed Interest funds
About Oliver Ge and Pendal’s Income and Fixed Interest team
Oliver 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
About Pendal Group
Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.