A key economic model used by Pendal’s multi-asset team is forecasting tougher times ahead. ALAN POLLEY explains what it means for investors
- Economic cycle model turns negative
- Caution warranted for second half
- Find out more about Pendal’s multi-asset funds
A LEADING economic indicator used by Pendal’s multi-asset team has turned negative after being positive for most of 2023 — a sign that tougher times may lie ahead for investors, says Pendal PM Alan Polley.
The first half of the year surprised markets with better-than-expected economic conditions, despite many forecasters earlier in the year anticipating that higher interest rates would have a significant detrimental impact on the economy.
Pendal’s economic cycle model has been one of the few forecasting tools to predict a robust economy, making its move into negative territory an important signal for investors.
“The model pretty much got it right for the first half,” says Polley, a portfolio manager with Pendal’s multi-asset team.
“It started the year suggesting we were in a positive economic environment — which is noteworthy because most people had a more bearish outlook.
“But it has recently ticked over onto the negative side.”
How it works
Pendal’s economic cycle model analyses the level and rate of change of leading economic indicators such as consumer and business surveys — while also examining how economic data surprises either positively or negatively.
The model is one of three key indicators that inform the multi-asset team’s active asset allocation process – alongside a valuation model and a model that analyses market trends. It has a successful long-term track record of picking turning points in the economic cycle, Polley says.
Services show signs of weakening
The key to the economy’s surprising resilience this year has been the strong performance of the services sector which has off-set a contraction in the manufacturing sector.
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“The manufacturing side of the economy has been in contraction for close to a year, so what’s surprised economists this year is that the services sector has been very strong,” says Polley.
“There’s still a lot of pent-up demand for services post-Covid lock-downs and there have been very high household savings rates.”
There are now early signs of that changing.
The household saving ratio — which was exceptionally high during the pandemic due to government payments and limited spending opportunities — has fallen to lows not seen since the GFC.
“The tide may finally be turning for the economic outlook,” Polley says.
“The services side of the economy may have peaked. In in our model, while it’s still in expansion, the rate of change is now on the negative side.
“So, the risk is that we are yet to truly feel the effects of rate increases, which generally take a one-to-two-year lag.
“We think it’s more likely that the services sector moves towards the manufacturing sector, than the other way around.”
Time for caution
The economy’s strength in the face of rate rises has been an important factor in this year’s surprising rally which has left markets largely pricing out the chance of a deep recession.
“The market isn’t the same thing as the economy, but normally they support each other. So, what’s been going on economically has provided some justification for markets rallying so hard,” says Polley.
“If you look back to earlier this year, pretty much everyone got this wrong.”
“Our economic cycle model has pretty much got it right up to this point. Now they’re turning negative.
“That makes us more cautious on the second half of this year, so we’re slightly underweight equities in response.”
About Alan Polley and Pendal’s Multi-Asset capabilities
Alan is a portfolio manager with Pendal’s multi-asset team.
He has extensive investment management and consulting experience. Prior to joining Pendal in 2017, Alan was a senior manager at TCorp with responsibility for developing TCorp’s strategic and dynamic asset allocation processes covering $80 billion in assets.
Alan holds a Masters of Quantitative Finance, Bachelor of Business (Finance) and Bachelor of Science (Applied Physics) from the University of Technology, Sydney and is a CFA Charterholder.
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
Investing in the energy transition aligns values and returns – but it’s best to take a diversified approach, argues Pendal’s head of multi-asset MICHAEL BLAYNEY
- Energy transition investing about values and returns
- Multi-asset approach optimal
- Find out about Pendal Sustainable Balanced Fund
NO MATTER your opinion on climate change, there’s no doubt we’re undergoing an energy transition – a global shift away from fossil-based energy to renewable sources.
The evidence is in renewable power growth, electric car adoption, regulatory and policy change, public sentiment – and yes, investment trends.
There are two main reasons an investor might show interest in the energy transition: aligning a portfolio with their values and making money.
“For retail investors, the number-one issue that arises when you survey them is climate change,” says Pendal’s head of multi-asset, Michael Blayney.
“People care about plenty of issues, but climate change is number one.”
The second reason is to make money.
“This massive transformational change in the world is happening fast,” Blayney says.
“It started in Australia with solar rooftops and now you see plenty of Teslas driving the streets.
“The transition is very real and there’s going to be a massive amount of money spent on it.”
Approach to diversified sustainable investing
The bigger question is how best to invest in the energy transition.
It’s not simply about identifying innovative, listed companies with strong pricing power and a growing addressable market, Blayney says.
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Sustainable investors should also “participate across multiple asset classes as part of a broader diversified portfolio”.
That might include infrastructure or sustainable bonds for example.
A diversified approach to ESG
“You want to maintain a robust multi-asset portfolio that’s competitive with any sort of traditional, unscreened investment,” Blayney says.
“It makes sense to participate across multiple asset classes as part of a broader diversified portfolio.
“Just like you don’t put all your money into one asset class, investors shouldn’t put their whole portfolio into one thematic or indeed access a large thematic via only one asset class.
“Investors should consider gaining exposure across many asset classes.
“You can invest in companies that are providing products and services for the energy transition. It might be a manufacturer of wind turbines.
“You can invest in operators of the infrastructure that’s part of the transition economy. And it is worth having some exposure to battery storage opportunities, which is part of the transition.”
A risk-reward approach
All of these investments need to be undertaken using the normal risk-reward framework, Blayney says.
“The sun shines with lower volatility than the wind blows. So solar is slightly a less volatile income stream than wind in many geographies.”
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More generally, the typical portfolio construction principles apply — equities are the top end of the risk-reward spectrum, cash is at the bottom end and renewable infrastructure is somewhere in the middle, Blayney says.
Investing in renewable infrastructure also provides exposure to energy prices via the cash flows which is something normally lacking in other parts of a portfolio when ethical screens are applied.
In debt markets, green bonds provide exposure to the energy transition.
Pendal’s head of responsible investing distribution Jeremy Dean adds more options: “There’s lending money to corporates which have the specific goals of reducing their carbon emissions through increasing energy efficient of their operations.
“And there’s retail bank syndication processes which might fund wind or solar farms.”
Blayney says commodity futures also provide opportunities for energy transition investors, particularly if buying into specific companies has been screened out.
“There are some obviously structural trends. Copper is needed to electrify and a vast amount is going to be needed. That provides a structural demand tailwind,” Blayney says.
“One way to play that, in a small way, is through commodities futures which allows you to participate in some of the upside in commodity prices, which you might miss out if you screen them out of your equities.”
Blayney’s final word: “Ultimately it comes down to developing a well-diversified portfolio that’s consistent with the client’s risk profile.”
Dean agrees: “You can have a high-quality, risk-adjusted returns while playing the energy transition theme.
“There are multiple ways of doing that, but fundamentally it has to be about making money.”
About Pendal’s multi-asset capabilities
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
These include Australian and international shares, property securities, fixed interest, cash investments and alternatives.
In March 2024, Perpetual Group brought together the Pendal and Perpetual multi-asset teams under the leadership of Michael O’Dea.
The newly expanded nine-strong team will manage more than $6 billion in AUM and create a platform with the scale and resources to deliver leading multi-asset solutions for clients.
Michael is a highly experienced investor with more than 23 years industry experience, including almost a decade leading the team at Perpetual.
The strength of global equities continues to surprise as we near the halfway mark of 2023 — but some markets make more sense than others, argues Pendal’s MICHAEL BLAYNEY
- AI revolution has spurred Wall Street
- Bonds offer risk-off defence and yield
- Find out about Pendal Sustainable Balanced Fund
- Browse all Pendal’s multi-asset funds
THE rally in big US tech stocks, Japan’s bourse and the performance of government bonds have been among the year’s main investing trends as we near the halfway mark.
Global equity markets have surprised many investors, notes Pendal’s multi-asset chief Michael Blayney — none more so than US tech stocks and the Japanese bourse.
But the two markets tell different stories, he says.
“The rally in US equities has been driven by a narrow number of large cap tech names with the artificial intelligence theme particularly important,” Blayney says, highlighting the run of high-end micro-processing chip maker Nvidia.
Its share price is up 175 per cent so far in 2023. With a market capitalisation closing in on $US1 trillion, it is now Wall Street’s fifth biggest company.
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But Blayney has a word of warning about Wall Street.
“The US remains one of our less preferred markets given stretched valuations and the heightened risk of recession.”
“While AI is clearly an important thematic for the world for the next decade, markets do have a habit of getting overly exuberant in the short term when a new theme emerges – and this would appear to be one of those occasions,” he says.
Japan a strong performer
The Japanese share market has also been a strong performer in 2023, rising more than 20 per cent this year, compared to 1 per cent for the S&P/ASX200.
“We’ve liked and been overweight Japan for some time,” says Blayney.
“Earnings estimates have been relatively flat in the last year whereas they’ve been downgraded in the US and Europe. It has been a case of pricing catching up with the fundamentals.”
Japanese companies have been more profitable in recent quarters than they have been for many years, with the exception of a run-up in earnings immediately before the Covid pandemic.
Japanese companies are also relatively under-leveraged compared to the rest of the world, putting them in a better position as interest rates rise.
“Finally, Japan has been ‘under-owned’ for a long time,” Blayeny says.
“The fundamentals are better than they’ve been for a long time, and so once the Japanese market’s performance improved, it quickly caught the attention of global investors.
“Even after the most recent increase, it’s still cheap.”
Bonds near 2022 highs
Pendal’s multi-asset team is also generally positive on bonds.
“Bond yields have headed back to almost their 2022 highs,” says Blayney.
“We like bonds. The higher yields available now mean they are able to fulfil their defensive function in a portfolio in a ‘risk-off’ environment, and also provide a ‘return cushion’ from further volatility.”
While inflation has come off its highs, it remains elevated, and employment remains resilient. That poses some risk to bonds, he says.
Blayney is more cautious about corporate debt.
“We’re still pretty bearish on credit, particularly high yield spreads. They don’t provide an adequate cushion from defaults in the case of recession.”
“Overall we are marginally underweight equities and close to neutral on bonds, while holding a little more cash and liquid alternatives, which also gives some exposure to inflation hedging assets.”
About Pendal’s multi-asset capabilities
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
These include Australian and international shares, property securities, fixed interest, cash investments and alternatives.
In March 2024, Perpetual Group brought together the Pendal and Perpetual multi-asset teams under the leadership of Michael O’Dea.
The newly expanded nine-strong team will manage more than $6 billion in AUM and create a platform with the scale and resources to deliver leading multi-asset solutions for clients.
Michael is a highly experienced investor with more than 23 years industry experience, including almost a decade leading the team at Perpetual.
The RBA retains a tightening bias after raising the cash rate again today, writes our head of cash strategies STEVE CAMPBELL
THE Reserve Bank retains a tightening bias after raising the cash rate by a further 0.25 percentage points today to 4.1 per cent.
In the days leading up to the meeting, the market was almost 50-50 on whether the RBA would tighten or not.
In its own words, the RBA has a narrow path to a soft landing.
That path is becoming narrower and narrower — and the risks of recession are rising.
As the RBA pointed out, a significant source of uncertainty comes from household consumption, as elevated prices and higher interest costs drain household coffers.
With only a blunt monetary policy tool to reduce demand, the RBA needs to deal with the economy from an aggregate perspective.
There are higher income households with excess savings that can weather the storm more easily. At the other end there are the more vulnerable.
Lower-income households are devoting more and more of their income to meet housing costs – whether higher rents or mortgage repayments – and elevated day-to-day costs.
So why another rate rise?
The RBA does not want to risk expectations that higher prices are becoming embedded.
May’s monthly inflation number had annual inflation at 6.8 per cent.
There were one-offs that pushed this number higher due to subsidies from early 2022 dropping out. But even so, inflation remains too high not to act.
The RBA would sooner a recession than embedded high inflation, as tough as that may sound.
The central bank continues to point out the risks of not doing anything.
“If high inflation were to become entrenched in people’s expectations, it would be very costly to reduce later, involving even higher interest rates and a larger rise in unemployment.”
The rate rise was not due to last week’s decision to raise the award wages by 5.75 per cent and the minimum wage by 8.6 per cent. The RBA sees wages at the aggregate level as consistent with its target.
There is one important caveat here though. This is the case provided productivity growth picks up.
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This is the key issue. Productivity is not picking up, driving up unit labour costs and exerting upward inflationary pressure.
What’s next?
The RBA will now be looking at the global economy, household spending and the outlook for inflation and the labour market.
The global economy is expected to grow at a sub-trend pace.
Inflation has continued to remain elevated and continues to exceed expectations, particularly in Canada and the United Kingdom.
While the Reserve Bank of New Zealand has indicated it expects to leave rates unchanged, the near-term bias from the major European and North American central banks is for higher rates. That is a club the RBA is firmly in.
About Steve Campbell and Pendal’s Income and Fixed Interest team
Steve Campbell is Pendal’s head of cash strategies. With a background in cash and dealing, Steve brings more than 20 years of financial markets experience to our institutional managed cash portfolio.
Find out more about Pendal’s cash funds:
Short Term Income Securities Fund
Pendal Stable Cash Plus Fund
Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.
Our multi-asset team uses a tool called r* to get a better idea of where rates are going and what returns we can expect. Pendal’s ALAN POLLEY explains
- The natural interest rate offers a useful tool for investors
- Long-term returns outlook more attractive
- Find out more about Pendal’s multi-asset funds
WHERE next for interest rates?
It’s probably the most important investment question going.
Rates have far-reaching implications for individuals, businesses and governments. They determine the cost of borrowing money and the value of investments — and they impact inflation, economic growth and employment.
Pendal multi-asset portfolio manager Alan Polley believes the key to unlocking the outlook for rates lies in comprehending the concept that there is an underlying or ‘natural rate’ of interest.
“When interest rates are low enough, they stimulate demand. And when they are high enough, they restrain demand,” says Polley.
“That means that somewhere in the middle, there must be a rate that is neither contractionary nor expansionary.
“That’s the natural interest rate — the level of real interest rates when the economy is in equilibrium.”
What is r*?
Known by economists as the r* (and pronounced ‘r-star’), the natural rate of interest is the real interest rate when the economy is at full employment and inflation is stable over a normal business cycle.
It is the reference point for how central banks manage rates across the business cycle.
Since the GFC, the r* has tended towards zero. In the boom time of the 1980s, it tended to exceed 2 per cent.
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Interest rates are fundamentally a factor of the supply and demand for capital. And over the next decade, demand for capital is likely to be higher than it has been since the GFC (though not as exuberant as the 80s), says Polley.
The energy transition and renewables rollout require substantial investment, national security is emerging as an issue that will require higher defence investment, companies are investing in rebuilding supply chains post-pandemic and governments are lifting public spending and running budget deficits.
Demographics will also play a role as ageing populations reduce available labour, forcing businesses to invest in synthetic labour like automation and AI.
“We take the view that a lot of these things mean there will be more demand for capital going forward than there has been since the GFC,” says Polley.
And as demand is rising, capital supply is falling as central banks switch from quantitative easing to quantitative tightening.
“Looking forward, we see the r* around the 1 per cent level — providing a reasonable compensation for the opportunity cost of supplying capital,” says Polley.
A 1 per cent natural rate fits neatly in an historical context, between the near zero rate of the post-GFC period and the 2 per cent rate of the three decades leading into the GFC.
It’s also a return to the very-long term natural rate, which has hovered around 1 per cent since 1900.
And it’s consistent with recent research from the US Fed and the RBA, which both assumed a 1 per cent r* in their long-term outlooks.
Using r* to understand rates
But how does that help with predicting the future of cash rates?
Polley explains that adding the r* to inflation provides a useful approximation of the long-term state of policy rates.
“In Australia, the centre of the RBA’s inflation target is 2.5 per cent. Adding the r*, that means the cash rate should end up at something like 3.5 per cent over the longer term.
“In the US, they have an inflation target of 2 per cent, which implies a long-term cash rate of 3 per cent.”
That provides investors with a powerful insight into the outlook for rates, says Polley.
“The RBA cash rate is currently 3.85 per cent — that’s pretty much in line with neutral.
“But in the US, the Fed cash rate is 5 to 5.25 per cent. That’s very contractionary.”
Potential for better long-term returns
The r* does more than help predict movements in rates, it also provides important information about the future returns for different investments.
“A higher r* means that the forward-looking return environment is higher than it has been since the GFC,” says Polley.
“Interest rates are your starting point — other asset classes’ risk premiums are added on top.
“If your base r* is low, then everything’s low.
“Reverting to a higher level means the base return for all asset classes is higher.
“Another nice aspect is valuations — with r* trending down before the pandemic we had valuations going up. High valuations mean more risk looking forward. Now, we have r* at more normal levels, valuations are back to more normal levels as well.
“These two things together mean that the longer-term return outlook looks more attractive than it was before the pandemic.
“We don’t think it’s a low-return world anymore — we think it’s more of a normal-return world.”
About Alan Polley and Pendal’s Multi-Asset capabilities
Alan is a portfolio manager with Pendal’s multi-asset team.
He has extensive investment management and consulting experience. Prior to joining Pendal in 2017, Alan was a senior manager at TCorp with responsibility for developing TCorp’s strategic and dynamic asset allocation processes covering $80 billion in assets.
Alan holds a Masters of Quantitative Finance, Bachelor of Business (Finance) and Bachelor of Science (Applied Physics) from the University of Technology, Sydney and is a CFA Charterholder.
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
As inflation falls, investors can have more confidence in bonds, argues our head of multi-asset MICHAEL BLAYNEY. Here he explains why
- Inflation has fallen from last year’s peaks
- Investors can have more confidence buying bonds
- Find out about Pendal Sustainable Balanced Fund
- Browse all Pendal’s multi-asset funds
AS inflation falls — while still remaining at uncomfortably high levels — investors can have more confidence investing in government bonds, says Pendal’s multi-asset chief Michael Blayney.
“On the raw numbers, inflation in the United States has come off a long way.
“It peaked above 9 per cent last year and most recently it has come in just below 5 per cent on a headline basis. This has important portfolio considerations.
“It means you can have a bit more confidence in your bond allocation, because the biggest risk to bonds, ultimately, is inflation.
“We have moved to slightly over-weight bonds, and that’s a big change because we previously had been underweight bonds for a long time.”
Global bond yields are broadly in line with Blayney’s estimate of fair value. But he warns that elevated services price inflation and a very tight labour market are key risks for bonds.
Offsetting this is the risk of recession in which bonds would provide their traditional “risk off” portfolio benefits.
Economists have been forecasting a recession in the US for several months and while the timing continues to get pushed out, it is still likely to occur, Blayney says.
With a slight tilt towards bonds and away from equities, Blayney’s team is running a “slightly cautious” stance.
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“It’s one to two years before you feel the full impact of rising rates and we are only halfway through that process. On that basis no-one really knows yet what the full impact of rising rates will be.”
The risk for central banks, including the US Federal Reserve, is that economies fall into recession but inflation remains high, hindering their ability to cut interest rates, he says.
“Realistically I think the Fed will want to see the whites of the eyes of inflation near its target before it starts cutting rates,” Blayney says.
US risks
Risks remain in the US economy, he says.
“There are still deposits being pulled out of US regional banks … and credit will be harder to get. And credit is very important to the health of the economy.
“Also, people’s purchasing power is being squeezed by inflation and there’s rising borrowing costs.
“And there’s a tail risk around the US breaching its debt ceiling. That’s not a very positive backdrop for investing.”
Equities at fair value
Away from bonds, equity markets, in aggregate globally, are around fair value, Blayney says, with Japan and the UK still cheap. But Wall Street and some European markets are expensive.
Blayney says that US equities haven’t priced in the potential for difficult times ahead and are still trading on a forward price-to-earnings ratio of nearly 19 times.
“The US is our key area of concern, and that is where our equity underweights are focused. We believe investors should focus on relative value between markets.
“We like some of the other value equity markets. Australia looks okay, and is one of a number of markets where prices are around fair value.”
About Pendal’s multi-asset capabilities
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
These include Australian and international shares, property securities, fixed interest, cash investments and alternatives.
In March 2024, Perpetual Group brought together the Pendal and Perpetual multi-asset teams under the leadership of Michael O’Dea.
The newly expanded nine-strong team will manage more than $6 billion in AUM and create a platform with the scale and resources to deliver leading multi-asset solutions for clients.
Michael is a highly experienced investor with more than 23 years industry experience, including almost a decade leading the team at Perpetual.
Pendal’s multi-asset team has been examining the performance of ESG-friendly companies over the longer term. Here’s what they found
- ESG-friendly companies more efficent, better valued over time
- Whole-of-portfolio management can hedge against short-term risk
- Find out about Pendal Sustainable Balanced Fund
- Browse all Pendal’s multi-asset funds
INVESTING in sustainable funds is intuitively attractive to more and more people.
But when oil and gas prices soar as they did last year — leading to underperformance among sustainable funds — it’s not easy to stay the course.
It’s the type of scenario that Pendal’s multi-asset team faces on a regular basis, for example when making investment decisions for Pendal Sustainable Balanced Fund.
What factors might persuade an experienced, long-term investor to stick with the plan?
Firstly, research from Pendal’s multi-asset team shows it’s worth sticking with sustainable investments in such scenarios, because better-rated ESG companies outperform over the longer term.
More on that below.
Secondly, during those times, an active multi-asset manager can take steps to guard against single-risk factors such as rising energy prices.
“Investors with ESG strategies needs to have a long measurement horizon and be prepared to accept that their investments will have a slightly different performance cycle to a traditional, unscreened strategy,” explains Michael Blayney, who heads up Pendal’s multi-asset team.
“Investors need to understand their tolerance to that.”
“When you have a strategy that involves exclusions of particular sectors of the market, your fund is going to run into headwinds at times.
“Last year, particularly in the first part of the year, there were soaring oil prices. If you had a strategy that excluded or underweighted oil companies, then you faced headwinds.
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“One way we managed that was to buy renewables in Europe, which gave us exposure to European energy prices within our alternatives portfolio,” says Blayney.
“Identifying and positioning for these types of risk factors can help portfolios perform better in the long term, and provide investors with a smoother, more comfortable ride in the short term.”
What the research tells us for long-term ESG investing
Pendal’s multi-asset team has spent a considerable amount of time looking at the long-term benefits of ESG investing.
Analyst Rita Bodrina recently examined MSCI ESG data going back to 2000, measuring the performance of companies that rate well on ESG metrics, companies that rate poorly and those with a relatively neutral rating.
One finding was that better ESG governance practices result in more efficient use of company assets.
Using sales on total assets as a proxy for efficiency, Bodrina found that companies in the top 20 per cent of ESG-rated stocks were more efficient that those in the middle segment of ESG ratings.
And they were sharply better than the bottom 20 per cent of ESG-rated companies.
The study also tested an assumption that a stronger ESG profile would result in more favourable valuations and a lower cost of capital.
The thesis was that ESG-friendly companies may be less exposed to risks and thus a safer investment.
Bodrina found that ESG companies were better valued by the market through time.
Most importantly the study also demonstrates that, based on cumulative returns over 22 years, low-rated ESG companies underperform. This occured on both a stock-specific basis, and by industry segments.
Better future outcomes
These effects could grow in the future, the team believes.
“This is due to a mixture of the regulatory backdrop globally, consumer and investor preferences, and a clear nexus between value creation and the fair treatment of all stakeholders,” Bodrina says.
Blayney says the bottom line is that more highly rated ESG companies do outperform — though historically this has been due to the underperformance of poorly rated ESG companies.
“It’s an interesting nuance that most of the return benefit comes from avoiding the bad stuff,” he says.
“Lower-rated ESG companies have also been more prone to downside risk, which supports the contention that a portfolio that tilts away from poor ESG companies should be expected to generate better risk/return characteristics through the cycle.
“Paying attention to ESG factors alongside traditional financial factors leads to better returns and better management of risk.
“Investors certainly don’t have to give up returns if they choose a sustainable strategy.”
About Pendal’s multi-asset capabilities
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
These include Australian and international shares, property securities, fixed interest, cash investments and alternatives.
In March 2024, Perpetual Group brought together the Pendal and Perpetual multi-asset teams under the leadership of Michael O’Dea.
The newly expanded nine-strong team will manage more than $6 billion in AUM and create a platform with the scale and resources to deliver leading multi-asset solutions for clients.
Michael is a highly experienced investor with more than 23 years industry experience, including almost a decade leading the team at Perpetual.
What’s behind the RBA’s surprise decision to lift rates – and what’s next? Here’s a snapshot from Pendal’s head of cash strategies, Steve Campbell
- Why bonds, why now? Find out more from our Income and Fixed Interest experts
THE Reserve Bank surprised most people – your scribe included – when they raised the cash rate today by 0.25 percentage points to 3.85%.
What was surprising was the RBA had revised down their forecast for 2023 from 4.75% to 4.5%, yet decided to tighten policy anyway.
In justifying the decision, the RBA noted that services inflation remained very high and the offshore experience indicated upside risks.
Productivity growth is anaemic, in turn exerting upward pressure on unit labour costs.
The strength of labour – with the unemployment rate at a 50-year low and most businesses struggling to find workers – only added to their concern.
Defending the decision to pause in April, the RBA said they held rates steady to provide additional time to assess the state of the economy and the outlook.
But they remained resolute in their determination to return inflation to target – and would do what was necessary to achieve that.
Why not go in April then?
Inflation is not forecast to be back in the target band before mid-2025 and the labour market is not cooling.
Wage inflation pressure may reduce in some sectors with the increase in migration.
But that brings a different type of price pressure, mainly via rental inflation.
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After the pause in April – and with the fixed rate mortgage cliff ever closer – I expected the RBA to wait and allow prior policy tightening to flow through the system.
I was wrong.
I doubt it’s a co-incidence that the RBA review released several weeks ago criticised the central bank for not getting inflation back to target quick enough.
Well, here is the response.
Previously I expected any policy change would occur more likely in a quarterly sequence following the release of quarterly inflation data.
That has gone out the window. Today’s decision means their next meeting in June is also a live meeting.
About Steve Campbell and Pendal’s Income and Fixed Interest team
Steve Campbell is Pendal’s head of cash strategies. With a background in cash and dealing, Steve brings more than 20 years of financial markets experience to our institutional managed cash portfolio.
Find out more about Pendal’s cash funds:
Short Term Income Securities Fund
Pendal Stable Cash Plus Fund
Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.
It’s time to consider shifting to liquid alternative investments, says multi-asset expert ALAN POLLEY
- Higher rates a headwind for illiquid alternatives
- Look for diversifying liquid alternatives with inflation protection and secular tailwinds
- Find out about Pendal’s multi asset funds
IT’S time to start transitioning from illiquid alternative investments to liquid alternatives, argues Pendal multi-asset portfolio manager Alan Polley.
“Illiquid assets have had a fantastic secular tailwind for the last two decades because interest rates have been falling and they have been chased by a wall of effectively free money bidding up prices, says Polley.
“These illiquid assets have had cash-flow benefits in terms of lower financing costs, and the lowering of the discount rate has led to positive valuation effects.
But the good times for illiquid assets are over, thanks to the accelerated rate tightening cycle, which in the US has been 500 basis points in a little over a year, Polley says.
Illiquid alternative assets are dominated by property and infrastructure and are private, or unlisted, assets. The economic environment for these assets has changed, he says.
“It’s certainly not free money anymore. This has been a step change.
“These assets tend to be very sensitive to interest rates in terms of financing costs and also the discount rate applied to future earnings.”
“There certainly isn’t a tailwind anymore and … given how sensitive to interest rates these assets are, there is potential downside.”
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Illiquid assets, by definition, don’t trade regularly in normal circumstances.
With even fewer sales over the last year, there are very few benchmarks to revalue assets.
Large investors need to revalue assets twice a year and, without the benefit of recent and relevant sales, tend to use dated sales prices or long-term averages for discount rates which are skewed towards lower rates.
But the interest rate environment in coming years will be very different to recent years, Polley says.
“No-one wants to sell the assets right now because they know they will take a haircut. There’s no transactions going on,” Polley says.
An indication of how much value has potentially been lost can be garnered from public assets that trade regularly.
“If you look at the REITs (real estate investment trusts) market, they’ve dropped about 25 per cent,” Polley says.
“The public markets tend to lead the private markets and are a clear indication that the private markets haven’t been priced to reflect the new reality. There is a lot more risk for private, or illiquid assets.”
The valuation question has triggered regulators, in recent months, to take an interest in the dearth of revaluations for illiquid assets. They are questioning valuations provided by some large managers.
“Regulators want to make sure that unlisted assets are being held at fair value in the new market environment,” Polley says.
Liquidity risk premium
Illiquid assets promise a “liquidity risk premium”. Because they are illiquid, there’s extra risk involved and that should attract a premium over time.
That risk will eventually be felt — the question is when?
“Illiquidity risk is a risk-on factor, so when the market environment is poor, that liquidity risk tends to underperform.” Polley says.
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“Often the hope is that an investor can ride through a poor market environment and not feel the effects of liquidity risk.
“But if the investor’s situation unexpectedly changes, then the true risk of illiquidity could be felt.
“Regardless, because these assets are priced infrequently, the true economic reduction in valuation can accumulate through time, and then an investor can get hit in one go.
“Plus, all illiquid assets will likely be affected at the same time. This leads to illiquidity risk having very fat tails.”
“A final disadvantage of illiquid assets is they introduce potential concentration risks and can reduce returns associated with being unable to effectively rebalance portfolios.
“Rebalancing can generate positive returns because it forces you to sell high and buy low. Having illiquid assets means you can’t always do that.
“Inability to rebalance means the portfolio could become overly exposed to illiquids, and potentially at the worst time.
Whole-of-portfolio consideration
It’s a whole-of-portfolio consideration that people often ignore or don’t think about when investing in illiquids.”
Shifting to liquid alternative investments will be a theme for this year, Polley says.
“Look for those that offer true diversification benefits and other forms of returns besides traditional equities and bonds.
“Look for assets that have a secular tailwind, such as sustainable investment companies, and investments with inflation linkage.”
About Alan Polley and Pendal’s Multi-Asset capabilities
Alan is a portfolio manager with Pendal’s multi-asset team.
He has extensive investment management and consulting experience. Prior to joining Pendal in 2017, Alan was a senior manager at TCorp with responsibility for developing TCorp’s strategic and dynamic asset allocation processes covering $80 billion in assets.
Alan holds a Masters of Quantitative Finance, Bachelor of Business (Finance) and Bachelor of Science (Applied Physics) from the University of Technology, Sydney and is a CFA Charterholder.
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
Inflation remains a key driver of investment markets, just as it was throughout the first quarter. Here’s how our head of multi-asset MICHAEL BLAYNEY is approaching asset allocation right now
- Inflation could remain sticky
- Some opportunities in equities and listed real assets
- Credit spreads a poor risk-reward proposition
- Find out about Pendal’s multi-asset funds
DESPITE yesterday’s news of a continued easing in Australia’s monthly CPI from 7.4% to 6.8%, inflation will remain a key driver of investment markets, just as it was in the first quarter, says our head of multi-asset Michael Blayney.
“While inflation looks to have peaked, it could become sticky in some economies,” Blayney says.
“In the US, for example, it could remain around the four to five per cent range with further falls dependent on softening wages and increased labour capacity.”
Investors are pricing in a normalisation of inflation.
“But markets react relative to what’s priced in. If inflation proves to be stickier than what’s priced in, that creates risks for both bonds and equities.”
Global equity markets have been erratic this year. The first couple of months equities rallied and then they fell back in March.
Where they go to next will be very much about inflation — and it’s similar for fixed income markets, he says.
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“Doubts remain as to whether central banks can engineer a controlled reduction of inflation pressures or whether their actions overshoot and create demand destruction and a deep recession.
“These considerations suggest a cautious risk stance across asset classes,” Blayney says.
How to approach this environment
For investors, the macro-economic backdrop means they need to seek out opportunities and understand relative valuations.
Equities
“Global equity markets are around fair value with Japan and the United Kingdom still cheap and the United States and some European markets still expensive,” Blayney says.
“We are marginally underweight overall, still cautious on downside risks to earnings.”
“Equities have ‘de-rated’ and valuations have become much more reasonable across a wide range of markets.
“But the outlook remains uncertain, given the downside potential in corporate earnings and risks from the lagged impacts of monetary policy tightening,” he says.
Midcaps on
the move
Hear from lithium industry pioneer
Ken Brinsden and Pendal’s
Brenton Saunders
On-demand webinar
Bonds
Pendal has now moved to slightly underweight government bonds on a shorter-term basis, Blayney says.
“Global bond yields have fallen significantly from their highs, for example Australian 5 year yields are down 0.8 per cent year to date” he says.
“Higher-starting yields — compared to what were on offer two years ago — provide a degree of insulation. But bonds have already priced in economic weakness on the horizon, so further gains are only likely if the economy gets even worse than what’s priced in now.”
Credit
In credit markets, both investment grade and high yield spreads are somewhat higher than their long-term medians, Blayney says.
“But the clouded economic backdrop provides a poor risk-return proposition given the asymmetry in potential outcomes from here,” he says.
“The spreads available do not compensate adequately for the risk of a recession.”
Real assets
There are opportunities in listed real assets, Blayney says.
“Select listed infrastructure assets with inflation-linked cashflows provide good insulation in case high inflation is more stubborn than currently priced by markets.
“This is particularly true given how the asset class down-rated last year.”
About Pendal’s multi-asset capabilities
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
These include Australian and international shares, property securities, fixed interest, cash investments and alternatives.
In March 2024, Perpetual Group brought together the Pendal and Perpetual multi-asset teams under the leadership of Michael O’Dea.
The newly expanded nine-strong team will manage more than $6 billion in AUM and create a platform with the scale and resources to deliver leading multi-asset solutions for clients.
Michael is a highly experienced investor with more than 23 years industry experience, including almost a decade leading the team at Perpetual.