Ultra-loose monetary policy is creating exceptions to risk and reward – and bringing opportunities for investors seeking better returns for their cash. OLIVER GE explains

• Bonds paying better returns than bank deposits
• 4x returns when held to maturity
• Find out more about Pendal fixed interest funds

THE link between risk and reward is a staple of investment theory.

But ultra-loose monetary policy as the Reserve Bank of Australia seeks to support the economy’s pandemic recovery is creating some exceptions to that age-old rule.

Investors who choose the safety of a government bond (held to maturity) are now offered better returns than a nominally higher-risk bank term deposit, says Oliver Ge, a portfolio manager with Pendal’s Income and Fixed Interest team.

“If you’re willing to hold government bonds for a year — just like you would with a bank term deposit — you’ll get four-to-six times more money than you’ll get from a bank,” says Ge.

Cash is an important asset for many investors. It provides security and flexibility, and importantly it offers protection from being forced to sell assets in a downturn.

But for investors seeking income, it can offer very poor returns.

“You go to one of the big banks and they’re offering about 0.25 per cent interest rates on a one-year term deposit — $25 on a $10,000 investment. That’s not a lot.

“But if you’re happy to lock your money away for a year, why not try a government bond? A one-year Australian government bond is paying 1 per cent, so you’re getting four times as much money.

“Unless you think the Australian government is going to default — and as long as you hold to maturity — you’re better off giving them your money.”

Ge points out that state government bonds can offer even better returns, with the Western Australian semi-government bonds offering returns as high as 1.6 per cent.

Protection against downturn

Bonds provide a further advantage over term deposits because alongside guaranteed income and capital protection, they offer protection against an economic downturn.

“If there was a catastrophic event like a Covid version two and the RBA decides not to lift rates, these bonds could return a lot more as they will rise in value,” says Ge.

“Bonds are just insurance policies that always pay you — and when things blow up, they pay you even more.”

Ge says the anomaly exists because the RBA is providing very cheap funding to the banks, meaning they do need to compete for deposits in the market and can keep deposit rates artificially low without affecting the financing of their lending businesses.

“They have so much money they can afford to do this,” he says.

By contrast, government bonds are issued into a competitive global market and rates are set by investor demand.

Ge says the anomaly is likely to stay in place as long as the banks have access to cheap funding.

“This is a genuine opportunity to get a lot more juice with the same or better safety – assuming you hold to maturity,” says Ge.

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About Oliver Ge and Pendal’s Income and Fixed Interest boutique

Oliver Ge is an Assistant Portfolio Manager with Pendal’s Income and Fixed Interest (IFI) team.

Oliver works on developing and running key quantitative investment models, and acting as trading support for the Income & Fixed Interest team. Oliver received his Bachelor of Commerce (Finance) from the University of Sydney and is also a CFA Charterholder.

Pendal’s IFI 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.

The invests across income, composite, pure alpha, global and Australian government strategies.

Find out more about Pendal’s fixed interest strategies here

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About Pendal Group

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

Contact a Pendal key account manager

Could Russia’s invasion of Ukraine prompt Chinese action in Taiwan? That’s not likely in the medium term argues Pendal’s OLIVER GE

ALARM bells are ringing in the East.

As fighting intensifies in Ukraine’s urban core, Chinese jets have entered Taiwan’s air defence zone, leading some to speculate that it’s only a matter of time before we see People’s Liberation Army boots on the ground.

At times like this it’s understandable that investors pondering their exposure to Russia’s invasion of Ukraine might also think harder about the China-Taiwan stand-off.

Pre-election positioning among Australian politicians pulls the China-Taiwan situation into even sharper focus for local investors.

However a Chinese invasion of Taiwan is a very low probability event in the short and medium term.

Near term, the Chinese Communist Party has other priorities at stake. 

President Xi has promised to rectify growing domestic discontent over diminished living standards. Housing affordability and employment opportunities are key focal points for the CCP leadership.

They do not have time for major external distractions.

In the medium term, Taiwan’s support from the US remains crucial. Remember that Taiwan (but unfortunately not Ukraine) is of great strategic importance to Washington. 

Its proximity over major shipping lanes and dominance in semiconductor manufacturing has seen consecutive US administrations pledge Taiwan military support in the event of a war. 

China has no appetite for a direct confrontation with the US.

In the longer term these reasons above do not negate the possibility of a future conflict. 

A unified China is arguably the biggest political objective of the CCP. China’s dominance in the region and military capacity continues to build.

But for now the carrot of economic cooperation remains the preferred policy over brute force.

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About Oliver Ge and Pendal’s Income and Fixed Interest boutique

Oliver Ge is an Assistant Portfolio Manager with Pendal’s Income and Fixed Interest (IFI) team.

Oliver works on developing and running key quantitative investment models, and acting as trading support for the Income & Fixed Interest team. Oliver received his Bachelor of Commerce (Finance) from the University of Sydney and is also a CFA Charterholder.

Pendal’s IFI 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.

The invests across income, composite, pure alpha, global and Australian government strategies.

Find out more about Pendal’s fixed interest strategies here

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About Pendal Group

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

Contact a Pendal key account manager

Even with the promise of meeting bond interest payments, the risk of contagion from Evergrande has increased as investors rotate away from equities and high yield credit. Pendal’s Oliver Ge explains what’s next

CHINESE property giant Evergrande has staved off default on the first of many payments covering some $US300 billion in debt.

But investors are still holding their breath to see whether Beijing will step in and what happens next.

Pendal’s Oliver Ge says the fallout on the domestic Chinese market would be minimal in the event of a controlled default.

Evergrande — which owns 1300 projects in 280 cities according to Bloomberg — represents a small 0.2% portion of China’s loan system, says Ge, an assistant portfolio manager with Pendal’s Income and Fixed Interest team.

“Right now Beijing has not been materially vocal on a rescue package, preferring instead that the company quietly sells down its assets and makes investors, suppliers and homeowners whole before quietly exiting the industry.

“But the issue is that Evergrande is unable to deliver on the ‘quietly’ part since they have no credibility in the financial system.

“No one will lend them any money. The only way they can quickly raise cash is to mark down their existing inventory of apartments.”

Markdowns as a high as 25% have been quoted, says Ge.

But going down this path means the rest of Evergrande’s peer group would have its asset book revalued too –prompting the sell-off we’ve seen so far.

Broader impact for investors

Until recently the contagion was limited to Asia and resource names such as BHP and Rio Tinto, which supply the iron ore for Chinese property projects.

Today, even with the promise of meeting bond interest payments, the risk of contagion has increased as people rotate away from equities and high-yield credit altogether, Ge says.

And the market implication for offshore USD bonds is significant.

“Right now Evergrande USD bonds are trading around 20-25c to the dollar (yuan).

“Default is almost guaranteed at those levels and other domestic peers will invariably get dragged into the sell-off.

“The current Asian high-yield default rate is around 3%. This could rise to 9% if Evergrande and its subsidiaries officially miss their debt obligations going forward.

“In lieu of a policy u-turn from the Federal Reserve, government bonds will likely thrive in this regime.”

Evergrande is just the tip of a large iceberg in China right now, says Ge.

“There is an ongoing vicious cycle that won’t stop until Beijing decides to scale back their social inequality reforms.

“Loose monetary and fiscal can help but it won’t be enough to offset existing headwinds.”

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About Oliver Ge and Pendal’s Income and Fixed Interest boutique

Oliver Ge is an Assistant Portfolio Manager with Pendal’s Income and Fixed Interest (IFI) team.

Oliver works on developing and running key quantitative investment models, and acting as trading support for the Income & Fixed Interest team. Oliver received his Bachelor of Commerce (Finance) from the University of Sydney and is also a CFA Charterholder.

Pendal’s IFI 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.

The invests 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.

Contact a Pendal key account manager

Market uncertainty means equity investors should consider positioning themselves across defensive and cyclical stocks. Pendal’s ANTHONY MORAN explains why

• Consider both defensives and cyclical stocks
• Building materials, steel and gaming less attractive
• Find out about Pendal Focus Australian Shares Fund

STOCKMARKET investors are experiencing how quickly inflation and policy responses can hit share prices.

So how should an ASX investor approach the stockmarket right now? Which sectors look promising and which should be reconsidered?

“The challenge is that all the sector outlooks are being challenged by the macro outlook at the moment — and whether central banks can engineer a soft landing, or maybe a mild recession as they get inflation under control,” says Anthony Moran, an investment analyst in Pendal’s Australian equities team.

“The uncertainty means investors need to be positioned across defensive and cyclical stocks right now.

“If we get a soft landing then cyclicals will do well and the defensives will underperform, and vice versa.”

Building materials

Some sectors may be better to avoid, says Moran. For example, the building materials sector is difficult to support given the macro outlook.

“We’ve been enjoying boom conditions globally for residential construction.

“Now we are seeing rates rise at different paces in different markets and Australia is behind the curve.

“We are going to see faster rate rises here, and we are still a long way from the bottom of the cycle, so building materials is an easy avoid.”

Still, every sector — including building materials — will feature stocks that are more likely to outperform.

James Hardie, which earns a large chunk of its revenue in the United States, is an example. It has more exposure to renovations than new buildings, and demand in that part of the sector is more resilient.

“It’s kind of perverse. You can’t afford a new home so you renovate instead,” Moran says. James Hardie also operates in the US economy which is further through its housing cycle than Australia.

Steel is probably a sector to broadly avoid, Moran says.

The sector did well last year, but now it is normalising down. Moran said the industrial warehouse market has now peaked, and that has been a material driver of steel demand.

Gaming

Another sector to reconsider given the macro-economic climate is gaming, Moran says.

“There was tremendous industry growth through the COVID years due to stimulus packages and a lack of alternative forms of entertainment.

“People were basically stuck at home playing mobile games or betting on the races and other sports.”

As those tailwinds subside, along with the drop in discretionary income thanks to higher cost-of-living expenses, gaming could be a sector to stay away from.

Though the newly demerged Lottery Corporation – which is the lotteries business of Tabcorp – may go against the trend.

“Essentially, it’s an infrastructure business with long dated concessions, very strong free cash flows, extremely resilient demand and some specific growth opportunities from increased digital penetration.

“It’s as much an infrastructure stock as a gaming stock and due to corporate activity there aren’t many of them left.”

What looks promising

What about sectors to invest in, given the macro-economic outlook?

“Paper and packaging is really interesting right now,” Moran says. “Some of the stocks in the sector have shown a tremendous ability to pass through inflationary cost pressures.

“In the case of Orora, it’s actually a tailwind because they’ve been able to pass on more than the price increases.

“Demand for their products is inelastic and it’s quite a defensive sector. There are also stock-specific factors that will help them.”

Rising inflation and supply chain disruption are a key AGM theme this year. But ASX investors can find opportunity if they know where to look. Pendal equities analyst ANTHONY MORAN explains

• Inflation pressures the talk of AGM season
• Opportunity for some to rebuild margins
• “Classic early cycle” 

RISING INFLATION could deliver improved earnings for companies agile enough to rebuild margins and capacity in the face of higher costs, says Pendal equities analyst Anthony Moran.

Supply chain constraints, rising input and energy costs and scarce labour are driving inflation higher. US consumer prices are up 6.2 per cent year-on-year to October and Australian inflation is up 3 per cent in the year to September.

But beneath the scare stories on the news, this year’s Annual General Meeting season suggests that a bout of inflation could turn out to be a benefit for some ASX companies.

“We’ve all seen the headlines around inflation and supply chain issues and there has been a bit of anxiety around that,” says Moran.

“But through AGM season we are now starting to get a real read on how inflation is affecting companies.

“What’s interesting is that companies with pricing power can pass through this cost inflation — and for some, it’s even got to the point where they are getting a little margin expansion.

“Some companies are seeing this as an opportunity.”

Several themes are converging to create favourable outcomes for certain companies, Moran says.

For a start, the very fact that inflation is headline news is conditioning consumers for higher costs, which creates a favourable environment for companies to push through price rises.

But perhaps more importantly, consumer demand remains strong.

Household budgets are in good order. Government stimulus payments have allowed people to top up savings, rising house prices are lifting home equity and low interest rates are releasing disposable income.

Demand is particularly strong for construction materials like siding, bricks and plasterboard.

And amid the strong demand, supply constraints are hampering the ability of overseas companies to compete, allowing domestic manufacturers to regain market share while pushing through price rises.

Classic early cycle

“This is the classic early stage of the economic cycle where inflation isn’t a negative yet,” Moran says.

ASX investors should look at large companies with pricing power and domestic manufacturing capability. He nominates US-based home siding maker James Hardie and bricks and plasterboard maker CSR as examples of companies winning in the current cycle.

But watch out for companies that cannot pass on price rises. Moran points to Dominos as an example of a company finding it hard to lift prices when its marketing relies on the promise of cheap pizza.

“There will be losers from all this but at this stage we’re actually finding more winners than losers,” he says.

The rebuilding of capacity and pricing power also gives some clues to how the debate over whether inflation is transitory or here to stay will play out, says Moran.

“We are wearing sky high inflation and freight costs in all these industries — timber is up 50 per cent, steel is up similar.

“But the response from companies to this is to build more capacity.

“And as new capacity is added, prices for all of these commodities will come off again so you will get a steady deflationary pulse.”

Supply chain outlook

Investors should watch US immigration trends for clues on how the supply chain constraints will resolve, Moran says.

“The real silver bullet for many of these issues like freight will be international migration of workers resuming.

“The fundamental issue with freight is a lack of truck drivers. To get more drivers you need higher wages and you need more migration.”

As always, investors need to consider the risks.

As inflationary pressures unwind and commodity prices fall, companies that had been benefitting from higher prices will come under pressure. And as freight normalises, imports will become competitive again.

“These things that have been positive drivers may reverse,” says Moran.

The other risk is that inflation begins to crimp demand.

“If we see a demand slowdown but inflation persisting, then pricing power may evaporate and you actually end up in the worst of both worlds with rising costs and lower revenues.

“You’ve got to watch that cycle like a hawk.

“The good news is that it appears that global policymakers are solving for slightly higher inflation and slightly higher demand for longer to help the global economy recover from COVID disruptions.”

Hunger for earnings growth certainty is driving valuation of quality companies and infrastructure businesses as investors set up portfolios for the re-opening, says Pendal equities analyst Anthony Moran

• Pension funds are driving infrastructure prices to records
• Stay diversified, says analyst Anthony Moran
• Find out about Pendal Focus Australian Share Fund

“PEOPLE are seeking certainty in an uncertain world,” says Pendal Australian equities analyst Anthony Moran.

“We’re seeing people willing to pay bigger premiums than we’ve ever seen before for the certainty of strong earnings momentum or the multi-decade earnings certainty of infrastructure.”

The recent ASX company reporting season shows investors are willing to pay a premium for companies with good operating momentum.

They are betting a demonstrated ability to perform well amid the pandemic disruptions means a company will be able to power out of lockdowns and deliver strong growth over the coming 12 months, Moran says.

Rising input prices have been a feature of the pandemic. Supply constraints from manufacturing disruption and a shortage of freight capacity have paired with strong demand to drive prices higher.

“One of the implications for portfolio construction is to be aware of stocks that have measures in place to manage those risks or have pricing power,” says Moran.

He highlights building materials companies James Hardie Industries (ASX: JHX) and Fletcher Building (ASX: FBU) as particularly good examples. The momentum they took into the pandemic has served them well in coping during the disruptions, he says.

“For Hardie, it was about having availability of products when their competitors didn’t — and having a strong brand and having invested a lot in customer relationships.

“For Fletcher, they were kicked around for years by cheaper importers as they held on to being a domestic manufacturer. Now the shoe is on the other foot because of the supply interruptions hurting imports.”

These trends are likely to persist, Moran says. Companies with strong operating momentum will continue to perform well, since strong underlying demand will continue to buoy sales, he believes.

Search for stable, long-duration assets

The second big trend underpinning the market is the urgency with which big superannuation and pension funds are searching for stable, long-duration assets.

This is driving a flurry of takeovers in the infrastructure sector and pushing valuations to all-time highs. It’s led by multi-billion-dollar bids for companies such as Sydney Airport (ASX: SYD), Spark Infrastructure (ASX: SKI) and AusNet (ASX: AST).

“It’s fascinating because we’re seeing unlisted money willing to pay a materially lower cost of equity than the listed markets. They say they have a longer-term time frame. We would say they have got too much money trying to find a home.”

Moran says only particular types of companies are attractive to the big super funds: “It’s got to be long-dated, it’s got to be a hard asset and it’s got to be ESG [Environmental, Social and Governance] friendly.”

How can investors play these twin trends?

Moran says the key is to hold a diversified portfolio and not get too caught up in the interest-rate driven games played by institutional investors.

“It’s about recognising there are different kinds of opportunities and you can make money in all sorts of ways in any given market.

“You want to have a balanced approach. If all you have in a portfolio is these stocks, the moment you get a switch in the market momentum away from growth and quality towards value, that could whip against you extremely quickly.”

It’s not a theoretical concern. A sustained lift in inflation, higher GDP revisions and rising interest rates could all potentially shift the dominant market view, says Moran.

The answer is to find exposure to stocks where there is a chance that earnings momentum will pick up as lockdowns pass or where there are clear catalysts to close the valuation gap, he says.

Rate rises and inflation are impacting consumer behaviour — but there are opportunities if you know where to look, says Pendal’s SONDAL BENSAN

• Rates and inflation drive consumer change
• Household spending holding up for now
• Find out about Pendal Focus Australian Share Fund

YOU may have noticed it’s tough to buy a new suitcase at the moment — but there’s suddenly an oversupply of laptops.

Rapid changes in buying behaviour — exacerbated by rising rates and inflation — mean challenges for equity investors focused on ASX-listed consumer cyclicals.

But there are opportunities if you know where to look, says Sondal Bensan, an analyst with Pendal’s Aussie equities team.

Unusual confluence

Companies selling goods and services to households are facing the twin headwinds of rising inflation and higher interest rates — even as they adapt to the post-Covid reopening.

This unusual confluence of events is causing volatility in stock prices and making it tricky to predict how the sector will ride out the cycle, says Bensan.

“There’s a big shift going on — in revenue and in costs.

“We are seeing shifts in the mix of what people are spending money on, and there’s a huge pressure wave of costs coming through that’s hitting margins.”

The Covid years were characterised by increased spending on household-related activities like homewares, renovation and electronics. But as economies revert to normal, people have shifted their spending to out-of-home experiences.

“During Covid you could barely get hold of a laptop,” says Bensan. “Now it’s almost the opposite. Now retailers are running out of luggage and they are being stuck with stock in the categories that did well during the pandemic.”

The impact of the shift is that many consumer cyclical companies are reporting above-trend revenues even as the cycle turns because of the extra purchasing pulled forward by the pandemic.

“Some of the retailers’ revenues are 30 per cent above what they were pre-COVID. In a normal market, they might grow 8 or 9 per cent in a two-year period so they are way above trend,” he says.

“The dilemma for investors is that the next move may not be back to trend — it may be that because of the excesses you end up moving below trend.

“People that found themselves with two or three televisions during the pandemic won’t need to replace them for some time.”

Inflation impact

At the same time, companies are facing the headwind of rising inflation.

“You’ve got cost pressures across the board. Supply chain costs due to fuel, due to capacity constraints, due to domestic supply chain because people are off ill with Covid.

“You’ve had all these negative forces on supply chain costs coming through at the same time revenue could start to go below trend.”

And now households now face rising interest rates, with the Reserve Bank lifting the cash rate to 0.85 per cent on Tuesday, raising the prospect that household themselves could start to come under pressure.

“Every 50 basis points in interest rate rises is about 0.8 per cent off household income,” says Bensan.

“And then there’s inflation itself — food inflation, petrol prices, gas and electricity prices. These are big movements in prices for households and they clip incomes.

“An extra 1 per cent on the CPI means there’s 1 per cent less money for households to spend.”

Households holding up

So far, households are holding up well.

Bensan says the pandemic prompted people to save more than they used to: the household savings rate is up to 11 per cent of income from 4 or 5 per cent pre-Covid.

“And the other component is incomes. The last data showed household wages growth at 5 per cent which is above inflation and a net positive.”

“There’s heaps of buffer. That’s why so far even though you’ve had all these things happen, revenue for discretionary stocks is holding up — even for the ones that had benefited from COVID.”

Bensan says ultimately the direction of the cyclical stocks will depend on the trajectory of interest rates.

“Another 1 per cent on rates and you’d still be fine — households have enough buffer there.

“But if it goes beyond that — NZ is talking about mortgage rates getting to 6 per cent — than it could be challenging. That would be a big drag and eat up all the buffer that’s there.

“But on balance, there’s more pessimism than what the reality probably is right now.”

What it means for investors

Bensan says one path for investors is to find companies that took the opportunity through the COVID period to restructure their businesses and reduce their cost bases.

He points to Qantas and Nine Entertainment as examples.

“A lot of companies that look like they are doing well are just pulling revenue forward from future years. If anything, they will end up worse off than they were before,” he says.

“But some others who have used the COVID period to reform will actually end up far better off.”

He says companies with variable costs bases that can be adjusted down as revenues fall will be better off than those unable to reduce costs.

And companies with resilient, subscription-based revenues will be better placed to weather a downturn in household spending than traditional retailers.

“It’s not just the revenue falling, they have inventory as well. When you have excess inventory, you have to clear it and discounts affect margins.

“Those kind of stocks have probably got a lot more earnings risk ahead of them.”