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

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

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

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

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

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

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

Very little will stop them.

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

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

Bonds a buy?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

---

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.

Contact a Pendal key account manager

Here are the main factors driving the ASX this week according to our head of equities Crispin Murray. Reported by portfolio specialist Chris Adams.

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

Markets continue to see sharp falls.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Central bank policy

It was a busy week for central bank watchers:

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

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

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

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

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

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

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

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

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

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

Australia

There were two important developments last week.

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

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

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

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

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

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

Europe

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

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

Switzerland

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

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

Japan

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

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

US economy

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

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

Second, the lead indicators of activity are deteriorating:

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

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

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

This is an important issue for commodities.

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

 

This economic risk has implications for the market.

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

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

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

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

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

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

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

Markets

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

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

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

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

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

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

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

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

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

Australian equities

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

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

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

---

About Crispin Murray and Pendal Focus Australian Share Fund

Crispin Murray is Pendal’s Head of Equities. He has more than 27 years of investment experience and leads one of the largest equities teams in Australia. Crispin’s Pendal Focus Australian Share Fund has beaten the benchmark in 12 years of its 16-year history (after fees), across a range of market conditions.

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

Find out more about Pendal Focus Australian Share Fund  

Contact a Pendal key account manager

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

Here are the main factors driving the ASX this week according to our head of equities Crispin Murray. Reported by portfolio specialist Chris Adams.

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

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

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

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

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

The market increasingly fears high interest rates and a recession.

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

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

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

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

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

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

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

Economics and policy

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

Some key points to note:

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

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

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

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

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

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

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

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

Europe

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

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

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

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

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

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

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

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

Markets

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

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

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

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

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

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

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

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

Beyond that, the pre-Covid level was 3250.

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

Australia

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

 

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

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

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

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

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

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

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

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

---

About Crispin Murray and Pendal Focus Australian Share Fund

Crispin Murray is Pendal’s Head of Equities. He has more than 27 years of investment experience and leads one of the largest equities teams in Australia. Crispin’s Pendal Focus Australian Share Fund has beaten the benchmark in 12 years of its 16-year history (after fees), across a range of market conditions.

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

Find out more about Pendal Focus Australian Share Fund  

Contact a Pendal key account manager

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Income cushion

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

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

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

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

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

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

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

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

Here are the main factors driving the ASX this week according to our head of equities Crispin Murray. Reported by portfolio specialist Chris Adams.

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

BETTER-than-expected economic data and signs of Beijing winding back Covid restrictions are fuelling concerns that inflation may not fall as quickly as some hoped.

This has prompted a rebound in commodity prices. It’s also seen US 10-year bond yields rise 20bps to 2.94%, down from a peak of 3.19%.

The move in bonds triggered a sell-off in US equities late last week. The S&P 500 finished down 1.2%. The S&P/ASX 300 was up 0.8%.

Cautious sentiment was reinforced by JP Morgan CEO Jamie Dimon’s reference to the “hurricane… right out there down the road coming our way” as a result of higher rates and quantitative tightening.

Elon Musk’s “superbad feeling about the economy” and need to cut 10% of Tesla’s workforce did not help.

The S&P 500 has rallied 7% off its lows and many sentiment indicators have shifted back from “oversold” to more neutral.

The near-term market direction is likely to be driven by this week’s inflation data and the potential for earnings surprises.

We believe we are in a holding pattern for now.

Rate expectations have shifted materially. Whether they will moderate or go higher still will be determined by the economy over the next three months. It’s just too early to call.

Soft landing or recession

Going back to 1929, the average US soft-landing bear market has been -26% — and for a recession
-41%. 

Here are the current scenarios for each of these “book-end” soft-landing and recession paths:

1) The path to a soft landing

• Building inventories mean consumer price rises ease off
• Chinese re-opening eases product supply, also helping inflation
• Wages ease as a lack of stimulus means companies no longer need to pay up to induce workers to return. Companies begin to stop hiring and even lay off workers. Tesla and Amazon’s recent comments are pertinent in this regard
• Commodity prices stop rising
• As a result, the Fed doesn’t need to go harder than what’s already priced in the forward curve

2) The path to recession

• Inflation remains resilient as the economy doesn’t slow sufficiently
• Companies continue to catch up to the cost impost they are wearing
• Housing costs keep rising
• The labour market stays tight as service jobs continue to recover, workers seek compensation for higher prices and so wage growth doesn’t slow
• Supply shortages combined with the return of China continue to underpin higher commodity prices
• This leads to the Fed remaining hawkish, triggering a recession

The path should become more apparent in coming months.

The risk-reward at this point favours caution. The Fed still cannot afford for financial conditions to loosen — which would be the case if equities rallied too far.

The key caveat is that Australian equities remain well placed in this environment and continue to hold up reasonably well.

Economics and policy

Monthly US payroll data was solid — 390k new jobs versus 318k expected.

The rate of new jobs has eased from the 600k level, but it’s generally considered too high to be consistent with an easing of inflationary pressure.

The three-month moving average remains at 408k. The market believes a level of 100k-150k new monthly jobs is needed.

Participation picked up 0.1%, but this is not enough. This gap helps explain tightness in the labour market with unemployment at 3.6%. There is material deviation by age cohort, with participation rates in the 55-and-over range remaining stubbornly low.

Average hourly earnings growth of 0.3% month-on-month was a bit lower than expected. The annual rate of 5.2% remains too high, though the three-month moving average has fallen into the 4-5% range. We need to see it drop into the 3-4% range.

The latest ISM manufacturing data was too strong for the market, rising to 56.1 versus consensus 54.5. Services ISM was marginally softer at 55.9 versus consensus of 56.5, but this clearly remain the strong part of the economy.

The orders backlog component fell back to pre-pandemic levels, indicating supply chains are improving. This reflects the build in retailer inventory we have been hearing about from companies.

Overall there is nothing here to reduce the likelihood of back-to-back 50bp moves from the Fed in June and July.

It also reduces the likelihood of a pause in rate hikes in September.

Oil

Oil markets saw a lot of action last week.

OPEC+ announced it would bring forward an increase in oil supply. Initially this was seen positively as a thawing of relations between Saudi and the US.

But the more you dug into it, the more it looked like another hollow effort to make it appear as though something was being done about high US fuel prices.

OPEC is bringing forward a slated September supply increase to July and August.

This equates to an extra 200k or so barrels per day for two months — allocated across all of OPEC+, including Russia. Many of these nations are unable to produce the extra barrels, so not all of that will come onto the market.

It is also apparent that Libya and Venezuelan production has been weaker than expected. Any agreement with Iran to potentially unlock another 500k bpd is still forthcoming.

Russian supply is estimated to be 1m bpd less than pre-invasion. The prospect of China re-opening could add 1m bpd of demand.

The risk of fuel prices to the economy is high.

US inventories are low. Globally they are being propped up by strategic petroleum reserve releases, but this is not sustainable.

An extremely tight refining market caps all this off. The NYMEX 3-2-1 spread — the gap between a price of three barrels of oil and the two barrels of petrol and one of diesel which can be refined from it — is multiples of its historical average.

This implies fuel prices at the pump are equivalent to US$175 oil. This is a challenge for the consumer and does not help the inflation outlook.

Australian Energy markets

There is increasing focus on Australian power prices.

A combination of outages and supply issues at coal-fired plants — plus cold weather and a limited supply of solar at this time of year — have left the domestic market relying on gas to fill the void.

This comes at a time of limited gas supply and a high global price. Wholesale prices have surged in response. The NSW average price is $200 — almost double the previous highest prices over the past 15 years.

In the near term this affects only a few commercial buyers, since most are on contract.

Consumers are protected for now. The main effect is on power providers reliant on purchasing power on the National Electricity Market. Smaller players are looking to shed customers and load as a result.

However the medium-term effects could be material.

Some analysis suggests it could translate to power price rises of 9% in Sydney in FY23 and 30% in FY24. The situation would be worse in Queensland and marginally better in Victoria.

Clearly, this is politically unpalatable and raises the risk of intervention in the industry.

Understanding the flow-on effects for the economy and corporate earnings is key here.

Markets

The consensus view that peak inflation meant peak bond yields was challenged last week.

We remain wary of this view. History suggests that in most cycles rates end up rising above inflation. If the latter isn’t below 3% in a reasonable time frame we still may see rate and bond yields head higher.

The issue for markets remains that central bankers will want to be seen to be hawkish until it is clear inflation is beaten — which will not help sentiment.

Commodities maintain their defensiveness. This partly reflects the oil issue flagged above — but also the belief that China appears to be reopening. Copper remains the best proxy for this sentiment, and rose 6% last week. The Australian market continues its resilient performance with energy and resources leading the way. Financials and utilities fell last week, relating mostly to stock-specific issues.  

---

About Crispin Murray and Pendal Focus Australian Share Fund

Crispin Murray is Pendal’s Head of Equities. He has more than 27 years of investment experience and leads one of the largest equities teams in Australia. Crispin’s Pendal Focus Australian Share Fund has beaten the benchmark in 12 years of its 16-year history (after fees), across a range of market conditions.

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

Find out more about Pendal Focus Australian Share Fund  

Contact a Pendal key account manager

Asset class snapshot, the case for mid-caps, how to tell if a green stock is a good investment, which EMs are ready for a supply recovery

31 May 2022

Changes to Funds’ Standard Risk Measure

Effective 31 May 2022, we are changing the Standard Risk Measure (SRM) of the Funds listed in the table below.

An updated Product Disclosure Statement (PDS) for each Fund, including the new SRM, will be available on or around 31 May 2022 on www.pendalgroup.com. If you would like a hard copy of the PDS, please contact us.

For the Funds indicated with an asterisk (*) in the table below, the change in SRM has also resulted in a change to the target market indicator for a consumer’s risk and return profile in the Fund’s Target Market Determination (TMD). An updated TMD for each of these Funds, including the new SRM and target market indicator, will be available on www.pendalgroup.com/ddo.

Fund name	Fund codes	Old SRM	New SRM
Pendal Active Balanced Fund	APIR: RFA0815AU, ARSN: 088 251 496	Medium	Medium to high*
Pendal Active Growth Fund	APIR: BTA0125AU, ARSN: 087 593 682	Medium to high	High*
Pendal Active High Growth Fund	APIR: BTA0488AU, ARSN: 610 997 674	Medium to high	High*
Pendal American Share Fund	APIR: BTA0100AU, ARSN: 087 594 509	Very high	High
Pendal Asian Share Fund	APIR: BTA0054AU, ARSN: 087 593 468	Very high	High
Pendal Australian Equity Fund	APIR: BTA0055AU, ARSN: 087 593 191	Medium to high	High*
Pendal Australian Share Fund	APIR: RFA0818AU, ARSN: 089 935 964	Medium to high	High*
Pendal Balanced Returns Fund	APIR: BTA0806AU, ARSN: 087 593 011	Medium	Medium to high*
Pendal European Share Fund	APIR: BTA0124AU, ARSN: 087 594 429	Very high	High
Pendal Focus Australian Share Fund	APIR: RFA0059AU, ARSN: 113 232 812	Medium to high	High*
Pendal Global Emerging Markets Opportunities Fund	APIR: BTA0419AU, ARSN: 159 605 811	Very high	High
Pendal Horizon Sustainable Australian Share Fund (formerly Pendal Horizon Fund)	APIR: RFA0025AU, ARSN: 096 328 219	Medium to high	High*
Pendal Imputation Fund	APIR: RFA0103AU, ARSN: 089 614 693	Medium to high	High*
Pendal Japanese Share Fund	APIR: BTA0130AU, ARSN: 090 666 621	Very high	High
Pendal MidCap Fund	APIR: BTA0313AU, ARSN: 130 466 581	Medium to high	High*
Pendal Multi-Asset Target Return Fund	APIR: PDL3383AU, ARSN: 623 987 968	Medium	Medium to high
Pendal Property Investment Fund	APIR: RFA0817AU, ARSN: 089 939 819	Medium to high	High*
Pendal Property Securities Fund	APIR: BTA0061AU, ARSN: 087 593 584	Medium to high	High*
Pendal Sustainable Australian Share Fund	APIR: WFS0285AU, ARSN: 097 661 857	Medium to high	High*
Pendal Sustainable Balanced Fund	APIR: BTA0122AU (Class R) or PDL4756AU (Class G), ARSN: 637 429 237	Medium	Medium to high*

 

What is a Standard Risk Measure?

A fund’s SRM is a simple risk descriptor to help investors compare the fund’s potential level of investment risk. More specifically, it is an estimate of how many years a negative annual return may be expected for a fund over any 20-year period. The SRM is calculated based on a fund’s asset allocation as well as capital market assumptions about the likely returns and volatility of those asset classes over the longer term.

Importantly, the SRM is not a complete assessment of all forms of investment risk. It is only one way of measuring the potential risk of an investment. For example, the SRM does not detail what the size of a negative return could be, or the potential for a positive return to be less than what an investor may require to meet their financial objectives. It is also based on gross returns and therefore, does not take into account the impact of fees, costs and tax on the likelihood of a negative return.

 

Why are the Standard Risk Measures changing?

The SRM changes are a change in risk classification only, resulting from changes to Pendal’s SRM calculation methodology to include forward-looking assumptions. There is no change to the investment strategy or actual risk of the Funds. Each Fund’s underlying asset allocation, investment return objective and benchmark remain unchanged. 

If you have any questions about your investment or would like further information regarding the changes, please contact our Investor Services Team on 1300 346 821 (for Australian investors) or +612 9220 2499 (for overseas investors) from Monday to Friday, 8.30am to 5.30pm (Sydney time). 

 

 

 

This Important Update has been prepared by Pendal Fund Services Limited (PFSL) ABN 13 161 249 332, AFSL No 431426 and the information contained within is current as at 31 May 2022. It is not to be published, or otherwise made available to any person other than the party to whom it is provided.

PFSL is the responsible entity and issuer of units in the Pendal Funds specified in this Important Update. Product disclosure statements (PDSs) are available for the Funds and can be obtained by calling 1800 346 821 or visiting www.pendalgroup.com. You should obtain and consider the PDS for each Fund before deciding whether to acquire, continue to hold or dispose of units in any of the Funds. An investment in the Funds is subject to investment risk, including possible delays in repayment of withdrawal proceeds and loss of income and principal invested.

This Important Update is for general information purposes only. It should not be considered as a comprehensive statement on any matter and should not be relied upon as such. It has been prepared without taking into account any recipient’s personal objectives, financial situation or needs. Because of this, recipients should, before acting on this information, consider its appropriateness having regard to their individual objectives, financial situation and needs. This information is not to be regarded as a securities recommendation.

 

 

 

 

Monetary policy will have to work harder to keep inflation in check if the new Labor government is still putting extra dollars into pockets, writes Pendal’s TIM HEXT

THE federal election was an exciting moment for all Australians, but a week later our fascination with politics is probably again confined to those in Canberra.

This time last week I was an expert in the comings and goings of seats like Fowler and Gilmore. In a month I won’t be able to tell you where they are, let alone who the local member is.

One thing that’s clear, though, is fiscal policy will stay expansionary under Labor.

The new government’s additional spending adds $19 billion to the budget while its aspirational revenue plan only takes off $11.5 billion.

Budget numbers were supercharged during Covid, so $19 billion is barely noticed. But let’s stop and think about the impact.

Let’s remember that a public sector deficit is a private sector surplus – more money is entering the private sector than is taken out.

When the RBA tightens by 1%, the interest bill on the $3 trillion debt goes up by $30 billion. However, two thirds of debt is lent by Australians – so $18 billion is a transfer between borrowers and savers within Australia.

Only one third of the interest leaves the country and goes into the pockets of foreigners. So the Labor spending plans on a dollar-for-dollar basis roughly negate the 1% rate rise. I understand this is not a straight comparison since rate rises have second-round impacts to economic activity and wealth more so than fiscal policy.

Also it does matter whether the money is entering or leaving pockets with a propensity to borrow or save.

But this does show that monetary policy will have to work harder to keep inflation in check if the government is still putting extra dollars into pockets.

If all goes well for Labor the global economy will open up quickly in the next few years, helping the supply side catch up to the strong demand side.

If not, they face a growing problem of entrenched inflation, spurred on by their fiscal policy pushing demand. Rates will then have to hit restrictive levels – which nearly always turns into recession, just in time for the 2025 election.

As bond managers we are constantly monitoring the interplay between demand and supply in the economy.

We will shortly publish an in-depth piece on the inflation outlook.  For now though, inflation is here to stay and long bond duration remains vulnerable.

---

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.

Contact a Pendal key account manager