Bonds are going digital, but they’re not going away. Pendal’s head of government bond strategies TIM HEXT explains why

AS A financial markets under-graduate 30 years ago I was sent off to see the plumbing of markets — how trades were recorded and settled.

I spent a few weeks wearing out my new leather soles walking around town with the couriers, getting stamps on physical bonds, writing bank cheques and heading up to the registry office to lodge them.

It was all very manual. (Many bonds were still bearer bonds, so you didn’t want to lose them!)

By the turn of the century technology enabled everything to be stamped and lodged electronically, meaning our rather old couriers could finally retire.

But bonds fundamentally never changed.

A bond is basically a loan that can be easily traded in secondary markets. It enables investors and savers to bring forward or defer their investment and spending decisions.

The technology behind them will continue to become more efficient.

Which leads us to…

Blockchain and bonds

Blockchain is basically a secure and decentralised (or distributed) ledger which records payments or ownership of property, equities or bonds.

It basically eliminates the need for a centralised registry. Custodians may initially continue to offer their services managing the blockchain on behalf of clients — but ultimately they may not be required.

Settlements can be instant, reducing counterparty and operational risk.

The terminology will change. Digital bonds can now be called “tokenised securities”. Paper-based contracts become “smart contracts”. Payments from the traditional banking system will need “on-chain payments solutions”.

Eventually all bonds will be digital — likely within the next decade.

But they will not disappear.

Why bonds will remain and governments won’t surrender their currencies

What is a government’s greatest power? To set laws and enforce them.

I would argue a federal government’s most important law is control of its currency — and more importantly the ability to create currency.

If you think about why the Australian Dollar (AUD) exists — why we don’t just transact in US dollars for example — it’s because the government makes us pay taxes and demands they be paid in AUD.

This creates a fundamental demand for AUD which underpins its acceptance for payments and savings by all Australians.

The government can then create as many AUD as it wants to pay for goods and services.

The only limitation to this is inflation — putting too much currency in the system for the available resources.

The government therefore usually drains the currency back out of the system via taxes or government borrowing.

However they don’t have to, as recent effective monetisation by the RBA has shown.

If a government was to surrender control of the printing presses — via a monetary union like the Euro or via fixing to another currency or commodity such as gold — its actions become captive to forces outside its control.

Some purists may see this as a good thing, imposing the invisible hand of the market on the government.

History suggests otherwise.

Governments would become pro-cyclical and make inevitable private sector boom/bust cycles worse, as seen in the early days of the Great Depression. (For a recent example just ask the citizens of Greece.)

Can a central bank maintain control of a currency if it’s digital?

The answer of course is yes — provided the digital currency is still issued by them.

I doubt the government will be accepting taxes in US dollars any time soon and certainly not in crypto.

Central Bank Digital Currency (CBDC)

Currency is largely already digital. Some of us still keep banknotes handy but in the age of tap-and-go it is largely digital.

A Central Bank Digital Currency (or CBDC) would be a new form of digital currency — but importantly still issued by the central bank.

Unlike cryptocurrency, which has no backing, CBDC would essentially remain a liability of the central bank.

The unit of account is still the currency (so for the RBA still AUD), still legal tender and exchangeable for non-digital currency.

For small retail transactions there seems few immediate benefits. Banks have largely moved to live transfers between accounts, effectively making the payments system instant.

In the US Fed official Christopher Waller recently gave a talk “CBDC – A Solution in Search of a Problem”.

However the RBA could still issue retail CBDC if it was seen as supporting competition and efficiency in the retail sector.

Governments would probably like to get rid of cash — but that is a separate issue.

However, for wholesale transactions a CBDC could be very useful, effectively being part of the blockchain for tokenised assets.

Maybe you might accept Bitcoin when settling your house sale in a blockchain, but I know I would prefer the certainly of an AUD digital currency.

I would also want to know there was still a trusted party ensuring it all ran smoothly.

The Future

The Australian dollar and bond markets are not disappearing.

It is not in the collective interest of citizens to remove these powers from the government. Although far from perfect, the government is the only institution (at least in a democracy) which fundamentally protects the wider interest of society.

Some cryptocurrencies like Bitcoin will no doubt remain a store of wealth. Some like Ethereum, which supports smart contracts and efficient payment systems, will thrive.

The private sector will keep looking into the development of Stablecoins to help transactions, although they are likely to become more regulated around the assets that back them.

However an effective CBDC, backed by blockchain technology for speed and efficiency, could become the dominant digital currency, at least locally.

It wouldn’t be a cryptocurrency as such, given the Central Bank would likely control the ledger rather than a distributed ledger, for control and privacy. And cross-border transactions would still need intermediaries.

Digitalisation would also help finance become more decentralised over time as the use of intermediaries become less important.

It may take time for trust to develop, but in decades ahead it would likely all be second nature.

However, the need to borrow and lend money is as old as time itself — and the need for efficiency in buying and selling loans packaged as bonds will also remain.

The need to be able to assess credit may be helped by innovation but diversification remains an important investment concept.

Would you rather own a slice of a large pool of assets or just one randomly chosen asset?

For example buying a Westpac bond outsources the credit work that financing one individual loan or mortgage would entail.

Add liquidity and credit quality and it means government bonds are not going anywhere.

Though how we trade and settle bonds hopefully will evolve.

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About Tim Hext and Pendal’s Income & Fixed Interest boutique

Tim Hext is a Pendal portfolio manager and head of government bond strategies in our Income and Fixed Interest team.

Tim has extensive experience in banking, financial markets and funding including senior positions with NSW Treasury Corporation (TCorp), Westpac Treasury, Commonwealth Bank of Australia, Deutsche Bank, Bain & Co and Swiss Bank Corporation.

Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.

Find out more about Pendal’s fixed interest strategies here

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About Pendal

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

In 2023, Pendal became part of Perpetual Limited (ASX:PPT), bringing together two of Australia’s most respected active asset management brands to create a global leader in multi-boutique asset management with autonomous, world-class investment capabilities and a growing leadership position in ESG.

Contact a Pendal key account manager

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

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

WE continue to face the combined challenges of geopolitical risk, Covid, inflation and rising rates.

This is creating an intractable policy dilemma — the need to raise rates at a time when risk premiums are elevated, coupled with the risk that a commodity shock will lead to an economic downturn.

We didn’t see any sign of this dilemma easing last week.

The conflict in Ukraine intensified, US inflation data was no softer than expected, the Fed’s tightening bias persisted, the ECB was more hawkish than expected and China was facing another Covid outbreak, potentially causing disruptions to growth and supply chains.

As a result equity markets were mixed. The S&P500 fell 1.6% and the S&P/ASX 300 was down 0.4%. European equities bounced 3.7% (Eurostoxx 50) after previous sharp falls.

The market is struggling to build on any bounce despite the S&P 500 being off 12.4% from its early-January peak.

Our key observations are:

• The near-term market is likely to remain weak, but we don’t expect stagflation and the start of a bear market
• We see Australia as a relative safe haven given the economy is in good shape and skews to commodity and financial stocks
• The environment we are in today is different to the post GFC era — what worked in the last six years won’t work going forward. We see corporate cash flow and consistency as critical. We do not expect high growth, speculative and profitless tech to resume market leadership
• Current drawdowns tend to be indiscriminate, thereby creating significant stock opportunities.

Commodity markets

Oil and wheat prices peaked early last week and then fell back, despite growing signs of self-sanctioning.

One key debate is whether Russian oil will be locked out of global markets or find its way in via alternative channels.

At this point there is an expectation that some of that oil will find a home. But this will extend trade routes and it’s unlikely all will be placed.

At this point there are about 2.5 million fewer barrels per day (bpd) in global markets, compared to before the invasion. There are a number of potential sources of new supply to replace this:

• Saudi, the UAE and Kuwait: These countries have about 2.1 million bpd spare capacity, which would probably require a couple of months to come on line. Doing so would signal the end of the OPEC+ arrangement with Russia. Saudi is unlikely to make any moves until it sees the outcome of potentials deals with Iran and Venezuela. 
• Iran: There is chatter the US and Iran may be nearing an agreement. But there is uncertainty over how many incremental new bpd would eventuate – and how long it will take. 
• Venezuela: Easing sanctions on Caracas may provide scope for an additional 0.5 million bpd over time.
• US Strategic Petroleum Reserve releases: There is uncertainty in outcome here since this mechanism remains untested. 
• US production: This will be a lot harder to ramp up due to shortages of equipment and people. For example, there is a lack of truckers due to the demand driven by online retail fulfilment. There are also capacity constraints in fracking as the Permian Basin, the most productive region, has already recovered to peak production.

There is also a persistent risk that Russia may itself disrupt supply, given its importance as a bargaining tool. 

The US is working with the likes of Saudi, Venezuela and Iran to bring other barrels back into the market to alleviate inflations.

Any success there will mitigate some of the pricing pressure. But we suspect we will be looking at US$100+ oil for at least a few months.

Economics

The market is starting to factor in the risk to economic growth. For example, Goldman Sachs cut its expected US GDP growth in Q2 2022 from 2% to 1.75% compared to Q4 2021.

This is driven by the impact on income and spending as a result of higher food and fuel prices.

Financial conditions continue to tighten as the US dollar and bond yields rise and equities fall. This adds to the headwind to growth in Q2 onwards by 0.3-0.4% of US GDP

We do not believe this will translate into a recession due to:

• The strength of the labour market
• Pent-up demand where supply constraints have been limiting  growth, eg autos
• Strong housing, which means consumer net worth continues to rise
• Strong loan growth and still negative real rates
• Good household balance sheets

In combination this should enable growth to continue, providing earnings support for the market in time.

US inflation

The good news is that the US CPI data was in line with expectations for the first time in eight months, rising 0.8% month-on-month and 7.9% year-on-year in February.

The not-so-good news is it’s the highest rate in 40 years.

Digging into the numbers we see food, energy and auto are driving almost two-thirds of the year-on-year figure.

These should unwind over time. But there is also a broadening of the number of components where prices are rising.

For example, the proportion of CPI components with deflation has fallen from more than 25% at the start of 2021, to about 5% today. This breadth issue is a concern for policy makers.

Rent is one component seeing a strong rise. This is likely to continue, slowing the normalisation of overall inflation.

We had been seeing shipping freight rates start to fall as supply chain issues improved. However this has stalled as shipping needs to be re-routed as a result of the sanctions on Russia and growing Covid issues in China.

On wages, the Atlanta wage tracker rose from 5.1% to 5.8% annual wages growth, countering the more positive signal that came with last week’s household employment survey

So the challenge for the Fed is that a number of key drivers of future inflation are signalling that the problem is not resolving itself.

This explains its hawkish stance, despite the wider geopolitical concerns.

Policy

The European Central Bank signalled that rate rises could come sooner than the market is currently pricing – potentially as early as July, though September is looking more likely.

The key point is they are signalling a greater preparedness to tolerate weaker growth to fight inflation.

If there is a risk of stagflation it is centred on Europe, given its greater sensitivity to energy prices and higher exposure to Ukraine and Russia.

There is talk now of a fiscal policy response to this threat, which could allow monetary policy to focus on inflation.

Covid

We are watching two issues here.

First, an emerging new variant looks to blend some characteristics of Delta and Omicron.  At this point it’s not expected to be any more transmissible that Omicron, so may not supersede the latter’s dominance.

Second, we are watching rising cases in China – particularly in north-east provinces – and a potential headwind for economy activity.

Markets

We saw a snap-back in European equities — the German index made its seventh-biggest single-day jump.

But history indicates such volatility is more often than not seen in a downward trend.

From a technical perspective we still haven’t seen enough breadth of selling to indicate a low has been reached.

Bonds sold off despite concerns over growth — a very different reaction to what we have been used to in recent years.

The number of rate increases priced in by the market have marginally increased for the US, so the need to fight inflation is seen to take precedence over growth concerns.

Bonds remains a good signal on what’s happening in the economy.

History indicates 10-year yields peak towards the middle or end of a rate cycle — rather than near the start. This suggests further to go on bond yields. If this is not the case it would indicate more economic risk in US.

The other signal to watch is 2-year yields, which have not yet peaked. A peak in 2-year yields is a reasonable proxy for potential recession risk.

There is also a debate around whether commodities are peaking in terms of relative performance. While they have run hard, the relative move has been minor compared to past commodity cycles in the early 2000s or 1970s.

These moves can be sustained over longer periods than we have seen so far.

The final signal worth noting is a continued decline in the Chinese tech index.

This was the first part of the growth universe to roll over in February 2021 and is now down 75% from its high. Recent pressure relates to the risk of forced de-listings from the US. 

It suggests the more speculative end of the growth cohort is still yet to find a bottom.

Australia

In Australia it was a pretty quiet week overall. Resources corrected from their recent run, while rising bond yields saw a rally in banks. Elsewhere the defensive rotation continued, with technology down and consumer staples up.

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About Crispin Murray and Pendal Focus Australian Share Fund

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

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

Find out more about Pendal Focus Australian Share Fund  

Contact a Pendal key account manager

Australia is as good a place as investors can be in this tough environment, says Pendal’s head of equities CRISPIN MURRAY

A UNIQUE collision of global challenges is clouding the outlook for equities in the near term, but Australia remains well-positioned to outperform, says Pendal’s head of equities Crispin Murray.

Four major challenges are hitting markets simultaneously, says Murray: the crisis triggered by Russia’s invasion of Ukraine, impending interest rate rises, the pandemic and the re-emergence of inflationary pressures (though Australia doesn’t face the same inflation challenges as other parts of the world).

“It’s not a great short-term message — we think markets are going to continue to struggle,” says Murray, speaking to investment professionals this week in his bi-annual Beyond the Numbers webinar.

Watch a replay of Crispin’s webinar here (registration required):

“There are however, two silver linings,” he says.

“The first one is that Australia is perhaps the most defensive market in the environment we’re in.

“And the second one is that when you see this sort of drawdown in financial markets, there tends to be an indiscriminate nature to those sell offs and they often lay the foundations for some of the best investment opportunities that we will be able to take advantage of over the next few years.”

Reliance on Russian commodities

Russia’s unprovoked invasion of Ukraine has first and foremost led to a terrible humanitarian disaster.

But it has also exposed the West’s reliance on Russia’s commodity exports and demonstrated that while Russia may be a mid-sized economy, it plays an outsized role in the global economy due to its commodity exports, says Murray.

Europe’s oil and gas purchases from Russia are in the order of 1 billion euros a day.

But government sanctions over the invasion are only part of the story of the global economy’s reaction.

Instead, widespread self-sanctioning is seeing companies avoiding trading with their Russian counterparts for fear of being seen to support the invasion.

“What the Western governments were thinking would be minimal disruptions to these key commodities is turning into major disruptions,” says Murray. Estimates are that half of Russia’s 5 million barrels a day of oil exports is failing to find its way to market.

The result is a commodity price melt-up — prices are soaring.

This leads to the second big pressure point for markets in inflation.

Recent spikes in inflation have been driven by short term issues like COVID-related supply chain disruption, a tightening labour supply driving real wages higher and commodity capacity constraints, says Murray.

But now longer-term issues are taking over as the core inflation drivers, including rebuilding supply chains, declining working age populations, the investment required to build a clean energy economy and China’s shift away from exports to a domestic self-sustaining economy.

“The challenge we’ve see over the last few months is that a lot of these inflationary pressures are becoming self-reinforcing,” says Murray.

“History will look back and judge policy decisions in 2021 as some of the worst that we’ve seen in many decades.

“The reason is that we had a supply shock brought about by the pandemic and the policy response was to continue to stimulate demand and that’s led to this inevitable inflationary pressure.”

Murray says it’s important to remember that inflation can choke itself off: “Prices of goods go up high enough, chokes off demand, people don’t have the spending power, economy slows and inflation goes away.”

But inflation can become sustained if it is underpinned by rising wages.

“We’re at effectively full employment in the US, and that’s leading to higher wages.”

Outlook for rates

The question of how far interest rates will need to rise to combat inflation is key to the outlook for markets.

Murray says there are two schools of thought for how rates will play out.

One school believes rates will not need to be lifted as much as the market fears, due to deflationary forces and excess debt.

That would lead to markets briefly correcting before rotating back quickly to long duration growth stocks, he says.

The second school of thought is that rates will need to rise and stay higher for a sustained period of time, similar to the period pre-GFC when the economy ran strong for years before slowing.

“If that is the model we’re looking at, then interest rates will have to go up materially more perhaps than the markets are thinking,” says Murray.

“This is the key debate from a macro point of view that we need to track,” he says.

Ironically, in the past, policymakers would likely respond to a geopolitical crisis by easing monetary policy, but that is highly unlikely this time.

“So, this is why near term we’ve got this irreconcilable conflict between these conflicting goals for policymakers.”

Where Australia fits

So, where does Australia fit in all this?

Surprisingly well, says Murray.

“Australia is as good a place as you’re going to be in this tough environment,” he says.

Partly this is because of the old-world make-up of the Australian stock market, dominated by finance, mining and energy companies.

But also, Australian companies are performing quite well.

Murray says Australian equity markets are declining despite improved earnings as a de-rating of prices due to higher interest rates and rising risk aversion is outweighing a good underlying earnings performance.

“So, what we’re seeing in markets so far is a reduction in the valuations rather than any earnings effect — if that remains the case, that would suggest that this is a correction within a longer term bull market, rather than the beginnings of a bear market.”

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About Crispin Murray and Pendal Focus Australian Share Fund

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

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

Find out more about Pendal Focus Australian Share Fund  

Contact a Pendal key account manager

Expect to see a lot more mentions of stagflation this year. TIM HEXT explains what it means for investors

WE’VE talked a lot recently about the easy days of central banking ending.

Russia’s invasion of Ukraine has sent this into overdrive.

Stagflation — a stagnating economy combined with rising prices — is a central bank’s worst nightmare. Should they risk sending the economy into recession to tackle inflation?

It is a scenario they haven’t had to face for about 40 years.

Inflation has reared its head since then, but it was always demand led. Slowing the economy was seen as responsible and investors were generally doing well.

Last week US Fed chair Jerome Powell was asked by Senator Richard Shelby if he was “prepared to do what it takes without any reservation” to tackle inflation.

Senator Shelby referenced former Fed chair Paul Volcker who aggressively tackled stagflation in the early 1980s — just before the US moved into a recession.

You can watch the video here:

It was clearly a dig at Powell’s so far muted response to rising inflation.

If taken at face value US rates may need to go far higher than the current 2% factored in by markets.

In Australia, Governor Philip Lowe is still living in 2020, claiming inflation is not yet clearly sustainable within the 2-3% band.

He is sort-of correct — just the wrong way around.

It looks like inflation will be sustainably above 3% this year and next, potentially hitting 5% on an annual basis. No doubt he will be forced to change the narrative soon.

Stagflation will get a lot more mentions this year.

Powell said a clear “yes”. 

We will have to dust off the textbooks, having not lived or at least invested through it.

Suffice to say it is bad news for most of us, seeing not only our investments but also our spending power go backwards. 

Another complicating factor for super funds is that stronger commodities may end up meaning a stronger AUD.

Since more than a third of assets sit offshore unhedged, super funds normally rely on risk-off moves driving a weaker AUD, somewhat reducing the negative performance.

A stronger AUD but weaker risk markets will increase the drag on asset returns.

As long as wages don’t lock in with inflation shocks — creating the vicious circle we saw in the 1970s — supply will eventually return to commodity and goods markets.

It just may not be a 2022 story — or even 2023.

Meanwhile will rate hikes assure another downturn as the cycle lives on?

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About Tim Hext and Pendal’s Income & Fixed Interest boutique

Tim Hext is a Pendal portfolio manager and head of government bond strategies in our Income and Fixed Interest team.

Tim has extensive experience in banking, financial markets and funding including senior positions with NSW Treasury Corporation (TCorp), Westpac Treasury, Commonwealth Bank of Australia, Deutsche Bank, Bain & Co and Swiss Bank Corporation.

Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.

Find out more about Pendal’s fixed interest strategies here

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About Pendal

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

In 2023, Pendal became part of Perpetual Limited (ASX:PPT), bringing together two of Australia’s most respected active asset management brands to create a global leader in multi-boutique asset management with autonomous, world-class investment capabilities and a growing leadership position in ESG.

Contact a Pendal key account manager

Be wary about holding growth assets right now — and consider some rotation to bonds says Pendal’s OLIVER GE

RUSSIA’S unprovoked invasion of Ukraine continues to attract sanctions aimed at limiting the terrible human toll in that part of the world.

The financial implications of those sanctions are of course reverberating far and wide in markets around the globe — and few investors would argue against such action.

But what does it mean in terms of asset allocation? Especially if the sanctions cause Russia to default?

“There is an increasing chance that Russia might default and that has implications for Europe,” says Oliver Ge, a portfolio analyst with Pendal’s Income and Fixed Interest team.

“That in turn hurts the United States and the rest of the global economy.”

“The average investor might take a cursory glance at what’s happening in Ukraine, but I’d argue it’s going to have major ramifications.”

“Russia has about $US640 billion of reserves of which $US400 billion is frozen in central banks around the world. On conservative estimates, it costs about $US1 billion a day to run the war so the impact to Russian coffers is material.”

“Even though energy products haven’t been sanctioned, many global buyers are staying away from Russian energy. If the war is protracted and the sanctions remain in place, pressure on the Russian economy will build.”

“It is also going to be a very challenging environment for neighbouring countries in Europe — not only through the energy channel and its effect on business margins but also through second-order effects via the banking sector in the form of bad debts.

“This will take time to fully play out but we are already seeing the cracks form.”

Financial impact in Australia

“At the start of the year, the consensus forecast for Aussie equities was for growth of about 5 per cent. Not a huge amount but a nice little bump. And that’s driven by the fact that we are in recovery mode.

“That hasn’t happened, predominantly because of Russia’s invasion of Ukraine. It doesn’t matter how much direct exposure our big companies have to Russia — once markets become concerned the effects spread around the world.

“The message to advisers is that if you were told at the start of the year that you’d get 5 to 7 per cent growth, that’s not going to play out in the current state of affairs.”

“So, you should be very wary about holding growth assets and potentially think about some rotation to bonds. Bonds will keep paying,” he says.

“It shouldn’t be a massive rotation, but investors should be more mindful around the expectations of growth assets.”

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

Oliver is an assistant portfolio manager with Pendal’s Income and Fixed Interest team.

Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia. In 2020 the team won the Australian Fixed Interest category in the Zenith awards.

With the goal of building the most defensive line of funds in Australia, the team oversees A$22 billion invested across income, composite, pure alpha, global and Australian government strategies.

Find out more about Pendal’s fixed interest strategies here

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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

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

RUSSIA’S invasion of Ukraine is creating second-order effects which the market is struggling to read, leading to dislocations.

We can see two ends of the spectrum in commodities which are “melting up” and European equities (banks in particular) which are plunging.

The markets are facing a four-way collision: the pandemic, a geopolitical crisis, an interest rate tightening cycle and an inflation shock. This is a unique combination.

Historically a geopolitical crisis such as Ukraine and the resulting supply side shock would be partly managed through a reduction in interest rates — as was the 1998 Russian default.

But last week we saw Fed Chair Powell deliver as hawkish a testimony as we have seen in decades.

The market’s saving grace has been the strength of the economy and corporate earnings. But this degree of uncertainty and risk is likely to drive markets lower in the near term.

European markets are bearing the brunt at the moment, but the consequences could spread.

Australia is proving to be the most defensive of markets, with the S&P/ASX 300 up 1.8% last week. It is down 3.5% so far in 2022 compared to -8.2% for the S&P 500 and -13.4% for the NASDAQ. It has also done much better than European or Japanese equities.

We expect this to continue given our combination of commodity exposure, geographic distance, less need to tighten policy and strong economic growth.

Ukraine crisis

Sanctions are becoming more severe, though many are subject to a grace period and so may not yet be fully biting.

There is a notable degree of self-sanctioning, where companies are refusing to buy Russian products. Trade and shipping companies are finding it difficult to insure Russian cargos, or unload them.

In the oil market it is estimated that 2-3 million barrels a day of the 5 million that Russia produce have been effectively removed from the market as a result, creating a squeeze.

Shell has been criticised for purchasing a cargo of Russian oil at a US$28.50 discount to spot. This highlights the public opinion that underpins self-sanctioning.

Shell’s statement — that they could not secure an alternative and had no option other than to stop producing refined products — highlights the growing complexity of supply chains in this environment and the risk of economic disruption.

Debate around potential solutions emphasises the uncertainty and unintended consequences that could eventuate from various courses of action.

For example, there is a view that there needs to be some face-saving scenario for Putin, such as the permanent deployment of troops and nuclear weapons to Belarus. This would result in a higher state of risk for European security than we have seen for some time.

At this point a clean resolution looks unlikely. While current market risk premiums will fall away, there will be a significant strategic shift in the West.

This is likely to see a significant rise in defence spending, an acceleration of the move to renewables, substantial investment in gas storage and the need for reinvestment in strategic commodities.

In combination, this means substantially more investment spending and less optimised supply chains.

This underpins a higher level of inflation.

Implications for commodities

Oil

Russia’s 5 million barrels a day account for about 12 per cent of global supply. This is already disrupted and hardening public opinion may see the US ban imports of Russian oil, with other countries likely to follow.

The political problem for the West is that at current prices Europe is paying an estimated 1 billion euros a day to Russia.

The question is whether this can be sustained in the face of growing public opposition. We may even see Russia ban exports as a reaction to sanctions. The situation is highly unpredictable.

Russia is believed to have enough storage to house surplus production for 2-3 months. Beyond this they would need to rein in production. Once done, this is hard to unwind. This would present a medium-term constraint on oil supply.

The potential for a deal between the US and Iran adds further complexity.

There is clearly motivation to get a deal done, which could see Iran’s roughly 1 million barrels a day return to global markets. (Although how much is already being sold via other channels is unclear).

This could provide some relief, but this would be short-lived if Russian volumes continue to disappear.

Gas

Russia produces about 8% of global LNG supply (roughly 30 million tonnes per year). Again, this may become hard to replace.

In addition Russia relies on Western technology and companies for infrastructure servicing and repairs. This could lead to further decreases in supply if withheld for an extended period of time.

Another 20 million tonnes of capacity are under construction in partnership with western firms. The latter’s withdrawal could see these projects delayed substantially. 

In the medium term, Australian gas projects potentially become more attractive given the security of supply and Europe’s desire to reduce reliance on Russian volumes.

Coal

Like oil and natural gas, coal prices are surging on tighter markets.

Russia provides 17% of the world’s thermal coal and 9% of metallurgical coal. This may drive more interest in Australian coal as a reliable alternative, though in the near term it means coal prices are likely to rise to the point where it chokes off demand. 

Soft commodities

Russia and Ukraine together supply 25% of the world’s wheat, 24% of its barley, 14% of corn and 58% of sunflower oils.

History suggests agricultural supplies are not disrupted during wars. But clearly there is risk given reliance on the region.

Planting season is from late March into April. The question is whether there will be access to seeds and fertiliser to allow a proper planting. The wheat price rising 50% in 10 days reflects the risk here.

There are also potential second-order effects. A surge in food prices has historically been the catalyst for civil unrest in some countries.

China will also be mindful of their exposure, especially since issues with swine flu are affecting pork supply. Beijing has apparently moved to withhold fertiliser exports to ensure domestic supply to support their crop yields.

Economics

We are seeing unprecedented disruption in the supply of critical commodities.

The longer the invasion continues, the more pressing this issue becomes, underpinning inflation and damaging global growth.

In the US, food accounts for just over 20% of the after-tax income for the lowest quintile of income earners, with gas another 7% or so.

Sustained increases in prices will start to drag on consumption and become more politically sensitive given the disproportionate effect on lower-income workers.

In terms of headline inflation, the average oil price was about US$75 in Q4 2021. Even if it comes back to $100 we are still looking at a 60-80bps increase in headline inflation.

The threat to growth has been the catalyst for a rally in bonds as the market moves to assume less central bank tightening will be required.

For example JP Morgan have cut Q4 2022 global GDP growth by 0.8% to 3.1%, driven largely by a downgrade in the outlook for Europe.

The most protected economies in terms of growth are those with their own domestic commodity supply and self-reliance. The US is in a reasonable position, as is Australia.

So the market is pricing in less rate hikes.

This, along with safe haven flows, continues to push the US dollar higher against most currencies — the Australian dollar being a notable exception.

While this market reaction is understandable, it is worth highlighting Powell’s comment to Congress last week.

The Fed Chair’s comments looked like a clear commitment to bring down inflation regardless of the political consequences.

Powell did not shy away from comparisons to Paul Volcker – notable for draconian measures to bring inflation under control in the 1980s – and agreed he was prepared to “do what it takes without any reservation” to protect price stability.

While the Fed was likely to hike only 25bp in the March meeting, Powell inferred it may need to lift 50bp in subsequent ones.

This highlights the collision between inflation pressure — tied to strong growth, supply chain issues and commodity disruption — and hawkish monetary policy.

There are two major view on how this unfolds over this year, based on two different phases of history:

1. The first is that we will see a replay of the 12 years post-GFC, when the market kept anticipating rate rises that did not eventuate until 2018. When they did, they were quickly reversed because the debt burden in the economy meant it could not handle the rise. We suspect the majority of the market still believes this is the world we operate in. This implies a broad expectation that this tightening cycle will not be too severe.  
2. The counter view is that we revert to the pre-GFC era, when the market was more accurate in predicting rates and extended cycles of increases were needed to slow the economy down. A combination of better household balance sheets thanks to the Covid stimulus; the need for substantially more investment in defence and decarbonisation; the move to shorten and build redundancy into supply chains; and the lack of investment in carbon-emitting industries (notably commodities) could mean we return to something like the pre-2008 environment.

This is currently the key call for markets and positioning.

The latest US payroll data was strong, with 678,000 new jobs versus 423,000 expected. Average hourly earnings grew 5.1%, versus 5.8% expected, which did lend some respite to inflation concerns.

The US has returned to full employment and pre-Covid levels in terms of hours worked, in contrast to the long trough that followed the GFC.

There are only 2.1 million fewer jobs than pre-pandemic. These can be accounted for by lower participation, given the leisure and hospitality sector is still 1.5 million jobs below February 2020 levels — and there is still a lot of tightness in the labour market.

The jury is still out on whether the signal from average hourly earnings represents a turning point.

The numbers have been affected by mixed effects, more growth in lower paid workers and volatility in hours worked due to unwinding of the Omicron disruption.

Markets and ASX reporting season

US equities struggled to follow through on their rally at the end of last week, but have held up relatively well in the face of the poor news.

The S&P 500 fell 0.5% last week. It continues to face the triple headwind of rising oil prices, rising rates and a stronger US dollar.

The Euro STOXX 50 fell 10.4%. The European economy is much more vulnerable to the challenges highlighted above. But it is unusual for markets to disconnect to this degree in the short term and the relative moves need to be watched to see if acts as a lead indicator.

Australia’s bounce reflected a “catch-up” on the US for the prior week. It also reflects the higher weighting in mining and energy companies. 

There has been huge dispersion this year on the ASX. The Energy sector is up 25.4% versus a 10.2% fall in the bond-sensitive AREIT sector. Nevertheless, this move remains small in a historical context, suggesting there could be plenty more to go.

The key conclusion from reporting season is that the underlying performance of Australian companies is in good shape, with the number of positive revisions almost double the long-term average.

One theme was that lower multiple stocks saw better revisions, reflecting an improved outlook for the domestic economy and higher rates helping financials.

Overall earnings per share (EPS) for the market is set to grow 13.8% for the financial year, versus 11.5% expected in January. This leaves the price/earnings ratio on 15.4x.  At this point FY23 is expected to see flat EPS growth.

Looking at the market’s components:

• Industrials: EPS for FY22 rose to 5.8% from 4.8% and the sector trades on 27x PE. FY23 EPS growth is now expected to be 13%, down from 14% previously.
• Banks: EPS growth for FY22 increased to 13% from 11.2% previously and it trades on 13x P/E. FY23 expectations shifted from 6.8% EPS growth to 6.1%.
• Miners: The market is expecting 10% EPS growth in FY22, then -17% in FY23. It trades on 9.3x PE.
• Energy: EPS expected to be +77% for FY22 and +6% in FY23. Trades on 11x P/E. Clearly both energy and mining could see material changes to these numbers.

The earnings shifts within the market mean the unwinding of the growth premium has not been as material as price movements would indicate.

There was not too much to report at a stock level post reporting season. 

Resource and energy stocks saw strong rotation last week as commodity prices rose.

Insurance stocks were hit by the floods, although they all have a lot of protection from reinsurance contracts and the price reaction is substantially overstating the cost. 

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About Crispin Murray and Pendal Focus Australian Share Fund

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

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

Find out more about Pendal Focus Australian Share Fund  

Contact a Pendal key account manager

During these tragic times, our sympathy lies with the people of Ukraine in their struggle to maintain their freedom.

As responsible investors, Pendal Group and its affiliates J O Hambro Capital Management, TSW (Thompson, Siegel & Walmsley) and Regnan have taken decisive steps to reduce our already minimal exposure to Russian securities.

We are limiting direct risk in client portfolios and taking decisive steps to comply with evolving sanctions and restrictions.

We will refrain from investing in Russian and Belarusian securities for the foreseeable future.

The situation is evolving rapidly and we continue to monitor the emerging risks, which may take an unexpected form as the consequences ripple through the financial and economic systems.

As active managers, our purpose is to navigate our clients through a world in flux to protect their interests during uncertain times.

Stocks that could benefit from inflation, the role of carbon credits in portfolios, what’s driving India in EM, two events to watch closely next week.

Amid all the disheartening news this week there was a bright spot in Australia’s GDP numbers. ANNA HONG explains in our weekly Income and Fixed Interest note

IT HAS been a tough week filled with geopolitical and humanitarian tensions, as well as the flood crises impacting us.

Clearly there is plenty of bad news to go around and our thoughts are with everyone impacted. 

Market volatility is making portfolio positioning challenging — we still believe rate hikes and rising yields are on the agenda in the medium-term. 

But this week’s Australian GDP numbers brought a much-needed pleasant surprise.

A bright spot for a once hard-hit industry reminded us of the general resilience of the wider economy. 

The Farm sector posted a 9 per cent growth in the last quarter and a whopping 50 per cent growth since the 2019 droughts as you can see below:

While March 2020 will always be associated with the outbreak of Covid globally, that month was significant in Australia for other reasons. 

At that time Australia suffered through hailstorms, cyclones and bushfires to cap off a horror run of droughts from 2017 to 2019. That led to Farm GDP declining 22% in that period. 

Australia experienced its warmest and driest year on record in 2019. Large areas were affected by high temperatures and well-below-average rainfall.

Those conditions contributed to one of the worst bushfire seasons on record.

Fast forward to 2021-22 and the cooler La Nina weather pattern is painting a very different picture, as these maps from the Bureau show:

Outlook 

This recovery demonstrates the resilience of the Australian society and economy.

Growth has rebounded, unemployment is down, prices are higher. 

The agriculture industry presents the same thematic as the broader economy. It’s now running close to full capacity with labour shortages a significant constraint, leading to rising prices. 

Despite geopolitical issues and setbacks from the flood, we are now firmly in a rate hike cycle globally as central banks stay focused on tackling inflation. 

Until the dust settles, it remains to be seen if demand-led inflation or stagflation (covered by our head of government bonds Tim Hext in last week’s weekly note) will emerge as the front-runner.   

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About Anna Hong and Pendal’s Income and Fixed Interest team

Anna Hong is an assistant portfolio manager with Pendal’s Income and Fixed Interest team.

Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia. In 2020 the team won the Australian Fixed Interest category in the Zenith awards.

With the goal of building the most defensive line of funds in Australia, the team oversees A$22 billion invested across income, composite, pure alpha, global and Australian government strategies.

Find out more about Pendal’s fixed interest strategies here

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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

What economic conditions would make the RBA happy? Pendal’s head of government bond strategies TIM HEXT has some answers

I SPOKE last week about central banks needing tighter conditions to help limit inflation in our Income and Fixed Interest Weekly note.

I mentioned the term a “hawkish hike” which prompted a number of readers to ask: “aren’t all hikes by definition hawkish?”

The answer is that they are… but the accompanying statement is a chance to influence expectations of future hikes. 

This is especially so in countries where longer term fixed rate home loans are predominant – no point hiking and seeing them go nowhere. We expect the Fed to do this in their March hike, possibly pushing up the terminal level of rates as well. This will not be bond friendly.

In the US Goldman Sachs produces a Financial Conditions Index (FCI) to try and capture this wider view. 

The FCI is largely made up of 10-year nominal Treasury yields and Corporate Bond spreads (as measured by non-financial BBB bonds 15+ years). They also include equities, the TWI and the Fed Funds rate — though these are much smaller.  

The important point is that moving Fed Funds — while other indicators stay put — does not tighten financial conditions. 

They need to see a measured sell-off in term rates. Wider credit spreads help. Lower equities also help, provided they don’t go into a tailspin. 

Any Fed ‘put’ for markets (where they jump in to protect them) is a very long way from here. 

What would make the RBA happy

In the Australian context, the RBA would be extremely happy if by the end of 2022 inflation is at 3.25%, unemployment sub 4%, wages 3.5%, equities 10% lower, 10-year bonds 2.75% and cash rates 1%. 

It is not the RBA’s job to make sure superannuation balances have positive performance in any given year. Or to protect house prices. 

Given the massive rises in 2021 a negative year for assets is not a major setback. A year where labour outperforms capital is long overdue.

Of course, the Ukraine disaster will have an impact. But prospects of higher inflation will mean the Fed will need to get on with its hiking path, even if near-term risk markets are unsettled.

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About Tim Hext and Pendal’s Income & Fixed Interest boutique

Tim Hext is a Pendal portfolio manager and head of government bond strategies in our Income and Fixed Interest team.

Tim has extensive experience in banking, financial markets and funding including senior positions with NSW Treasury Corporation (TCorp), Westpac Treasury, Commonwealth Bank of Australia, Deutsche Bank, Bain & Co and Swiss Bank Corporation.

Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.

Find out more about Pendal’s fixed interest strategies here

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About Pendal

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

In 2023, Pendal became part of Perpetual Limited (ASX:PPT), bringing together two of Australia’s most respected active asset management brands to create a global leader in multi-boutique asset management with autonomous, world-class investment capabilities and a growing leadership position in ESG.

Contact a Pendal key account manager