The RBA looks set to re-build our financial system’s plumbing. Pendal’s head of government bond strategies, TIM HEXT, explains what it could mean for investors

• The RBA has announced the “Ample Reserves” system
• It will set a price for Open Market Operations and offer unlimited quantity 
• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Browse Pendal’s fixed interest funds

THE plumbing of Australia’s financial system is a bit like the plumbing in your house – of little interest until something goes wrong.

For those few who do take an interest in the RBA and our financial system’s plumbing, the Assistant Governor Chris Kent gave a speech on Tuesday: “The Future of Monetary Policy Implementation”.

By the end of this year, he explained, Australia will have a new system called “Ample Reserves”.

In short, the central bank will set a price for “Open Market Operations” (repos) and offer unlimited quantity – instead of setting the quantity and letting the market determine the price, as was the previous system.

Banks have been flush (so to speak) with liquidity since early 2020, courtesy of RBA quantitative easing and the term funding facility over the pandemic.

These are now slowly rolling off, reducing excess reserves in the system.

The RBA is worried that the pre-pandemic “corridor and low reserve” system may not work so well.

That system relied on the RBA accurately forecasting government inflows and outflows into the system (think taxes and welfare payments) and offsetting them by adding or draining the cash back into the system through repos and reverse repos.

READ NEXT: Private credit has its place in portfolios. So do bonds. In her latest article, Pendal head of income strategies Amy Xie Patrick explains why, as rates normalise, investors should remember that those roles are different. 

You lend them securities and they give you cash that you then pay interest on or vice versa.

The corridor meant banks could always borrow or lend unlimited funds with the RBA at 0.25% above or below target cash, but hardly ever did.

With Ample Reserves, banks can go to the RBA and offer unlimited securities to repo in return for cash (OMOs) at a pre-set margin to the official cash rate.

The price and frequency of these operations are yet to be determined but look like at least weekly and something like the target cash rate plus five basis points (currently 4.40%).

The RBA will release more details later in the year after market consultations.

So, what does this mean for investors?

The good news for leveraged portfolios is that there is now an “ample” supply of central bank liquidity at a reasonable price.

For investors, the good news is that overnight cash should eventually drift back towards target cash levels rather than sit at the ES level.

This would mean closer to 4.35% than 4.25% at current cash targets.

The bad news for investors, however, is that bank bills are less likely to drift too far above cash again.

Also, for relative value funds, government bond baskets (where bonds trade to futures) are less likely to get too cheap again.

Overall, it is a new era for the RBA.

It is not only temporarily moving out of the asbestos-ridden 65 Martin Place while expensive and long overdue renovations are undertaken, but it now has a new way of ensuring system liquidity is always rock solid.

---

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

Pendal assistant portfolio manager ANNA HONG unpacks the latest monthly CPI data and highlights some of the key takeaways for investors

• The last mile will not be a smooth run
• There remains optimism that inflation will fall closer to 3% by mid-year
• Why bonds, why now? Find out more from Pendal’s income and fixed interest team

AUSTRALIAN monthly CPI of 3.4% year-on-year (YoY) came in a touch lower than market consensus.

Meanwhile, trimmed mean CPI (with the top and bottom 15% cut off) came in at 3.9%.

Though the monthly CPI shows clear signs of disinflation, it appears that the last mile will not be a smooth run.

The Reserve Bank of Australia references the quarterly CPI measure in its decision-making, and February’s numbers update the quarterly CPI basket.

We expect headline and underlying inflation, released in late April, to be around 0.8% for Q1.

It is evident that the rate hikes have taken a toll on the Australian consumer, with real consumption in negative territory.

Goods inflation is back below 2%, while services remains sticky – above 5%.

The table below highlights improvements over the past six months along with the need for further falls.

We have also had important updates in a few key service areas this month.

Housing

Rents remain elevated at 7.6% (YoY), which is not a surprise given the apartment supply challenges driven, in part, by the current immigration wave.

Adding to this is the 4.9% (YoY) increase in new dwelling prices (the cost of building) in February.

Builders have been able to pass higher labour and material costs onto homeowners.

Education

Education prices are measured only once a year (in February) and represent 4.4% of the CPI basket.

Education prices rose 5.9% (YoY) over February, with the main contributor being primary and secondary schools passing on the high wage rises for teachers announced in late 2023.

Teachers’ wages will show more moderate growth in 2024, however, so next year’s number should be lower.

Looking ahead, tertiary education inflation remains high, as lags in indexation came through this February.

Health

The news on the health front (which is 6.2% of the CPI basket) was better than education.

Health fund rises approved for April (also measured once a year in the CPI) were set at an average of 3.1%.

The RBA needs services inflation at or below 4% before it will be comfortable with inflation.

What does this mean for investors?

It was unlikely that the RBA was going to cut in the first half of 2024 – these numbers and the slowing of the disinflation impulse all back this up.

However, there remains optimism that inflation will fall closer to 3% by mid-year, which would allow rate cuts from August.

In the meantime, movements from the US Federal Reserve in between will also play a role in the last mile.

---

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.

With the goal of building the most defensive line of funds in Australia, the team oversees some $20 billion invested across income, composite, pure alpha, global and Australian government strategies.

Find out more about Pendal’s fixed interest strategies here

---

About Pendal Group

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

Contact a Pendal key account manager

Private credit has its place in portfolios. So do bonds. As rates normalise, investors would do well to remember those roles are different, writes Pendal head of income strategies Amy Xie Patrick

• Asset classes like private credit have important roles to play in portfolios
• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Browse Pendal’s fixed interest funds

INCREASINGLY I find myself a lone voice on conference panels speaking in favour of public market debt offerings such as bonds.

When I look left and right, I see experts in private credit, private equity, unlisted property and venture capital.

Depending on your investment goals, there are solid reasons for each of these to feature in a portfolio.

But I generally disagree with the use of private debt to replace the job that active bonds are supposed to do in a portfolio.

What is private debt (otherwise known as private credit or direct lending)?

Private debt is a type of credit.

Credit is a sub-asset class of fixed income where companies are borrowers and investors are lenders.

In the public debt space these loans take the shape of bonds or syndicated loans.

Both are freely-traded instruments whose values may change with every transaction. Sometimes, in the absence of any transaction, prices can change as market conditions change.

On the other hand, private debt is lending undertaken directly between companies and investors.

Borrowers are typically companies looking for more advantageous terms than they can get from a bank.

These companies may face more onerous bank lending terms due to lower credit quality, an unproven business concept or the riskiness of a project.

Investors include private debt funds, insurance companies and so on.

In Australia, private debt funds benefit from the conservative nature of our major banks. This leaves a significant slice of smaller and medium-sized enterprises “unbanked”.

It also provides a return opportunity for private debt managers who have the risk appetite and capability to assess and manage the risks.

As a result, private credit portfolios are able to generate higher levels of yield and income than portfolios of investment-grade corporate bonds.

Unprecedented growth

Five-to-ten years ago most private debt funds in Australia would have had only 20-30% exposure to the residential property market.

An unprecedented period of strong inflows into these funds followed as end investors searched for yield in a low-interest-rate world.

Today, the average private debt portfolio in Australia would have 50% or more exposure to the residential market.

This alters the risk and compositions of these portfolios compared to more diversified positions a decade ago.

Growth in these exposures has been forced rather than intended, since there haven’t been enough non-property opportunities to participate in.

In the world of equities, small and micro-cap fund managers are usually frank about the capacity of their offerings.

Good managers will cap the growth of their funds to sizes commensurate with the liquidity and the likely pool of good opportunities in their market.

Private debt funds have generally not done this in the face of strong inflows.

As a result, I expect the overall quality of portfolios will continue to get dragged by the concentration in property.

No volatility

Lack of market volatility is another attraction of private debt funds over publicly traded bonds.

This was a particularly strong draw after 2022 when most asset classes other than cash and oil were under water.

Why is there no volatility? Because there is next to no liquidity in private debt.

From time to time, private debt positions may transition between different fund managers. But these are bilaterally arranged deals unseen by the rest of the market.

Even if a manager sells a position from her portfolio to another manager at a sub-par value, it does not force every other private debt manager to take a paper loss on similar assets in their portfolios.

By no means does the red line in Figure 1 (see below) paint the lived experience of every private debt investor.

But it reminds us that just because something doesn’t move, that doesn’t mean it’s sellable at the price it was bought.

Figure 1: What if private debt were publicly traded? US high yield and an index of asset managers who specialise in private debt

Source: Bloomberg

Of course, no private credit index has enough history to tell us anything reliable about the true volatility of the sub-asset class.

But we can consider the red line above as a proxy.

It tracks the share prices of listed companies whose main business is in direct lending and private credit.

It’s no surprise that the undulations of the red line follow those of public high-yield markets. But the draw-downs are deeper, reflecting greater risks in private debt.

Historically, this has been true of every private version of asset classes, from debt to equity to property.

A cyclical asset class

The market volatility makes sense when you see that private debt is a cyclical asset class.

Figure 2: The cyclicality of private debt

Source: Bloomberg

This direct-lending data comes from the Cliffwater Direct Lending Total Return Index.

The index measures the unlevered and gross-of-fee performance of US direct loans by looking at the asset-weighted performance of the underlying assets of the direct-lending companies.

The ISM manufacturing employment index signals cyclical trends in the overall economy. When overlaid to the year-over-year returns of the Cliffwater index, we can see the returns to direct lending follow the cycle.

The data for the latest periods of returns from US direct lending are not yet available. But we can see from the ISM index that the trajectory of those returns are likely to be headed lower as the economic cycle softens.

Government bonds, on the other hand, have always rallied into every economic recession.
There has been a long-held relationship between the quits rate and wages.

Valuations

Rather than speculate about private debt valuations and methodology, I’d look to recent findings from KBRA Direct Lending Deals on the state of valuations ahead of defaults among the US community of private debt managers.

The same data is currently unavailable in Australia, but the KBRA analysis references a US$1.7 trillion industry.

The study addresses a key assertion of the private debt industry that they are in stronger lender positions than banks.

The reasoning includes closer relationships with companies, more senior positions in the capital structure and stronger protections when borrowers get into trouble.

If that were true, you should expect that recovery rates on defaulted positions in private credit portfolios should have an average value in excess of what is achieved in public bond and loan markets.

The KBRA results showed the opposite.

Private credit firms were able to recover only 48 per cent of the value of loans made to defaulted companies over the last year, compared to 55 per cent in syndicated loans.

The seniority and protected position assertions may also lead managers and valuation agents to be overly optimistic when assessing potential loss in their portfolios.

Figure 3: Mind the gap. Private vs public debt valuations ahead of defaults

Source: Bloomberg

As Figure 3 illustrates, in the three months leading up to default, direct-lending portfolios tend to mark troubled assets at a higher value than both the markets of leveraged loans and high-yield bonds.

The phenomenon may be more simply explained by the wisdom of crowds.

Given many market participants are looking at the same thing in leveraged loans and high-yield bonds, there are more opinions weighing in on what the right asset value should be at any point in time.

In private debt, it’s usually just the opinion of the manager and a third-party valuation agent.

The dangers of private debt replacing traditional fixed income

Even the most conservative private debt managers in Australia will have a higher level of credit risk through their portfolios than a bond or credit manager.

In addition, even the most liquid of private debt funds will not be able to offer daily liquidity for their clients.

I highlight these two points because I think they get to the heart of how most investors see the role of fixed income in their portfolios.

At the very least, it is a part of the portfolio that they don’t expect to worry about when their equities, property and Bitcoins are falling out of bed.

Most investors also expect to be able to tap their fixed income allocations for some liquidity once their cash has been used up.

In orderly normal market sell-offs, high-quality investment grade bonds offered for sale by one manager will usually find a home with another – even if it’s at a lower price that the former would like.

Perhaps the same can be said of private debt, though the discounts would have to be far steeper.

This highlights the need for some non-credit fixed income in the portfolio as well. This is where exposure to government bonds comes in.

Government bonds don’t have to be defensive.

The experience of 2022 reminded markets that bonds move as much with inflation as they do with growth. Since inflation was the bigger problem then, bonds could not rally as equities sold off.

If growth becomes the bigger problem, bonds should perform – just as they have in every recession in the past. This has been regardless of the starting point in yields.

Recession is the worst-feared scenario for equities, property and probably Bitcoin. It is also the worst-feared scenario for leveraged and private credit because corporate defaults skyrocket.

As KRBA’s findings have shown, the relatively benign valuations on private debt portfolios may only mask the impending shock to come in such an environment.

With most private credit funds requiring investors to provide two-to-four months’ notice on capital redemptions, that may be just the perfect amount of time for the value of their investments to go from whole to sub-par.

Conclusions

Asset classes such as private credit have important roles to play in portfolios.

They provide a way to amplify returns – and in some cases even diversify the sources of those returns.

In times of ultra-low interest rates, the space they occupy in portfolios have grown to crowd out traditional fixed income.

But now that interest rates have normalised, it is time to ask whether traditional fixed income needs to find its way back in.

If fixed income is supposed to be the true diversifier – with an ability to protect or defend in times of economic stress – private debt will not fulfil that purpose.

If fixed income is supposed to be a source of liquidity in times of market stress, a greater consideration needs to be made for government bonds.

That liquidity was available even in the depths of severe financial crises.

It proved invaluable for investors who used that flexibility to take advantage of beaten down prices in other asset classes.

Again, private credit will not serve investors well who are in need of that liquidity or flexibility in those stressed market environments.

It’s been easy to get away with replacing private debt for traditional fixed income for a decade. Let’s not wait for a deeper episode of economic stress to remind ourselves of the value of bonds.

Here are the main factors driving the ASX this week, according to Pendal investment analyst JACK GABB. Reported by portfolio specialist Chris Adams

• Find out about Pendal Focus Australian Share fund
• NEW: Watch Crispin Murray’s bi-annual Beyond The Numbers ASX outlook

THE first central bank domino fell last week.

The Swiss National Bank pushed through a surprise 25bp cut to 1.5%, pre-empting expected moves by the US Fed and European Central Bank as soon as June.

The Fed kept rates unchanged but reiterated that it expects three cuts this year.

The ECB continues to flag June as the month by which it should know whether to cut. And even Bank of England hawks have dropped their push for more hikes.

It is small wonder then that the Reserve Bank of Australia walked back commentary warning of further hikes.

In short, most central banks appear increasingly poised for a scramble to cut rates, despite plenty of macro-level data suggesting there’s no need to do anything quickly. 

Against that backdrop the S&P 500 rose 2.31% (its best week since January) and hit another record high – its 20th year-to-date.

The S&P/ASX 300 also managed reasonable gains, up 1.29%.

Though neither matched Japan. The Nikkei jumped 5.6% on further signs the economy was strengthening – forcing the Bank of Japan to raise rates for the first time in 17 years.

Bonds rallied on higher rate-cut expectations, with yields on longer-dated Treasuries ending the week on lows.

It’s been a volatile month and a tough quarter for commodities, though most moved higher last week.

In particular lithium spodumene rose 18.2%, recovering from an oversold position.

Oil ended the week flat, giving up mid-week gains. Brent crude remains up 11% YTD, but lower gas prices and freight rates are acting as an inflationary offset.

Commodity Trading Adviser positioning in commodities was unchanged from the previous week with strategies continuing to hold “max long” positions in oil and gold, silver and copper.

Rate expectations

The US Fed remains odds-on to cut in June. Expectations were up 19% last week despite better-than-expected economic data released after the meeting.

We also note the Core Personal Consumption Expenditures (CPE) index – the Fed’s preferred gauge of inflation – is accelerating.

In Australia, stronger unemployment data offset the RBA’s shift to a more neutral stance, with a full cut now not priced in until November (versus September previously).

However, if the Fed and ECB cut in June, pressure will mount for the RBA to follow sooner.

US outlook

The Fed held rates unchanged for the fifth meeting in a row, as expected.

More importantly, it stuck to its view of three cuts by year-end. This was the main driver of a positive market reaction, though we recall the market started the year pricing in seven cuts.

As has previously been discussed, US inflation continues to move in the right direction despite the odd bump.

The Fed “judges that the risks to achieving its employment and inflation goals are moving into better balance”, according to Fed chair Jay Powell.

However it was a lot closer than the market reaction suggested.

Changes in the “dot plots” of each member’s expected rate levels very nearly skewed the median towards two cuts – which would likely have driven a different market reaction.

The market was also happy to shrug off a reduction in expected cuts next year from four to three, as well as a lifting in long-term rate expectations from 2.5% to 2.6%.

Other key changes to 2024 forecasts included raising expected inflation from 2.4% to 2.6%, expected GDP from 1.4% to 2.1% and cutting expected unemployment from 4.1% to 4%.

Powell also said it would be appropriate to begin tapering so-called quantitative tightening “fairly soon”.

Better GDP and employment forecasts weren’t the only indicators that the US is economy is doing well.

In data released after the Fed meeting, existing home sales rose 9.5% month-on-month to 4.38 million – the highest point over the past year and ahead of an expected 3.95 million.

The Conference Board Leading Index (a composite index that averages ten key economic variables) also rose 0.1% for the month, versus an expected 0.1% fall. It was the index’s first rise since February 2022.

As we highlighted back in November, this index has bottomed at a median of 61 days before the end of every recession since the 1969-70 downturn – and stocks have gained a median 23.4% in the year after these troughs.

The most recent trough was April 2023. Since then the S&P 500 is up 26%.

In short, the data is coming in stronger. However, as one commentator put it: “This is a Fed that wants to cut rates.”

The next Fed meeting is May, though the market is only pricing in a 16.5% chance of a cut then.

Instead, committee members are likely to wait for more CPI prints. Three more are due before the June decision, with the last one the day before their next meeting.

It seems inconceivable that the Fed could cut in November given the US presidential election.

So that leaves just four meetings (June, July, September and December) to put through three cuts.

Australia

There were no surprises from the Reserve Bank’s mid-week meeting (rates were held at 4.35%), though we noted a change in language “in response to some data that makes us more confident about the path we are on”.

The RBA effectively walked back commentary warning of further hikes, by “not ruling anything in or out” rather than the previous “a further increase in interest rates cannot be ruled out”.

Semantics maybe, but there’s no doubt the previous stance was increasingly at odds with other central banks eyeing rate cuts sooner.

At this point the Fed is rated 85% chance of a cut by the end of June, the ECB above 90% and the RBA at only 40%.

There are three factors affecting the outlook for Australian interest rates:

1) Labour market challenges remain

One issue the RBA has to contend with is continued strength in the labour market.

Data after the RBA meeting revealed unemployment declined to 3.7% in February, down from 4.1% prior (4% expected). Some 116,500 jobs were added in the month versus 40,000 expected (500 prior).

While the data can be volatile, it nevertheless challenges a dovish view and sent rate cut expectations lower.

We note that is a parallel with the Fed, where Powell has previously noted that “in and of itself, strong job growth is not a reason for us to be concerned about inflation”.

This is only an issue if workers are spending and driving up inflationary pressures. Still, it is something to watch.

2) Then there’s the tax cuts

Some $20 billion in annual income tax cuts will begin kicking in from July 1.

This is clearly inflationary – some estimates say it is worth two-to-three rate cuts – and may well encourage the RBA to pause while gauging the inflationary impact.

3) Borrowers are coping

Commentary from the RBA Financials Stability Review added more weight to a hold-for-longer view.

Despite mortgage repayments rising 30-60% since May 2022, borrowers are seen as being able to cope if rates stay higher for longer.

While arrears would rise, they are expected to remain low at less than 1% in terms of home loans 90 or more days in arrears.

Japan

As expected, the Bank of Japan became the last central bank to exit the era of negative interest rates, raising the benchmark to an eye-watering 0.0-0.1% from -0.1% – the first increase in 17 years.

The move marks a step back towards mainstream central bank policy after decades of experimentation.

While negative rates no doubt helped stem the tide of deflation, ultimately it was quantitative easing, Covid and Russia’s invasion of Ukraine that drove inflation back above 2%.

As a former BOJ director in charge of monetary policy said: “the negative rate did nothing, nothing at all” to stoke inflation.

Interestingly, the start of Japan’s last three hiking cycles (going back to 1986) has preceded a global recession.

Though we note that is clearly at odds with most of the current macro data.

Markets

It was a good week for nearly all sectors in the US last week.

Tech stocks continued to do a lot of the heavy lifting – apart from Apple, which fell on an anti-trust investigation.

Artificial intelligence was again front and centre with Nvidia up for the 11th straight week after holding its GTC event (the ‘Woodstock of AI’) which packed in some 11,000 people.

Industrials also did well with bellwether FedEx reporting a third-quarter beat.

Real estate was weaker, with Equinix down on a short report.

Elsewhere Nike and Lululemon reported weaker results – the latter warning it had seen a shift in the shopping behaviour of its high-end US consumers.

Overall though it was a good week, pushing the price/earning multiple back to January 2022 levels.  Materials led in Australia, offsetting weakness in utilities and consumer staples.

---

About Jack Gabb and Pendal Focus Australian Share Fund

Jack is an investment analyst with Pendal’s Australian equities team. He has more than 14 years of industry experience across European, Canadian and Australian markets.

Prior to joining Pendal, Jack worked at Bank of America Merrill Lynch where he co-led the firm’s research coverage of Australian mining companies.

Pendal’s Focus Australian Share Fund has an 18-year track record across varying market conditions. It features our highest conviction ideas and drives alpha from stock insight over style or thematic exposures.

The fund is led by Pendal’s head of equities, Crispin Murray. Crispin has more than 27 years of investment experience and leads one of the largest equities teams in Australia.

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.

Find out more about Pendal Focus Australian Share Fund  

Contact a Pendal key account manager

 

---

As investors prepare for lower rates, our head of income strategies AMY XIE PATRICK sat down with portfolio specialist DALE PEREIRA to answer some common client questions

DALE PEREIRA (Pendal’s head of client solutions): As economic growth slows and inflation comes under control, markets are expecting interest rates to fall in the US and Australia this year.

How are you managing fixed income portfolios in this environment?

AMY XIE PATRICK (Pendal’s head of income strategies): “We manage our portfolios to a simple philosophy when it comes to the interest rate cycle.

“When the RBA is hiking interest rates, we like to take our credit exposures in floating-rate form.

“This means the income returns of the portfolio will be able to keep up with the rising interest rate environment.

“But when the RBA is cutting interest rates, we like to switch our exposures to fixed rate. This locks in a higher level of income, even as interest rates fall to much lower levels.

“It’s the same as a homeowner taking out a mortgage, only in reverse.

“When you think the RBA is going to cut interest rates, you want your mortgage rate to be variable so those rates fall as the RBA slashes rates.

“When you think the RBA is going to raise rates, you fix the rate on your mortgage at low levels.

“We do the same thing for Pendal Monthly Income Fund portfolio – but we want as high a yield as possible.”

Dale: Are you fixing the rate of your credit portfolio now?

Amy: “We’re not rushing to do it just yet.

“Bond yields do look really attractive compared to the last decade. But when you take a longer-term perspective, these are just more normal levels of interest rates.

“The RBA is also not entirely convinced that it’s won the inflation battle, especially with strong immigration flows still pushing up demand in our economy.

“So we’ve been dipping our toes in, but we’re not yet ready to fix the whole portfolio.

“By doing it in slices, it maintains flexibility in our portfolio as well as protection in case bonds have another sharp sell-off like they did last October.

Dale: What signals indicate it’s time to turn your income portfolio towards fixed-rate assets rather than floating-rate bonds?

Amy: “Wages matter to the RBA almost more than any other central bank.

“I’d want to see wage inflation in Australia roll over and head convincingly down to that 3.5% type of level where the RBA feels is consistent with their 2% to 3% inflation target.

“Our proprietary wage indicators at Pendal have stopped rising, but they appear a bit sticky at just over 4%.

“That doesn’t mean there won’t be opportunities along the way in rates.

“We will seize these opportunities with our active interest rate process just like we did during the regional banking crisis in the US last year and during the fourth quarter of 2023.”

Dale: Most of us think of fixed income as a defensive asset class. When equities are strong and the market isn’t worried – and isn’t looking for protection – why bother with bonds?

Amy: “My career in markets has taught me that bonds will do their own thing.

“There is no hard rule that says bonds have to go up when equities go down.

“The main things that drive bond performance are growth and inflation. The macro fundamentals are usually what matters to bond market direction.

“For example, in 2022 bonds didn’t work to protect against falling equities because inflation was a far bigger problem than slowing growth.

“Today growth is still not a problem, but inflation is coming down all over the world. The shocks from the pandemic are finally working their way out of the system.

“If the downward inflation trend continues, bonds can still do well regardless of whether the economy slows from here.

“Look at 2023, Australia grew more than 2% and yet Aussie government bonds returned more than 5%.

“The US economy grew at over 3% and global bonds returned close to 6%.

“Those data points tells us you don’t need to be bearish on the economy in order to be bullish about bonds in your portfolio. “

“While cutting cycles are great for bonds, actually the best time for bond returns is simply when the hiking cycle stops.

“Bonds tend to outperform equities in this part of the cycle.

“That means you’re coming into the best period for bond returns right now. And wouldn’t it be a shame to say no to bonds and miss out on all this opportunity?”

Dale: Why would you invest in a bond portfolio rather than a term deposit?

Amy: “For some investors, term-deposit returns on cash are enough – they’re more than happy to take those returns after years of really slim pickings in this area.

“But for most investors who chose term deposits over fixed income last year, their biggest frustration was missing out on the upside.

“Both bonds and equities outperformed term deposits in 2023.

“This year, locking in 5% term deposits might sound nice at first.

But you would also be locking up your capital for a year.

“It makes it harder to move your money around when things change, which means you can’t deploy it quickly or easily to buy the dip if we get a decent correction in markets.”

Here are the main factors driving the ASX this week, according to Pendal’s head of equities CRISPIN MURRAY. Reported by investment specialist Chris Adams

• Momentum remains strong across most equity markets
• A period of consolidation is still likely, however
• Find out about Pendal Focus Australian Share fund
• Watch Crispin’s Beyond the Numbers webinar – now on-demand

INFLATION concerns prompted consolidation in most equity markets last week, following unconvincing US CPI and PPI data.

This inflation data means that the market is now expecting fewer rate cuts this year.

The S&P 500 finished down 0.09%, while bond yields continued to rise. US 10-year yields are now 53 basis points higher than their lows in December.

Generally, higher commodity prices added to the angst as they may act as a further headwind for the “last mile” reduction in inflation to 2%.

This early sign of potential market consolidation following a strong run was concentrated in previously high-momentum sectors.

In Australia, this saw banks underperform (-4.4% for the week), though they still have a total return of 9.06% for the calendar year-to-date.

Resources continued to underperform (-2.93% for the week) as iron ore fell further (-5.2%).

That said, there were signs of a sentiment shift in oil (+4.1%) and copper (+3.9%).

With both banks and resources down, the S&P/ASX 300 lagged global markets, falling -2.14%.

Inflation watch

US February Headline CPI rose 0.44% month-on-month to 3.2% year-on-year.

It is running at 3.4% on a six-month and 3.4% on a three-month annualised basis, respectively.

Meanwhile, the Core CPI measure was up 0.36% month-on-month and 3.8% year-on-year.

It is running at 4.3% on a six-month and 3.4% on a three-month annualised basis, respectively.

While the Headline index was broadly in line with expectations, Core was hotter than the expected 0.32% month-on-month.

The three-month annualised rates are picking up, increasing the risk that inflation proves stickier than expected.

Breaking down the Headline year-on-year increase:

• Core goods (-0.3%) are back towards the previous four-year mean levels of 0.1% year-on-year growth, as is Food & Beverages which grew 2.3% year-on-year and at a mean of 2.4% over four years.
• Energy (-1.7% year-on-year) is well below the four-year mean of 5.2%.
• Core Services (5.2% year-on-year) remains elevated, given a 2.9% four-year mean.

Within the Core basket, services are still not showing any sign of breaking lower.

At the same time, the deflation in goods is coming to an end and may no longer provide a tailwind for a lower CPI.

Other measures of “sticky” inflation, such as the Atlanta Fed Sticky Core CPI and Cleveland Fed Median CPI, confirm the risk that inflation remains stuck in the range of 3.0%-3.5%.

February’s PPI data was also stronger than expected, rising 0.6% month-on-month – versus consensus expectations of 0.3% – to 1.6% year-on-year. 

This was driven by sharp jumps in both food and energy prices.

Core PPI was up 0.3% month-on-month (with a consensus of 0.2%) to 2.0% year-on-year, due to both services and goods.

The combination of this data allows the market to predict the February Core Personal Consumption Expenditures (PCE) inflation data, which the Fed uses as its preferred inflation measures.

This is implied to come in around 0.3% month-on-month, with an upward revision to January leading to a 2.8% year-on-year gain.

The three and six-month annualised rates are expected to be higher, shifting expectations around the first rate cuts as a result.

Other leading inflation indicators are mixed.

There is a lot of focus on rising US gasoline prices, which reflects both oil prices creeping higher and increased refinery crack spreads.

There is some offset from freight rates declining, though they remain at historically elevated levels.

Interest rates

Given recent inflation data, the market is now only pricing in a 2% chance of a rate cut at the FOMC meeting this week, while May is priced at 6% and 60% for June.

Median expectations have now shifted to only two-and-a-half cuts in 2024.

The market will be looking at whether the Fed shift its median dot plot expectations from three to two rate cuts.

Chair Powell’s tone will also be scrutinised, though the general view is that he will not want to be too hawkish given:

• there is still three months’ worth of inflation data to come through before the June meeting
• there are some signs that consumer demand is cooling
• he will be as wary of extrapolating two months of hotter data as he was when extrapolating the cooler data late last year
• the perception that the Fed will not want to wait until July or September for the first cut as it becomes politicised by the Presidential election.

Economic growth outlook

US February Headline retail sales grew 0.6% month-on-month – a smaller-than-expected bounce back from a weak January figure.

The discretionary component of Core retail sales is negative year-on-year, though other categories are holding the overall number in the 2-3% range.

Clothing and furniture sales are particularly weak.

This softness has flowed through into the Atlanta Fed GDPNow tracker, which has declined due almost entirely to lower expectations on personal consumption.

All this highlights that the economy is slowing down gradually which, combined with potentially lower Q2 inflation, should still be enough to allow the Fed to cut in June.

Japan

The Bank of Japan is under scrutiny, with last week’s wage data seen as the catalyst for a rate hike.

To put this significance into perspective, the last time the BOJ hiked was in 2007 – an era before iPhones, Bitcoin, Uber or Instagram.

The market is implying an 80% chance of the BOJ ending yield curve control and negative rates.

The bigger issue for global markets is how the balance sheet will be managed going forward – whether there will be some form of quantitative easing – and the likely extent of rate hikes in the next 12-18 months.

Australia

The monthly NAB Business Survey suggests business confidence remains subdued, however, current conditions are marginally better than January – notably in the trading and profitability category.

Forward orders were slightly lower than in January, but the pricing outlook improved which should support margins.

Australian bond yields followed the US higher.

This, combined with the Fair Work Commission wage settlement for aged care workers which impacts overall wages growth, could delay the first cut from the RBA.

Markets

Momentum remains strong across most equity markets.

A period of consolidation is likely, with the potential for a 5% drawdown in the US market.

But underlying technicals – such as the increasing breadth of the uptrend – remain positive. 

Copper is another market to watch – it has risen to its highest levels in twelve months despite all the pessimism on China.

The ASX has been a narrower market, with increased liquidity in the largest stocks a feature.

Looking over the year to date, it is interesting to see how concentrated the rally has been in the large cap industrials.

The returns from the Big Four banks, Macquarie Group (MQG), Goodman Group (GMG) and Wesfarmers (WES) – which are 26% of the index – can explain over 100% of the index return in 2024.

On both price-to-earnings and price to pre-provision-profit, the banking sector is at all-time high valuation (going back as far as 1996).

---

About Crispin Murray and the 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 a 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

Following a review of Perpetual Group’s multi asset capabilities, a decision has been made to combine the Perpetual and Pendal Multi Asset businesses to create one team, the Perpetual Multi Asset Strategies team. The new team will be led by Perpetual’s current Head of Multi Asset, Michael O’Dea.

Michael O’Dea has been appointed as the portfolio manager of the Pendal Multi Asset Funds with effect from 14 March 2024. Michael replaces Michael Blayney as the portfolio manager of these funds.

Why one team?

We are bringing together the Perpetual and Pendal multi asset teams as one enhanced team with greater scale and resources to support better client outcomes. This team will be uniquely placed to build investment solutions to meet emerging client needs by accessing the combined intellectual property and experience of both the Perpetual and Pendal multi asset teams.

Who forms part of the new team?

The new Perpetual Multi Asset Strategies team will consist of nine highly experienced investment professionals with average industry experience of 23 years. Please refer to the link here to view the new team profile.

As a result of the appointment of Michael O’Dea to lead the combined team, Michael Blayney will be leaving the organisation, however he will continue to support the new team in an advisory capacity over the next six months.  

What does this mean for your investments? 

There are no immediate changes to your investments as part of this announcement. The investment approach and asset allocation as stated in the applicable Fund’s product disclosure statement has not changed. 

Pendal’s sustainable investment products will retain their sustainability approach.   

Fees and buy and sell spreads for the Pendal Multi Asset Funds remain unchanged, as a result of the announcement.

The Pendal brand and names of the Pendal Multi Asset Funds remain. 

What do you need to do?

No action is required. You will be able to continue to invest or withdraw in the same way, except for the Pendal Balanced Returns Fund where applications are no longer being accepted.[1]

If you have any questions about your investment or would like further information regarding the changes, please contact our Investor Service Team on 1300 346 821 (for Australian investors) or +612 9220 2499 (for overseas investors) from Monday to Friday, 8.00am to 5:30pm (Sydney time).

[1] For further details see the “Notice of Termination Pendal Balanced Returns Fund“, dated 13 March 2024.

The Pendal Balanced Returns Fund (Fund) will terminate on Tuesday, 18 June 2024.

Why is the Fund terminating?

The Fund’s small size means that it has high running costs and cannot be managed in a cost efficient way.

We also consider that the Fund has little prospect of significant growth in funds under management in the foreseeable future. If the Fund were to continue, the Fund’s size would result in higher management costs for investors, which would reduce their investment returns.

How this affects you?

We will terminate the Fund on Tuesday, 18 June 2024.

Any applications received after 1:00pm (Sydney time) on Wednesday, 13 March 2024 will not be accepted.  There will be no reinvestment of distributions from 1:00pm (Sydney time) on Wednesday, 13 March 2024.

Withdrawals and transfers will continue to be processed up until 1:00pm (Sydney time) on Monday, 17 June 2024.

As soon as practicable after the Fund is terminated on Tuesday, 18 June 2024, we will begin winding up the Fund. The assets remaining in the Fund will be realised and the proceeds distributed to all investors in proportion to their unit holding.

What does this mean for you?

Cash proceeds from this termination will be paid directly to your nominated bank account on file on or around the week commencing Monday, 24 June 2024 or shortly thereafter.

Any distributions paid from 1:00pm (Sydney time) on Wednesday, 13 March 2024, including the March 2024 quarter will be paid as cash into your nominated bank account on file.

Details of any distributions paid to you during the current financial year will be included in your final AMIT Member Annual (AMMA) statement. This statement will set out the components of the income that have been attributed to you following the end of the financial year ending 30 June 2024.

Questions?  

If you have any questions, please contact our Investor Relations Team during business hours on 1300 346 821.

 

Here are the main factors driving the ASX this week, according to portfolio manager OLIVER RENTON. Reported by portfolio specialist Chris Adams

• Find out about Pendal Focus Australian Share Fund
• Tune into our latest on-demand webinar: Beyond the Numbers

IT was a light week in terms of macro data.

We saw February non-farm payrolls and the Job Openings and Labor Turnover Survey (JOLTS) released which, overall, were supportive of inflationary pressure continuing to ease.

The Fed’s Chair Powell’s comments to Congress were taken positively.

Australian economic data painted a picture of an economy which is slowing, but still growing – albeit with some softer pockets.

There were few surprises from the opening days of China’s National People’s Congress sessions.

Beijing confirmed a target of 5% GDP growth for 2024.

The S&P 500 fell 0.23%, while the S&P/ASX 300 gained 1.85% due to a strong Friday.

US economy and inflation

There were a number of data prints which supported the view of a slowing economy and easing inflation.

While non-farm payrolls rose 275,000 in February – well ahead of consensus expectations – there were large downward revisions to December and January’s data.

As a result, net new jobs grew 108,000.

Average hourly earnings rose 0.1% versus consensus expectations of 0.2%, while the unemployment rate rose from 3.7% to 3.9%.

The “Quits” rate in the JOLTS data continued to fall.

This is important because there is a close correlation between it and the Employment Cost Index measure of private sector wages and salaries, with a lagged effect.

This suggests that the latter could fall below 4% in coming months.

The February ISM services index dropped from 53.4 to 52.6, below the 53.0 expected by consensus.

Demand-based components showed some strength – with New Orders rising 1.1 points to 56.1.

Employment and inflation components, however, fell.

It was also interesting to note that the Congressional Budget Office increased its estimate of population growth in the US in 2023 from 0.5% to 1.1%.

It also raised the 2024 estimation from 0.5% to 1.2%, noting the impact of undocumented migrants.

Fedspeak

Atlanta Fed President and FOMC voting member Raphael Bostic said that he expects the Fed’s first rate cut, which he pencilled in for the third quarter, to be followed by a pause.

In separate commentary, he expressed concern that businesses are too exuberant and could unleash a burst of new demand after easing boosts price pressures.

Meanwhile, in his testimony to Congress Fed Chair Powell noted that easing will probably be appropriate “at some point this year” and that the number of cuts depend on the data.

The market took Powell’s comments positively, with US Treasury yields falling and gold rising.

US election

Donald Trump had wins in both the courtroom and on the campaign trail last week.

The US Supreme Court said Trump can appear on presidential ballots this year.

The unanimous decision overturned a Colorado Supreme Court ruling barring Trump from running again due to his efforts to overturn his 2020 election loss.

Republican candidate Nikki Haley dropped out of the presidential contest after losing all but one of the Super Tuesday primaries – though she has not endorsed Trump’s candidacy.

Senate Minority leader Mitch McConnell subsequently endorsed Trump, which he’s previously been reluctant to do.

Australia

Australia’s GDP increased 0.24% in Q4 2023, which was largely in line with expectations.

The economy grew 1.55% year-on-year.

Consumer spending was positive but subdued, rising 0.1% for the quarter.

As a component, spending on discretionary items fell 0.9% quarter-on-quarter.

Housing construction activity fell, but this was offset by non-housing construction.

Importantly, labour productivity is improving following last year’s plunge, with the six-month annualised growth in productivity rising back towards 3%.

The current account surplus rose to $11.8 billion, which was well ahead of the $5-6 billion expected by the market due to a larger-than-expected rebound in net exports.

Europe

The ECB has reached its 2% inflation target, according to a Bloomberg Economics Nowcast.

The gauge, which uses 32 variables from unemployment to energy costs, fell to 1.95% after January’s drop in producer-prices was added.

China

The first week of the National People’s Congress session did not yield much in the way of surprises.

The 2024 GDP growth target has been set at “around 5%”, which was largely as expected.

There has been rhetoric around AI, automation, technology, renewables, new energy vehicles (NEVs) and biotech as drivers of economic growth.

A special sovereign bond issuance plan, estimated to be around RMB 1 trillion for 2024, is designed to help mitigate the risk of local governments struggling to pay debt.

Markets

The small 0.23% fall in the S&P 500 meant that it only equalled its best run on record of rising in sixteen of the last eighteen weeks – last seen in 1971.

We note that on a historical basis, a strong start to the year typically has some persistence.

Going back to 1950, when the S&P 500 has risen in January and February, it has gone on to record gains over the remaining ten months of the year 92.9% of the time, with an average return of 8.1%.

That said, we also observe that this is starting to look like a relatively long run without a 2% retracement on a historical basis.

The put/call ratio is at the bottom end of its range, suggesting that sentiment remains very bullish.

In other news, as expected, OPEC+ agreed to extend the current curbs on oil supply through to June in order to support prices.

However, the gas price remains weak due to the combination of a mild European winter, high levels of gas in storage, and emerging concerns about increased supply from Qatar.

We also saw index changes on the ASX.

QBE Insurance (QBE) replaced Newmont (NEM) in the S&P/ASX 20, while Flight Centre (FLT) and Pro Medicus (PME) moved into the S&P/ASX 100, and Alumina (AWC) and Region Group (RGN) fell out.

---

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 here.  

Contact a Pendal key account manager here.

Drawing on more than 25 years of experience investing in top-performing Australian companies and a background in accounting, Jim manages our Long/Short Fund and co-manages our Imputation Fund. He is a Chartered Accountant with membership of the Australian Institute of Chartered Accountants.

Pendal Focus Australian Share Fund is managed by Crispin Murray. The fund has beaten its benchmark in 14 years of its 18-year history (after fees), across a range of market conditions. Find out more about Pendal Focus Australian Share Fund here.

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

Lessons from the latest GDP data | How to invest in troubled times | AI opportunities outside the Magnificent Seven