Here are the main factors driving the ASX this week according to our head of equities CRISPIN MURRAY. Reported by portfolio specialist Chris Adams
MOST equity markets held their recent gains or advanced incrementally last week, despite bond yields rising after a big move lower the previous week.
The S&P/ASX 300 gained 0.1% and the S&P 500 lifted 1.35%.
Recent equity market resilience has been driven by a combination of:
- A slower-than-expected bond issuance calendar for the December quarter
- A dovish Federal Open Market Committee (with chair Jerome Powell highlighting the work done by bond yields on tightening financial conditions)
- Softer data from the US Institute for Supply Management manufacturing index
- Jobs data sitting in the “goldilocks zone”
However, these factors were offset last week by:
- Powell adopting a sterner tone in an IMF speech, perhaps with an eye on an easing financial conditions index
- A disappointing US Treasury auction, reminding the market that supply is a risk to bond yields
- Worse-than-expected inflation expectations, which highlights Powell’s mantra that there is “a long way to go” to get inflation sustainably back to 2%
Despite this more negative tone, there was resilience in equities. This can be attributed to short-covering by systematic funds which were bearishly positioned and caught out by the prior positive reversal.
Investors were also possibly mindful of the market moving into what has historically been a positive part of the year for equities.
Due to the technical nature of the bounce, it was concentrated in the mega cap “magnificent seven” of the S&P 500, with breadth not as supportive.
Find out about
Pendal Horizon Sustainable Australian Share Fund
This could suggest price action from here will be more subdued. Though we expect to see a continued grind higher given prior bearish positioning, unless fundamentals change.
Oil continued lower with Brent crude down 5.7% last week, which also supported equities.
The rate hike in Australia was well anticipated and therefore had limited market impact.
Dovish RBA commentary helped support equities and led to a sell-off in the Australian dollar.
Markets
We have often referenced the importance of positioning both at a stock and market level. This has been recently demonstrated again.
Systematic strategies such as commodity trading advisor (CTA), risk parity and volatility-controlled funds are often the marginal dollar in the market.
Going into November they were very underweight US equities with CTAs at their lowest exposure since 2018.
This coincided with historically the most positive seasonal period of the year, encouraged by reduced tax loss selling and the resumption of buy-backs.
A reversal in bond yields provided the catalyst for systematic strategies to cover their position in equities. The rush to cover led to an initial sharp move which has subsided.
But the current equity exposure is still low and vulnerable to any squeeze into market, which is why it could be supportive.
From here, there are two disparate views on the medium-term outlook:
- The bear case
The bears expect material weakening or recession in the US in 2024.
This view points to the effects of monetary tightening lagging more than usual due to longer debt duration, though still flowing through.
Recent weakening in economic data and continued tightening in credit conditions are taken as early signs of this.
In this scenario unemployment might rise materially, affecting consumption.
This could result in rate cuts sooner than expected in response to economic weakness. Though lingering inflation concerns could still cause delays.
In this scenario we could see a fall in corporate earnings and a de-rating in equity markets.
- The bull case
The bulls believe the peak in tighter financial conditions has passed and presents a lighter headwind going forward.
In this scenario, core inflation has fallen more quickly than feared. Unemployment has stayed low and GDP growth resilient, reflecting a different kind of cycle tied to the distortions of the pandemic rather than a classic ‘overheating’ cycle which requires a recession.
This view sees the recovery in labour force participation enabling wages to ease off, consumption to remain supported and real disposable income growth improving.
Should inflation continue to fall, this could facilitate potential rate cuts, providing protection against a slowdown.
The global picture
The global picture on current market valuations is mixed.
The US looks expensive at 18.5x 12-month forward price/earnings versus a 20-year median of just under 16x.
However this is distorted by mega-cap tech. Without these stocks, the market is at 16x, versus a median of around 15x.
Asia and Australia are around the 20-year median point while the UK and Europe are looking cheap by historical standards.
With almost 90 per cent of the US index having reported quarterly earnings, EPS growth is coming in at 4% year-on-year, versus 0% in Q2 2023. That reflects a stronger economy. (Ex-energy EPS is +10%.)
Despite this, expected earnings have fallen 4% for Q4 and 1% for the calendar year so far.
Q4 expectations indicate margins are set to fall, suggesting the market is reasonably cautious in terms of outlook.
US policy and economics
There were four factors to take note of in the US last week:
- Powell comments – a shift in tone from the previous week
Powell’s IMF speech struck a more hawkish tone than a week earlier. This was likely due to the risk of prompting too much optimism and becoming counter-productive. He said there was still a long way to go to get inflation sustainably down to 2%, while also noting previous “head fakes” on inflation.
Powell also toned down comments on the impact of improved supply chains versus. The benefits from supply might now wane, requiring tighter financial conditions to reduce inflation.
He also didn’t cite the impact of higher bond yields as a counter to recent strong growth, effectively recognising the rapid fall in bond yields has diminished this economic brake.
- Conditions remain tight in Senior Loan Officer Opinion Survey
A lot of the bears focus on this Federal Reserve quarterly series. The latest survey reinforced the idea that conditions remain as restrictive as they were in the prior release — which usually signals slowing credit growth.
This is understandable given the cost of debt has risen close to 10 per cent for small-to-medium enterprises.
The US relies less on bank lending than any other economy given alternatives such credit and private credit. So it may not be as negative a signal as in previous years.
- Inflation expectations deteriorating
US consumer sentiment deteriorated for second consecutive month, according to the latest University of Michigan survey on inflation expectations.
Expectations one-year forward shifted from 4.2% to 4.4%, having risen from 3.2% in September’s survey.
Five-year forward expectations rose from 3% to 3.2% — a 12-month high.
While an important signal for the Fed, this series has some caveats given a smallish sample and the historic influence of energy prices.
That said, it reinforces the Fed’s need to strike a balanced line on policy messaging and ensure expectations remain anchored.
- Atlanta Fed’s wage growth tracker slightly lower
There was no major shift in this signal on US wages. The three-month moving average of median wage growth was at 5.2%, but it did validate a recent move lower.
This measure is typically about 1% ahead of other measures of wage growth, which suggests they may be in the low-4% to mid-3% range.
This is closer to being consistent with 2% inflation.
China
There was little newsworthy from China last week. But it’s worth noting some of the real-time trackers of the economy deteriorated again in October, reinforcing the need for ongoing stimulus.
Property is still not bouncing off depressed levels and confidence remains weak.
Australia
The Reserve Bank raised rates 25bp to 4.35% but softened its language regarding the need for further hikes — perhaps to dampen down reaction to the hike.
The RBA is effectively indicating it will not raise rates again unless the data demands it.
The RBA’s updated forecasts for inflation suggest why it remains more benign on the outlook for rates.
The actual rise in CPI forced it to raise forecasts. But it’s now expecting CPI to return to a previous forecast by mid-2024 — so it’s seen as six-to-12-month phenomenon.
A lower CPI forecast comes despite higher GDP growth, driven by stronger net exports and private and public investment.
Higher employment growth and lower unemployment is expected. But wage growth is anticipated to fall as higher award wages partly offset moderating wage growth in IT, professional services and construction.
The RBA therefore seems optimistic on inflation fixing itself, as has been the case in US.
The logic is that we may be just beginning to see the first signs of consumer slowing, while falling global inflation should also help.
The RBA’s six-month stability report and quarterly monetary statement highlighted the resilience of households and businesses.
Households have taken on extra work, reduced discretionary spend and drawn on savings. Businesses have been helped by large cash buffers.
Employment income growth has been strong, particularly at the lower-income levels, even as real base wages have declined. This reflects household ability to add extra sources of income.
For the lowest quintile of households by wage real (ie inflation-adjusted) employment income has grown more than 10 per cent.
Spending remains supported by savings buffers, which are only being run down slowly and still represent more than 15 per cent of household disposable income.
The RBA stability report noted some early signs of emerging financial stress. For example:
- The National Debt Helpline has seen demand for services rising 25%, albeit off a very low base.
- Another metric uses baseline household expenditure measure (HEM) for essential expenses. The proportion of households with variable-rate mortgages where baseline HEM plus-mortgage repayments is greater than income has risen from 1% to 5% since April. If rates went to 4.6% this 5% would rise to 7%, of which 30% are at risk of depleting buffers within six months (2% of all mortgages).
- Using a broader HEM (including some discretionary expenses), the proportion of mortgage holders where HEM plus mortgages is higher than income has risen from 3% to13% since April.
- Around 25% of households have less than a three-month buffer on their mortgage.
We are approaching the end of the fixed rate re-pricing peak, with two of the eight peak months left to go.
Mortgage principal plus interest payments is now reaching the threshold of percentage of disposable income that households have historically paid, when they were making voluntary payments over and above principal and interest.
This means mortgages are now starting to eat into disposable income.
Negative equity is not near to being an issue given the loan-to-value ratio distribution.
This shows that in the event of a 10% fall in house prices there would be almost no losses for the lender — even if a portion of borrowers could no longer service mortgages.
This all highlights that the economy, households and the financial system are under strain, but have so far absorbed the rise in interest rates and the headwind of tighter financial conditions.
These headwinds may begin to fade and we may see some support from higher real disposable incomes as inflation falls relative to wages.
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 a global investment management business focused on delivering superior investment returns for our clients through active management.
Opportunities emerge in China | How rates are impacting private credit | Promising mid-cap themes | Rate pause expected
Pendal equities analyst ELISE MCKAY is bullish on data centre stocks. But some are better positioned than others. Here’s why.
- Generative AI putting pressure on data centres
- Power and water major constraints on sector
- Find out about Pendal Focus Australian Share fund
“I’M very bullish on the outlook for data centres,” says Pendal Aussie equities analyst Elise McKay, who’s just returned from a US trip where she met with participants across the “DC” supply chain.
Data centres are facilities which house heavy-duty computer systems and components used to support resource-intensive applications such cloud computing, artificial intelligence training and data storage.
In Australia an example would be NEXTDC (ASX: NXT), which is held in a number of Pendal Aussie equity portfolios.
The accelerating shift to cloud computing (on-demand access to computing resources over the internet) is driving demand, along with “generative AI” applications such as ChatGPT.
But some data centre stocks are better positioned than others, cautions McKay.
She prefers established DC owners with existing capacity — due to the time it takes to acquire land, undertake construction and manage power requirement and other complexities.
“There’s strengthening demand for DCs and supply is tightening,” McKay says.
“In some major DC locations, such as Northern Virgina in the US, vacancy rates are at one per cent. In Australia it’s closer to 17 per cent.”
Demand for energy and water
Strong demand and tight supply are conditions ripe for data centre owners to outperform — though there is a potential emerging constraint.
“There is not enough power available, especially for artificial intelligence (AI) applications,” Elise says.
Data centres use huge amounts of energy, estimated to be more than one per cent of global energy markets — and power requirements will grow demand is expcted to grow iline with DC footprints.
Access to power will a significant constraint for some players, particularly as the world focuses on the energy transition.
“It means that providers of data centres with available capacity will benefit while new entrants will be constrained by access to power,” she says.
“Power constraints are very material and data centre players need to be planning five to ten years out.
“They are now looking for solutions that go behind the meter. They are thinking about self-generation – in the future can they do small scale nuclear reactors to power data centres?
“US data centre giant Equinix is powering two Dublin two facilities with gas. This is a complex issue that needs to be solved.”
Data centres also need large amounts of water. The energy used in data centres produce heat, and the servers need to be cooled.
Technology is addressing some of the water challenges in data centres.
“New cooling technologies are being deployed with limited need to retrofit. While this is slightly more expensive, I don’t expect it to change return targets.”
“Because data centres are both power and water hungry, sustainability is now an increasing focus,” Elise says.
Elise believes it will ultimately result in stronger pricing and better returns for data centres with capacity.
About Elise McKay and Pendal Australian share funds
Elise is an investment analyst and portfolio manager with Pendal’s Australian equities team. Elise previously worked as an investment analyst for US fund manager Cartica where she covered a variety of emerging market companies.
She has also worked in investment banking and corporate finance at JP Morgan and Ernst & Young.
Pendal Horizon Sustainable Australian Share Fund is a concentrated portfolio aligned with the transition to a more sustainable, future economy.
Pendal Focus Australian Share Fund is a high-conviction equity fund with a 16-year track record of strong performance in a range of market conditions. The Fund is rated at the highest level by Lonsec, Morningstar and Zenith.
Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.
China equities are not about to outperform the broader emerging markets benchmark. But there are opportunities if you know where to look, argues Pendal’s JAMES SYME
- Over-reaction in some parts of China market
- ‘Real opportunities at these price levels’
- Find out about Pendal Global Emerging Markets Opportunities fund
PARTS of the Chinese equity market are showing opportunities at current price levels, argues Pendal emerging markets portfolio manager James Syme.
Syme and his team members — who manage Pendal Global Emerging Markets Opportunities fund — believe the EM equities asset class is dominated by bottom-up investors who, in the aggregate, alternatively underreact and then overreact to top-down developments.
“Sometimes over-reaction can occur to the downside, when groups of stocks within markets sell-off indiscriminately to unjustified levels on top-down concerns,” says Syme.
“We believe that’s happening in parts of the Chinese equity market — and that real opportunities are being presented at these price levels.”
Does that mean China equities are set to outperform the broader emerging market benchmark?
No, he cautions. “The property sector continues to struggle and the loss of market share in US imports will not easily be regained.”
But there are opportunities if you know where to look, argues Syme.
Chinese retail sales in September were up 5.5% year-on-year, but that broad measure hides greater strength in particular segments, he says.
Find out about
Pendal Global Emerging Markets Opportunities Fund
For example restaurant and catering sales were up 13.8% annually, while tobacco and alcohol sales gained 23.1%.
Stock examples
Below Syme outlines three stock examples which are held in Pendal Global Emerging Markets Opportunities fund:
Tsingtao Brewery is China’s second biggest brewer, with a 15% domestic market share.
As well as benefiting from the cyclical recovery, Tsingtao is a beneficiary of the down-shifting of Chinese consumers away from more expensive foreign brands into the company’s own premium brands, and also of a political preference for domestic brands, Syme says.
“In recent results the company showed strong growth in average selling prices and margins.
“In the first nine months of 2023, the consensus forecast for the company’s forward earnings rose 30.5%, but the stock itself declined 16.8%, putting it at an all-time low P/E ratio.”
Trip.com
Trip.com is China’s dominant domestic online travel agency providing full travel booking services domestically and internationally.
Again, the company is performing very strongly, says Syme.
“Chinese Valentine’s Day in late August saw booked hotel room nights reach a record high.
“The third quarter of 2023 saw profitable results from all listed Chinese airlines and revenue per room reach a record high for Chinese hotels.
“The shift online was hugely accelerated during the pandemic, helping Trip.com gain market share and achieve economies of scale reflected in rising margins.
“As well as domestic and international tourism, recovery in China in music festivals, business conferences and exhibitions should remain supportive.
“Yet, in the first nine months of 2023, the consensus forecast for the company’s forward earnings more than doubled but the stock itself declined slightly.”
Meituan and Tencent
Elsewhere in the consumer e-commerce space, Meituan’s continued success as a business seems to be ignored by equity markets.
The pattern is the same at online giant Tencent, Syme says.
“Tencent’s under-performance is particularly stark given the current global investor enthusiasm for stocks with AI exposure.
“Tencent is likely to be a global leader in the space, combining its existing technological strengths with a major investment program in a Chat-GPT-style artificial intelligence ‘Large Language Model’.
“You wouldn’t know that from the share price though.”
What it means for investors
This is not a ‘buy-the-dip’ argument, stresses Syme.
“It is not a deep value argument — we remain growth-at-reasonable-price investors.
“But what we are seeing within the Chinese equity market are stocks with supportive top-down conditions, strong and steady earnings growth, upbeat results and guidance from management – and valuations that look attractive relative to peers and to the stocks’ own valuation histories.
“As always with our process, it is crucial for the top-down and bottom-up investment cases to align.”
About Pendal Global Emerging Markets Opportunities Fund
James Syme, Paul Wimborne and Ada Chan are co-managers of Pendal’s Global Emerging Markets Opportunities Fund.
The fund aims to add value through a combination of country allocation and individual stock selection.
The country allocation process is based on analysis of a country’s economic growth, monetary policy, market liquidity, currency, governance/politics and equity market valuation.
The stock selection process focuses on buying quality growth stocks at attractive valuations.
Find out more about Pendal Global Emerging Markets Opportunities Fund here
Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management.
Investing in a higher-rates world | Time to consider bonds | AI’s not done yet | Watch-out on capital-intensive stocks
Equities investors have focused on operating cost inflation in recent years. Now it’s time to think more about capital expenditure, argues Pendal equities analyst ANTHONY MORAN
- Investors should focus on capex cost inflation
- Risk of blowouts in some sectors
- Find out about Pendal Focus Australian Share fund
- Watch Crispin Murray’s bi-annual Beyond The Numbers webinar
EQUITIES investors have rightly kept a close eye on company operating costs during the recent period of high inflation.
Now it’s time to pay greater attention to capital expenditure, says Anthony Moran, an analyst with Pendal’s Aussie equities team.
Operating cost inflation refers to increases in the price of goods and services a company needs to operate its business. Higher costs for raw materials, labour, energy and the like can squeeze profit margins.
Capital expenditure inflation refers to rising costs associated with long-term assets like buildings, machinery or technology, which can affect a company’s ability to grow, expand, or modernise.
“We’ve obviously gone through a period of very high inflation and spent time figuring out which stocks can pass that on to their customers through higher prices — and which stocks are exposed to the worst of the cost rises,” Moran says.
“While the market has focused on the operating cost side, it’s time to give more focus to the capital expenditure side. Any company with a fair bit of capital intensity will be exposed to price rises in coming periods.”
Price rises have occurred across the board, from gas turbines and other hard equipment to construction costs, Moran says.
“If you’re a capital-intensive company, capex inflation is going to erode returns, especially if you don’t have pricing power,” he explains.
“If you’re in an industry where there are just a few manufacturers and they all have the same cost base, maybe they can pass through the higher costs.
“But if it’s an industry like steel, which is a globally traded commodity, there is no pricing power.”
Capital intensive stocks
Moran highlights ASX-listed BlueScope Steel (ASX: BSL), which is undertaking a $1 billion reline of its blast furnace in Port Kembla, NSW.
It’s also considering increasing capacity in North America and building a coating facility in western Sydney.
Pendal Focus Australian Share Fund
Now rated at the highest level by Lonsec, Morningstar and Zenith
“They are going through a very capital-intensive phase and it’s something BlueScope must be wary of because capex blowouts could eat into the cash flow of the company,” he says.
Other examples of companies needing to maintain a strong focus on capital expenditure inflation include Star Entertainment (ASX: SGR) which is finishing off a multi-billion-dollar development in Brisbane and toll road operator Transurban (ASX: TCL).
“The revenue side of Transurban is very attractive because it rises with the CPI.
“But the company has no incremental pricing power, and it is still building its West Gate Tunnel Project in Melbourne.
“What will catch people out is when there is irregular, bumpy capex – something like replacing a plant every five years when the price of the plant has gone up considerably in that period.”
About Anthony Moran
Anthony Moran is an analyst with over 15 years of experience covering a range of Australian and international sectors. His sector coverage has included Australian Industrials and Energy, Building Materials, Capital Goods, Engineering & Construction, Transport, Telcos, REITs, Utilities and Infrastructure.
He has previously worked as an equity analyst for AllianceBernstein and Macquarie Group, spending a further two years as a management consultant at Port Jackson Partners and two years as an institutional research sales executive with Deutsche Bank.
Anthony is a CFA Charterholder and holds bachelor’s degrees in Commerce and Law from the University of Sydney.
Market sentiment may have dipped on US tech and AI stocks. But Pendal equities analyst ELISE McKAY has no doubt AI technology will be an enduring investment theme.
- Companies with data are likely to be early winners
- Infrastructure winners could change as market shifts
- Find out about Pendal Focus Australian Share fund
SENTIMENT is down on the so-called magnificent seven US tech stocks, but it would be a mistake to believe the AI theme has run its course.
That’s the view of Elise McKay, an investment analyst with Pendal’s Aussie equities team who has just returned from a US tour where she met with dozens of companies.
AI was a topic in almost every meeting, McKay says.
“AI is not a fad,” says McKay.
“Economic wobbles and geo-political uncertainty have contributed to a recent sell-off in the Nasdaq.
“But there’s strong evidence that over the longer term generative AI will have a big impact across the business landscape.”
ChatGPT is the best-known example, but the technology is driving efficiencies in everything from video creation to medical diagnosis and cyber-security.
Equities investors should keep an eye on how companies are investing in AI, as well as which infrastructure suppliers are best placed to take advantage of a fast-evolving market.
“Over the medium term I expect to see company budgets moving from things like administration, sales and marketing to IT,” McKay says.
Researcher IDC estimates IT budgets will grow by 3.5 per cent this year, and 7 per cent in 2024. A proportion of that spend is being reallocated into generative AI solutions.
An October Gartner poll found 55 per cent of organisations were in pilot or production mode with generative AI — up from 19 per cent in April.
Which companies are likely to benefit quickly from reallocation of IT spend into AI?
Look for companies with access to high-quality data as potential winners of early competitive advantage in the AI race.
“Companies with access to data which they can use to train AI models should generate further barriers to entry,” says McKay. “The strong get stronger.”
Potential infrastructure winners
There is will also be evolving opportunities among infrastructure providers, says McKay
Computer chip maker NVIDIA is regarded as a leading infrastructure winner, because its graphics processing (GP) units are in big demand by data centres needed for AI training.
But it is not the only winner.
Find out about
Pendal Horizon Sustainable Australian Share Fund
“Not only do we need ‘training models’, but we also need large numbers of ‘inference models’ and the infrastructure required to support them,” says McKay.
Generally, a generative AI model is trained by exposing it to a large amount of data. This model training is resource-intensive and often happens in big, centralised data centres powered by thousands of computer chips. Over the long term, McKay expects this market to become more commoditised.
On the other hand, inferencing makes use of previous training or live data to solve a task.
This process requires less computing power and can take place on the “edge” of a network – closer to applications.
The inference market will be more highly distributed with greater opportunity to value-add, predicts McKay.
“Inference will need to take place away from big data centres at ‘the edge’ in metro data centres, smart phones, cars and the Internet of Things to ensure mass adoption and minimise latency.
“Infrastructure requirements will be wide and varied with no one player controlling the market.
Next week: Elise will share more insights on the AI infrastructure market
About Elise McKay and Pendal Australian share funds
Elise is an investment analyst and portfolio manager with Pendal’s Australian equities team. Elise previously worked as an investment analyst for US fund manager Cartica where she covered a variety of emerging market companies.
She has also worked in investment banking and corporate finance at JP Morgan and Ernst & Young.
Pendal Horizon Sustainable Australian Share Fund is a concentrated portfolio aligned with the transition to a more sustainable, future economy.
Pendal Focus Australian Share Fund is a high-conviction equity fund with a 16-year track record of strong performance in a range of market conditions. The Fund is rated at the highest level by Lonsec, Morningstar and Zenith.
Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.
Here are the latest insights on inflation, rates, bond yields and credit from Pendal’s head of government bond strategies TIM HEXT
- Why bonds, why now? Pendal’s income and fixed interest experts explain
- Browse Pendal’s fixed interest funds
Another week, another rise in yields; Australia the worst developed market
AT THE time of writing, Australian 10-year bond rates were up another 0.24% for the week – despite little hard data to explain it.
True, the Reserve Bank is expected to hike rates next week. But long bonds have underperformed short rates, which is not what you’d expect.
Interestingly, Australia was by far the worst performer among global markets. Europe was largely unchanged and the US was only 0.05% higher.
So we’re left with various possible explanations — though if truth be told, the scale of the selloff is a surprise to all.
One economic explanation is that our inflation seems to be settling down near 4% while the US is at 3%.
Even though our short rates are lower than the US, markets (for now) do not expect that to last in the medium term.
Maybe it was the avalanche of supply this month finally catching up with markets.
The Australian government issued $8 billion of 30-year bonds which seemed to fill in all buyers requirements.
Find out about
Pendal’s Income and Fixed Interest funds
Added to this was $13 billion of semi-government issuance this month, nearly all 10-year maturity or longer.
Corporates also issued $11 billion, larger than normal, with no signs of slowing down.
10-year yields knocking on 5%; semi-government bonds above 6%
Markets are now pricing inflation of 2.75% and real yield near 2.25% for the next 10 years.
South Australia on Tuesday today issued a 2038 maturity at 6.15%!
Perhaps term deposits will keep creeping up to 6% and stay there for the next 15 years. But I suspect that will not be the case.
This highlights the increasing hurdle rate for any other investment — be it equities, property or even absolute return strategies.
RBA likely to hike on Tuesday; but probably not beyond
The RBA has cornered itself into a rate hike through overly optimistic inflation assumptions made in August.
Though, we must emphasise the numbers were not that bad.
Market reaction would have you believe inflation is once again accelerating — though it was largely oil based, the price of which has now come back.
Inflation is still too high, but the RBA is not playing catch up.
The Q4 numbers out late January should be in the region of 0.7 to 1%, again confirming a pattern of inflation slowing to under 4%.
This makes a February rate hike, now priced at slightly over 50%, unlikely.
We have therefore tentatively dipped our toes into short-end duration, though saving some firepower for a move closer to 100% priced.
Credit has largely ignored equities this month
Finally, we should note the impressive performance of credit this month.
No, it hasn’t contracted. But it has also barely widened, despite higher yields and weak equities.
Last year those two events would have led to a decent widening in credit. This year the mood is different, since inflation is seen as under control and central banks largely done.
Earnings have also held up well with the stronger-than-expected economy. Liquidity could become more challenged into year end. But for now credit markets are functioning well.
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.
Here are the main factors driving the ASX this week according to portfolio manager PETE DAVIDSON. Reported by portfolio specialist Chris Adams
CONCERNS about the Middle East and Ukraine, ongoing tight money conditions and an opaque inflation outlook are weighing on equity markets.
On a positive note, we’ve seen an improvement in US domestic politics with the appointment of a House speaker after a three-week hiatus. Though the underlying US political backdrop remains deeply partisan.
Oil prices remain elevated but have not spiked despite Middle East mayhem. Crack spreads — the pricing difference between a barrel of crude and all the petroleum products refined from it — are actually pointing to lower oil prices.
Gold and natural gas prices also remain high.
Iron ore prices are up on expectations of a China stimulus package and lower Chinese domestic iron ore production.
In Australia, a September quarter consumer price index (CPI) of 1.2% pointed to a re-acceleration of inflation, with stickiness in rents and services.
Aussie two-year and 10-year government bond yields were up 10bps and 7bps respectively last week.
The S&P/ASX 300 shed 1.05% for the week, led down by interest-sensitive sectors such as real estate (-4.33%) and technology (-3.60%)
Simply put, higher rates are likely to reduce an already muted earnings growth outlook.
US macro and policy
Overall, the economic consensus in the US is now the Goldilocks scenario of inflation on a glide-path to 2%, with GDP slowing and a soft landing.
This is what’s currently in the price.
US GDP growth remains strong and US consumers are still spending.
However there are straws in the wind that suggest growth might be slowing — including a plunge in the recent EVRISI homebuilder survey and some softer manufacturing indices.
Labour costs and services inflation remain thorny issues for inflation. However Covid-inspired quit rates are slowing, helping the outlook for slowing labour price gains.
It’s interesting to note the US has a real (inflation-adjusted) cash interest rate of 1%, versus zero for Europe, about -1% for Australia and -3.5% for Japan.
Find out about
Crispin Murray’s Pendal Focus Australian Share Fund
Higher real cash rates help lower inflation. Jamming the Fed funds rate above the inflation rate worked in 1979 for Fed governor Paul Volcker, who broke the back of inflation.
The US yield curve is now much less inverted than it was mid-year. The spread between 10-year and two-year nominal yields has fallen from about -100bps to -20bps.
We continue to watch a number of factors which have driven 10-year yields to 20-year highs. These include:
- Strong Q3 GDP growth of 4.9%
- Increased supply of Treasuries as the fiscal deficit expands
- Reduced demand for US government bonds from global investors. There is also competition from rising yields on offer in Japan
- Reduced demand from the Fed
Looking at the past eight Fed tightening cycles, bond yields fell post the final hike each time by 90bps on average over the following six months — irrespective of whether a recession or soft-landing followed.
However history also shows that sharp rises in 10-year bond yields often culminate in a financial “accident” such as the 2018 global sell-off or the 2013 “taper tantrum”.
We did see the US banking crisis earlier in the year and we remain on watch for other signs of stress.
Australian macro and policy
September’s CPI came in at +1.2% for the quarter, up from a +0.8% rise in the previous quarter.
It was 5.4% year-on-year, down from 6% in the June quarter.
The trimmed means were 1.2% for the quarter and 5.2% for the year.
The devil was in the detail. Food grew only 0.6%, helped by deflation in the fresh food category. Meanwhile subsidies helped rein in growth in the childcare and electricity components.
Services inflation remains elevated, driven by rents and insurance. It’s likely that growth in the rental component is understating the actual state of rents.
An RBA rate hike is now more likely in November.
We do note that accounting software company Xero’s data suggests wages rose just 1.9% in the year to September and averaged 2.7% in the prior three months for Australian small businesses. This is a positive trend for inflation.
Labour cost growth is starting to trend down, according to the latest NAB business survey.
About Pete Davidson and Pendal Focus Australian Share Fund
Pete is Pendal’s head of listed property and a portfolio manager in our Aussie equities team. For more than 35 years, he has held financial markets roles spanning portfolio management, advisory and treasury markets.
Pendal Focus Australian Share Fund is Crispin Murray’s . 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.
What to expect on Cup Day | Outlook for China stimulus | Stock-picking in a higher-for-longer world | The wider impact of GLP-1 drugs