Effective 3 October 2022 we are changing the Fund’s custodian from the Hong Kong and Shanghai Banking Corporation Limited, Sydney Branch (HSBC) to the Northern Trust Company.

Also effective 3 October 2022 we are changing the Fund’s administrator from Westpac Financial Services Group Limited to The Northern Trust Company.

The Great British Sell Off: The fiscal support package announced in the UK on the weekend could make inflation even harder to control, TIM HEXT explains.

CENTRAL Banks, led by the Fed, have spent the last few months pushing hard their hawkish credentials.

We have been told that combating inflation is priority one and if it means a recession then so be it. Markets have reacted by selling off risk but also moving rate expectations a lot higher.

However, the new UK Prime Minister Liz Truss and her Treasurer Kwasi Kwarteng have taken a more unconventional approach.

They seem to be focused on avoiding recession and hoping that somehow inflation will sort itself out.

Inflation is at its heart a demand versus supply problem. Central banks can’t control supply so they try to impact demand through rates. Fiscal policy can impact supply but it needs to be very targeted.

As a large energy importer the UK has little control over energy supply, at least short to medium term.

The fiscal support package announced on the weekend is partly an attempt to help address supply problems, but markets have taken it as merely propping up demand that is already too high.

GBP 72 billion of tax cuts were made across national insurance, corporate taxes, stamp duty and income taxes. Much of it will find its way to the wealthy, with more of a propensity to save than spend.

All this is on top of energy price caps that at current rates are worth GBP 160 billion over the next three years. They at least will keep headline inflation in single digits.

The Bank of England is now faced with an even harder job to rein in inflation.

Markets have taken it that way, now pricing terminal rates above 5%. This was nearer 4% last week.

However, it is the extra supply that the bond market and currency market are struggling to assess.

At an extreme the price of 30yr UK Debt fell 10% after the mini budget. So far in 2022 UK 30 year debt has halved in price.

This all impacted on global bond markets in another tough week.

UK investors will potentially move money back onshore as their currency and rates become relatively more attractive.

Terminal rates in Australia are now back to pushing near 4.5%. Whilst domestically this looks very restrictive, global investors are not hanging around to find out.

Time will tell whether this huge gamble by Liz Truss pays off.

If global energy prices plummet, then they may get away with it. As it stands now though, markets are taking the view that the UK is falling deeper into a hole.

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

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

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

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

Find out more about Pendal’s fixed interest strategies here

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About Pendal

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

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

Contact a Pendal key account manager

Here are the main factors driving the ASX this week according to Pendal’s Head of Equities, Crispin Murray. Reported by portfolio specialist Chris Adams

CHAIR Powell reiterated his message that the Fed will continue to tighten quickly, even if that threatens to trigger a recession.

This prompted market pain last week. The S&P 500 fell -4.63%, through a previous support level, and is now retesting year-to-date lows. So too are high yield credit spreads, the copper price and Australian equities (which fell -2.48%).

Elsewhere the US dollar index rose to year-to-date and twenty-year highs, US bond yields hit year-to-date and twelve-year highs, the oil price fell to its lowest point since the invasion of Ukraine, and both French and German equities broke to new lows for the year.

In the US, commodity prices, freight rates and used car prices are all falling. But service sector inflation continues to rise and the labour market has not cooled enough.

The market fears the Fed will break the economy, with rates rising too quickly. As a result, we appear to be entering the capitulation / liquidation phase of this bear market, where the orderly sell-off gives way to fear and more indiscriminate selling.

Currency appears to be at the nexus of this sell-off. There is less confidence in the British Pound and the Japanese Yen due to fiscal and monetary policies. This is driving strong flows into the US dollar, which causes stress on risk assets generally.

There is a circularity in FX markets. As the US dollar rises it increases inflationary pressure in other countries, forcing them to consider more rate hikes. The on-going sell-off in bonds, despite growing concerns on recession, also points to liquidity issues.

Bulls are pointing to extremely weak sentiment, that we are at peak inflation hawkishness and the belief that the support levels currently being tested can hold. It is also possible that the Fed may send some small signal to prevent the market becoming disorderly.

Overall, we remain cautious in the near term. However we are mindful that these episodes can present attractive opportunities on a medium-term view.

Policy and economics

US

While the 75bp hike in rates to a 3.0-3.25% range was largely expected, the Fed’s hawkish stance weighed on markets.

Powell’s comments that there “isn’t a painless way to get inflation down,” that “the housing market may have to go through a correction,” and that there will “very likely be some softening in the labour market” all point to a clear effort to change the market’s mindset and flush out any hope of pivoting.

This rhetoric, combined with the shift in “dot plots” of future hikes moved the expected rate profile higher. November is now expected to see another 75bp hike, with 50bps more in December and 25bps in February. This implies rates peak at 4.5% to 4.75%.

The Fed also increased their expected unemployment rate at the end of 2023 from 3.9% to 4.4%. Such a move would be consistent with a recession, suggesting that they are prepared to keep hiking rates into a recession.

The 2 year government bond yield rose 34bps to a cycle high of 4.21% in response.

One challenge for the Fed – and the market – is that the economic data is not looking that soft. It may also remain supported by the fiscal drag easing off and by pent-up demand in autos and services, while the backlog of unfinished homes will underpin construction in the short term.

In addition, the labour market remains tight. The difference between job openings and unemployed peaked at 5.9m, which is the highest ever as a percentage of the workforce. This creates pressure on wages.

Goldman Sachs estimate this has to fall to 2m to loosen the labour market enough to get to back to 3.5% wage growth, which is consistent with 2% inflation. So far, this has only dropped to 5.2m.  This makes it difficult for the Fed to signal a significant pivot in approach.

The market’s fear is that the pace of hikes is too quick to be able to assess their impact and the Fed is therefore making a significant policy mistake that sends the economy into recession and may trigger some form of financial shock.

In response, the Fed is saying this is not a mistake. Rather, it is what needs to happen to solve the inflation problem.

Either way creates risk to corporate earnings.

UK

The scale of fiscal stimulus in the new UK Chancellor’s “mini” budget went beyond most expectations.

The government will spend GBP45bn, equivalent to 1% of GDP. Most expected something in the order of GBP30bn. This comes on the heels of the energy pricing policy, which is expected to cost at least GBP60bn in its first year.

This largesse has been widely condemned on the premise that such strong fiscal expansion in an inflationary environment will only force the Bank of England to raise rates more aggressively.

UK government bond yields surged 35-50bps across yield curve in short order. The UK 5 year bond was yielding below 2% on 15^th August and is now 4.15%.

The broader fear is loss of confidence in the UK. This is reflected in currency markets, where the GBP fell 5% against the USD over the week to reach record lows.

The Bank of England raised rates 50bps during the week, but would not have anticipated this degree of fiscal stimulus. The market is now pricing in a potential intra-meeting rate hike by the BOE, to try to protect the pound.

Japan

Intervention by the Bank of Japan on behalf of the Ministry of Finance to support the yen – for the first time in twenty four years – shows another source of stress in forex markets.

It came in response to the BOJ’s continued commitment to yield curve control and comments that there would likely be no need to raise rates for two years. While providing short-term relief for the yen, the market remains sceptical that it will ultimately prove successful, with Japan the only buyer. There is also the question of how deep are Japan’s pockets. It has US$1.3 trillion of forex reserves, but much of this is in US Treasuries, which it is unlikely to liquidate to fund intervention – although it does highlight some concerns regarding liquidity in the treasury market.

Markets

Both the S&P 500 and the NASDAQ look set to test their year-to-date lows. There are plenty of negative signals at present, including:

1. Bond yields hitting new highs for the cycle. The ten year yield is at decade highs for the first time in forty years, perhaps signalling a regime shift. Higher rates means lower valuation ratings and the US equity market is still sitting at higher-than-average P/E ratios. This means valuation is not a supportive factor.
2. Key equity markets in Europe have already broken to new lows and may potentially lead the US.
3. Major stocks such as Microsoft and Google – and key sectors such as semis and software are hitting new lows. Although at this point stocks such as Apple and Tesla haven’t broken to new lows and are helping prop the index up.
4. Sectors such as energy which have held the market up are now seeing significant selling.
5. Market breadth remains wide as the index falls. Typically trend shifts are preceded by narrowing markets, which we are yet to see.
6. Volatility hasn’t yet spiked to levels normally seen near a market bottom.
7. The option market – as measured by the put / call spread – is not positioned at extremes.
8. Real rates (nominal rates minus inflation) have risen sharply, which has been required to anchor breakeven inflation expectations. One thing to note is that real yields have been the driver of the relative performance of growth versus value in recent years, which would indicate there is risk of further rotation away from growth.

Overall, this feels like the capitulation phase is beginning to kick in. This will present opportunities, but the lesson of prior bear markets is to be careful not to jump in too soon.

There is a risk the moves we are seeing trigger forced selling. We note that US households still have high holdings in equities and some foreign central banks may liquidate to get access to their reserves. There is also now a decent carry on cash and fixed income, offering an alternative to equities.  The counter-risk, mentioned above, is that the Fed steps in with some signal to calm markets.

Australia

We continue to see the Australian market as more defensive. It trades on a P/E of 12x, versus the S&P 500 at 17x, while the economy is supported by higher savings, a less aggressive central bank, supportive terms of trade and immigration.

The issue for Australia is as much as the RBA may want to limit rate rise, there may be a limit to the gap between our short-term rates and those in the US, before it creates issues with the currency which would exacerbate inflationary pressures.

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About Crispin Murray and Pendal Focus Australian Share Fund

Crispin Murray is Pendal’s Head of Equities. He has more than 30 years of investment experience (including 28 years at Pendal) and leads one of the country’s biggest equities teams.

Crispin’s Pendal Focus Australian Share Fund has beaten the benchmark in 12 years of its 16-year history (after fees), across a range of market conditions.

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

Find out more about Pendal Focus Australian Share Fund 

Contact a Pendal key account manager here

Here are the main factors driving the ASX this week according to portfolio manager Jim Taylor. Reported by portfolio specialist Chris Adams

THE market was positioned for good news on the US inflation front – and took a hit when the CPI came in slightly stronger than expected.

A strong inflationary pulse across a broad range of categories ran contrary to a prevailing narrative of softer inflation.

In an environment where the Fed is driven by data – rather than by its own forecasts – sentiment on the monetary policy path shifted quickly.

The Fed funds rate is now expected to reach 4.2% in December 2022, up from 3.9%.

Equity markets took a hit. The NASDAQ fell 5.54% on the day of the data print – its worst fall since March 2020. The S&P 500 was off 4.3%, its worst since June 2020.

Poor sentiment was compounded by pre-released earnings from Fedex, which saw quarterly EPS at $3.44 versus $5.15 consensus expectations and an even bigger shortfall on next-quarter guidance.

Management cited softer demand, weakening further into the quarter’s end, both in the US and internationally. This exacerbated concerns around the economic backdrop.

The S&P 500 fell 4.7% for the week. The S&P/ASX 300 was down 2.2%.

US inflation

Headline CPI rose 0.1% month-on-month in August, against an expected decline of 0.1%. On an annualised basis inflation is running at 8.3% versus 8.5% last month – again higher than the expected 8.1%.

Core CPI rose 0.3% to 0.6%, higher than 0.35% forecast. Annualised, it is running at 6.3% m/m, versus 6.1% expected – the highest print since March.

The key concern was the breadth of disappointing numbers across multiple buckets including shelter (34% component), new and used cars (8%), medical services (7%), food away from home (5%), apparel (2%), utility gas service (1%) and motor vehicle repair (1%).

Inflation is no longer driven by energy and food.

Housing inflation is a slow-moving part of the US CPI data. Landlord rent expectations have fallen recently but will take a while to flow through into the data.

The next biggest segment is new and used car prices. These have definitely turned down, which is helpful.

Wage pressure in healthcare is a global phenomenon and is likely to continue ticking up as wage demands are met.

More positively, airline fares fell by 4.6% in August – less than expected. This should continue to fall as airfares follow jet fuel prices quite closely, and they have reversed most of the spike triggered by the war in Ukraine.

Food inflation is finally moderating. The 0.7% increase in food-at-home prices was the smallest since December, after seven straight 1%-plus increases.

Lower global food commodity prices are starting to work through, with more to come.

Petrol pump prices are down to $3.69/gallon – 26% below an all-time high in June and the lowest level in six months.

The “peak inflation” narrative is probably still intact, but the core components remain stubbornly sticky.

Producer Price Index data (see below) suggests some relief is on the way. But it won’t matter this week.

Fed officials have made it very clear they will not slow the pace of rate hikes until they see convincing evidence that core inflation pressure is easing on a sequential basis.

The chance of a 50bp hike this week has gone.

The market has wavered between a 20%-30% chance of a 100bp hike.

The chance of a soft economic landing has fallen for two key reasons:

1. Strength and stickiness in both goods and services inflation indicate meaningful reductions toward 2% are impossible without a recession and a big fall in employment
2. The risk of a Fed overshoot has increased, meaning a recession gets induced almost regardless of what the data does from here.

US PPI

The Producer Price Index data was more reassuring than the CPI print.

Headline PPI fell 0.1%, in line with consensus, helped by falling energy prices. Annualised, it is 8.7%. This is down from 9.8% in July and 11.2% in June.

The key message here is that Core PPI inflation is now falling across both goods and services.

Core goods rose at a 6.1% annualised rate in the three months to August, exactly half the peak pace in the three months to May.

Core services rose 3.9% in the three months to August. This was an even bigger slowing from the 10.8% peak in the three months to March.

Consumer inflation expectations have plunged for both the three and five-year time horizons.

Other US data

The Atlanta Fed Wage Tracker grew to 6.7%.

Companies that have high turnover of low-paid workers are feeling the full force of wage pressures in the economy. Wage growth for job switchers far exceeds that for people staying with their current employer. 

Retail sales were slightly disappointing with core sales down 0.3% versus flat expectations. 

But they haven’t fallen off a cliff and may reflect higher petrol prices over the past few months, which have now reversed.

Australia

GDP data in the second quarter showed continued strength in consumer spending, driven by a rebound in services. This included a quarter-on-quarter rise of about 30 per cent in tourism-related spending.

It seems likely that the consumer hangs in there for another few months, before feeling the pinch in the December quarter as increased mortgage rates flow through to household cash flows.

Employment increased 33,000 in August. This was in line with consensus but only partially reversed the prior month’s 41,000 decline.

At the same time, labour participation moved back close to its record highs (66.6%) and unemployment ticked up to 3.5% (consensus expected 3.4%).

Hours worked also recovered most of the prior month’s losses (0.8%) and the under-employment rate fell to 5.9%.

It’s notable that the number of workers affected by sickness remains nearly double its usual amount (about 750,000).

The data hasn’t moved expectations for another 100bps of tightening across Q4, taking rates to about 3.35%.

Europe

The EU has proposed a redistribution of excess profits from energy companies and non-gas-power generators (nuclear and renewables), totalling an estimated EUR 140 billion.

This would involve a price cap of 180 euros per megawatt hour, which would raise about EUR120 billion.

The balance would come from energy companies contributing a third of any profit more than 20% over the last three-year average.

The plan is complex and will take time to put into practice. Each member state would have jurisdiction over key aspects.

The plan includes a binding agreement to get winter peak electricity use down by 5% – and overall 10%.

Markets

Australia held up better than other markets last week due to index composition.

Large caps did better than small caps. Small resources and REITs bore the brunt of the sell-off. Interestingly, consumer staples did not prove to be defensive in the weak market and we saw a clean sweep of negative returns across all sectors.

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About Jim Taylor and Pendal Focus Australian Share Fund

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

Why RBA will likely stay patient | What Albo’s emission targets mean for investors | What looks good in listed property | This year’s big ESG themes

US rates are heading for 4% after inflation remained high in August. But the RBA may have more patience. Pendal’s TIM HEXT explains why

ALONG with many other observers, we expected US inflation to moderate more than it did in August.

Headline CPI came in overnight at 0.1% (8.3% annual) and underlying at 0.6% (6.3% annual).

A new group of unrelated components (including vehicle repair, dental charges and tobacco) showed fresh signs of inflation, pushing the rate positive for the month.

We still expect goods deflation in the months ahead. Oil prices and most other commodities are weak.

But US wage growth is spreading inflation wider into services. Services inflation is now the battleground and labour supply lines are normalising far slower than goods.

What little patience the US Federal Reserve may have had is running out.

Fed funds now seem destined for 4% or higher. As little as six weeks ago the market was expecting terminal rates closer to 3%.

RBA may be more patient

As always, Australian bonds will follow the US. But the RBA seems prepared to show a bit more patience.

This is due to a number of factors — but the two main ones are wages and our floating rate mortgage market.

The NAB business survey showed that rate hikes are yet to have any impact.

This is not surprising as the economy is now almost fully open, many have pent-up savings to spend and fixed rates are protecting 40 per cent of mortgage holders.

The RBA remain on course for 3% cash rates by year end (either 2.85% or 3.1%).

It will likely rely on the fixed rate mortgage cliff and immigration to do the heavy lifting to combat inflation in 2023.

Bond markets are caught in the loop of pushing rates up with the Fed but also with one eye on increasing recession risks.

Flatter curves seems to be the favoured way of reconciling these two outcomes.

Credit and equity markets were hit by the high inflation numbers, but for now look to be range-trading rather than breaking down.

The only certainty for now is volatility is here for a while yet.

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

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

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

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

Find out more about Pendal’s fixed interest strategies here

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About Pendal

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

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

Contact a Pendal key account manager

Energy security and workplace relations were the big ESG themes in this year’s ASX reporting season, says Pendal’s RAJINDER SINGH

• Labour and energy were key ESG themes this year
• Investors should scrutinise capital spending
• Find out about Rajinder’s Pendal Sustainable Australian Share Fund

ENERGY security and workplace relations were among the big ESG themes to emerge from this year’s annual reporting season, says Pendal’s Rajinder Singh.

The volatility of energy supply amid disruption in energy markets has become abundantly clear in the last six months, leaving companies with real challenges on how to respond, says Singh, who manages sustainable Australian share funds for Pendal.

And the emerging theme of labour shortages and industrial action by workers is starting to show up as a key risk for Australian companies.

“This reporting season was quite interesting because we have this ongoing bounce-back out of Covid, while at the same time there are top-down geopolitical issues and the bogeyman of inflation and interest rates,” says Singh.

“And we’re seeing ESG perspectives play out as well.

“A lot of companies have momentum on planning for net zero and building out renewable energy targets. But at the same time they are getting hit by massive volatility in energy prices.”

“My one-liner to clients has been this: there’s plenty we don’t know about the energy transition, but what we do know is that there’s going to be increased volatility.

“That is the real challenge for companies on how they respond to that.”

Energy is a material input for many companies, meaning the cost of electricity, gas and fuel can be important factors affecting profitability.

Singh says this reporting season saw companies weathering energy volatility on the back of fixed price energy contracts entered before price rises.

“The question will be what happens when those contracts reset.

“Perhaps ironically, the companies that signed power purchase agreements using renewables are beneficiaries of this environment.

“Even though they may have signed their agreements at a higher-than-prevailing electricity prices a year ago, that’s a fraction of what the spot prices are now so they’re effectively hedged.”

Energy security issues and supply chain problems are playing out against the backdrop of decarbonisation across industry.

“Companies are scrambling to solve today’s supply chain and energy problems, but they are also in the medium to long-term grappling with decarbonisation goals.

“Previously, signing up to renewable energy, putting solar panels in and making your vehicle fleet a bit more efficient by buying EVs was easy. Now there’s a problem.

“You can’t get EVs, electricity prices are moving all over the place, and you can’t back it up with gas.

“There’s a lot more considerations that companies need to make because of this energy volatility.”

Industrial relations back on investor radar

Another ESG theme that emerged from reporting season related to labour supply, from COVID-related absenteeism to industrial action and wages.

“The federal government’s recent Jobs Summit elevated industrial relations back onto the national agenda, but it was already showing as an issue in reporting season,” says Singh.

“What we’re seeing is the importance of how companies do their human capital management – labour was taken as given but that’s changed. Labour has become harder to find.”

What does it mean for investors?

For labour, Singh says investors should seek to understand the nature of companies’ agreements with workers.

“When strikes in Sydney mean the trains aren’t working every second day, it provides a precedent for how things will get resolved going forward.

“If you’ve got an agreement that’s due for renegotiation in the next 12 months versus one that was signed for five years, that could have a material impact on your forecast growth of your labour costs.”

Look for energy security

For energy, security of supply is critical, says Singh.

Partly this can be solved simply through dealing with larger companies – “there’s security in size,” says Singh.

But it’s also important to seek security in geography, he says, using battery mineral lithium as an example.

“The two biggest sources of lithium are hard rock in WA and brine at altitude in the Andes in South America. The regulatory environment is a lot different.”

Singh says investors should seek out companies that are clearly facing up their energy problems no before the problems become more acute.

“That could be contingency plans in the short to medium term, but you also want to see evidence that the plans will enhance their transition in terms of energy efficiency, replacement of vehicles and investment in technology.

“The other thing that matters for investors is understanding the required capital expenditure.

“What’s the capital allocation to these initiatives? And is there an actual measurable benefit for the amount they are planning to spend?”

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About Rajinder Singh and Pendal’s responsible investing strategies

Rajinder is a portfolio manager with Pendal’s Australian equities team. He has more than 18 years of experience in Australian equities.

Rajinder manages Pendal sustainable and ethical funds including Pendal Sustainable Australian Share Fund.

Pendal offers a range of responsible investing strategies including:

• Pendal Sustainable Australian Share Fund
• Crispin Murray’s Pendal Horizon Fund
• Pendal Sustainable Australian Fixed Interest Fund
• Pendal Sustainable Balanced Fund
• Regnan Credit Impact Trust
• Regnan Global Equity Impact Solutions Fund

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

Responsible investing leader Regnan is part of Pendal Group.

Contact a Pendal key account manager here

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

MARKETS bounced last week on the back of falling European power prices, a lower oil price, a stalling US dollar and signs that the US economy continues to hold up.

This offset a 75bps rate hike and hawkish message from the European Central Bank and a continued rise in bond yields.

The S&P 500 rose 3.7%, off a key technical support level around 3900. This suggests it may be in a 3900-4200 trading range. 

The Australian market was more subdued, up 1.5% (S&P/ASX 300) since it had not undergone as sharp a fall in recent weeks.

Australian 10-year government bond yields fell 9bps — disconnected from a 12bp rise in US 10-year Treasuries — on the back of a dovish interpretation of the RBA governor’s speech.

This week’s key data point will be US inflation (out Tuesday night Australian time), which will help shape the outlook for rates.

The market remains at a “sliding doors” moment between two potentially very different outcomes, shown here:

The market is like a pendulum swinging between the two outcomes.

It is reacting badly to signals of more tightening, fearing a policy mistake will trigger a recession.

It then swings more positively when data indicates the economy is more resilient and inflation signals are improving.

Policy outlook

There has been a clear shift in the market’s view on monetary policy in recent weeks.

It is now expecting more hawkish outcomes from central banks, pricing in a 75bp hike at the Fed’s next meeting, with rates peaking around 4%.

This view was bolstered by the ECB raising rates 75bps, with unanimous support from committee members.

It is also signalling further hikes over the next three-to-four meetings, with President Lagarde saying they are still far from “neutral” settings.

The market is now pricing a 60% chance of another 75bp in November, a further 50bp in December and 30bp in February. This would mean rates peaking at 2.25% early next year.

This is a substantial shift in expectations. Only two months ago the market was pricing a peak rate below 1%.

The ECB, like the Fed, has decided to front-load rate hikes.

We suspect the motivation is a combination of:

1. Faster moves are containing inflation expectations and wage growth sooner, which ultimately means lower rates in the medium term
2. The economy is still in reasonable shape. If it weakens, there will be greater political pressure to avoid rate increases. So it is best to act now while they can.

Real rates (nominal rates minus inflation) have risen in response to the shift in expectations around central bank policy.

US real rates were about -1% a year ago. They rose to 0.5% in June, fell back to zero, then have risen to 1% in the past six weeks.

This has contained inflationary expectations in the US and has helped support the US dollar.

We also note that rising real rates have a negative correlation to tech sector relative performance.

So the call on how much further real rates rise is key for sector positioning. 

European energy impact

Ironically, European gas and power prices fell 30% and 50% respectively in response to Moscow’s decision to stop gas flow through the Nordstream 1 pipeline.

This is probably because it is seen as Russia’s trump card against the EU and there is little else to escalate an economic war.

This has given some relief to the European economic situation. But it remains very fragile, with power prices still far too high, forcing the ECB to hike faster.

We are seeing an emerging policy response to the situation.

The UK announced plans to hold power prices flat at current levels for consumers and some businesses. This effectively means the UK government is short the gas market.

The support package is set to cost GBP150 billion over two years at current gas prices. If gas prices returned to recent highs it would add about GBP100 billion to the bill.

The consequences are intriguing.

It reduces the expected inflation peak from more than 15% to sub 10%, occurring in Q4 2022 instead of early next year. This helps keep inflation expectations anchored.

However it requires a lot more borrowing and helps support consumption.

This means the Bank of England may need to raise rates higher than previously expected to achieve the targeted slowdown in core inflation. UK 10-year bond yields rose 20bps to 3.1% in response.

Europe is expected set to unveil its response in the next few days.

The short-term policy will seek to:

• Cap gas prices
• Tax fossil fuel companies
• Encourage a co-ordinated reduction in energy consumption (targeting a 15% fall in gas consumption and a 5% reduction in peak energy consumption across winter)
• Examine liquidity requirements for the utility industry to prevent unintended issues such as counterparty risk.

In addition, the EU commission is reviewing the fundamental design of power markets and will report back in 2023.

This combination of a hawkish ECB, lower European gas prices and fiscal policy response led to the Euro bouncing off its lows against the US dollar. There is a school of thought that with other central banks stepping up rate hikes — and the Fed potentially slowing after September — this may mark a top in the US dollar index (DXY).

This would support a more benign outcome for markets. 

Russia does have the ability to escalate the economic war should it choose to.

There is still some gas going through Ukrainian pipes (about 10% of previous Russian supply). More significantly, it still provides some 30% of Europe’s diesel supply.

US economics

On balance, US economy data remains positive.

Gas prices and freight rates continue to fall quickly. Evercore ISI survey data suggests consumer confidence is holding up, probably reflecting the lower gas prices.

The same set of surveys show retail pricing power is falling and rents are showing signs of slowing.

It is not all good news.

A research piece from the Brooking Institute flagged that the Beveridge Curve (the relationship between job openings) shifted materially as a result of the pandemic.

The analysis indicates this is the best measure of labour market tightness and is signalling there is still substantial labour market supply shortages.

Even if two thirds of this move reversed, it would still mean inflation remaining higher for longer and requiring significantly higher interest rates to resolve.

The fact that inflation was not just a supply shock (which is resolving) but also a demand shock (notably in durable good) adds to the challenge.

The paper concludes that the Fed would need unemployment to hit 6.5% if it wanted to meet the 2.5% inflation target by December 2024.

This would mean rates have to go much higher to go than the market is currently expecting. It would also mean a significant recession.

The other conclusion to draw is that the inflation target could be shifted “temporarily”.

For example, a target of 3% inflation would require a 4% unemployment rate in 2023-24.

This is academic research and many variables could change the outcome.

But the point is that while the market focuses on near-term signals shaped by commodity price moves and inventory swings, the longer-term driver of inflation is the labour market.

There is a risk that this leads to inflation outcomes disappointing in the future.

Oil

Oil continues to trade poorly and broke down through support levels last week.

Oil bulls maintain that fundamentals are very supportive. They say financial market factors are affecting the price in the near term and these could unwind.

There are two key elements of this argument:

1. Inventory levels are declining once the strategic petroleum reserve (SPR) releases are excluded, leaving underlying markets very tight
2. Contrary to perceptions of a weaker global economy, demand has not been materially softer

The long-awaited Iranian oil deal now looks less likely, which removes a potential supply shock.

Australia

The RBA raised rates another 50bp, but the market was more focused more on the governor’s post-meeting comments.

There was the obvious observation that as rates get higher, there is a rising likelihood of a slowdown in rate increases.

But reference to the 2-3% inflation rate as a medium-term target was a more important dovish signal.

If central banks are prepared to allow inflation run a bit hotter for a bit longer, they don’t need to be as aggressive on the level of rates.

This is what the market and the government wants to happen. The RBA, under pressure and not wanting to be blamed for causing a downturn, appears prepared to oblige.

There is some logic to this. Australia has had a lower consumption boom, higher savings and lower wages growth than the US.

The RBA will be hoping that other central banks actions will ease global inflationary pressures, doing a lot of their work for them.

A more benign rate cycle would be good for Australian equities relative to other markets.

The risk to this approach is that inflation doesn’t fall as quickly as hoped — and we are left needing to do more later. Interestingly this is the opposite approach of most other central banks, which are signalling they will be more aggressive sooner and front-end hikes.

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About Crispin Murray and Pendal Focus Australian Share Fund

Crispin Murray is Pendal’s Head of Equities. He has more than 30 years of investment experience (including 28 years at Pendal) and leads one of the country’s biggest equities teams.

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  

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