Did this week’s RBA statement this week signal fewer rate hikes ahead? Probably not, says Pendal’s head of government bond strategies TIM HEXT

THE RBA statement this week played a reasonably straight bat.

Who can blame them given all the criticism and the upcoming review? They seem less keen to take on the market.

But it’s also reasonable in a highly uncertain and complex world that you maintain maximum flexibility.

Anyone with a strong opinion on the economy at the moment is likely displaying misplaced bravado.

What we do know is rates are going to hit neutral this year. Another 1% of hikes can be expected, moving the cash rate to 2.85%.

Whether it’s four lots of 25bp across four meetings or 50bp at fewer meetings is only of interest to short-end traders.

Hence the RBA’s line that “the Board expects to take further steps in the process of normalising monetary conditions over the months ahead, but it is not on a pre-set path”.

Sounds like an opportunity for everyone to interpret this with their own confirmation bias — which on Tuesday seemed to be fewer hikes, not more.

I think that’s reading too much into it.

Much like the US Fed, the RBA will be keeping a close eye on overall monetary conditions.

As asset owners we must remember the “central bank put” is now also a “central bank call”.

That is, if bonds, equities and credit spreads rally too much without a significant easing in inflation pressures, they will lean against the easing of conditions.

The rally of the past month suggests this is in danger of happening — so expect more hawkish speeches from officials, especially in the US.

RBA officials will have time over summer to sit back and see the impact of hikes on the economy.

I suspect the hikes will not have a big impact yet — but will do so next year.

This is when 30% of total mortgages come off 2% fixed rates onto 5%-plus floating rates.

However, while goods price inflation will be falling, services inflation will be becoming more embedded in the economy, courtesy of labour shortages.

This will limit any further rallies in bonds.

They are not expensive, but recent rallies mean they are no longer cheap.

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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

A re-assessment of fixed income securities and yields — and their defensive qualities — have made bonds attractive again. Here’s a quick overview from Pendal’s head of client solutions DALE PEREIRA

AFTER a decade of strong returns, bond markets have been challenging for investors over the past year.

Returns have not been kind.

But in recent few months a re-assessment of fixed income securities and yields — and their defensive qualities — have made bonds attractive again.

Bond returns don’t predict future returns – they reflect what has happened. That’s where the opportunity lies: they may be showing negative returns now, but the future looks a lot brighter.

Why bond yields are up

Markets are forward-looking – prices reflect where the economy is heading.

Bonds typically lead equities in terms of market reaction.

From the end of 2021 and into the first half of 2022, bond yields moved in line with expectations of future rate rises – which in turn reflected inflation expectations.

But markets often over-react when extrapolating good and bad news. And that’s the case now.

The market has likely priced in too many rate rises. It’s priced in a good chance that central banks around the world won’t be able to control inflation. (Though recently that pricing has started to dissipate, making yields less volatile.)

This means the bond market is at a much better entry point for investors.

But aren’t central banks already lifting interest rates?

They are, but remember bonds are priced on expectations.

We’ve seen a big jump in yields because investors initially expected things could get out of control with supply-chain problems and higher prices.

There was plenty going on – Covid restrictions in China, the war in Ukraine, soaring oil prices and an energy crisis. It wasn’t long ago that people were talking about oil at $US200 a barrel.

Hence, central banks have acted aggressively.

In Australia we’ve seen consecutive 50-point rate hikes – the fastest rate-rise path in our history.

Other countries such as the US, UK, Canada and New Zealand have been even more aggressive.

Central banks understood their objective and acted to curtail inflation expectations. If they hadn’t, inflation expectations could quite easily have become reality.

What’s the prognosis for inflation?

In recent weeks there are early signs that inflationary pressures may be dissipating.

The flipside to reduced economic activity and price pressures is the prospect of a recession.

That’s an environment when bonds outperform.

Why bonds could be a good investment now

If inflation has peaked — and we’re now only expecting moderate inflation – that’s a good environment for bonds, since the starting point is a higher yield.

Coupon payments (and income) is higher. Plus there’s limited downside risk in terms of capital loss.

If we head into a recession, there’s a call option on bonds. That means the issuer can redeem the bond before its maturity date.

So the asset from which you are getting a coupon is at least in line with long-term inflation.

And it will appreciate in value if we do head into a recession.

What about corporate bonds?

Until recently, many corporate bond investment strategies were hit with a double whammy of interest rate risk and credit risk.

Corporate bonds are more susceptible to an economic growth slow-down and potential recession. Investors may worry that companies won’t be able to repay their debt.

The market has anticipated this and re-priced corporate bonds.

The riskiest companies don’t have a strong balance sheet. They may be operating in an environment where margins are under pressure because costs are going up while sales are flat or falling.

But that’s the worst-case scenario.

In Australia there are many investment-grade corporates with strong balance sheets.

How to invest in the bond market now?

Investors should consider a “barbell” approach.

At one end of the barbell, consider buy high-quality government bonds for duration.

Australia looks like a good place to re-enter the market. If investors already hold government bonds, now is not the time to sell because that would lock in losses.

Look for actively managed portfolios, because opportunities depend on choosing the right maturities of a government bond.

For example 5-and-10-year bonds — which take into consideration medium-term impacts of inflation and growth — now present interesting opportunities that active managers can exploit.

At the other end of the barbell, investors should consider investment-grade bonds which represent quality companies with good cash flows.

In Australia the level of default in investment grade bonds is much lower than the US, because of our higher-quality balance sheets.

Investors can also look for floating rate investments issued by corporates.

This means investors are less impacted by rate rises. They get an increase in income every quarter as the cash rate rises.

Floating rates haven’t been a good investment in recent years as interest rates tended down.

But in this environment they can outperform term deposits since investors pick up extra accrual as rates rise.

Other opportunities can be found in the fast-growing impact or “use-of-proceeds” bonds, often known as green, social or sustainable bonds.

Strong tailwinds in climate, regulation and human behaviour change mean there is increasing demand for these types of bonds — and not enough issuance.

This dynamic is likely to continue.

Dedicated strategies can find strong returns along while aligning with client principles.

ESG (environment, social and governance) has a different meaning in bonds compared to equities. Capital can be ring-fenced for specific projects or uses and the main elements of credit risk and duration risk can be managed.

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

MARKETS took a glass-half-full view last week, despite data showing inflation was still running hotter than central banks would like.

This was in stark contrast to recent market action.

There were two reasons for this more positive stance:

First, the market interpreted Fed Chair Powell’s remarks after last week’s 0.75 percentage point rate rise as leaving the door open to a more moderate pace of tightening.

The reaction suggests the Fed may have restored a degree of credibility in the market’s eyes.

Second, comments from several big US companies during reporting season suggest that while the economic slowdown is real, it isn’t derailing corporate earnings at this stage.

The S&P 500 gained 4.3% last week, while the S&P/ASX 300 was up 2.3%. Commodity prices rallied, while US 10-year bond yields fell 38bps.

Australia

Last week’s inflation data was seen as enough to support today’s 50bp rate increase, but not sufficient to warrant the 75bp “shock and awe” move that many feared.

CPI inflation rose 1.8% in the June quarter — slightly less than the 1.9% consensus expectation and down on the 2.1% gain in Q1.

Annual CPI growth was 6.1%, up on the 5.5% of Q1 and the strongest growth since 1990.

Trimmed mean CPI — the RBA’s preferred measure — rose 1.5% over the quarter, in line with consensus. It is at 4.9% for the year versus 4.7% expected. This remains well above the RBA’s 2-3% target.

Price growth was broad-based with sharp rises in food, transport and housing costs.

US Fed

The Fed raised its target band by 75bps to 2.25-2.5%.

The decision was unanimous and returns rates to a range the Fed considers neutral — though some observers disagree.

The market wanted to hear there was some chance hikes get throttled back. People saw enough in the accompanying statement to deliver this hope.

Chair Powell flagged some softening in spending and production. But he pointed out that labour markets remain strong and inflation elevated.

The Fed would need to see growth and inflation slowing to ease the pace of hikes, he said. Hence the market’s positive reaction to the data print of negative GDP growth in Q2, slipping the US into technical recession.

That said, Powell reiterated that failure was not an option in achieving price stability.

He could not rule out another out-sized rate hike for September, depending on the data. He wanted to see “compelling evidence” of slowing inflation in the core Personal Consumption Expenditures price index.

Powell also noted the natural rate of unemployment was likely a lot higher today than prior to the pandemic. At 3.6% the labour market looks extremely tight — and hence a generator of primary inflation.

US GDP

The US economy contracted 0.9% in the June quarter after falling 1.6% in Q1 — signalling a recession.

But it does not feel like a recession, given strength in the jobs market and an unemployment rate of only 3.6% in the past four months. This remains a key factor to watch.

Unemployment benefit applications last week were the highest this year, which may signal a shift.

Consumer spending rose 1% annualised, down from 1.8% in the previous quarter.

The slowing pace of inventory restocking was a big draw-down on economic growth. Changing consumption patterns have left many retailers with excess stock that needs to be discounted and cleared.

Most economists have growth in the September quarter and for calendar 2022 — so the current contraction is not expected to continue.

US inflation

A few other data points indicate that inflation remains high.

The Employment Cost index rose faster than expected, up 1.3% for Q2 and 5% year-on-year.

However the market is seeing signs of near-term softening in labour markets and at this stage seems happy to look through this print.

The Core Personal Consumption Expenditure index (which excludes food and energy) rose 4.8% in June, up from 4.7% in May. Prices rose 0.6% in June, following several months of 0.3% increases. Consensus expected a 0.5% gain.

One positive is that US petrol prices have now fallen for more than 40 days straight.

Markets

Last week was strong across the board.

Every major equity index except Japan made gains, while commodities and bonds were both stronger.

It topped a strong month. The S&P 500 gained 9.2%, the NASDAQ lifted 12.4% and the S&P/ASX 300 moved ahead 6%.

US mega-cap stocks caught a strong bid, reflected in growth outperforming value.

So far 56% of US companies have reported Q2 results.

About 75% have delivered better than expected EPS results, versus an 81% average over the past year and 77% over five years.

Overall, earnings are on track to rise 6% — the slowest rate since the end of 2020.

Amazon delivered an unexpected loss for the quarter — though sales for the quarter were up 7% to US$121bn versus $119bn expected.

Management guided to $125-130bn of sales next quarter, versus $126bn consensus. Crucially, management indicated it was getting costs under control and productivity at fulfilment centres was improving.

Revenue grew 33% for Amazon Web Services and advertising was up 18%, continuing the theme that the stronger franchises are taking revenue from the weaker franchises. Amazon shares were up 29% in July — their best month since October 2009.

Intel shares tanked after missing quarterly profit and revenue expectations. Revenue fell 22% — the biggest drop in a decade. The chip-maker flagged weaker PC sales and poor execution on a rollout of a new generation of chips for data centres.

Microsoft’s 12% revenue growth fell short of expectations. However an upbeat outlook saved the day, with management expecting double-digit growth in sales and operating income for FY23.

Apple revenue rose 2%, driven by stronger-than-expected demand for iPhones. Sales rose 2% while the market was expecting a 3% fall. CEO Tim Cook said he was seeing pockets of softness but expected even stronger year-on-year revenue growth next quarter.

Google’s parent Alphabet reported sales up 13% on the previous comparable period. It was the slowest growth in two years as advertising decelerated in many areas. Net income was down 14%. The company has slowed down hiring plans.

Meta (previously Facebook) reported a decline in revenue versus the previous comparable period for the first time and a third sequential fall in operating profits. Ad revenue declined 18% and pricing fell after recent strong gains. Meta also flagged slower hiring.

Shopify’s stock fell 14% after cutting 10% of its global staff in response to the reversal of sales back to physical retail.

Australia

In Australia materials (+5%) led the market higher as miners dominated the leader board, led by the lithium and EV-related names.

Real estate (+3.9%) was also strong.

Health care (-0.8%) lagged, as did consumer discretionary (-0.3%).

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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

What the latest CPI data means; Why we’re probably not facing long-term global inflation; What ESG investors should look for in banks; why investors should consider Mexico

The RBA’s path back to neutral cash rates this year is on track. The bigger story for long bonds is the US path to potential recession, writes our head of government bonds Tim Hext

UNTIL next year we remain stuck with quarterly Consumer Price Index numbers, meaning they carry huge importance.

(The ABS is planning a monthly CPI indicator — but for now the quarterly data is more important than ever.)

Wednesday’s June quarter CPI numbers landed almost on expectation, bucking the recent global trend of upside surprises.

That doesn’t mean the number wasn’t high — rather it was already factored in, even generating relief that it wasn’t worse.

Headline CPI for Q2 was 1.8%, meaning 6.1% annual.

Underlying inflation (the average rate after trimming away the highest and lowest 15%) was 1.5% or 4.9% annual.

Under the hood there was decent dispersion.

Food prices were up 1.45% — but given the stories and input prices this was a low result. We expected above 2%.

Commodity prices have eased in the past month so the worst of food price inflation — perhaps some vegetables excepted — may not eventuate for now.

Housing inflation remains buoyant  (2.5% q/q)  due to the cost of building new homes. Rents remain benign despite mounting signs they are moving higher.

A rare sighting of inflation in clothing and footwear (up 3.5% q/q) and furnishings (up 2.5% q/q) plays into the theme of higher goods prices.

Service prices to rise

We expect goods price inflation to be peaking, but service inflation to pick up in the year ahead.

Services remain contained for now. Health and education costs tend to be seasonal but overall are running closer to 3% than 6% annually.

Labour costs are moving higher. Skilled migration is picking up but it won’t be enough to stop cost-push inflation.

The move lower in goods prices may lead to some short-term easing of concerns overall, but we remain wary of current market pricing.

Expected inflation levels are back below 2.5% beyond 2023.

Inflation bonds are cheap and investors should consider picking them up around these levels as insurance for a decade of higher inflation.

What it means for investors

The monetary policy implications of this CPI number are not large.

The RBA will be happy its current path and pace back to neutral cash rates this year (2.5% to 3%) seems about right.

The market is still expecting more (3.25% to 3.5%) than the RBA thinks it will have to deliver this year, so there is the chance for a small rally in rates.

The bigger story for long bonds remains the US path to potential recession.

We get a Fed rates update and US GDP number shortly, so on we move.

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

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

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

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

Find out more about Pendal’s fixed interest strategies here

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About Pendal

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

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

Contact a Pendal key account manager

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

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

THE market is seeing signs of inflation easing, the economy slowing and policy having an effect.

As a result, concerns over the extreme tail risk of substantial central bank overtightening may be receding.

It remains a challenging environment. The key questions around where inflation settles, the path of rate hikes and the economic impact are still unanswered.

Energy remains a wildcard. But at this point there is a reduced probability of some of the most negative projected scenarios.

The market bounce continued last week.

The S&P 500 gained 2.6% and the S&P/ASX 300 3.6%. This was despite more bad news on economic growth and the European Central Bank (ECB) striking a more aggressive stance than expected with a 50bp rate hike.

At this point bad news is seen as good news. Weaker growth is seen as helping drive inflation lower, bringing forward an expected peak in rates and bond yields.

US 10-year government bond yields are now 66bps lower than the June high, which is helping support the equity market. The S&P 500 is up about 8% from its lows. We are also seeing a rotation back to longer-duration sectors.

Oil prices, bond yields and the US dollar all remain tightly correlated and a key driver of markets. Recent falls in yields and oil and a pause in US dollar gains are all helpful for equities.

Early US corporate earnings signals are supportive. It was interesting to see Netflix bounce about 25 per cent despite weaker subscription numbers.   

Where to next for markets?

It is too early to call whether we have seen a bottom or if this is another bear market rally.

Technical measures of market breadth and volumes are not indicating a sustainable turn in sentiment.

Seasonally, August and September are typically soft months for equities.

That said, a market moving higher on bad news suggests some stale positioning and the squeeze could continue.

Bear markets don’t tend to end until policy direction shifts. It would also be unusual to see markets bottom before the extent of any earnings recession is known.

The challenge is that bear market rallies and squeezes can be large.

The average NASDAQ bear market rally since 1985 has been 30% — and the NASDAQ is only up 11% from its recent low.

The S&P/ASX 300 is now down 7.2% for the year to date. Technology is off 27%, consumer discretionary is down 17.6% and REITs has lost 16.8%. This leaves plenty of scope for these sectors to squeeze higher during reporting season.

This week will bring a lot of new information including a Fed meeting, the US Q2 GDP print and a raft of US earnings results.

Macro and policy outlook

Europe

The ECB raised rates 50bps — the first hike in 11 years — in response to a worse-than-expected inflation print of 8.6% year-on-year. The market was not expecting such a big move, only ascribing a 25% chance.

The market’s reaction was positive.

This could be partly because the ECB stated there was no change to the ultimate expected terminal rate. There was also likely some relief that the bank was catching up to the reality of dealing with inflation.

Given the likely slump in the European economy, there is a view the ECB has only a small window politically to raise rates — and therefore they are better to front load.

The ECB also provided the latest “tool” to manage the “fragmentation” risk of bond spreads blowing out in the periphery and creating the next Euro crisis.

The Transmission Protection Instrument (TPI) represents a form of Quantitative Easing in an era of rate tightening and Quantitative Tightening. The purpose is to prevent the upcoming recession from putting pressure on the Euro.

It is said to have no budget limit on the purchases or periphery bonds (refers to being “proportionate”) or any need to negotiate some economic reform package.

There is no stated threshold for use, which will be determined by the European Council. It will also likely relate to circumstances beyond the country’s control, so the current Italian political crisis is unlikely to trigger its use.

As with most European tools, this is deliberately vague. We suspect the market will want to test this at some point.

United States

It is almost unanimously expected that the Federal Reserve will hike rates 75bps this week. Speculation about a 100bp hike has dwindled along with the latest inflation expectations data.

The Fed is maintaining a hawkish tone.

We suspect they would rather wait for more firm evidence of slowing inflation over next two months – remembering they do not meet in August – than ease up too early and risk another embarrassing U-turn.

The curve of expected future policy rates shifted down 15bps last week. It now has rates peaking at the end of 2022, rather than the previous end of Q1 2023.

This is a big shift from where we were a month ago. It is likely the economy will need to be a lot weaker for this to happen.

Elsewhere there were limited data releases last week.

Regional Fed manufacturing indices were soft. But the Flash US Manufacturing PMI was better than expected at 52.3 vs 52.7 in June.

Interestingly the Services PMI was weak at 47 vs 52.7 in June, with the pricing component notably lower.

Overall, it painted a constructive picture of inflation easing.

Energy markets

Gas resumed flowing through the Nordstream pipeline from Russia to Europe after maintenance, calming some fears.

It is running at 40% capacity. This enables Germany to build enough reserves for winter – but only just. It remains vulnerable to any change in the Russian approach.

We now have the perverse situation where the West has imposed sanctions to constrain Russia’s ability to sell oil, but is desperately hoping Moscow keeps supplying gas.

Germany suffered the ignominy of asking the rest of Europe to reduce gas consumption 15%. Greece and Spain refused. The latter drew on Germany’s own Euro crisis era rhetoric noting that “unlike other countries, we haven’t been living above our means in terms of energy”.

Oil and gas will be key to determining whether sentiment around inflation continues to improve.

The growing consensus is that weak global growth will see oil prices fall below US$90, relieving pressure on headline inflation and consumer inflationary expectations.

This would allow softer Fed rhetoric perhaps as early as September.

 

The alternate view is that supply constraints, an end to strategic petroleum reserve (SPR) releases and Chinese re-opening could drive energy prices higher even as the global economy slows.

This would leave central banks facing an impossible choice.

China

Chinese equities have rallied since May on the easing of Covid restrictions.

However sentiment has turned more negative.

This is partly driven by the mortgage strike in relation to unfinished homes and also by the lack of any meaningful stimulus. Measures enacted recently really only serve to offset the negative impact from housing weakness.

At this point, it appears growth with be sluggish for the next few months. It is hard to see China as a big driver of any improvement in sentiment towards global growth in the near term.

The US dollar continues to drag the Chinese Yuan (CNY) higher, affecting its ability to compete with Korea and Japan. There is a risk we may see another step down in the CNY, which would likely be negative for commodities.

Australian market

Last week’s broad ASX rally was led by tech (+7.3%), financials (+4.5%) and small caps (+5.8%).

Small cap resources had a good bounce (+6.9%) after a sharp fall in recent weeks (about -33% since April).

This is symptomatic of being oversold and the market chasing beta into the bounce, rather than a shift in fundamentals.

We are seeing small signs of rotation from consumer defensives to discretionary. This was helped by an upgrade from JB Hi-Fi (JBH, +10.1%).

This will be something to watch in reporting season. We note Nine Entertainment (NEC) as a good example of stock that has been heavily de-rated without any sign of earnings softening.

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About Crispin Murray and Pendal Focus Australian Share Fund

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

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

Find out more about Pendal Focus Australian Share Fund  

Contact a Pendal key account manager

A positive story for bonds; Inflation-driven sustainability opportunities; Investing amid inflation; Defining a neutral cash rate 

Bonds are back. Here Pendal’s head of income strategies AMY XIE PATRICK explains why

• Ten-year bond rates close to 4 per cent
• Benchmark returns for other asset classes higher
• Negative correlation between bonds and risk assets has re-emerged

INVESTORS have struggled to earn good returns from fixed income assets in recent years.

But yields on government bonds have risen over the past year — and the negative correlation between bonds and risk assets has re-emerged.

That reflects the narrative around a recession in the United States, Europe and possibly even Australia, says Pendal’s head of income strategies Amy Xie Patrick.

“The bond story of recent years has been flipped on its head,” says Xie Patrick.

“Buying 10-year government bonds in Australia can get you nearly 4 per cent. At the height of the pandemic, it was 50 basis points.

“Now the credit risk-free rate is 4 per cent, which raises the bar for other asset classes.”

Those other assets might be riskier fixed income instruments including junk bonds and private sector debt, or other asset classes such as equities and alternatives.

When government bonds yields have risen so much, so quickly, the economics of all other investments change.

“You can get credit-risk free, 10-year yields in Australia for 10 per cent. That sounds pretty good,” Xie Patrick says.

Investors should consider buying high-quality sovereigns, such as United States or Australian bonds, which are free from credit risk, says Xie Patrick.

Changing attitude to bonds

Investors have been hesitant to include bonds in portfolios in recent years — but that’s changing, says Xie Patrick.

“For the last three years equity yields were much higher than bond yields. Investors were better off sitting in equities and collecting the dividend.”

But fears of a recession have changed all that. Xie Patrick points out that it isn’t central banks around the world that will trigger a recession. Rather, it’s tumbling consumer sentiment that reflects inflation.

“You’re filling up your petrol tank and the cost at the bowser just keeps going up. Grocery bills are so much higher and feeding a family is becoming expensive. None of that is good for consumer sentiment,” she says.

Private sector sentiment is critical to economic growth because confidence leads to higher spending. The most recent Westpac-Melbourne Institute of consumer confidence in Australia (PDF) – the long-time benchmark – this month fell to its lowest level since the beginning of the pandemic.

In the US, the benchmark measure from the University of Michigan has hit a record low.

No quick turn-around

Consumer sentiment isn’t going to improve quickly, Xie Patrick says.

“High levels of inflation tends to lead consumer sentiment by six to 12 months, so even if inflation has peaked, we’ve still got six to 12 months of poor consumer sentiment. That’s not great.”

This adds to the argument why bonds are back.

One lingering question for investors is whether four per cent is a good return, given inflation is currently higher than that.

“To put that value into perspective, inflation markets infer that over ten years inflation will be, on average, around two-and-a-half per cent, which is the Reserve Bank’s inflation target,” Xie Patrick says. “Ten-year bonds are yielding a nominal rate of four per cent.”

“By owning a 10-year Australian bond, you are taking effectively no credit risk, keeping up with the two-and-a-half per cent long-term rate of inflation and then getting another one-and-a-half per cent.

“You’re getting paid to own something without credit risk and keep up with inflation.

“The value proposition for bonds is really back.”

The Reserve Bank considers a neutral rate around 2.5% and a bit. But how much is the bit? TIM HEXT has some answers

IT’S BEEN clear for a number of months that the Reserve Bank wants rates back to neutral sooner than later.

Quite simply nothing about high inflation and low unemployment cries out for expansionary rates.

Governor Phil Lowe has implied he would like to see neutral rates by year-end — and he considers neutral around 2.5% or slightly higher.

I was therefore quite excited to see the RBA has been working on “what is neutral” and whether it’s changed since the pandemic.

They referenced this work in this week’s RBA minutes, but the contents will have to wait for public release at a later date (we hope).

The concept of a neutral cash rate is very fluid to begin with.

The best notion is a rate that reflects long-term inflation expectations plus any adjustment for productivity.

That is, you should expect your cash returns through the long-term cycle to keep pace with inflation and (assuming positive productivity) deliver some small extra return.

This leads to the notion of 2.5% (the RBA target) plus a bit.

The size of that “bit” becomes crucial — and for that we need a view on productivity.

There are many reasons and views on why the last decade has seen poor productivity growth (less than 1%) and cash rates have been at or lower than inflation.

The neutral rate was roughly the inflation rate as evidenced by cash rates stuck at 1.5% from 2016 to 2019 — just below inflation at the time.

Have we experienced, as with many things, a Covid reset that changes this outlook for productivity?

That question will be answered in time, but there are some positive signs.

Firstly, business lending is strong. Private sector credit is nearing double-digit growth (currently 9%) for the first time since the mining investment boom more than 15 years ago.

And it’s not just housing driving it. Labour shortages are playing into the idea of replenishing capital stock and using existing labour more efficiently.

Secondly, Covid-driven supply shortages have seen businesses and households rethink efficiencies, whether reducing commuting or streamlining processes.

Against this, of course, are the challenges of reduced globalisation and sustainable energy. Both of these, though necessary to meet other challenges, introduce potentially less productivity at least in the medium term.

As investors, a return to positive real yields should be seen as an encouraging sign that demand for money is picking up again.

Businesses see productive uses for borrowing. While higher cash rates in response may reduce longer-term valuations for assets, it is not a sign of imminent recession as some risk markets are now pricing.

Investors should welcome news that a risk-free asset can not only keep pace medium term with their cost of living, but also earn a return above that — something not seen for a decade.

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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

What is the neutral cash rate in Australia? The debate rages on. Pendal assistant portfolio manager ANNA HONG explains

Today’s RBA minutes provide insights into the central bank’s decision making in its last policy meeting on July 5.

The minutes clearly lay out the uncertainty around price risks due to the continued war in Ukraine and China’s Covid-zero policy.

One thing is certain however. There will be another rate hike in August — most probably 50 basis points and a chance it could be higher.

The Reserve Bank expects inflation to peak late in 2022. We are merely a few weeks into the second half.

This means the RBA believes the inflation problem will worsen in the months ahead.

With only one blunt instrument in the monetary toolkit, there is no other option but to raise rates again in August.

How much? The case is much stronger for a rate hike of 50bps or more.

Why? The Australian June Labour report obliterated any lingering doubts that we are in in full employment.

Employment gains almost tripled expectations, leading to an unemployment rate of 3.5% — even accounting for the improvement in participation rate.

There is now one unemployed person per job vacancy in Australia. In other words, filling all our job vacancies will require every single unemployed person.

The economy is running red hot and the tightest labour market in almost 50 years is driving consumption demand on an upward trajectory.

The only way to cool off is to slam the brakes hard.

With other central banks raising the hawkishness stakes by hiking rates 0.75% to 1% in each board meeting, it will come as no surprise if the RBA raises cash rates by more than 50bps.

Despite earlier “guidance” indicating the most likely rate hike scenarios are 25bps and 50bps, Dr Lowe may once again have to correct himself.

The RBA governor is well practised on backflips — most notably Yield Curve Control and no rate rises til 2024.

Not surprisingly short rates drifted higher this week.

Longer rates are caught between expectations of higher cash rates and the damage to the economy and potential recession those higher rates may cause.

For now, 10-year Australian government bonds are holding around 3.5% but are vulnerable to drifting back towards 4%, where they were only a month ago.

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

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

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

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

Find out more about Pendal’s fixed interest strategies here

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About Pendal Group

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

Contact a Pendal key account manager