As inflation falls, investors can have more confidence in bonds, argues our head of multi-asset MICHAEL BLAYNEY. Here he explains why
- Inflation has fallen from last year’s peaks
- Investors can have more confidence buying bonds
- Find out about Pendal Sustainable Balanced Fund
- Browse all Pendal’s multi-asset funds
AS inflation falls — while still remaining at uncomfortably high levels — investors can have more confidence investing in government bonds, says Pendal’s multi-asset chief Michael Blayney.
“On the raw numbers, inflation in the United States has come off a long way.
“It peaked above 9 per cent last year and most recently it has come in just below 5 per cent on a headline basis. This has important portfolio considerations.
“It means you can have a bit more confidence in your bond allocation, because the biggest risk to bonds, ultimately, is inflation.
“We have moved to slightly over-weight bonds, and that’s a big change because we previously had been underweight bonds for a long time.”
Global bond yields are broadly in line with Blayney’s estimate of fair value. But he warns that elevated services price inflation and a very tight labour market are key risks for bonds.
Offsetting this is the risk of recession in which bonds would provide their traditional “risk off” portfolio benefits.
Economists have been forecasting a recession in the US for several months and while the timing continues to get pushed out, it is still likely to occur, Blayney says.
With a slight tilt towards bonds and away from equities, Blayney’s team is running a “slightly cautious” stance.
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“It’s one to two years before you feel the full impact of rising rates and we are only halfway through that process. On that basis no-one really knows yet what the full impact of rising rates will be.”
The risk for central banks, including the US Federal Reserve, is that economies fall into recession but inflation remains high, hindering their ability to cut interest rates, he says.
“Realistically I think the Fed will want to see the whites of the eyes of inflation near its target before it starts cutting rates,” Blayney says.
US risks
Risks remain in the US economy, he says.
“There are still deposits being pulled out of US regional banks … and credit will be harder to get. And credit is very important to the health of the economy.
“Also, people’s purchasing power is being squeezed by inflation and there’s rising borrowing costs.
“And there’s a tail risk around the US breaching its debt ceiling. That’s not a very positive backdrop for investing.”
Equities at fair value
Away from bonds, equity markets, in aggregate globally, are around fair value, Blayney says, with Japan and the UK still cheap. But Wall Street and some European markets are expensive.
Blayney says that US equities haven’t priced in the potential for difficult times ahead and are still trading on a forward price-to-earnings ratio of nearly 19 times.
“The US is our key area of concern, and that is where our equity underweights are focused. We believe investors should focus on relative value between markets.
“We like some of the other value equity markets. Australia looks okay, and is one of a number of markets where prices are around fair value.”
About Pendal’s multi-asset capabilities
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
These include Australian and international shares, property securities, fixed interest, cash investments and alternatives.
In March 2024, Perpetual Group brought together the Pendal and Perpetual multi-asset teams under the leadership of Michael O’Dea.
The newly expanded nine-strong team will manage more than $6 billion in AUM and create a platform with the scale and resources to deliver leading multi-asset solutions for clients.
Michael is a highly experienced investor with more than 23 years industry experience, including almost a decade leading the team at Perpetual.
Pendal’s multi-asset team has been examining the performance of ESG-friendly companies over the longer term. Here’s what they found
- ESG-friendly companies more efficent, better valued over time
- Whole-of-portfolio management can hedge against short-term risk
- Find out about Pendal Sustainable Balanced Fund
- Browse all Pendal’s multi-asset funds
INVESTING in sustainable funds is intuitively attractive to more and more people.
But when oil and gas prices soar as they did last year — leading to underperformance among sustainable funds — it’s not easy to stay the course.
It’s the type of scenario that Pendal’s multi-asset team faces on a regular basis, for example when making investment decisions for Pendal Sustainable Balanced Fund.
What factors might persuade an experienced, long-term investor to stick with the plan?
Firstly, research from Pendal’s multi-asset team shows it’s worth sticking with sustainable investments in such scenarios, because better-rated ESG companies outperform over the longer term.
More on that below.
Secondly, during those times, an active multi-asset manager can take steps to guard against single-risk factors such as rising energy prices.
“Investors with ESG strategies needs to have a long measurement horizon and be prepared to accept that their investments will have a slightly different performance cycle to a traditional, unscreened strategy,” explains Michael Blayney, who heads up Pendal’s multi-asset team.
“Investors need to understand their tolerance to that.”
“When you have a strategy that involves exclusions of particular sectors of the market, your fund is going to run into headwinds at times.
“Last year, particularly in the first part of the year, there were soaring oil prices. If you had a strategy that excluded or underweighted oil companies, then you faced headwinds.
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“One way we managed that was to buy renewables in Europe, which gave us exposure to European energy prices within our alternatives portfolio,” says Blayney.
“Identifying and positioning for these types of risk factors can help portfolios perform better in the long term, and provide investors with a smoother, more comfortable ride in the short term.”
What the research tells us for long-term ESG investing
Pendal’s multi-asset team has spent a considerable amount of time looking at the long-term benefits of ESG investing.
Analyst Rita Bodrina recently examined MSCI ESG data going back to 2000, measuring the performance of companies that rate well on ESG metrics, companies that rate poorly and those with a relatively neutral rating.
One finding was that better ESG governance practices result in more efficient use of company assets.
Using sales on total assets as a proxy for efficiency, Bodrina found that companies in the top 20 per cent of ESG-rated stocks were more efficient that those in the middle segment of ESG ratings.
And they were sharply better than the bottom 20 per cent of ESG-rated companies.
The study also tested an assumption that a stronger ESG profile would result in more favourable valuations and a lower cost of capital.
The thesis was that ESG-friendly companies may be less exposed to risks and thus a safer investment.
Bodrina found that ESG companies were better valued by the market through time.
Most importantly the study also demonstrates that, based on cumulative returns over 22 years, low-rated ESG companies underperform. This occured on both a stock-specific basis, and by industry segments.
Better future outcomes
These effects could grow in the future, the team believes.
“This is due to a mixture of the regulatory backdrop globally, consumer and investor preferences, and a clear nexus between value creation and the fair treatment of all stakeholders,” Bodrina says.
Blayney says the bottom line is that more highly rated ESG companies do outperform — though historically this has been due to the underperformance of poorly rated ESG companies.
“It’s an interesting nuance that most of the return benefit comes from avoiding the bad stuff,” he says.
“Lower-rated ESG companies have also been more prone to downside risk, which supports the contention that a portfolio that tilts away from poor ESG companies should be expected to generate better risk/return characteristics through the cycle.
“Paying attention to ESG factors alongside traditional financial factors leads to better returns and better management of risk.
“Investors certainly don’t have to give up returns if they choose a sustainable strategy.”
About Pendal’s multi-asset capabilities
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
These include Australian and international shares, property securities, fixed interest, cash investments and alternatives.
In March 2024, Perpetual Group brought together the Pendal and Perpetual multi-asset teams under the leadership of Michael O’Dea.
The newly expanded nine-strong team will manage more than $6 billion in AUM and create a platform with the scale and resources to deliver leading multi-asset solutions for clients.
Michael is a highly experienced investor with more than 23 years industry experience, including almost a decade leading the team at Perpetual.
What’s behind the RBA’s surprise decision to lift rates – and what’s next? Here’s a snapshot from Pendal’s head of cash strategies, Steve Campbell
- Why bonds, why now? Find out more from our Income and Fixed Interest experts
THE Reserve Bank surprised most people – your scribe included – when they raised the cash rate today by 0.25 percentage points to 3.85%.
What was surprising was the RBA had revised down their forecast for 2023 from 4.75% to 4.5%, yet decided to tighten policy anyway.
In justifying the decision, the RBA noted that services inflation remained very high and the offshore experience indicated upside risks.
Productivity growth is anaemic, in turn exerting upward pressure on unit labour costs.
The strength of labour – with the unemployment rate at a 50-year low and most businesses struggling to find workers – only added to their concern.
Defending the decision to pause in April, the RBA said they held rates steady to provide additional time to assess the state of the economy and the outlook.
But they remained resolute in their determination to return inflation to target – and would do what was necessary to achieve that.
Why not go in April then?
Inflation is not forecast to be back in the target band before mid-2025 and the labour market is not cooling.
Wage inflation pressure may reduce in some sectors with the increase in migration.
But that brings a different type of price pressure, mainly via rental inflation.
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After the pause in April – and with the fixed rate mortgage cliff ever closer – I expected the RBA to wait and allow prior policy tightening to flow through the system.
I was wrong.
I doubt it’s a co-incidence that the RBA review released several weeks ago criticised the central bank for not getting inflation back to target quick enough.
Well, here is the response.
Previously I expected any policy change would occur more likely in a quarterly sequence following the release of quarterly inflation data.
That has gone out the window. Today’s decision means their next meeting in June is also a live meeting.
About Steve Campbell and Pendal’s Income and Fixed Interest team
Steve Campbell is Pendal’s head of cash strategies. With a background in cash and dealing, Steve brings more than 20 years of financial markets experience to our institutional managed cash portfolio.
Find out more about Pendal’s cash funds:
Short Term Income Securities Fund
Pendal Stable Cash Plus Fund
Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.
It’s time to consider shifting to liquid alternative investments, says multi-asset expert ALAN POLLEY
- Higher rates a headwind for illiquid alternatives
- Look for diversifying liquid alternatives with inflation protection and secular tailwinds
- Find out about Pendal’s multi asset funds
IT’S time to start transitioning from illiquid alternative investments to liquid alternatives, argues Pendal multi-asset portfolio manager Alan Polley.
“Illiquid assets have had a fantastic secular tailwind for the last two decades because interest rates have been falling and they have been chased by a wall of effectively free money bidding up prices, says Polley.
“These illiquid assets have had cash-flow benefits in terms of lower financing costs, and the lowering of the discount rate has led to positive valuation effects.
But the good times for illiquid assets are over, thanks to the accelerated rate tightening cycle, which in the US has been 500 basis points in a little over a year, Polley says.
Illiquid alternative assets are dominated by property and infrastructure and are private, or unlisted, assets. The economic environment for these assets has changed, he says.
“It’s certainly not free money anymore. This has been a step change.
“These assets tend to be very sensitive to interest rates in terms of financing costs and also the discount rate applied to future earnings.”
“There certainly isn’t a tailwind anymore and … given how sensitive to interest rates these assets are, there is potential downside.”
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Illiquid assets, by definition, don’t trade regularly in normal circumstances.
With even fewer sales over the last year, there are very few benchmarks to revalue assets.
Large investors need to revalue assets twice a year and, without the benefit of recent and relevant sales, tend to use dated sales prices or long-term averages for discount rates which are skewed towards lower rates.
But the interest rate environment in coming years will be very different to recent years, Polley says.
“No-one wants to sell the assets right now because they know they will take a haircut. There’s no transactions going on,” Polley says.
An indication of how much value has potentially been lost can be garnered from public assets that trade regularly.
“If you look at the REITs (real estate investment trusts) market, they’ve dropped about 25 per cent,” Polley says.
“The public markets tend to lead the private markets and are a clear indication that the private markets haven’t been priced to reflect the new reality. There is a lot more risk for private, or illiquid assets.”
The valuation question has triggered regulators, in recent months, to take an interest in the dearth of revaluations for illiquid assets. They are questioning valuations provided by some large managers.
“Regulators want to make sure that unlisted assets are being held at fair value in the new market environment,” Polley says.
Liquidity risk premium
Illiquid assets promise a “liquidity risk premium”. Because they are illiquid, there’s extra risk involved and that should attract a premium over time.
That risk will eventually be felt — the question is when?
“Illiquidity risk is a risk-on factor, so when the market environment is poor, that liquidity risk tends to underperform.” Polley says.
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“Often the hope is that an investor can ride through a poor market environment and not feel the effects of liquidity risk.
“But if the investor’s situation unexpectedly changes, then the true risk of illiquidity could be felt.
“Regardless, because these assets are priced infrequently, the true economic reduction in valuation can accumulate through time, and then an investor can get hit in one go.
“Plus, all illiquid assets will likely be affected at the same time. This leads to illiquidity risk having very fat tails.”
“A final disadvantage of illiquid assets is they introduce potential concentration risks and can reduce returns associated with being unable to effectively rebalance portfolios.
“Rebalancing can generate positive returns because it forces you to sell high and buy low. Having illiquid assets means you can’t always do that.
“Inability to rebalance means the portfolio could become overly exposed to illiquids, and potentially at the worst time.
Whole-of-portfolio consideration
It’s a whole-of-portfolio consideration that people often ignore or don’t think about when investing in illiquids.”
Shifting to liquid alternative investments will be a theme for this year, Polley says.
“Look for those that offer true diversification benefits and other forms of returns besides traditional equities and bonds.
“Look for assets that have a secular tailwind, such as sustainable investment companies, and investments with inflation linkage.”
About Alan Polley and Pendal’s Multi-Asset capabilities
Alan is a portfolio manager with Pendal’s multi-asset team.
He has extensive investment management and consulting experience. Prior to joining Pendal in 2017, Alan was a senior manager at TCorp with responsibility for developing TCorp’s strategic and dynamic asset allocation processes covering $80 billion in assets.
Alan holds a Masters of Quantitative Finance, Bachelor of Business (Finance) and Bachelor of Science (Applied Physics) from the University of Technology, Sydney and is a CFA Charterholder.
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
Inflation remains a key driver of investment markets, just as it was throughout the first quarter. Here’s how our head of multi-asset MICHAEL BLAYNEY is approaching asset allocation right now
- Inflation could remain sticky
- Some opportunities in equities and listed real assets
- Credit spreads a poor risk-reward proposition
- Find out about Pendal’s multi-asset funds
DESPITE yesterday’s news of a continued easing in Australia’s monthly CPI from 7.4% to 6.8%, inflation will remain a key driver of investment markets, just as it was in the first quarter, says our head of multi-asset Michael Blayney.
“While inflation looks to have peaked, it could become sticky in some economies,” Blayney says.
“In the US, for example, it could remain around the four to five per cent range with further falls dependent on softening wages and increased labour capacity.”
Investors are pricing in a normalisation of inflation.
“But markets react relative to what’s priced in. If inflation proves to be stickier than what’s priced in, that creates risks for both bonds and equities.”
Global equity markets have been erratic this year. The first couple of months equities rallied and then they fell back in March.
Where they go to next will be very much about inflation — and it’s similar for fixed income markets, he says.
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“Doubts remain as to whether central banks can engineer a controlled reduction of inflation pressures or whether their actions overshoot and create demand destruction and a deep recession.
“These considerations suggest a cautious risk stance across asset classes,” Blayney says.
How to approach this environment
For investors, the macro-economic backdrop means they need to seek out opportunities and understand relative valuations.
Equities
“Global equity markets are around fair value with Japan and the United Kingdom still cheap and the United States and some European markets still expensive,” Blayney says.
“We are marginally underweight overall, still cautious on downside risks to earnings.”
“Equities have ‘de-rated’ and valuations have become much more reasonable across a wide range of markets.
“But the outlook remains uncertain, given the downside potential in corporate earnings and risks from the lagged impacts of monetary policy tightening,” he says.
Midcaps on
the move
Hear from lithium industry pioneer
Ken Brinsden and Pendal’s
Brenton Saunders
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Bonds
Pendal has now moved to slightly underweight government bonds on a shorter-term basis, Blayney says.
“Global bond yields have fallen significantly from their highs, for example Australian 5 year yields are down 0.8 per cent year to date” he says.
“Higher-starting yields — compared to what were on offer two years ago — provide a degree of insulation. But bonds have already priced in economic weakness on the horizon, so further gains are only likely if the economy gets even worse than what’s priced in now.”
Credit
In credit markets, both investment grade and high yield spreads are somewhat higher than their long-term medians, Blayney says.
“But the clouded economic backdrop provides a poor risk-return proposition given the asymmetry in potential outcomes from here,” he says.
“The spreads available do not compensate adequately for the risk of a recession.”
Real assets
There are opportunities in listed real assets, Blayney says.
“Select listed infrastructure assets with inflation-linked cashflows provide good insulation in case high inflation is more stubborn than currently priced by markets.
“This is particularly true given how the asset class down-rated last year.”
About Pendal’s multi-asset capabilities
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
These include Australian and international shares, property securities, fixed interest, cash investments and alternatives.
In March 2024, Perpetual Group brought together the Pendal and Perpetual multi-asset teams under the leadership of Michael O’Dea.
The newly expanded nine-strong team will manage more than $6 billion in AUM and create a platform with the scale and resources to deliver leading multi-asset solutions for clients.
Michael is a highly experienced investor with more than 23 years industry experience, including almost a decade leading the team at Perpetual.
Managing through the current volatility takes perspective and patience. Pendal’s MICHAEL BLAYNEY has a few tips
- Rapid pace of rate hikes triggered failures
- Investors need to manage through volatility
- Hold cash. Be ready for opportunities
- Find out about Pendal’s multi-asset funds
THE past few weeks have demonstrated the need for perspective as investors manage portfolios through increased volatility, says Pendal’s head of multi-asset Michael Blayney.
As the graph below shows, the CBOE Volatility Index spiked to its highest levels for the year after crises involving Credit Suisse and Silicon Valley Bank.
CBOE Volatility Index so far this year
“We are not at extreme panic right now,” says Blayney. “But we are starting to see problems emerging.
“Central banks have raised interest rates at a rapid pace over the last year. By doing so it was always a possibility, or even a probability, that they’d break something.
“That’s what we are now seeing, and regulators are coming out and playing a game of whack-a-mole.”
Investors shouldn’t underestimate the extent to which policymakers will act faced with a crisis, he says.
“Regulators aren’t sitting on their hands for long periods of time – they’re dealing with each problem as it arises.”
Is it a buying opportunity?
Investors need to decide if the recent sell-off in equities is a buying opportunity, or whether markets are mid-crisis, and there’s further to fall.
A big positive this time around, compared to 2007, is that the financial system has been de-risked,” Blayney says.
“The fact that banks are generally better capitalised should give investors a little bit more confidence.
“There’s less downside risk than there was in 2008.
“Last year was poor in markets and that’s made valuations cheaper. Right now you are starting at fair value, so your downside risk is less than if you start at expensive valuations, like markets did in 2007.”
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However higher interest rates are affecting corporates and consumers — and tighter lending standards are having an effect, Blayney says.
“This adds weight to the argument that the US is heading for a recession, which would trigger a fall in corporate earnings, and in share prices.
Outlook for equities
“In equities, while we are cautious, we are not massively underweight,” says Blayney.
“Valuations are relatively OK and trend-oriented components of our investment process are not bearish.
“But there are economic downside risks.
“If we do see economic weakness but inflation remains entrenched – the stagflation scenario – that’s going to be very difficult for equities.”
“In that sort of environment you want to make sure you have some assets with decent inflation hedging cash flows in your portfolio to give you that defensiveness,” he says.
Time for bonds?
Bonds have been volatile not only in recent weeks, but for much of this year.
“In the US you are starting to see the market price in cuts later this year,” Blayney says.
“The market has shifted its concern to the economy and financial stability, rather than simply higher inflation and rates
“It’s a conundrum for central banks because inflation is still running too high. The consumer price index is certainly not within the US Federal Reserve’s target range yet.
“But central banks also need to maintain financial stability.
“It puts central banks in a very difficult position and creates a very uncertain backdrop for investors.
“From a portfolio perspective, if we see a more significant economic downturn and a tightening in the availability of credit, then bonds should be a pretty good place to be.
“But there is a caveat — because bond yields are below the cash rate, markets are already pricing some economic weakness ahead.
Currency exposure
Another thing that can help a portfolio, particularly for Aussie dollar investors, is currency exposure, says Blayney.
“In times of crisis, particularly if you see falling prices for key commodities, then the Australian dollar can sell off too. Foreign currency exposure can act as a bit of a stabiliser.
“From a portfolio perspective, take a slightly cautious approach. Don’t panic. Hold a little bit more cash. And be ready for a buying opportunity.”
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About Pendal’s multi-asset capabilities
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
These include Australian and international shares, property securities, fixed interest, cash investments and alternatives.
In March 2024, Perpetual Group brought together the Pendal and Perpetual multi-asset teams under the leadership of Michael O’Dea.
The newly expanded nine-strong team will manage more than $6 billion in AUM and create a platform with the scale and resources to deliver leading multi-asset solutions for clients.
Michael is a highly experienced investor with more than 23 years industry experience, including almost a decade leading the team at Perpetual.
A recession is still looking likely for major economies — but it may be further out, says Pendal’s head of multi-asset MICHAEL BLAYNEY
- Full impact of inflation, rates yet to hit economies
- US recession is still likely
- Disciplined investing will reap rewards
- Find out about Pendal’s multi-asset funds
WHY hasn’t the US already fallen into recession?
Why haven’t corporate earnings been crushed given inflation and the number of interest rate hikes?
Does it mean the United States, Australia and other major economies might escape a recession?
The short answer is no. The long answer involves lags in the economy, says Michael Blayney, head of multi-asset investments at Pendal.
“We know from history that it takes a while for inflation to flow through and hit earnings, and we know that monetary policy works with a lag,” Blayney explains.
The recently completed ASX earnings season demonstrates the lag effect, he says.
“Earnings haven’t massively disappointed, but they haven’t been awesome either.
“The word to use is ‘tepid’, both domestically and offshore. There’s been pressure on margins, but not at recessionary extremes.”
Turning points take time
Turning points in economic cycles take time and normally involve plenty of “noise” – information that can often be contradictory and not always conducive to good investment decisions or policy making.
That’s because changes in economic variables, like high inflation and interest rates, take time to hit the real economy, Blayney says.
Another variable in this unusual economic cycle is that consumers have been sitting on piles of cash saved during COVID.
Also, many corporates have fixed rate debt and it will take time for higher repayments to flow through. That is, consumer and corporate balance sheets have been pretty healthy to date.
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“As a result you have to be very careful when saying all is good post earnings season,” Blayney says.
Adding to the argument that a recession is on the way, is the growing view that central banks won’t stop interest rate hikes any time soon.
“Bond yields have been rising, and equity markets falling, because people just have a few more questions around the narrative that inflation is moderating,” Blayney says.
Recession likley — but further out
“The odds are still reasonably good that the US will fall into recession,” he says.
“The playbook says rates go up the escalator and down the elevator. But in the last year, rates have gone up the elevator and that creates a lot of risk.
“While there are things that might delay it – COVID savings for example – ultimately if inflation pressures persist, central banks have to make a choice to beat inflation over short term economic growth.
“A recession is still likely, but it’s going to be pushed further out.”
What does it mean for portfolio construction?
Investors should remain calm and try and look beyond the noise.
“If you look at the lead story on the television every day and invest on that back of that, you probably won’t get a good result,” Blayney explains.
“But if you have our own disciplined process and follow it consistently through time, you should make money in the long term.”
“We are ever-so-slightly on the defensive side of neutral, holding a little more cash than usual and waiting for opportunities.”
Adviser Sam is invested
in making our world
A better place.
Watch as Sam meets a
mum rebuilding her life
thanks to responsible
investing
About Pendal’s multi-asset capabilities
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
These include Australian and international shares, property securities, fixed interest, cash investments and alternatives.
In March 2024, Perpetual Group brought together the Pendal and Perpetual multi-asset teams under the leadership of Michael O’Dea.
The newly expanded nine-strong team will manage more than $6 billion in AUM and create a platform with the scale and resources to deliver leading multi-asset solutions for clients.
Michael is a highly experienced investor with more than 23 years industry experience, including almost a decade leading the team at Perpetual.
The RBA is getting close to pausing, but another rate rise is probable in May, says Pendal’s head of cash strategies STEVE CAMPBELL
THE Reserve Bank lifted the cash rate for a tenth consecutive meeting today – up 0.25 percentage points to 3.6%.
“When and how much further interest rates need to increase” would depend on “developments in the global economy, trends in household spending and the outlook for inflation and the labour market”, the RBA said.
The next Australian labour market data is due on March 16.
Unless the data is exceptionally strong, it’s unlikely to be the sole catalyst for the RBA to move again in April.
The RBA made reference to recent wage inflation data which suggests a lower risk of a wages-prices spiral.
The key data release that will determine the next move is first-quarter inflation, due for release on April 26.
This will be the RBA’s own version of two-up played a day earlier on Anzac Day.
At this stage a rate hike looks less likely in April, but probable in May.
The RBA is getting close to pausing, particularly with the large amount of fixed rate mortgages rolling off from mid-year.
Household balance sheets have withstood policy tightening to date reasonably well, drawing on accumulated reserves and benefitting from a tight labour market.
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The risk to the system though is the tail.
Many households that took out a mortgage in 2020 and 2021 have little or no buffer to fall back on.
The key factor here is the labour market.
The unemployment rate will rise as the participation rate increases with an influx of foreign workers.
It’s when the hiring turns to firing that true stress in the market from policy tightening will emerge. Already for some it’s been a case of heads I win, tails you lose.
About Steve Campbell and Pendal’s Income and Fixed Interest team
Steve Campbell is Pendal’s head of cash strategies. With a background in cash and dealing, Steve brings more than 20 years of financial markets experience to our institutional managed cash portfolio.
Find out more about Pendal’s cash funds:
Short Term Income Securities Fund
Pendal Stable Cash Plus Fund
Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.
The market’s turnaround from last year’s pessimism is a short-term reaction to a “perfect storm” of positive events – and investors should take a cautious approach, says Pendal’s ALAN POLLEY
- Perfect storm of positive news buoying markets
- Medium-term outlook less clear
- Find out about Pendal’s multi asset funds
THE monetary policy outlook and the effect of higher rates on households and business earnings will dictate how markets trade over the rest of the year, after a strong start to 2023 that leaves more room for downside than upside, says Pendal’s Alan Polley.
Polley believes recent rising markets are the result of a “perfect storm” of positive news, with softening rhetoric from central banks, China’s reopening, mild weather in Europe and better-than-expected corporate earnings.
But he cautions that much of the 15 per cent-plus gains in equities so far this year can be explained by near-term events like investors closing out last year’s short positions — and there is less clarity about the medium-term prospects for shares.
“We’ve been fading some risk exposure here and there into the strong rally and the reason for that is we think the cumulative effect of higher interest rates is still out there on the horizon,” says Polley, a portfolio manager with Pendal’s multi-asset team.
“We’re still concerned. Markets have pretty much priced out a deep recession but while conditions are better than what you may have thought a few months ago, there is still the risk of recession. Yes, less than before — but it is still a material risk.
“We think the market went too far and has been too optimistic.”
Markets have staged a remarkable turnaround from last year’s pessimism.
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“Last year, we had a massive bear market — top to bottom was about a 25 per cent drawdown.
“So going into the end of last year, there were a lot of people short — if there’s all these fundamentally positive events in quick succession, they have to cover their shorts.
“That’s a big reason why equity markets have rallied — 15% is a big rally.”
But short-term gains mean markets no longer offer the value they did a few months ago, meaning the risk is tilting to the downside.
“This is a short term, exuberant rally. Yes, some fundamentals were better than expected which gave it some credence, but positive short-term sentiment has compounded the rally beyond a point that is consistent with the fundamental outlook.
“There is a significant accumulated increase in interest rates that will affect the real economy at some point in the near to medium term.”
Polley says the effect of accumulated rate rises could take a year or more to be fully reflected in the real economy.
“That’s why we think there’s more downside than upside.”
He says investors should pay close attention to corporate earnings, which is where the effect of higher rates on household spending and business activity will start to show up.
So far results are mixed in the current ASX half-year reporting season.
“There’s downside risk on earnings. If earnings are further adjusted down, then equities have more downside risk than upside so there’s not much rationale for material gains at this point, especially after we’ve had markets rally 15%.
“We don’t see reason to have a lot of risk. Our signals are suggesting being reasonably neutral.”
About Alan Polley and Pendal’s Multi-Asset capabilities
Alan is a portfolio manager with Pendal’s multi-asset team.
He has extensive investment management and consulting experience. Prior to joining Pendal in 2017, Alan was a senior manager at TCorp with responsibility for developing TCorp’s strategic and dynamic asset allocation processes covering $80 billion in assets.
Alan holds a Masters of Quantitative Finance, Bachelor of Business (Finance) and Bachelor of Science (Applied Physics) from the University of Technology, Sydney and is a CFA Charterholder.
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
Markets are around fair value, economic data is contradictory and market momentum is patchy — so it’s a good time to be close to neutral, argues Pendal’s MICHAEL BLAYNEY. But be ready for opportuities
- Inflation still high but moderating
- US rates likely to rise another 50 basis points
- Investors should be neutral in equities and bonds
- Find out about Pendal’s multi-asset funds
INTEREST rates are set to rise again after this week’s US CPI figures, though the data shows some heat is coming out of inflation.
The January headline rate of inflation in the US was 6.4 per cent higher than a year earlier. Core inflation was up 5.6 per cent.
It was “pretty much as expected”, says Pendal’s head of multi-asset Michael Blayney. “Inflation is too high but it’s coming down.”
How should investors react?
“There are always risks,” says Blayney. “It’s a natural feature of the economic/market cycle. Inflation, interest rates, earnings and the potential for a recession are all in focus.
“For investors, that means sticking to their plan.
“Markets are fair value at the moment and it’s a good time to be a bit like Switzerland – neutral. It’s time to be patient and wait for an opportunity.”
Market expectations matter
While the absolute CPI numbers matter, markets tend to react relative to expectations, notes Blayney.
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Market reaction to this week’s CPI print was relatively muted.
“For the market, it’s not what the number is,” says Blayney. “It’s what the number is relative to what the market expected.”
“The US inflation figures reinforce the high probability of a 25-basis point hike to 5 per cent in March.
“But it doesn’t change the overall picture of high-but-moderating inflation.
Futures markets are implying the Fed Funds rate will peak around 5.25 per cent mid-year.”
Inflation will fall before rates
One difference this cycle is that the Fed will be determined to see inflation falling before cutting interest rates – having learnt from past experiences, Blayney says.
He notes that market volatility after an inflation print or Fed rates decision has lessened in recent months.
“Those factors remain very important, but markets have shifted their attention somewhat to recessionary risks and corporate earnings.”
Recession outlook
In terms of recessionary risks, Blayney says leading indicators have been weakening over the past year, though there has been a small bounce recently.
“They’re still bad, but less bad – and that usually makes markets reasonably happy.”
And while corporate earnings have been downgraded, things aren’t as poor as first feared.
Blayney adds a caveat: “Historically spikes in inflation and the related Fed hiking cycles have flowed through to earnings with a lag.”
Another factor is Pendal’s in-house market stress indicator, which has been falling for a number of months as markets start to see a turning point for inflation.
Finally, China reopening, and Europe emerging from winter much better than expected in economic terms, has mitigated global recession risks.
Where to look for opportunties
Blayney says it’s a good time for investors to be Switzerland – neutral.
“Markets are around fair value. Economic data is contradictory and market momentum is patchy so it’s a good time to be close to neutral.
“But there are still some reasonable relative value opportunities.
“For example in equities, small caps all around the world are cheap relative to large caps. In the US for example, small and mid-caps as a percentage of market cap are near 20-year lows.
“That doesn’t necessarily mean they outperform in the short term if there is a recession, but it does mean they have a great set-up for the next decade.”
Bond holdings should be around investors’ strategic long-term level.
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“They will still be helpful in the case of a recession, and are now generating much better yields,” Blayney says.
“It’s hard to make a compelling case for credit at the moment given spreads have shrunk. Right now you simply aren’t paid well to take on credit risk.”
Stay diverse
As always, it’s about having a diversified portfolio, Blayney says.
“You need to own some assets that will do well if growth is better than expected, like equities, and some assets that will do better in a recession, like bonds.
“And you should hold some assets with cash flows that are indexed to, or resilient to, higher inflation.
If market pricing is wrong and there’s persistent inflation, investors are going to want this because historically inflation has tended to be bad for earnings and bad for bonds.”
About Pendal’s multi-asset capabilities
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
These include Australian and international shares, property securities, fixed interest, cash investments and alternatives.
In March 2024, Perpetual Group brought together the Pendal and Perpetual multi-asset teams under the leadership of Michael O’Dea.
The newly expanded nine-strong team will manage more than $6 billion in AUM and create a platform with the scale and resources to deliver leading multi-asset solutions for clients.
Michael is a highly experienced investor with more than 23 years industry experience, including almost a decade leading the team at Perpetual.