Russia’s unprovoked invasion of Ukraine is causing structural changes to commodity markets that will be with us for a generation, says Pendal resources and midcap manager BRENTON SAUNDERS

• Commodity markets undergoing structural changes
• Not widely understood by investors
• Find out about Pendal MidCap Fund

RUSSIA’S unprovoked invasion of Ukraine is causing structural change to commodity markets which will not be easily reversed as the world weans itself off Russian energy and mineral exports, says Pendal’s Brenton Saunders.

Saunders, who manages Pendal Midcap Fund and has extensive experience in resources, says the market is underestimating the depth and longevity of the changes that will result from Russia’s aggression.

The war will lead to long-term rises in commodity prices, he says. And buyers are likely to turn to Australia for commodities they once bought from Russia.

“Russia is such a big player — natural gas and coal but also steel, aluminium, fertiliser, nickel and palladium,” says Saunders.

“The eventuality, extent and longevity of the Ukraine invasion has led to an evolution of thought about what it means — not only for Russia, but how the free world reorganises itself to lower its dependence on Russia and protect itself against further military issues with Russia.”

Long-term support for commodity prices is enhanced because rising energy prices drive production costs higher, Saunders says.

“When energy prices go up, the cost curves for all the commodities go up. As long as energy prices stay high, commodity prices stay high for longer.”

The market dislocation should also take some of the pressure to decarbonise off the fossil fuel industry as the world reorganises itself to go without Russian energy.

Saunders sees a growing role for uranium and nuclear power as the once-maligned fuel gets new consideration as a climate friendly energy source.

“Uranium has been sidelined in the wake of the Fukushima disaster, but it should play a much bigger part in the decarbonisation process,” says Saunders.

“Now it’s being recognised as a necessary part of the landscape again by a whole host of OECD countries.”

Implication for portfolios

The implication for portfolio construction is to seek exposure to the commodities that with be beneficiaries of the transition away from Russia, Saunders says.

“By and large we are in a defensive frame of mind, but it’s a stock-picker’s market and there are some real gems out there that we’re finding.”

Pendal analysts recently met with BHP’s marketing team who relayed stories of sustained disruption in commodity supply.

“When you speak to the BHP marketing and logistics team that are dealing with these cargos for their customers all over the world, you can see that the impact and implications from this are wide-ranging and immediate.

“You have got ships that won’t go to certain parts of the world anymore to transport commodities. Ships that can’t get insurance to go to certain parts of the world. Traders that can’t get collateral to deal with parts of the world they have been dealing with for decades.

“This is the biggest dislocation I’ve ever seen in commodity markets.

“The war will — and we pray it does quickly — but the implications will be with us for a generation.

“I’m not sure the markets completely understand that.”

Sustainable investors may receive APRA letters informing them that their super fund has failed a performance test — even though it’s doing precisely what was intended. Pendal’s ANTHONY SERHAN explains

• APRA testing compares super funds to unscreened, cap-weighted indices
• Sustainable funds that screen out sectors like fossil fuels are left at a disadvantage
• Find out about our sustainable Aussie equities Pendal Horizon Fund

THE federal government’s Your Future, Your Super annual testing regime for super funds is disadvantaging investors seeking to do good with their savings by investing in sustainable or impact funds, says Pendal’s Anthony Serhan.

Sustainable investing is a fast-growing part of the superannuation industry. Responsible investing now influences strategic asset allocation for most super funds in Australia (55% up from 39% in 2019).

But the YFYS test administered by the Australian Prudential Regulation Authority benchmarks super funds against pre-set, cap-weighted, broad-based indices — without regard to factors like the environmental impact of the underlying companies.

“If you’re investing in a sustainable way, you can be investing a long way from unadjusted market capitalisation weighted indexes,” says Serhan, Pendal’s distribution director.

“In Australia, an investor who wants to support net zero carbon emissions will not want to invest in anything related to fossil fuels — but that takes out a huge chunk of the market.

“Yet you’re being compared to something that does include those fossil fuels stocks, as well as other sectors of concern including tobacco, gambling and armaments.

“That’s clearly going to create noise. While it’s reduced over longer periods, the YFYS test is dealing in basis points — so if there’s a significant move at the start or end of a reporting period it will still impact the results.

“And while the eight years used in the test is a long period, some of the themes addressed in sustainable strategies are multi-decade.”

Serhan says the result is that some investors will receive letters informing them that their super fund has failed the performance test — even though it’s doing precisely what they intended it to do.

“It is highly probable sustainable super funds will fail the test at some point because they are not owning certain parst of the market.

“Is that a good policy outcome? Probably not.”

Impact on global equities

And it’s not just investors in Australian equities that are disadvantaged by APRA’s tests.

Global sustainable investors tend to be underweight developing countries that naturally have fewer large companies fitting ESG criteria.

Yet they are now compared to indexes that fully weight emerging markets and pay no regard in the allocation process to issues such as human rights and the rule of law, corporate governance standards, or environmental impact.

“What do you do about that? If you’re a sustainable manager you’re likely underweight emerging markets which creates a mismatch between the index and your portfolio — that either creates noise or you’re going to have find a way to close that gap,” says Serhan.

Potential solutions

Serhan says the solution for APRA would be to adopt more flexible frameworks to assess super funds, judging them more on performance against their stated aims rather than against a passive index approach.

The APRA tests are likely to see a convergence of portfolios around the stated benchmarks which will push some investors to self-managed super funds where there is currently greater flexibility to do good with their super savings while investing for retirement, he says.

“The market cap weighted indices are simply a reflection of what has worked in the past — they are not a reflection of where markets are going in the future and they certainly don’t reflect which companies will be the winners from the move to net zero.”

So, what should you do when you get that letter saying your fund has failed APRA’s tests?

“Take a look at the fund and make your own assessment — is this fund delivering what I wanted it to deliver?” says Serhan.

“The letter will point you to government websites or super comparators — but these are very poor forms of financial advice.

“Instead, just ask yourself and your financial planner: am I happy with the returns and what the fund is achieving in the way it invests my money?”

Investors willing to pick through the market stock-by-stock have an opportunity to uncover good companies that have been oversold in the market’s volatility, says Pendal’s BRENTON SAUNDERS

• Rate rise cycle to be steeper and longer than usual
• Growth stocks derated
• Opportunity for stock-picking approach

THE volatile start to markets in 2022 has been well-documented — the expected tapering of covid stimulus, higher inflation and rising interest rates have prompted investors to recalibrate portfolios.

Market decline has been substantial in some sectors as investors absorb US Fed policy refinements.

But the wholesale sell-off is creating opportunities for investors willing to take a stock-picking approach, says Pendal portfolio manager Brenton Saunders.

“The market is changing gear substantially in quite a short period of time,” says Saunders, who co-manages Pendal’s Midcap Fund.

“Even though the catalyst for the change has been consensus view for a while now, investor positioning is only now changing to reflect the macro environment.”

In recent weeks the US Federal Reserve has spent time educating markets that the rate hike cycle this time around is likely to be longer and steeper than previous cycles, says Saunders.

“The current macro economic backdrop is very different from cycles in recent times.

“Previous rate hike cycles have been short and sharp — this one will be different.”

This has important implications for asset allocation and for sector allocation within equities, Saunders says.

“A lot of the stocks and sectors that were beneficiaries of the huge stimulus we’ve seen through Covid are now starting to battle the impact of higher bond yields and the prospect of higher interest rates down the line.”

The result has been an asymmetric sell-off: highly rated stocks, especially those that are not yet profitable, have sold off hardest.

And while the headlines have been about well-known technology stocks, this phenomenon has also affected early-stage Australian resources stocks like explorers and developers.

“Many long-duration stocks have been hit hard.”

Stock-by-stock approach

The result is that investors willing to pick through the market stock-by-stock have an opportunity to uncover good companies that have been oversold in the market’s volatility.

“We think asset performances will be quite moderate this year and stock selection will be more important than it has been in recent years.”

Saunders says a rising rate environment typically hurts the share prices of highly rated, high-growth companies, while more defensive high-quality stocks with high dividend yields and strong earnings tend to be better favoured.

“With a notional increase in the cost of capital, long-duration companies — especially companies that have most of their profits in prospect and not in the present — tend to get hurt more,” he says.

But that does not mean all growth stocks will do badly, he says.

“One of the characteristics of this current cycle is that the fundamentals underlying many growth stocks remain incredibly robust.

“In many cases the demand for services in these areas remains strong along with a strong pricing environment. They continue to have cyclical tailwinds.”

Caution on earnings

Risks associated with earnings disappointments are currently high.

The risk of highly rated stocks failing to meet the market’s expectations is a sharp de-rating.

“For the first time in a while, it’s our sense that 2022 will be less about beta and more about alpha.

“That’s an environment that we typically thrive in — identifying stocks on their individual characteristics and investment theses, as opposed to making directional bets over where the market is headed.”

Further bolstering the argument for stock picking in Australia this year is the recent reunification of BHP’s dual-listed structure into a single, ASX-listed company.

This lifts BHP’s weighting in the ASX200 from around 6 per cent to above 11 per cent.

“For anybody investing in an index-aware fund that includes large caps, there’s stepwise increase of around 5 to 6 per cent in your exposure to materials and the iron ore price and everything that that goes with that.

“That’s a significant change in a short period of time.”

The outlook for major ASX-listed miners is looking positive again. But investing in resources is now more nuanced with issues such as ESG and China. Pendal’s BRENTON SAUNDERS explains

• Outlook for miners is mixed and heavily dependent on China
• But conditions should be right for a rebound next year
• ESG issues come to the fore in AGM season

WITH a combined market cap of $190 billion, BHP, Fortescue and Rio Tinto are all top 15 companies and key pillars of the ASX.

They’re hard to avoid if you’re investing broadly in the ASX.

Iron ore is the major export of all three. When the price of the ore was above $US230 a tonne, the big three miners were reaping the benefits, and all three paid shareholders a special dividend this year.

But iron ore prices have dropped back to around $US100 a tonne and the share prices of the big three have underperformed in recent months.

So what’s ahead?

“The landscape for resources is pretty dynamic at the moment,” says Saunders, an experienced geologist and manager of Pendal’s natural resources portfolio.

“Investing in resources is now much more nuanced and that has to do, in large part, with how the Chinese economy has evolved.

“The outlook is also dependent on how demand and supply evolves for some of the major commodity groups, particularly energy.

“To that extent, the outlook for the large cap miners is looking more positive again, in part because they have sold off as much as they have, as has their principal commodity, which is iron ore.”

Improved outlook for 2022

“I think it’s reasonable to think that in the first half of next year — and probably the second quarter — that the sector will improve again, albeit off a highly eroded base,” Saunders says.

The next few months could still be bumpy though.

Chinese demand for iron ore and steel is low and could get worse, Saunders says. But most of the negative sentiment is priced in.

“Also, this time of year is difficult for China from a pollution perspective as the country heads into winter and generates a large temperature inversion layer across the big metropoles, making pollution worse,” Saunders says.

“Typically at this time of year, there are restrictions on production. Then we move into Chinese New Year and after that there’s normally a rebound.”

But 2022 will be different with the Winter Olympic Games being held in Greater Beijing in February and the government determined to keep pollution levels down.

“The Beijing region does host a large percentage of the country’s steel production, so that will probably be depressed until the end of February,” Saunders says.

“Then as we move into spring, we could see an aggressive rebound that could be concurrent with stimulus and a lightening of some of the regulatory imposts on the property sector.

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“There should also be a partial restocking of the steel value chain that’s been quite heavily denuded.”

ESG issues come to the fore in AGM season

It was an interesting AGM season for the major miners — in large part thanks to the evolution of environmental, societal and governance (ESG) concerns, votes on remuneration and the emergence of vocal, activist investors.

Faced with volatile commodity prices, ESG challenges and plenty of activist investors, two of the big three — BHP and Fortescue Metals — have fronted shareholder in recent weeks. Rio’s AGM is later in the year.

One of the key benefits of Fortescue’s AGM is that it allows shareholders to learn more about what Fortescue Future Industries (FFI), the company’s green offshoot, is doing, says Saunders.

“It’s been a bit frustrating for shareholders because there isn’t a lot of transparency in FFI,” he says.

“The FFI business is evolving fast and it’s difficult to keep track of,” he says. “But at AGMs we learn more about it and this year was no exception.”

Two weeks ago, at the Fortescue meeting, chief executive Elizabeth Gaines revealed FFI had an unspent allocation of funds from last year, and the offshoot plans to spend $US600 million on clean energy projects this year.

BHP’s AGMs have demonstrated how the company has evolved and has been paying more attention to ESG issues.

“Over the last three years at its AGM, BHP has faced at least one quite controversial ESG proxy, or proposal,” Saunders says. “And over those three years they have become much more embracing of them because BHP’s ESG process in the background has evolved.

“BHP has actually approved some of these proposals, though when these issues first emerged several years ago the approach from them initially was to throw their hands up in the air and say that’s not feasible, or it’s unrealistic.

“There’s been quite a big evolution along the ESG lines specifically for BHP to become more aligned with some of the objectives of these action groups.”

What are the major factors impacting iron ore prices, what’s likely to happen next and what role should big miners play in a portfolio right now? Pendal’s Brenton Saunders explains

• Falling iron ore prices depressing the miners’ stock prices
• Outlook hinges on Beijing policies
• Strong dividends make sector hard to ignore

A dramatic fall in iron ore prices has delivered a swift turn in fortunes for the big mining companies that only months ago were enjoying posting record profits.

We asked What is the outlook impact for inevstors and

The price of the steel-making commodity has almost halved from its July record of nearly $220 a tonne to trade briefly below $100 in recent days as a change in China’s demand for the commodity drives lower prices.

The decline is raising questions about the prospects for the three big Australian iron producers, BHP, Rio Tinto and Fortescue Metals Group, which until recently have used their inflated margins to reward shareholders with all-time-high dividends.

“There are not many large businesses whose revenue can double and halve inside of 12 months — and these are some of them,” says Brenton Saunders, an analyst and portfolio manager at Pendal who follows the iron ore market.

Investors should take a step back to understand the recent history of the commodity and the ebbs and flows of steel production in China which make up half the global demand for iron ore, he says.

A change of gears

“Iron ore has been through an amazing change,” says Saunders, driven by Covid-related stimulus in China.

“We just absolutely changed gears,” says Saunders. “China implemented a range of fairly old-school stimulus measures that resulted in a further acceleration of housing and infrastructure investment.”

The result was that much of 2020 was characterised by enormous iron ore demand from China, compensating for pandemic-related shutdowns elsewhere in the world.

“Then by the third quarter of 2020, the rest of the world had also implemented a large amount of stimulus and was starting to recover from the first Covid wave.

“That created the perfect storm — China was taking all the iron ore the world could offer and the rest of world was starting to recover.

“There just wasn’t enough iron ore to go around.”

Then China changed its tune.

China moves to lower demand

The price of iron ore got so high it was starting to cause dislocations in the downstream products that steel is used for, and Beijing took a strategic decision to lower demand and bring prices back down.

One move was to target improved environmental outcomes and improved air quality by limiting steel production. The second was the tightening of controls around property developers’ leverage.

Both moves worked.

“They announced they were going to limit steel production to the same level as 2020,” says Saunders.

“That seemed an impossibility, but steel production in China has fallen so far that it looks like we will get pretty close to flat year on year, which means the decline in the second half of 2021 has been about -12% on 1H 21 and -17% from the peak in May.”

It was that decline that brought about the initial downdraft in the iron ore price, which was then compounded by a deterioration in sentiment in the property industry which accounts for around a third of steel demand in China.

“It created the perfect storm in the opposite direction,” says Saunders.

What it means for investors

The question is what happens next?

Saunders says he expects Chinese property construction to enter a sustained decline.

Land sales — a leading indicator and normally hotly contested — are seeing low clearance rates and lenders are less inclined to make credit available.

Environmental and air quality concerns will likely also see steel production capped, especially with Beijing hosting the Winter Olympics in February.

Chinese steel production will remain depressed until at least the end of February next year before a more fundamental rebound, Saunders says.

“But by that stage, the Chinese supply chain in steel is going to be fairly heavily depleted and will need to be restocked.

“There is the potential for a much better end of first quarter next year — but it could get worse before it gets better.”

Portfolio point of view

So, given that background and volatility, what role can iron ore stocks play in a portfolio right now?

Are they a must-hold or something investors can safely ignore?

“The volatility is intimidating at times,” says Saunders. “But the volatility can be offset by high, fully-franked yields.”

Fortescue Metals Group will pay a fully franked yield of more than 10 per cent over the next year for shareholders buying now. That yield may well be unsustainable, but it is a substantial fillip to a portfolio’s income.

BHP and Rio Tinto’s dividends will also be high, approaching 10 per cent and underpinned by the fact both businesses have significant non-iron ore operations.

BHP’s metallurgical coal operations are still enjoying strong price rises even as iron ore prices fall. Rio’s massive, vertically integrated aluminium operations produce one of the world’s fastest growing metals that is critical to the transition to net zero carbon emissions.

Saunders says the trick to making portfolio decisions on iron ore is to have a well-held view on the value of the big companies based on a “through-the-cycle”, long-term iron ore price derived from cost-curve analysis.

From there, a cyclical overlay tells you whether to buy or sell at any given point.

And right now?

“I’d have to say it’s a relatively easy and low-risk decision to buy the iron ore stocks at the moment,” says Saunders.

“The valuation overlay is attractive as the stocks have come back significantly, and the forecast yields are high.”

Think impact investing is only about solving problems in less-developed nations? You might be surprised to find opportunities in the developed world — such as water preservation. Regnan’s Tim Crockford explains in this fast podcast.

Listen to the podcast above or read the transcript below

Interview with Tim Crockford, head of Regnan’s impact investment team

Interviewer Sean Aylmer: Tim Crockford, explain exactly what impact investing is.

Tim Crockford, senior portfolio manager of Regnan Global Equity Impact Solutions Fund:
Impact investing is ultimately a form of investing where your investments are going towards companies that can solve problems relating to some of the major environmental or social challenges that we face globally

The idea behind the concept is if you can finance the companies that are trying to solve these challenges, ultimately these companies are able to come up with some pretty innovative and unique solutions for this set of problems, which of course is getting increasingly urgent to solve.

Interviewer: Why are we hearing so much more about impact investing now than say two years ago, let alone five years ago?

Tim Crockford: Good question. There are multiple catalysts, not least the Covid crisis we’ve all been facing over the last 18 months. That’s brought to light the effect of human activity and human economic activity. More generally we’ve got a number of underlying challenges which have been snowballing over the last five or 10 years. They are probably accelerating more recently since we’re getting to the stage that we can no longer procrastinate. We can no longer delay trying to address them.

Interviewer: What are the sectors or geographies where impact investing is most likely to play its greatest role?

Tim Crockford: It’s broad. It’s really across the board. The UN Sustainable Development Goals (SDGs) – when they were released back in 2015 – brought to light how some of the sustainability challenges that we face.

We tend to think of sustainability challenges as something for the more remote corners of the earth, in developing regions or frontier regions. But the interesting thing about the UN SDGs is they brought to light the extent to which some of these challenges are much closer to home to us.

You have issues like extreme poverty and improving social mobility which are typically challenges faced by some of the less-developed nations.

But if you look at challenges we face around waste and waste management and water, you’re talking about developing nations or indeed some of the most developed and mature countries.

So what’s increasingly changed over the last few years is this view that some of the major sustainability challenges are much closer to home.

Interviewer: In some ways that must make them more investable.

Tim Crockford: Yes, absolutely. We’ve been talking a lot this year about water as one of the major issues that needs to be addressed sooner rather than later. When it comes to water transmission and water infrastructure, the biggest problem is in the most developed of nations like the US, the UK and Australia, where you have water infrastructure, that’s aged so much and has been in the ground for so many years.

And it’s facing challenges, for example leaking. If you look at the US there is this massive problem where the US grid system loses the equivalent of 4 million Olympic-sized swimming pools worth of water every year, just through infrastructure leakage.

So one of the challenges there is just plugging the holes and stopping that massive loss of water – which would otherwise be potable and going to more productive uses.

So that is a good example of something that is a challenge being met by companies that are investable in places like the US.

Interviewer: So if I’m thinking about investing impact investing in terms of portfolio construction, it’s not really a discrete part of my portfolio. It’s more tied to the different asset classes that I want to invest in?

Tim Crockford: That’s what we think. We don’t see this as something that should be niche or the cherry on the cake in people’s portfolios.

The vast majority of our clients tend to not have a specific allocation for sustainable or impact equity. The vast majority will place us in their broader global equity allocations. Ultimately the fund we are running (Regnan Global Equity Impact Solutions Fund) is a global equity fund.

Given the differentiated collection of equities that they get with our portfolio, when they put our portfolio together with their other global equity managers they get access to a collection of companies and stocks which otherwise wouldn’t typically be in your average global equity fund.

So there’s a have-your-cake-and-eat-I approach taken by a lot of our investors. They’re seeing an opportunity to get exposure to some of these themes and to allocate more of their portfolios towards sustainable and impact.

On the other hand, from a portfolio construction point of view, they’re getting a nice diversified and differentiated collection of companies which they otherwise wouldn’t be investing in.

Interviewer: We’re five weeks away from the 26th United Nations Climate Change Conference in Glasgow at the beginning of November. What sort of difference does a conference like that make to investing?

Tim Crockford: At the margin it’s another catalyst bringing to light the huge financing gap that needs to be plugged.  A lot of this is about raising awareness of just how much funding is required to solve some of these environmental, as well as social challenges.
But we are more likely around that time to be making a bit of noise, not just about the problem aspect, but about the solutions. Because from an investment point of view, the flip side of the coin is that this is a massive investment opportunity for those investors who are willing to get ahead of the curve.

This is a massive investment opportunity for investors who can see that this gap in financing exists and those early players – those investors that are early to the party – are going to be well-rewarded.

So it is an opportunity on one hand to bring the challenge and the problems to light, but for us it will be making noise about some of the solutions that exist and the opportunity side of things.

Interviewer: Tim, thank you for talking to Pendal newsletter The Point. That was Tim Crockford, lead of the Regnan Equity Impact Solutions team.

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About Tim Crockford

Tim Crockford leads Regnan’s Equity Impact Solutions team and is senior fund manager of Regnan Global Equity Impact Solutions Fund. Tim previously managed the Hermes Impact Opportunities Equity Fund after co-founding the Hermes impact team in 2016.

Significant Features: The Regnan Credit Impact Trust is an actively managed portfolio of fixed interest securities. The trust focuses on investments anchored to impact goals adapted from the United Nations Sustainable Development Goals.

Fund Objective: The trust aims to generate positive and measurable social or environmental impact, or both; and a return (before fees, costs and taxes) that exceeds the RBA cash rate over rolling 3-year periods.

CFA, GAICD

Anthony joined Pendal Group as Distribution Director in October 2018 and is a member of the Australian Executive team. Anthony is responsible for leading the Distribution, Marketing and Client Service functions, drawing upon his extensive experience in retail and institutional funds management.

Anthony joined Pendal following his tenure of fifteen years in senior leadership roles at Morningstar. Most recently Anthony was Managing Director, Research Strategy Australasia where he was responsible for the development of research and commentary on investment themes and trends within the Asia-Pacific region, in addition to representing Morningstar’s manager, equity and credit research capabilities. Anthony’s remit also extended to the development of retirement research, public policy initiatives, and engagement with regulatory authorities. Prior to this role, Anthony was also CEO, Australia and New Zealand from 2010-2014 and Managing Director of Morningstar Investment Management from 2009-2010. Anthony’s prior experience includes senior appointments ASSIRT Research and AMP Consulting.

Anthony is a director and immediate past president of the CFA Society of Sydney and a member of the National Advocacy Council. He is a Graduate Member of the Australian Institute of Company Directors, a CFA charterholder, holds a graduate diploma in Applied Finance and Investments from FINSIA, and a bachelor’s degree in Business from the University of Technology, Sydney.

Here are the main factors driving Australian equities this week according to our head of equities Crispin Murray. Reported by quantitative analyst Lee Ma

GLOBAL markets rebound marginally last week. The S&P500 gained 0.5% while the S&P/ASX 300 index finished in the red (-0.8%).

The market is clearly weighing up negatives around central banks removing stimulus earlier than expected versus the positives of a strengthening global economy.

Our view is that the taper is now largely priced in by the market. The incremental news is that the global economy is re-accelerating after the Delta-driven slowdown and an easing of some supply chain bottlenecks.

This should lead to an equity market rally into the year’s end.

The main news last week was the ongoing Evergrande story amid Chinese property concerns; and the Fed’s slightly more hawkish messaging, with the pace of tapering now slightly faster than the market expected.

Covid and vaccinations

Global trends have continued to improve, notably in the US. After school re-openings led to a rise in cases, US infection rates are now falling along with hospitalisations in some states.

Emerging markets are also improving as they ramp up vaccination. This is important since supply bottlenecks stemmed from factory closures in a number of EM countries such as Vietnam.

US data continues to show most hospitalisations and deaths are among the unvaccinated. This shaped the US Food and Drug Administration’s view on booster doses — which are approved only for over-65s.

The view is that the role of the vaccine is to stop people getting too sick, rather than completely stop the virus. The FDA did not see a need to approve an extra dose for the broader population given a lack of data on long-term effects.

This will give time for a variant-specific booster to be trialled (which is now underway).

At home, NSW is going better than expected and Victoria is in line with forecasts.

First-dose vaccination rates in NSW are averaging 42k per day v 46k last week. This has taken NSW to 88% first dose and potentially 90% this coming week. Second-dose vaccinations are more in line with expectations at 70k per day v 61k last week. The run rate is expected to pick up to 72k this week.

NSW is on track to reach 70% on October 5 and 80% by October 15.

Hospitalisations in NSW appear to have peaked at 1268 and are now down to 1146. ICU cases peaked at 234 and are now 222. Both figures are well below forecasts from the start of September.

We remain of the view that we will see a sharp recovery in activity on the east coast coming into November.

We are positive on domestic stocks leveraged to this.

Economics and policy

Updates from the US Federal Reserve last week were broadly in line with market expectations — with a slightly more bearish tilt.

The taper is due to start in November and finish by mid-year — two-to-three months earlier than consensus.

This implies a reduction of $15 billion per quarter rather than per meeting as the market previously thought (or $18 billion per meeting v $15 billion expected).

The dot plots were in line with an even split for the first hike in 2022 versus 2023. The logic for the faster taper is to give the central bank some flexibility if inflation stays higher next year.

The market has 25bp priced in by the end of 2022.

On the data front, median expectation for inflation has risen 20bp to 2.3%, implying the 30bp average increase in rate levels by the end 2022 in the dots.

The 2022 median GDP growth rate forecast has also risen by 50bps to 3.8%. Unemployment is now expected to fall to 3.8% by the end of 2022.

Fed chair Jerome Powell’s language has become more cautious on inflation, with the “transitory” period now lasting into 2023 and even 2024.

Overall, the underlying message was that inflationary pressures have been more resilient, particularly given supply chain bottlenecks.

This extended period of higher average inflation means the Fed will need more flexibility to respond, potentially before the end of 2022.

China

China remained in the limelight last week. Property giant Evergrande appears to have missed interest payments due on bank loans and offshore bond issues due last week. A grace period is likely to involve negotiating some form of restructure.

Cash flow appears to be directed into funding projects, which is politically sensible. We may see unfinished units sold at a discount to other developers, potentially those backed by the state.

Our view remains that this will not be a systemic issue. There will be some attempt to put a floor under the economy given the importance of the property market.

Market moves suggest this is the case — the Chinese currency, credit spreads and equity market did not move much despite the headlines.

Against this backdrop we think the case for a policy shift in China is high, which will support cyclicals.

There is a lot of sensitivity about an overly sharp slowdown next year as president Xi Jinping locks in his third term. The need for economic growth remains important.

Meanwhile the UK is experiencing some chaos from rising electricity prices, gas shortages and labour shortages (notably truck drivers).

This is leading to some food and fuel shortages. The issue reinforces the need for more inventories of strategic commodities, higher wages and more investment. This probably contributed to a more hawkish Bank of England meeting last week. A rate hike is now becoming likely by May.

A positive outlook

Overall we are becoming more positive as falling global Covid cases allow economies to re-open.

We can see the Fed GDP numbers start to tick better, having weakened sharply over the last two months.

The bond market also continues to signal that the economy is faring better. US bond yields are following their European counterparts in breaking out of their recent trading range.

The economic surprise index also looks to be bottoming. And a significant inventory re-build is required in a number of industries as soon as supply chain blockages are resolved.

All in all, this should be supportive of cyclicals and financials v defensives. Cyclical growth will continue to do well, but more defensive growth, such as healthcare may underperform.

Markets

Bond yields went up last week in the US and Australia. Commodities generally recorded gains.

Iron ore had a wash-out last week, bottoming in the US$90s, before sharply bouncing off these lows. In the $90s, the cost curve will start to move.

We have already seen a lot of marginal suppliers for iron ore — such as Ukraine and India — redirect stocks back into their own markets as prices fall. This will make China more reliant on Australian ore.

While we don’t expect a big bounce in iron ore, we do believe the falling prices have come to an end for this year.

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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 here.  

Contact a Pendal key account manager here.