China’s property slowdown and weak consumer demand dominate the debate, but they tell only part of the story, argues the Pendal Global Emerging Markets Opportunities team

Key points:

• China’s exports strengthen growth in emerging markets despite domestic weakness
• Technology and industrial exports challenge developed markets
• Learn more about Pendal Global Emerging Markets Opportunities Fund

CHINA’S export-led growth is creating opportunities that may be underappreciated by emerging markets investors. While attention remains focused on the country’s property downturn and subdued domestic demand, Chinese technology and industrial companies are expanding their share of international markets. The Pendal Global Emerging Markets Opportunities team believes this strengthens the investment case for selected Chinese businesses while increasing competitive pressure on exporters elsewhere in Asia.

A powerful export engine, led by technology and industrial sectors, is helping to drive growth as Chinese firms gain share in international markets.

However, the investment implications, both for China and its competitors, are not yet fully reflected, according to the Pendal Global Emerging Markets Opportunities team.

China’s economic narrative is dominated by its prolonged property downturn and slowing domestic demand and consumption.

Both are real. However, in the second quarter of this year, Chinese real GDP still grew by 4.3 per cent year-on-year.

The missing piece of the puzzle is China’s powerful export growth, which has led to a large external surplus (evident in both the trade balance and current account balance).

China’s trade surplus has nearly doubled, from US$670 billion in 2021 to US$1.2 trillion in the 12 months to August 2026, as export volumes have significantly outpaced imports.

The result is an economy that has become increasingly reliant on net exports at a time when domestic demand remains subdued.

How China’s exports are reshaping emerging markets

More importantly, for investors and politicians globally, the composition of China’s exports has fundamentally changed.

As with other Asian ‘tiger economies’, the first wave of Chinese export growth was driven by labour-intensive manufacturing and assembly.

Today’s export expansion is increasingly concentrated in higher-value-added industrial and technology sectors.

Analysts at the US Federal Reserve argue that a ‘China Shock 2.0’ is underway, characterised by growing Chinese competitiveness in areas such as advanced machinery, electronics, power infrastructure and other technology-intensive industries.

Some European economists have described China’s strategy as ‘a growth model aiming at industrial and technological dominance’.

What both agree on is that an undervalued renminbi is key to this approach. The US analysis suggests that the renminbi, the currency of the world’s second-largest economy, is 24 per cent undervalued. This is having a growing impact on the world’s more developed economies.

China is capturing a growing share of global exports, increasingly competing in higher-value sectors once dominated by developed markets.

Chinese industrial overcapacity and exchange-rate management policies are becoming a central feature of policy discussions in Washington, Brussels and European national capitals.

Investment implications for emerging markets investors

For emerging market equity investors, we believe this presents opportunities.

While investor attention continues to focus on cyclical domestic challenges, we believe the strength of China’s export sector is not fully appreciated.

We remain overweight China, including Chinese technology and industrial businesses that are benefitting directly from the country’s growing share of international markets.

By contrast, we remain cautious on several Asian export-oriented industries, including in Korea and Taiwan, where the overlap with China’s export profile is increasing and competitive pressures are intensifying.

We believe the ‘China Shock 2.0’ strengthens the investment case for China.

Emerging markets: frequently asked questions 

Why are China’s exports important for emerging markets? 

China’s export growth is supporting the economy while domestic demand remains subdued. Its move into higher-value technology and industrial sectors is also reshaping competition across emerging markets and developed markets. 

Which sectors are driving China’s emerging markets export growth? 

Export expansion is increasingly concentrated in advanced machinery, electronics, power infrastructure and other technology-intensive industries. 

What does China’s export growth mean for emerging markets investors? 

The Pendal Global Emerging Markets Opportunities team sees opportunities in selected Chinese technology and industrial businesses that are gaining international market share. 

What are the risks for other emerging markets in Asia? 

Export-oriented industries in Korea and Taiwan face increasing competition where their export profiles overlap with China’s growing technology and industrial capabilities. 

About Pendal Global Emerging Markets Opportunities Fund

James Syme, Paul Wimborne, Ada Chan and Roshni Bolton are co-managers of Pendal’s Global Emerging Markets Opportunities Fund.

The fund aims to add value through a combination of country allocation and individual stock selection.

The country allocation process is based on analysis of a country’s economic growth, monetary policy, market liquidity, currency, governance/politics and equity market valuation.

The stock selection process focuses on buying quality growth stocks at attractive valuations.

Find out more about Pendal Global Emerging Markets Opportunities Fund here
 
Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management.

Contact a Pendal key account manager here

Here are the main factors driving the ASX this week, according to portfolio manager RAJINDER SINGH. Reported by investment specialist Chris Adams

• Find out about Crispin Murray’s Pendal Focus Australian Share Fund

MARKETS have been buffeted by the unwind of the AI trade, particularly in those areas more leveraged to the thematic.

AI-heavy markets such as US (S&P 500 -1.9%) and Korea (KOSPI -14.5%) were down last week but others were relatively resilient as investors rotated to other sectors.

Bonds were generally stronger as yields retreated from their recent highs, though high credit risk areas remained under pressure. 

More uncertainty in the Middle East and Ukraine saw energy prices rise again (Brent crude +4.9%) while other commodities such as copper (-1.7%) aluminium (-1.4%) and lithium (-9.1%) were softer.

In the US, we saw both September consumer price index (CPI) and producer price index (PPI) inflation data surprise to the upside.

These, along with strong retail sales and industrial production figures, indicate the US economy is experiencing solid economic growth but also generating increasing inflationary pressures.

In Australia, the main release was September labour force data which showed a jump in the unemployment rate. Slowing employment growth pointed to a softening in the labour market and the economy more broadly.

Australian equities were up for the week (S&P/ASX 300 +0.9%) however we saw significant dispersion in the performance of various market components.

Large caps performed well (S&P/ASX 50 +1.5%) while Small Caps (S&P/ASX Small Ordinaries -2.8%) delivered a negative performance.

At the sector level, Materials -2.5%) and IT (-1.4%) were weak while there was rotation into other sectors such as Financials (+3.2%), Healthcare (+3.5%) and Consumer Staples (+3.1%).

Australia macro & policy

There were two releases closely watched last week, given potential implications for the path of domestic interest rates.

First was the RBA minutes from the September monetary policy board meeting. They specified that due to rising global cost pressures, Australia must accept weaker growth in employment and economic demand as the cost of bringing inflation back to target.

They also stressed the additional effect of domestic cost pressures and noted that further price increases, followed with rate rises, could be on the horizon.

Local economists noted that these September minutes were consistent with the hawkish tone struck in the statement accompanying last month’s rate rise announcement.

Then we had the Australian Bureau of Statistics release September labour force data.

It showed Australia’s total employment fell 39,300, versus the increase of 20,000 expected.

This was driven by a decline in part-time employment (73,700) and was partially offset by a rise in full-time employment (34,400).

This led to the overall unemployment rate being “steady” at 4.7%, but only because August unemployment was also revised up to 4.7%. Both were above market expectations of 4.6%.

This provided further evidence of a gradual softening in the labour market, with the unemployment rate averaging 4.6% over Q3 2026, from 4.4% over Q2 2026 and 0.6% higher than the start of the year.

Overall, following the weaker job numbers along with other indicators of slowing in the Australian economy, the market has pushed out the likelihood of another rate rise. The market is now pricing only a 22% chance of a hike at the Melbourne Cup RBA meeting and peaking at an 86% chance of one additional hike by April 2027.

US macro & policy

US Federal Reserve

Despite US Federal Reserve Chair Kevin Warsh’s desire for a “quieter” Fed, we saw several representatives give their views on the central bank’s future interest rate moves last week.

New York Federal Reserve President John Williams reaffirmed his view that the Fed may need to ‌raise interest rates once more this year to lower inflation, though at this point doesn’t think they would need to do more in 2027.

Fed Governor Christopher Waller said the surge in long-term US Treasury yields is helping to dampen demand in interest-rate-sensitive sectors and so doing some of the work of tighter monetary policy.

Warsh himself appeared at an IMF meeting in Thailand, and his remarks conveyed no urgency to further increase rates in the aftermath of the September inflation print.

He stated “the world has broadly conformed to our expectations” since the last Federal Open Market Committee (FOMC) meeting in September, in which the majority of Fed officials indicated one more hike by end of 2026.

CPI and PPI inflation

The headline September CPI increased 0.6% (3.7% year/year) which was in-line with consensus.

However, the core CPI measure came out at +0.3% for the month which was above consensus of +0.2% and 2.6% for the year.

There were notable contributions from airline fares, reflecting elevated fuel price pressures, as well as telecommunication costs.

The number of CPI components printing at above 3% rose to almost half of all categories, indicating broad based inflationary pressure in the economy.

Importantly rent inflation, which is a large component of the basket by weighting, remains relatively anchored for the time being.

The PPI also showed increasing inflationary pressure. Headline rose by 1.3%, substantially above the consensus expectation of +0.6%.

Core PPI increased by 0.7%, also significantly above the consensus of +0.3%.

Producer prices have historically been correlated with commodity prices and energy in particular, and these higher input prices indicate, as they transmit through the economy, upwards pressure to the CPI and personal consumption expenditures (PCE) measures of inflation in coming periods.

Other data

We also saw the release of existing home sales data, with sales rising to 3.99 million in September from 3.93 million in August.

However, given the recent rise in 30-year mortgage rates, existing sales are yet to feel their full effects.

In other releases:

• Retail sales for September came in at +0.8% which was substantially above the +0.3% expected.
• Industrial production increased 0.7% in September with Q3 increasing at an annualised rate of 2.8%.
• The US fiscal deficit was US$1.99 trillion in FY26, equal to approximately 6.2% of GDP.

The surprise CPI, along with strong PPI, retail sales and industrial production figures, indicate the US economy is experiencing solid economic growth but is also generating increasing inflationary pressures from higher AI investment and energy/commodity prices.

The market is now pricing only around ~27% probability of the Fed hiking rates at next week’s October meeting but has fully priced one in by calendar year-end.

A further two rate hikes are now also fully priced in by mid-2027.

AI concerns

Last week saw growing concerns around the durability of the previously robust AI thematic.

The AI infrastructure industry (data centres, neoclouds etc) was in the crosshairs, but the sell-off affected other areas including AI beneficiaries such as chipmakers, memory-makers, contractors and resource stocks, as well as the broader tech sector.

The key change is the market moving from trying to dimension AI upside, to worrying about the ability to access the capital required and the subsequent cost of this funding.

The traditional risks of any development are arising and compounding here; increasing construction and financing costs, with uncertain and possible depressed end asset values, is threatening the business case for many of these investments.

The moves were triggered by a combination of events including:

• Blackstone-backed AirTrunk pulling a REIT data centre IPO in Singapore.
• The Firmus IPO on the ASX aborted in the previous week.
• Doubts on Anthropic’s IPO and valuation over concerns on the state of its latest growth and revenues.
• A hot US CPI print increasing fears of a further rise in interest rates.
• Research firm Gartner estimated that 80% of neoclouds could go out of business by 2030.
• A blowout in the credit and credit default swap (CDS) spreads of Neoclouds such as CoreWeave.
• A five-character post from Elon Musk; “Yikes,” in response to a chart showing CoreWeave’s yields.

Not surprisingly, Nvidia and the most prominent Neocloud – CoreWeave – attracted the most attention.

Starting with the debt components of its capital stack, the yield to maturity of CoreWeave’s 2031 bond rose to over 15% while its five-year CDS moved out from 800 basis points (bps) to over 1000bps during the week.

In terms of its listed equity, it swung wildly and finished down around 25% for the week.

Jensen Huang (CEO of Nvidia) came out in public support of CoreWeave but this had limited impact.

Nvidia’s equity and debt were also affected, but to a much lesser extent.

The other main area of weakness has been in the semiconductor space.

In the US, the semiconductors led the move lower, finishing down eight consecutive sessions. This is the longest negative streak since May 2006 and memory stocks were at the epicentre, with Micron Technology and SanDisk lower in seven out of eight sessions.

South Korea’s Kospi stock index has been one of the largest beneficiaries of the AI investment boom and there are increasing parallels to price action moves in the Nasdaq in 2000.

It is important to remember that to some extent these issues may be self-correcting: any slowdown in future AI capex plans due to funding concerns actually reduces the total capital required and may partially alleviate the overall cost and availability of funding needed.

That said, we may see some further pain in AI players as they all eventually adjust to these new market conditions.

Markets

Meanwhile, despite the significant fluctuations in AI, the broader equity market continues to be hold up reasonably well. This is due to a rotation in the sector leadership with areas such as Healthcare providing stocks with new recent highs.

Even many Tech names, epitomised by the MAG 7, are only back to where they were at the beginning of October while Apple hit an all-time high during the week.

Last week we saw the kick off for quarterly results in the US. Earnings have been steadily revised up due to AI investment etc, but the median stock is still sitting on an elevated but reasonable multiple.

There are multiple ways to assess EPS growth and valuations but one of the simplest ways is the price/earnings-to-growth (PEG) ratio – and this is undemanding relative to history

While there are growing concerns in funding markets, outside of higher-risk areas credit spreads are relatively stable and benign at the moment.

Another area to watch in fixed income markets is in the Euro area, with French and Italian spreads to Germany bonds rising rapidly in recent periods.

While the overall Australian equity market had a solid week, we saw significant dispersion in various market components during the week.

Large caps did well while Small Caps were weak.

At the sector level AI trade linked sectors and stocks (IT, Resources, REITs with data centre exposure) were weak, while “old world” sectors such as Banks/Financials, Healthcare and Consumer Staples performed well.

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About Rajinder Singh and Pendal’s responsible investing strategies

Rajinder is a portfolio manager with Pendal’s Australian equities team and has more than 18 years of experience. Rajinder manages Pendal’s sustainable and ethical funds, including Pendal Sustainable Australian Share Fund.

Pendal offers a range of other responsible investing strategies, including:

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

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

Contact a Pendal key account manager here

Here are the main factors driving the ASX this week, according to Pendal’s head of equities CRISPIN MURRAY. Reported by portfolio specialist Chris Adams

• Find out about Pendal Focus Australian Share fund

WHILE the cancelled Firmus IPO dominated local headlines, an easing of bond market concerns helped equities in what was otherwise a quiet week.

There was limited economic data, although purchasing managers indices (PMIs), an indicator of the outlook, continue to suggest the underlying global economy remains firmer than expected.

In the US, the S&P 500 gained 1.2% while locally the S&P/ASX 300 was up 0.4%.

Equity markets saw rotation away from AI/semiconductor sectors, partly due to some noise around OpenAI’s revenue run rate, however there were some issues with the accuracy of these claims.

The market for US Q3 earnings season to kick off for a lead on the latest AI capex updates and insight on the revenue benefits from that investment.

It is interesting to note that any expectation of slowing AI spend is now seen as bond friendly, due to less crowding out, and would lead to less monetary tightening which in turn would support the financial, consumer discretionary and REIT sectors.

In Australia the cancelled Firmus IPO was the main event. It was thwarted by an interplay of valuation, funding and execution concerns as well as a potential stock overhang.

This does not derail the company’s prospects, in our view, but we suspect we will see them undertake another private funding round and any future IPO to be in a different market.

Energy

Somewhat paradoxically, the oil price remains high (brent crude $104/bbl) while the flows through the Strait of Hormuz have returned to pre-war levels.

Around US$20 of the current price is estimated to be risk premium, reflecting the ongoing attacks on tankers going through the strait and fears of an escalation in the conflict either ahead of the US election by Iran – or after it by the US.

There is a significant additional issue with freight, as the movement of oil is relying on using smaller shuttle carriers through the strait, which then do ship-to-ship transfers which can tie up very large crude carriers (VLCCs) for up to 10 days.

In addition, 126 Iranian VLCCs are off the market (~13% of the global fleet) and a number of the tankers are taking longer routes.

All this means there is almost no spare capacity in freight, leading to transit costs rising to ~US$30/bbl and beyond, versus around US$2 to US$5 pre-crisis.

A buyer in China is now effectively paying close to US$140/bbl for oil from the Middle East, which is seeing them bid up for oil from other regions.

The likely outcome is that this will force European hydroskimming refiners (which produce lower-margin fuel oil) to curb production and reduce oil demand to alleviate the pressure, but this will add to the supply pressures on refined products.

There were attempts to alleviate the diesel shortage with the G7 announcing 100 million barrels to be released from emergency stocks over four months.

A portion of this had previously been announced, so it is not necessarily going to shift balances meaningfully, although there will be a greater focus on diesel releases over crude.

The release of Russian diesel announced by US President Donald Trump is also relatively small and likely to have limited impact.

This gets to the core challenge for markets; diesel is very expensive.

The price in AUD has doubled this year and this is an input into a broad range of sectors including mining, goods freight, agriculture, and building materials. We are beginning to hear about surcharges being reintroduced, all of which will continue to put pressure on inflation.

Global macro

There was limited data last week outside of the global manufacturing and services PMIs.

The latter signalled the global economy is getting stronger, despite all the issues with fuel prices.

This is good for equities and earnings but continues to put pressure on central banks to contain inflation.

Regionally the US is strong and in Europe, Germany is picking up.

The Fed and outlook for rates

The Federal Open Market Committee (FOMC) minutes provided the forward guidance that Chair Kevin Warsh is so reluctant to give, essentially signalling a pause in October but another hike before the year’s end and the need for at least two more hikes this cycle.

In addition, Fed Governor Christopher Waller, speaking at a central bank forum in Turkey, noted the reasons why he has pivoted from a previously more doveish perspective. The key factors were:

1. The persistence of disruption from the Iran conflict and the flow on effect to diesel prices,
2. The apparent flow on effect of the AI boom on other prices, and
3. The emergence of new potential tariff pressures (e.g. Canada).

Given inflation has exceeded the Fed’s target for five-and-a-half years, these new pressures may lead to a shift in expectations of inflation.

Markets

Bond markets were calm last week, with US 10-year yields ending down 4 basis points (bps) at 5.24%.

This Wednesday’s (US time) release of September consumer price index (CPI) data will be the next test.

Yields have backed up a lot recently, with the move exacerbated by market positioning and the need to hedge positions.

It appears this pressure has eased and the 10-year yield has found some resistance at 5.35%

The global AI/semiconductor sector was weaker last week, on not a lot of news flow.

Some noise around OpenAI’s revenue run rate may have been a factor, with reports that the end September number was US$50 billion versus previous reports of US$70 billion.

However there appear to be issues around the basis of this measure and accuracy of some of the statements.

Regardless, this does highlight the issue that the AI trade currently relies on Anthropic and OpenAI to underpin compute demand.

Both these companies are private, so don’t provide audited financial numbers and we don’t know how sustainable these revenues are.

For example, there is a view that Anthropic revenue is currently inflated by other companies using their models in the intensive phase of developing their own products but once completed, the likes of Microsoft and Meta may migrate to cheaper, open-weight models.

Overall, the tech sector retains good technical support going into US quarterly reporting season.

What saw a bounce in some of the rate sensitive sectors (REITs, consumer discretionary, utilities) last week, partly on the stabilisation in bonds which reduced the probability of a spike towards 6% yields, helped with the rating on these sectors.

It is also becoming apparent that the rate trade is negatively correlated to the AI trade on the view that the stronger the AI investment cycle, the higher rates will have to go and the more that will impact on rate sensitives.

The key sector to watch is financials, particularly banks, which have struggled since Warsh’s Jackson Hole speech on concerns high rates will negatively affect the economy.

The US financial sector appears technically oversold in a long run uptrend going into results, which start this week.

Australia saw a similar theme with REITs (+3.5%), utilities (+3.6%) and discretionary (+2.5%) performing the best last week.

The rally in rate-sensitive stocks reflects recent economic data showing weakening momentum across housing (building approvals down), manufacturing (PMI back in contraction), broader activity (composite PMI slowing), and consumer sentiment (falling to a six-month low).

If growth slows, this may limit the hikes required by the RBA.

There is risk to this view given the inflationary pressures we are seeing globally and the need for the Fed to continue to raise rates.

Australia is one of the most sensitive economies to rising fuel prices given its diesel usage, which may lead to ongoing inflation pressures even with lower growth.

When it comes to rate sensitives we believe we should distinguish between longer-duration bond sensitive stocks and those with economic risk (e.g. consumer discretionary) as the only reason for the RBA to stop hiking is a weak consumer, which would impact that sector’s earnings.

About Crispin Murray and the 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 flagship Pendal Focus Australian Share Fund is a high-conviction equity fund with a two-decade track record across a range of market conditions.

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

Find out more about Pendal Focus Australian Share Fund  

Contact a Pendal key account manager

Data centres have moved from a niche property segment to essential infrastructure, fuelled by cloud computing and a continued rise in AI-related demand. Pendal’s PETE DAVIDSON provides more insight

• Where investors can find data centre returns
• Why power, scale and valuations matter
• Learn more about Pendal Property Securities Fund

IN THIS video podcast, Pendal head of listed property Peter Davidson explains the scale and economics of the build-out, where property investors can potentially capture returns, and why access to power, capital and suitable sites matters.

He also examines the growing role of data centres in Australian listed property and the risks investors should weigh when assessing developers and valuations.

Here’s an excerpt from the video podcast:

“Of AI capex, about a quarter of it is data centres.”

“The pure juice in data centres, from a property investor’s point of view—the great returns at the moment—is really to be had in development.”

“The biggest constraint by far is the power—having the power and the power availability.”

“Data centres just become another sleeve of the opportunity set.”

Watch the full video interview

Listen to the audio version

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About Peter Davidson and Pendal listed property strategies

Peter Davidson is Pendal’s head of listed property.

Peter has held financial markets roles spanning portfolio management, advisory and treasury markets over more than three decades.

Specialising in the Property, Retail, Insurance and Infrastructure sectors, he has previously held roles with Midland Montagu Australia, Daiwa Securities and has served as the non-executive director of the Industry Superannuation Property Trust.

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

Pendal Property Securities Fund invests mainly in Australian listed property securities including listed property trusts, developers and infrastructure investments.

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About Pendal Group

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

Contact a Pendal key account manager

Here are the main factors driving the ASX this week, according to analyst and portfolio manager ELISE MCKAY. Reported by portfolio specialist Chris Adams

• Find out about Pendal Focus Australian Share fund
• Find out about Pendal Horizon Sustainable Australian Share Fund

THE bond market remains at the centre of discussions. 

The US 10-year bond closed last week at 5.28% after touching 5.34%, the highest since 2002, despite a soft payrolls print that effectively took an October US Federal Reserve hike off the table. 

The takeaway is that the long end of the yield curve is no longer pricing the policy path, but it is pricing term premium – compensation for uncertainty over the Fed policy direction, the Iran conflict and energy.  

On the latter, Brent crude held above US$100/bbl despite flows recovering and a further release of strategic reserves, with tightness migrating to refined products and a geopolitical premium that physical supply alone cannot unwind. 

In contrast, iron ore hit 52-week lows. 

In Australia, the RBA delivered its fourth hike of the year to 4.6% (the highest since 2011) but a softer inflation print has reduced the odds of another rate hike in November, and the consumer is visibly slowing. 

Equities have so far looked through all this on the strength of corporate earnings; the upcoming US reporting season will test whether this holds. 

The S&P 500 was off slightly (-0.3%), the Nasdaq gained 0.5% and the S&P/ASX 300 finished +0.1%.

Investors in Australia were quick to buy consumer discretionary on a potential pause in the rates hiking cycle. 

Tech also had its best week since August (+6.8%) driven by stock specific upgrades. 

US bond yields

US 10-year bond yields last week hit their highest point since 2002, piercing through both the 2007 and 2023 peaks.

We touched on the key drivers last week – the shift in Fed rhetoric, the energy shock, strong nominal economic growth and competition for capital from AI-related issuance.

There are two additional points to highlight this week:

First, the composition of the move:

• Friday’s softer payrolls report effectively removed the prospect of an October Fed hike, yet the 10-year yield still rose.
• This suggests long-end yields are no longer rising because investors expect the Fed to do more, but rather despite expectations that the Fed will do less.
• This means the market is increasingly demanding additional compensation for holding duration, reflecting uncertainty around inflation, energy prices, fiscal deficits, geopolitical risks and the future path of monetary policy.

Second, the shape of the curve is notable:

• During previous periods when the US 10-year traded around 5%, the Fed funds rate sat above the 10-year yield and the yield curve was inverted.
• Today, the Fed funds rate (3.75-4%) remains below long-dated Treasury yields, with the curve positively sloped and the 30-year Treasury yielding around 5.6%.
• This means the market is repricing long-term risks independently of the Federal Reserve, with investors demanding higher yields to hold long-duration assets.

Investor demand for duration remains another important question. For example, Goldman Sachs is posing the view that the buyer base for long-dated bonds may have structurally changed over the past decade.

Historically, higher yields would typically attract demand from relatively price-insensitive buyers, including insurers matching long-dated liabilities, sovereign reserve managers recycling trade surpluses into Treasuries and leveraged investors able to earn the carry trade through repo markets.

Goldman argues each of these buyer cohorts may be less important today.

Ageing populations are moving from accumulation to drawdown, reserve managers have increasingly diversified into assets such as gold, while leveraged investors have little incentive to add duration with carry compressed and recent bond-market losses still fresh.

If that assessment is correct, the marginal buyer increasingly becomes the unlevered household sector, which may require materially higher yields before stepping in.

While difficult to quantify, it provides one explanation for why yields have continued to rise despite reaching levels that historically would have attracted stronger demand.

The consequence is that bonds are increasingly behaving like a momentum asset rather than a traditional safe haven, in that rising yields are triggering further selling from systematic investors, hedge adjustment activity and reduced duration across portfolios.

While this dynamic can reverse sharply once buyers return, the catalyst remains unclear.

A meaningful de-escalation in the Middle East, a sustained decline in energy prices or greater certainty around the Fed’s reaction function could all provide relief, but none appear imminent.

For equities, higher yields have so far been offset by resilient earnings and ongoing economic growth.

The key issue from here is not simply the level of yields but the reason they are rising; equity markets can generally tolerate higher rates when they reflect stronger growth expectations, but they struggle more when yields continue rising despite evidence that growth is slowing.

With US reporting season commencing shortly, investors will be watching closely to see whether earnings remain strong enough to justify current valuations against an increasingly challenging bond market backdrop.

Positioning remains surprisingly cautious – Goldman Sachs estimates US hedge fund net exposure has fallen to its lowest level since April 2025 and is close to five-year lows, despite major equity indices trading near record highs.

Investor reluctance to add risk reflects ongoing concerns around oil, interest rates and geopolitics.

Notably, Russell 2000 positioning remains extremely depressed, with systematic exposure near the 7th percentile and leveraged funds carrying record short exposure, suggesting significant short-covering potential should yields stabilise.

Conversely, healthcare experienced significant short covering during the week, while energy remains heavily under-owned despite oil prices remaining above US$100/bbl. 

US macro and policy

Data released on Friday suggests a labour market which is stable with softer payrolls, a slightly higher unemployment rate (+3 basis points to 4.18%) and muted wages (average hourly earnings +0.1% month/month and +3% year/year) not indicative of an economy which is overheating. 

Payrolls increased by 29,000 in September (versus consensus at +90,000) with -60,000 revisions to the prior two months. 

As a result, monthly gains averaged just 51,000 in Q3, down from 81,000 in Q2.

A pause at the Fed’s October meeting, signalled by Federal Reserve Vice Chair Philip Jefferson and New York Fed President John Williams before the employment report, looks very likely with the market only pricing a 22% chance of a hike.

Beyond payrolls, other US data was broadly consistent with a gradual cooling rather than a sharp slowdown.

• Weekly jobless claims remained near cycle lows, suggesting employers continue to hoard labour despite tighter financial conditions.
• Personal consumption expenditures (PCE) inflation was broadly in line with expectations and revisions were marginally dovish.
• Manufacturing surveys continued to point to ongoing cost pressures, reinforcing the view that while the labour market is easing, inflation risks have not fully disappeared.

This combination helped remove expectations of an October Fed hike, although longer-dated Treasury yields continued to rise as investors focused on inflation, fiscal and geopolitical risks rather than near-term monetary policy.

Oil

Brent crude finished the week at $102/bbl despite data showing Middle Eastern crude exports recovering to ~95-98% of pre-war levels, in addition to the US announcing a 40 million barrel strategic reserve release. 

The resilience in prices suggests factors beyond physical crude availability are driving the market. 

First, markets continue to assign a significant geopolitical risk premium to oil.

• While flows through the Strait of Hormuz have largely normalised, investors remain concerned that if Iran cannot materially disrupt tanker traffic it could instead target ports, pipelines or energy infrastructure, leading to a more severe supply shock.
• This risk premium was reinforced during the week by reports the US was considering deploying additional naval assets and troops to the region.

Second, investors increasingly view energy as an inflation hedge as bond yields continue to move higher.

• Higher oil prices contribute to inflation concerns, while inflation concerns support demand for energy exposure, creating a somewhat self-reinforcing dynamic.

The market’s focus has also shifted from crude to refined products. While crude exports have largely recovered, diesel and other product markets remain tight due to ongoing logistical disruption, constrained Middle Eastern product exports, Russian export restrictions and lower Chinese product exports.

As a result, refining margins remain elevated even as crude flows improve. 

The release of 100 million barrels from G7 strategic reserves (split between half crude and half diesel) helps – as well as confirmation by Trump that a US export ban is off the table – but does not fully address the issue. 

For context, a 50 million barrel release over four months is roughly equivalent to 416,000 barrels per day – versus a ~1.6 million barrel/day disruption to diesel from disruption in the Middle East and Russia, in a 30 million barrel/day diesel market. 

The key question from here is what breaks the cycle.

A return to negotiations and continued recovery in Middle Eastern exports could gradually unwind the geopolitical premium and allow inventories to rebuild at lower prices.

Conversely, any escalation in the conflict or disruption to infrastructure could see the current risk premium persist, with inventories needing to be rebuilt at materially higher prices.

Iron ore

Iron ore fell to a 52-week low of US$92.1/t, with Chinese demand seasonally soft during the Golden Week holiday period (through to 7th October).

Free on board (FOB) prices – which reflect production, shipping to port and loading onto the ship – have declined to approximately US$75/t in Australia (-16% since February) and US$48/t in Brazil (-35% since February), while freight costs briefly reached US$43/t last week.

Early signs of supply discipline are beginning to emerge, with three Brazilian producers announcing output curtailments over the past month.

Given the steep and highly elastic iron ore cost curve, lower prices are likely to drive a market rebalancing over time.

Australian producers remain among the lowest-cost suppliers globally, but investor sentiment has deteriorated, with short interest in both Fortescue (FMG) and Rio Tinto (RIO) reaching one-year highs as the earnings impact of lower prices is yet to fully flow through.

Ongoing discussions with China’s centralised unit buying on behalf of steel mills – China Mineral Resources Group (CMRG) – add to uncertainty by creating product placement and demand risks across the sector.e “AI as a tailwind to software” pivot is supportive for Xero, Technology One and Wisetech. But it remains important that these companies deliver positive earnings with any misses potentially interpreted as supporting the AI disruption thesis. 

Australia macro and policy

The RBA raised the cash rate by 25bps to 4.60%, marking its fourth rate increase of 2026 and taking the cash rate to its highest level since 2011.

The decision was unanimous and reflected the Board’s continued concern that inflation remains above target despite signs that household demand is slowing.

Consumer spending softened further through September as households continued to reallocate spending away from discretionary categories and toward essentials.

Higher fuel prices, rising utility bills and elevated mortgage repayments are increasingly absorbing household budgets, with spending holding up in fuel, pharmacy, groceries and travel, while household goods, fashion, dining out and recreation remain softer.

The latest rate increase is likely to reinforce these trends heading into the important Christmas trading period.

Inflation data released during the week was modestly softer than expected, with August trimmed mean CPI rising 0.24% month/month versus market expectations of 0.3%.

The result provided the RBA with some breathing room and saw markets significantly reduce expectations of a follow-up rate hike at the November meeting.

Despite the softer inflation print, several near-term inflation risks remain.

Rising oil and diesel prices continue to place upward pressure on transport, logistics and household fuel costs, while the removal of payment surcharges from 1^st October has prompted a wave of announced price increases across parts of the consumer and service sectors as businesses seek to recover those costs through headline pricing.

As a result, while demand conditions are weakening, inflation is likely to remain uneven across the economy.

The key question for markets is whether slowing consumption and a weaker consumer ultimately outweigh these cost pressures – if spending continues to deteriorate and inflation moderates further, the RBA may be able to leave rates unchanged.

However, sustained energy price inflation and ongoing cost pass-through from businesses could slow the disinflation process and delay any future policy easing.

Markets

In Australia we saw strength in technology (+3.5%), consumer discretionary (+2.6%) and communication services (+1.8%), while healthcare (-1.4%) and energy (-1.1%) underperformed.

Stocks were driven by changing expectations for the rate hiking cycle, M&A activity and the occasional upgrade last week.

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About Elise McKay and Pendal Australian share funds

Elise is an investment analyst and portfolio manager with Pendal’s Australian equities team. Elise previously worked as an investment analyst for US fund manager Cartica where she covered a variety of emerging market companies.

She has also worked in investment banking and corporate finance at JP Morgan and Ernst & Young.

Pendal Horizon Sustainable Australian Share Fund is a concentrated portfolio aligned with the transition to a more sustainable, future economy.

Pendal Focus Australian Share Fund is a high-conviction equity fund with a 16-year track record of strong performance in a range of market conditions. The Fund is rated at the highest level by Lonsec, Morningstar and Zenith.

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

Contact a Pendal key account manager here

Here are the main factors driving the ASX this week, according to Pendal’s head of equities CRISPIN MURRAY. Reported by portfolio specialist Chris Adams

• Find out about Pendal Focus Australian Share fund

MARKETS are focused on the global rise in bond yields which pushed US 10-year yields up 15bps last week – or more than 40bps for the month.

The yield hit 5.16% on Friday and by Monday had passed 5.2%.

This has been driven by a shift in Fed rhetoric earlier this month, as well as high fuel prices, strong economic growth and a high degree of debt issuance.

This has not yet affected US equity markets. The S&P 500 gained 1.2% last week and the Nasdaq rose 2.1%.

This is because economic growth remains supportive, while the debt supply issue relates to AI investment – which is also helping drive earnings.

Energy markets were flat-to-down last week, on evidence of more oil getting through the Strait of Hormuz. Overall, oil flows from the Persian Gulf could be only 3-to-5 million barrels per day below pre-conflict levels.

However, refined product and LNG flows remain more constricted and prices remain very elevated. There is an increasing probability (albeit still well below 50% in our view) of some form of US diesel export restriction, which would be bad for the rest of the world.

Brent crude finished up 0.4% at US$104.3/bbl, while NYMEX Crude fell 7.9%.

The US-China summit was largely uneventful unless you’re a panda enthusiast. But two more meetings are planned this year and dialogue reduces the risk of a renewed escalation in tensions.

Australia saw a slight easing in employment tightness, but nothing of substance to shift expectations of an RBA rate hike this week (currently priced at 90% probability).

The S&P/ASX 300 shed 0.8% for the week.

On the stock front, the launch of Meta’s Muse AI assistant product ignited renewed concerns over companies that rely on consumer inertia in terms of pricing and margin (such as travel, insurers and subscription-related businesses).

Bonds

Markets remain focused on rising bond yields, although the impact on equities has been muted so far.

Yields are rising due to a combination of:

1. The Fed striking a hawkish tone. On September 16 the Fed unanimously voted to raise rates, and language such as “removing accommodation” suggests they are not seeing one hike as enough. They are framing the context as an inflation rate that has been above target for five years, while unemployment rates remain low. The signal is that they are catching up to a sustained problem – rather than reacting to recently inflation data – which suggests more resolve for further tightening.
2. The energy shock. With inflation now above target for five years, the Fed believes it has no buffer to allow another supply shock without a policy response if it wants to maintain inflation expectations and credibility.
3. A strong economy. USD GDP is growing at a nominal 5-6% and we saw very strong global purchasing managers indices (PMIs) last week.
4. Competition for capital. The Fed is focusing on the short end of the yield curve and is letting the market set the 10-year yield. Here, at the long end, yields are not just about inflation and real yields – supply of and demand for debt are also a factor. There were two poorly supported auctions of five-year and 20-year auctions last week, highlighting weaker demand to step in and buy yields at these levels. This reflects concerns about increasing supply as even while the government is shortening its issuance the private sector (driven by AI capex) is adding to supply at longer durations. 

The supply issue is exacerbated by expectations of rising demand for private funding – also mainly driven by AI capex.

Traditional buyers at the long end of the yield curve – such as pension funds and insurers – are understandably wary of stepping in given supply, geopolitical uncertainty, inflation and growth.

This means yields have been pushing higher. While there is an argument they may look cheap, we note they can remain cheap for an extended period.

The other related issue is why this has not weighed on equities. The reasons are:

1. The pace of the rise in yields has been relatively moderate. 10-year yields had held their 4.8% level until this month. The spike to 5.15% in the last two weeks is the first time we have a more material step higher in a short space of time.
2. The rise in yields reflects good economic growth. At the same time debt supply relates to the need for AI investment, which is also broadly positive for equities and for pricing power in certain industries. Therefore the market is not yet viewing rising yields as de-railing the outlook for growth. This can be seen in credit spreads (excluding technology, where supply is an issue) remaining low.
3. Earnings growth remains strong. This has allowed equities to de-rate as well as rise, consistent with the rise in real yields. S&P 500 return on equity (ROE) has also risen materially, supporting the market rating.

In terms of earnings, we are two weeks away from the first third-quarter results.

The market expects a deceleration from last quarter’s 50% year/year S&P 500 EPS growth – but a still-strong level in the high 20%-30% range.

Macro

The September US S&P Global Composite PMI – a leading indicator of economic activity – hit the survey’s highest point since early 2022.

The Composite measure came in at 58.4 versus 56 in August and 53.7 expected.

The Services PMI was 58.7, versus 55.8 forecast, while the Manufacturing PMI was 57 versus consensus at 55.3.

The implied growth in GDP is around 4% for the quarter – well above consensus expectations – while the employment component was at a four-year high.

Most analysis downplayed the survey’s strength as it was not consistent with other manufacturing and services surveys – such as those from the Philiadelphia and Richmond Federal Reserves – which indicate more moderate growth.

This does highlight that the US economy has a very different feel to other parts of the world. A lot of capital is being deployed there due to cheaper energy, a lighter regulatory environment and the tail wind of AI.

It also indicates that US growth remains well supported despite the rise in yields and energy costs.

This can be seen in the Goldman Sachs current activity indicator – a “real-time” measure of growth – which has been rising in recent months and is seeing tailwinds from the manufacturing sector.

This differential is helping support the US dollar.

Energy markets

Global refining capacity is under pressure from closures and disruption in both the Middle East and Russia.

As a result, jet fuel, diesel and LNG have all seen far greater moves in price relative to oil.

In the US, for example, diesel has risen to US$6.50/gallon, up from around US$3.50 before the attack on Iran and well in excess of the previous highs reached in the wake of Russia’s invasion of Ukraine.

Diesel is key input for agricultural industries. As we head into US midterm elections this could affect some key Senate and state contests.

As a result there has seen speculation around some form of diesel export restriction from the US.

This is almost universally seen as bad policy that could potentially create chaos in global refined product markets. The US is a key supplier to the rest of the world and restrictions could trigger a scramble for product.

It could also potentially lead to a cut in supply in the US if it led to a rebuild of inventory to the point where storage costs rose too high and refiner margins fell.

There is a view that any restriction may be only partial and for a limited-time period, which may limit some of the effects.

But there is risk of a further 10-15% increase in refined product prices outside of the US. This would be material for large diesel-consuming countries including Australia.

In terms of oil, there appears to be enough flowing through the Strait of Hormuz to check prices moving meaningfully above US$100/bbl.

The East-West Pipeline in Saudi Arabia is resuming operations. Overall there seems to be a shortfall of about 3-to-5 million barrels per day in terms of oil flows from the Persian Gulf, versus pre-conflict (ie we are at 70-80% of pre-war levels).

This continues to be mitigated by lower demand from China and release of strategic petroleum reserves.

US-China Summit

There were no specific measurable outcomes from talks between Presidents Trump and Xi.

There was a two-month extension to the current tariff waiver (to January 10); additional summits pencilled in for November and December; and the loan of giant pandas Ping Ping and Fu Shuang to the Atlanta Zoo.

That said, it is important that dialogue is ongoing despite issues with AI, trade, Taiwan and Iran.

Beijing eased its Taiwan rhetoric as the US delayed arms sales, though on Iran there was little comment of substance.

Neither side can afford to be more aggressive on trade.

The US remains reliant on critical commodities from China while China relies on imported microchips. Beijing did agree to buy 10 million tonnes of coal in 2027 and 2028.

On AI, China said it “respects” the Trump Administration’s push to rebrand AI as “super intelligence”.  Both countries agreed to a bilateral communication channel, though there was no action on slowing AI development.

Australia

August employment data indicated that tight labour markets have eased somewhat. The unemployment rate rose from 4.5% to 4.6% – the highest in five years.

This was driven by higher participation while labour supply grew – probably as people feel compelled to re-join the workforce for cost-of-living reasons.

Employment rose by 40,000 in the month – more than expected, but all driven by part-time work.

Hours-worked picked up marginally, but was still lower over the last three months versus the prior half-year, which suggest demand is softening.

Overall there was nothing to stop the RBA from hiking this week.

The RBA’s challenge is it needs GDP growth to fall to below 1.5%. Given population growth, government spending and corporate investment, this indicates the consumer has to be slowed, probably to 1% growth or below.

This factor will drive the number of rate hikes.

The only issue that could prevent rates going up more than once more is the housing slowdown or the impact of fuel prices hitting the economy harder.

Either way, we remain wary of consumer discretionary stocks.

About Crispin Murray and the 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 flagship Pendal Focus Australian Share Fund is a high-conviction equity fund with a two-decade track record across a range of market conditions.

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

Find out more about Pendal Focus Australian Share Fund  

Contact a Pendal key account manager

Rising bond yields have weighed on markets globally, but emerging markets have been more resilient than expected, argues Pendal’s emerging markets team

Key points:

• Emerging market currencies supported by strong real rates
• Environment remains supportive for selected emerging market equities
• Learn more about Pendal Global Emerging Markets Opportunities Fund

EMERGING markets have held up better than expected during the 2026 bond sell-off because their fundamentals are stronger this cycle: high real interest rates, improved government budget management and a weaker US dollar have lifted emerging market currencies and returns — leaving them less exposed to the fiscal fears hitting developed markets.

Higher interest rates, better government budget management and a weaker US dollar have lifted currencies and returns in emerging markets in recent times.

That’s been particularly the case in higher-yielding countries such as Brazil, Mexico and South Africa.

But how will the current global bond sell-off affect emerging market investors? Where are the opportunities and risks?

As most investors know, emerging market equities are highly influenced by global financial and economic conditions, including moves in global bond and currency markets.

Weaker bond markets and higher yields in developed markets – especially the US – can be a drag on the emerging market world due to higher global funding costs.

Meanwhile a stronger US dollar can tighten domestic liquidity, weaken currencies and force central banks to maintain higher interest rates.

But the current global bond sell-off may be developing differently.

Long-term yields have risen sharply across developed markets, with US Treasury yields close to three-year highs.

Japanese and UK yields have reached levels not seen for decades, as a combination of higher energy prices and inflationary pressures meet structural pressures from ageing populations and voters’ choices.

Different emerging markets, different outlook

Importantly, the pressure has not been transmitted uniformly across emerging markets.

Long-term yields in emerging markets have risen less than in developed markets and have shown a degree of resilience that exceeds what historical sensitivity to higher US yields would typically imply.

This is largely the legacy of more orthodox fiscal and monetary policy in emerging markets. The median emerging market now has a better medium-term fiscal outlook than the median developed economy.

Currency markets provide further evidence of this divergence.

US dollar-funded emerging market carry trades have generated positive returns for seven consecutive quarters, their longest run since 2008.

Returns have been strong from classic emerging markets carry trades such as Brazil, Mexico and South Africa, while US dollar weakness has more recently spread into Asian currencies, and the MSCI emerging market currency index is at a record high level.

Consequently, we are not convinced that higher global interest rates will mean tighter financial conditions in emerging markets.

With higher developed market yields reflecting fiscal risk, rising capital demand and increased term premia, we see a growing likelihood of weaker developed market currencies and capital outflows from developed markets into emerging ones.

Dollar matters more than rates for emerging markets

We continue to believe the direction of the US dollar matters more than the direction of US bond yields for emerging markets.

The Pendal Global Emerging Markets Opportunities Fund maintains significant exposure to Brazil, Mexico and South Africa, where high real interest rates and attractive carry have supported currencies and financial markets.

We also have meaningful exposure to liquidity-sensitive sectors across emerging markets, including investment real estate, investment banks, brokers and exchanges, alongside positions in gold miners within the materials sector.

Since the US dollar’s recent peak in January 2025, the MSCI Emerging Markets Index has substantially outperformed the developed market MSCI World Index, the S&P 500 Index and the NASDAQ Composite Index.

In our view, investors may want to consider remaining bullish on emerging markets, with a focus on carry trade economies and liquidity plays.

Frequently asked questions

Why have emerging markets held up better during the 2026 bond-sell off?

Emerging markets have been more resilient than expected because their fundamentals are stronger this cycle. High real interest rates, better government budget management and a weaker US dollar have supported currencies and returns — leaving emerging markets less exposed to the debt and deficit fears driving developed-market yields higher.

How do rising bond yields affect emerging markets?

Rising bond yields usually raise borrowing costs and pull capital toward developed markets. But strong real rates, better budget management and a weaker US dollar have helped emerging markets stay resilient through the 2026 sell-off.

Why do emerging markets perform well when the US dollar weakens?  

A weaker US dollar is one of the biggest tailwinds for emerging markets. Local currencies rise, equities lift, and US dollar-denominated debt becomes cheaper to repay. It also lowers import costs, helping to keep inflation and interest rates lower.

What is the outlook for emerging markets in 2026 and beyond?

The outlook for emerging markets is supported by China’s manufacturing strength and a weaker US dollar over the next few years. The main note of caution is around stretched valuations in AI chip stocks in markets such as Korea and Taiwan.

About Pendal Global Emerging Markets Opportunities Fund

James Syme, Paul Wimborne, Ada Chan and Roshni Bolton are co-managers of Pendal’s Global Emerging Markets Opportunities Fund.

The fund aims to add value through a combination of country allocation and individual stock selection.

The country allocation process is based on analysis of a country’s economic growth, monetary policy, market liquidity, currency, governance/politics and equity market valuation.

The stock selection process focuses on buying quality growth stocks at attractive valuations.

Find out more about Pendal Global Emerging Markets Opportunities Fund here
 
Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management.

Contact a Pendal key account manager here

Australian mid-caps may sit between the market’s giants and emerging small companies — but BRENTON SAUNDERS argues that is exactly where some of the most interesting opportunities can appear

In this video podcast, Brenton Saunders, portfolio manager of Pendal MidCap Fund, explains how the mid-cap universe differs from the broader Australian share market, with fewer dominant stocks and a broader spread of sector exposures.

He also discusses the major shifts reshaping the benchmark, from gold and lithium to infrastructure, AI-driven data centre demand and the rise of private superannuation platforms.

While opportunity is broadening, portfolio balance and disciplined stock selection remain critical.

Here is an excerpt from the video podcast:

“There’s a bunch of first order and then second order kind of ways you can do that. In the first order ways are most obviously the companies that are being asked to deploy this capital, namely contractors.

“We’re well represented in the contractor space in midcaps, generally always have been, but if you think about companies like Ventia, Downer, Worley Parsons are in the space, but we’ve had some great new additions more recently.

“Some of the second order ways of doing it is just upstream of that in some of the basic materials, again, that are being used to populate a lot of this infrastructure, and I guess I’m referring more specifically to the data centres.

“Copper plays a big role in that. Lithium will play a big role in storage for those kind of things. So there’s a bunch of first and second order ways to play that.”

Watch the video interview

Listen to the audio version

Here are the main factors driving the ASX this week according to Pendal investment analyst GRAEME PETRONI. Reported by portfolio specialist Chris Adams

• Find out about Pendal Focus Australian Share fund

RISING oil and bond yields gathered pace last week.

Brent crude rose 9%, bond yields increased 20-25 basis points (bps) and equities responded, falling 1-2% across most markets.

The key economic focus was the US consumer price index (CPI) where core inflation surprised to the upside and bond markets responded by increasing the odds of a rate hike at this week’s Federal Open Market Committee (FOMC) meeting.

But offshore equity markets reacted more positively on Friday night (Australian time) because the CPI detail left room for debate on whether it will be a prolonged hiking cycle.

The Australian market (S&P/ASX 300 -2.8%) underperformed the S&P 500 (-0.8%) and most other major European and Asian markets.

Domestically, RBA speakers focused attention on the need for local rate rises to contain inflation.

This brings renewed risk for a household sector already struggling with weak sentiment post-budget.

Oil

There is renewed concern at the prospect of persistently higher oil prices. Key issues are:

• Flows through the strait have improved but remain constrained.
• Renewed conflict brings risk, with news of an attack on the Saudi East West Crude Oil pipeline.
• China is back in the market buying crude.
• There is continued focus on falling reserves.

Looking first at flows through the strait, US Energy Secretary Chris Wright made comments suggesting a return to 17 million barrels per day (mb/d), which is on par with pre-conflict levels.

The US has been providing safe passage, clearing mines, and widening sea lanes – all of which is improving flows, but not back to pre-conflict levels. Market estimates are in the range of 7-10 mb/d, based on satellite analysis of ship-to-ship transfers.

In the near term, there is a risk that progress slows.

There have been press reports suggesting the US is now asking tankers to restrict passage to two time slots per day, which will vary by day, saying safety was no longer assured during nighttime passage.

The latest hope for easing tensions has shifted to a deal between Iran and Oman, who will meet members of the Gulf Cooperation Council to try and build support. The key issue is that the US has said it will not tolerate tolls.

There were also some negative developments outside the strait late last week.

First, Saudi Arabia officially confirmed temporary closure of its East-West pipeline, which typically facilitates the transit of ~5 mb/d, following a drone attack.

The extent of damage remains unclear, with Saudi Arabia not confirming fires that have been reportedly detected by satellite and instead describing the shutdown as precautionary.

It is therefore unclear whether the shutdown will last days, weeks or longer.

Second, Houthis have also seized control of the port city of Mocha and three islands in the Red Sea, giving them control over the Bab al-Mandeb, with a military spokesperson claiming the strait was safe for everyone except Saudi ships.

Even before tensions resurfaced in the Middle East, the oil price was rising with renewed purchases by China.

A sharp decline in its crude imports has been a key factor in helping contain the oil price response to the conflict-related disruption.

However, since June its crude imports have lifted from 7 mb/d to 9 mb/d in August, with the market watching whether this returns to pre-conflict levels of 10-12 mb/d.

Reserves have also been cited as a contributing factor for oil price moves, although they do not appear to be an imminent risk.

Over the past six months, US strategic petroleum reserves (SPR) have reduced from 413 million to 285 million barrels, which is a drawdown of 21 million barrels per month.

If that continued, there would only be 1.5 months before reaching the congressional minimum of 252 million barrels.

However, on a weekly basis the drawdown has started to slow significantly, from 7 million to 3 million barrels, with the latest read just 1.2 million.

While the SPR is in focus, it doesn’t appear likely to be a hard stop.

While oil prices dominate headlines, the move in refined products is equally stark with US diesel spreads (the difference between the price of a barrel of crude oil and that of an equivalent barrel of diesel) at all-time highs – from a range of US$30-40 for 2024-25, to over US$100 today.

During the week, there were comments from the CEO of Vitol (the world’s largest independent energy and commodity trading company) that only 1 mb/d of shipments through the strait relate to refined products.

He suggested the market was missing 2 mb/d day from each of the Middle East and Russia and highlighted that refined stockpiles were “pretty much at the bottom”.

Pressure on oil and refined product spreads is showing up in inflation prints. There has been little flow through to other prices. But further pressure will add to central bank concerns.

Bond yields

The oil price was fuel to the fire in bond markets, adding to concerns over persistent inflation, fiscal sustainability and AI investment.

The US Treasury tried to lean against what it viewed as liquidity issues at the long end, with a buyback program of US$5.19 billion during the week, up from an initially flagged US$2 billion.

But this wasn’t the shock and awe US$10 billion program that some had expected, and ultimately fundamentals dominated.

US two-year yields rose 26bps and 10-year yields were up by 19bps, to 4.97%.

US economic data

Kevin Warsh made some hawkish comments a couple of weeks ago at Jackson Hole.

He said he wasn’t worried about the labour market; inflation was the bigger concern, the personal consumption expenditures deflator (PCE) remained the preferred measure and underlying inflation needed to move towards 2% at sufficient speed.

However subsequent Fed speakers have been more cautious, so the data was always going to be crucial.

The producer price index (PPI) came out first showing the impact of energy prices with headline inflation 0.4% month/month versus consensus at 0.3%.

Core PPI ex food, energy and trade was in-line with expectations at 0.3%, although there was pressure in components relevant to the PCE like airfares and hospital services.

This placed some small upward pressure on PCE forecasts.

CPI was more relevant as it accounts for a larger proportion of PCE components.

Heading in, the market view was that a core CPI (ex food and energy) of 0.3% month/month would force the Fed to hike – and core did indeed print stronger at 0.29% month/month (versus consensus at 0.2%) and 2.45% year/year.

This prompted the market to lift the odds of a September hike to 85-90%, after dipping as low as 51% following Fed Governor Christopher Waller’s comments a week earlier.

However, the equity market responded positively, perhaps because the detail left room for debate on whether it will be a prolonged hiking cycle, as is currently priced into bond markets.

One category – communication services – added ~0.1% to core CPI, with a one-off boost from AT&T repricing legacy plans. If not for that, CPI would have been 0.2%.

Core goods inflation was contained at 0.1%, which is important as it suggests no flow-through of higher oil prices.

Having said that, if energy prices are elevated, there will be renewed pressure on headline inflation.

EU economic data

The ECB delivered an expected 25bp hike to 2.50%. This is the upper end of the neutral range but revised economic forecasts suggest more work is required.

Inflation is expected to remain elevated through 2027 and 2028, even under the ECB’s baseline scenario which had been based on inputs in mid-August – current energy markets are closer to the “adverse” scenario.

The result was an increased likelihood of a further hike, with the market now pricing a 50% chance of a hike in October and 90% by December.

China economic data

China CPI and PPI data was released.

CPI picked up modestly to 0.8% year/year reflecting higher energy prices.

The 3.8% year/year lift in PPI was more notable, affected by energy and semiconductor prices.

The contrast between CPI and PPI highlights China’s K-shaped economy with weak domestic demand and continued strength in exports.

Trade data released during the week remained strong, with August exports +25% year/year, supported by AI and green technology (including EVs/hybrids, batteries, solar).

Australian economic data

Westpac’s consumer sentiment survey dropped 5% to 84.4, versus a long-term average of 100.

This unwound gains from a month earlier, reflecting the renewed outlook for rate rises.

The survey highlighted weakness in family finances versus a year ago, with more negative responses from homeowners, particularly those with a mortgage.

The latest house price data from Cotality has Sydney house prices down 7.5% from the peak six months ago.

The deterioration in NAB’s business survey was even more stark, with conditions down 5 points to a reading of -1, the lowest level since August 2020.

The survey had previously remained relatively robust despite higher oil prices and interest rates, but there are now more signs of margin being squeezed by input costs.

Conditions deteriorated for six of eight industries and for almost all states, with trends most negative for retail, manufacturing and Victoria.

Despite weak surveys, RBA speakers quickly returned the focus to inflation and suggested further tightening might be needed.

Chief Economist Sarah Hunter gave a fireside chat at a property conference and Deputy Governor Andrew Hauser appeared on the 7:30 Report.

Both talked about inflationary pressure from the Middle East and about demand running above a supply constrained economy, with Hauser also referencing pressure from the AI build out.

Hauser was particularly vocal when talking about people across the country being furious about persistent inflation and said the Board was alive to the risk of inflation taking too long to return to target.

Declining house prices were referenced by both but viewed as a partial offset to inflationary pressures.

The market is now pricing a 76% chance of rate rise in September and a 77% chance of a further rise over the next six months.

Australian markets

Macro dominated market moves. Energy (+2.3%) was strong on oil prices, while insurers were strong on higher bond yields.

Gold and lithium stocks came under commodity pressure plus some stock specifics, while software and platforms came under pressure following OpenAI’s launch of GPT-6 Astra.

Merger and acquisition activity is returning to the smaller end of the Australian share market, as buyers look through short-term uncertainty and focus on mispriced assets. Pendal’s LEWIS EDGLEY explains

• Small-cap M&A is accelerating amid mispricing
• Buyers see value in quality industrials
• Find out about the Pendal Smaller Companies Fund

AFTER several years in which small caps have lagged their larger peers, valuation gaps have become hard to ignore — and strategic buyers and private equity appear increasingly willing to act.

Lewis Edgley, co-portfolio manager of Pendal’s MicroCap Opportunities and Smaller Companies funds, says the recent pickup has been striking.

“We observed around 15 small cap bids or approaches in the eight weeks to the end of August,” he says. “This was a huge pickup compared to this level of M&A activity we’ve seen in the preceding year.”

The activity has been broad but not evenly spread.

Edgley notes that 10 of the 15 approaches were for industrial companies, the remainder were in resources.

That split reflects where buyers are finding value: in quality industrial businesses that have been de-rated, and in resource names benefitting from stronger commodity momentum.

Where bidders see hidden value

Among the industrial names attracting interest, FleetPartners has been one of the clearest examples, according to Edgley.

The fleet leasing business received an initial proposal at $3.60 a share, representing a 27 per cent premium to its last traded price, before the situation developed into what Edgley describes as “a four-party bidding war with subsequent bids as high as $4”.

While the stock is trading around $4.20, above the initial bids, he says the small caps team sees meaningful further upside from here.

“Our view of value sits in excess of the current share price, but the ultimate price will be a function of where the current bidders see value. We expect this to become evident in coming weeks.”

Other companies that have caught buyer interest include Peet, which received a cash-and-scrip proposal from Ingenia; Austal, where an offer for its US business highlighted significant value in the remaining Australian operations; and SkyCity, which disclosed approaches it considered too low and opportunistic.

Edgley also points to AUB Group and Iress as businesses where potential M&A optionality remains, while stressing that the investment case for both does not rely on a takeover.

“We think that M&A is not over, there’ll be continued activity,” he says.

“When we look at our own fund, we think about where we are likely to see bids come from. We think both Iress and AUB Group for us are obvious candidates for future M&A.”

Both businesses have been approached previously, but a takeover didn’t progress for one reason or another.

However, Edgley says the potential for another takeover approach is strong given the strategic nature of the assets as well as a “significant amount of valuation upside”.  

“AUB is now the sole listed insurance broking business on the ASX. There were three, but over the last two years Steadfast and PSC Insurance have been taken out.

“It is important to note, our thesis on both AUB and Iress does not rely on M&A and a takeover – we just see this as upside optionality.”

Pendal holds investments in FleetPartners, Austal, SkyCity, AUB Group and Iress.

Why small caps look ripe for re-rating

The backdrop is a market where small caps have materially underperformed large caps.

“We’ve seen small caps underperform significantly for the last couple of years versus large caps,” Edgley says. “The valuation divergence has become even more significant.”

He adds that small caps are trading close to one standard deviation cheap relative to their long-term average, and a full standard deviation below large caps on a relative basis.

“When there is mispricing of stocks in public markets, eventually there’s always another buyer out there that will look to take advantage of that,” Edgley says.