What can we learn from the latest RBA meeting minutes? Head of government bond strategies TIM HEXT offers readers a look inside the meeting of “two-handed” economists

• Less spare capacity in economy than previously thought
• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Browse Pendal’s fixed interest funds

IF anyone complains about RBA transparency, they are not paying attention.

The minutes from the central bank’s early August meeting were released today, though I am not sure minutes is the correct word – at 3,667 words, transcript might be a better term.

Together, with the post-meeting press conference, the RBA is putting its best foot forward in communicating with the public, as encouraged by the RBA review.

There was so much to say but so little confidence in anything.

Even the new Deputy Governor Andrew Hauser chose a recent speech to warn of false prophets and said we should have little confidence in any forecasts.

In the minutes we were treated to such gems as:

• “It was not possible to either rule in or rule out future changes in the cash rate.”
• “Members will rely on the data and evolving assessment of risks to guide the Boards decisions.”
• “Members observed that a range of uncertainties could influence the outlook for inflation, including the evolution of the labour market, household saving behaviour and the extent of spare capacity, as well as global geopolitical developments.”

However, the one thing the RBA was keen to say is that if the Board was to do anything near term it is hiking – not cutting.

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

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

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

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

The team won Lonsec’s Active Fixed Income Fund of the Year award in 2021 and Zenith’s Australian Fixed Interest award in 2020.

Find out more about Pendal’s fixed interest strategies here

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About Pendal

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

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

Contact a Pendal key account manager

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

• The gravest fears for a material market sell-off look to be over
• Positive first week for ASX reporting season
• Find out about Pendal Focus Australian Share fund
• Register here to join Crispin’s upcoming Beyond the Numbers live webinar

A BOUNCE-BACK in equities accelerated last week as the market gained confidence that the US economy was not entering recession, liquidity remained supportive and the bulk of the Japanese yen carry-trade unwind had played out.

The S&P 500 rose 3.99%, breaking through technical resistance levels to get within 2% of the July high, while the S&P/ASX 300 gained 2.57% and is also within 2% of its highs.

Key US data points indicated the labour market was holding up. Retail sales and Walmart results pointed to a solid consumer and survey data suggested August may be stronger relative to July.

Since a back-track from the Bank of Japan, the yen has stabilised and the Topix has staged a strong recovery. This materially reduces the risk of a negative liquidity spiral.

The VIX (a measure of stock market volatility) has unwound its spike and is back to the levels of late July, which means the forced cutting of positions should have finished.

So, the gravest fears for a material market sell-off look to be over.

With negative seasonal effects and limited new positive news, we expect that the market can now consolidate. It has shown impressive resilience and that should help underpin returns into the year end.

All eyes are on Fed Chair Powell and his Jackson Hole speech this Friday.

In Australia the first major week for results was positive.

Banks, telecom and discretionary stocks are seeing upgrades and the broader read on the economy suggests things are holding up well.

US growth – recession risk reduced, the soft-landing narrative has resumed.

A series of data points, while not strong, highlight the economy is holding up and the payrolls panic is now dissipating.

1. Survey data is supportive — Indicators such as the Evercore ISI Company Survey are ticking higher in August.
2. Solid US retail sales growth — Headline retail sales rose 1.0% month-on-month in July, helped by a weather-related bounce back in auto sales. But even the underlying ex-auto data was solid, growing +0.3% month-on-month and taking the three-month annualised rate back to 4.9%, the highest level since late 2023. The market was relieved there were no signs of renewed weakness and encouraged by the improvement in some of the discretionary sectors such as consumer electronics, hardware and auto. Survey data such as the Evercore ISI Retailers Sales Survey indicate August may be good, with firm back to school sales. Decelerating income growth remains the risk to consumption.
3. Strong Walmart sales — Walmart, along with Amazon, is the proxy for US retail sales at ~10% of market. It reported 4.2% sales growth, which is ~150bps above the US average. This is driven by its E-com business, but also signals disinflation easing. General merchandise saw the first positive sales growth since Q4 2021. It is interesting to note that Walmart represents 15% of total US retail sales growth, while Costco (with 3% market share) is capturing 6% of total growth and Amazon is getting 45% of the growth.
4. Initial jobless claims eased off — The market was focused on this as a read on non-farm payroll data, given the latter prompted recent volatility. A longer term look at continuing claims, which are correlated to job losses, also suggests we are not at recessionary levels.

We did see some weakness in housing starts and also in the homebuilder survey, despite the recent move lower in US mortgage rates.

This is an interest rate-sensitive sector and will motivate the Fed to cut rates.

Inflation gives them scope to do so:

• July’s headline consumer price index (CPI) rose +0.2% month-on-month and is at 2.9% year-on-year. Core CPI is up +0.2% for the month and 3.2% for the year.
• “Super-core” inflation is running below the 2% target on a three-month annualised basis.

This suggests inflation is not a barrier for rate cuts, that there is no need to hold rates in the 5% range, and that we should see 75-100bp of cuts by the end of the 2024.

On the political front, the RCP Betting Average data indicates that Kamala Harris is currently the clear favourite to win this year’s Presidential election. Her win probability is sitting at ~53% versus ~46% for Donald Trump.

We are beginning to see some indication of policy from Harris. The most relevant for our market was the potential for first time home buyer support for new homes, which would be positive for James Hardie.

Australia

We saw more strong employment data, with employment rising 58k month-on-month versus market expectations of about 10k. Full time employment rose 62k.

Both the three and six-month rise in employment is accelerating, which highlights that the economy is fine.

Hours worked also rose, up 0.4% month-on-month, although there were material reductions to prior months, which should help productivity measures look better.

Unemployment did rise, up 0.1% to 4.2%. This is due to labour participation rising to record levels of 67.1%.

The bottom line is the economy remains in good shape, and the consumer should hold up while the labour market remains as it is.

We also saw the RBA talking hawkishly about the outlook for inflation and clearly signalling rates won’t be cut until next year. The market is expecting the first cut in February.

Markets

The rally in markets has broken the technical downtrend and now looks likely to test the highs, but will probably consolidate in a trading band through to October, in our view.

Technical indicators such as the stock advance/decline ratio show some good strength, albeit now as positive as we saw at the market low in October last year.

The proportion of stocks above their 200-day moving averages also suggests the market is unlikely to break down.

Bonds are hovering around the support levels of 3.80% (for US 10-year treasuries). We would probably need to see more weak data for them to go lower from here.

All this suggests we are back to the best of both worlds – inflation low enough to cut rates combined with a slowing economy that is avoiding recession.

ASX reporting season

Australia also had a strong week, benefiting from the broader global market bounce and a good start to reporting season.

The first big week of results season was a clear positive for the market:

• Large index stocks are all doing well. Commonwealth Bank saw positive earnings revisions on better margins and lower bad debts. Telstra also saw positive revisions. CSL was revised down 4%, but this was seen more as them being conservative.
• Stocks exposed to the domestic economy all point to solid back drop. JB Hi-Fi said June and July retail sales were good. Seven Group, a bellwether for industrial demand, was positive on the outlook.
• Popular growth names like Pro Medicus and Car Group were comfortable with their outlooks
• Any negative surprises tended to be limited and generally stock specific. Cochlear and Origin Energy had cost issues, while Seek’s challenges relate to job advertisement volumes, which are more tied to labour turnover than job losses.

M&A activity is providing additional support. Orora received a takeover approach while Sims sold off a business at a good price.

It is worth highlighting the substantial sector rotation between banks and resources.

Another ~7% relative move last week takes calendar year-to-date outperformance of banks versus resources to more than 30%, which is a material move in a historical context.

This reflects domestic economic resilience and better margins, while China remains weak with an uncertain outlook.

Iron ore weakness is weighing on Resources. China’s largest steel maker, Baowu, warned China’s steel industry is facing a crisis more serious than the downturns of 2008 and 2015.

This prompted both Tangshan and Yunan provinces to announce steel production cuts in an attempt to improve margins.

We also continued to see weakness in lithium with a poor auction for material in China leading to talk of stock having to be dumped on the market.

We are approaching levels where we may see supply adjustment.

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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.

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

The past few years have played havoc with market assumptions. Here, Pendal’s AMY XIE PATRICK explains what’s really going on with inverted yield curves and other misunderstood investing concepts

• Bonds not a “servant asset class” to equities
• Owning bonds at this stage of the cycle could be useful
• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Browse Pendal’s fixed interest funds

THE past few years have played havoc with conventional market assumptions.

Inverted yield curves don’t mean recessions are imminent. Expensive valuations can get more expensive. An aggressive hiking cycle need not bring about recession. Bonds don’t have to go up when equities go down.

These kind of outcomes cause head-scratching among modern-day market participants.

But viewed through a longer-term lens (think multiple cycles and regimes) it becomes clearer.

Let’s have a look at each of these broken relationships.

Are yield curves a recession predictor?

An inverted yield curve happens when short-term interest rates are higher than long-term ones — an unusual occurrence traditionally viewed as a sign of economic slow-down or looming recession.

In my view, inverted yield curves don’t signal imminent recession.

Yes, every US recession has been preceded by an inverted yield curve.

But if you look back through enough history, you’ll discover that the lag between the moment of curve inversion and when a recession eventually hits is highly variable (three months to two years).

As far as recession indicators go, the inverted yield curve is about as useful as a wet paper bag.

So, what does an inverted yield curve tell us? Simply that the market expects interest rate cuts at some point down the line, and that current policy settings are restrictive and will be normalised (for whatever reason) in the future.

Two things cause policy settings to normalise from restrictive territory: either growth slows, or inflation cools. It can also be both, but disinflation is possible without slower growth. 2023 was evidence of that.

Valuations are not a trading tool

Valuations should provide investors with information on risk-reward dynamics, but they have never been a good timing tool for investment decisions.

With the hype of generative artificial intelligence (Gen AI) building over the past year has come plenty of scepticism over where that now puts overall equity valuations. That scepticism is probably what makes expensive tech stocks more expensive when markets are benign.

It takes a reality that falls short of expectations to make those stocks cheaper. Maybe even then, they won’t be outright cheap.

Hikes weren’t the only thing that happened

The rate hikes of 2022 and 2023 were supposed to cause a recession.

What we didn’t expect was a break from fiscal prudence and outright austerity.

The market lacked muscle memory for how to incorporate the pandemic fiscal response. Nowhere was it larger or more enduring than the United States.

The result of this stimulus, which happened in multiple forms over most of the world, was to put cash into people’s pockets.

That liquid spending power mutes the effect of interest rate hikes. Who cares if the cost of borrowing is soaring when there’s all this cash in my pocket?

That doesn’t mean those rate hikes will never matter. The effects will reveal themselves when the cash runs out.

Ironically, for the next economic cycle to begin, this current cycle needs to find a landing.

Soft or hard landing probably doesn’t matter too much – either way, interest rates will come down and borrowing can then become affordable to fuel the next wave of spending.

Bonds reveal their true colours

In the two decades after the Global Financial Crisis — and indeed because of the GFC — central banks extended a “put” to equity markets. If things got bad enough, they would cut interest rates.

Since bond yields and policy rates are inextricably linked, lower yields would lead to a boost in bond prices.

The negative correlation between bonds and equities during this period somehow made its way into tautology.

We are taught in Finance 101 that bonds are a “defensive” asset class, but what we ignored was that the only thing that afforded the “central bank put” was the absence of any real inflation impulse.

Bonds have never been a servant asset class to equities.

The same fundamentals that matter to bonds have always mattered: where inflation goes, where growth goes, and where central banks will take interest rates. That’s why bonds always rally at the start of recessions.

Whether central banks are late or right, a rapid cutting cycle will accompany any recession. The irony is that most recessions are baked in before the first rate cut.

What caused so much grief in 2022 was that higher inflation was a bigger problem than growth. Bonds did their job: yields rose and prices fell in anticipation of higher policy rates.

Since a high-inflation problem is a problem for all asset classes, bonds couldn’t help when equities derated. This time, the inflation backdrop meant that the central bank put was unaffordable.

Supportive part of the cycle for bonds

Bonds respond to the economic cycle.

As an asset class price returns tend to be mean reverting, with the forty-year bond bull run being an anomaly rather than the norm.

What matters more for bonds now isn’t whether the US fiscal situation is out of control, or whether Asian central banks have stopped buying US bonds. Political noise injects volatility bond markets, but their course will be set by the forces of the cycle.

For the next 12 months, what matters is inflation and growth, and on both fronts there’s reason to believe that bonds will be quite useful.

The path of disinflation has been bumpy and slow, but most major economy inflation data are coming within sight of central bank targets. This alone removes the need to fear more hikes and opens the door for easing.

Growth is also softening. No aspect of growth or demand is falling off a cliff, but it’s telling that oil has not been able to rally despite two unfortunate wars taking place in oil-heavy regions.

Europe has been teetering on the edge of recession for almost two years. China is going through its own version of the GFC aftermath. The bright spots have been where most fiscal ammunition was deployed during the pandemic.

The news here is that excess cash from pandemic-related fiscal stimulus is running out. A high US deficit alone won’t replenish that cash – that requires an ever-increasing higher deficit. That positive fiscal impulse is absent from current events.

The not-so-new news is that even if rate cuts were to start immediately, they are unlikely to offset the rise of average borrowing costs as older fixed-rate loans reset. This is especially true in the US.

Effects like these contribute to those long and variable lags of monetary policy.

What’s good for bond won’t always be good for equities

Given the positive correlation between bonds and equities, the market now thinks what’s good for bonds is also good for equities.

That’s true, but only up to a point.

As mentioned, lower inflation and growth are both good for bonds, but only the first of those things is good for equities.

When looking at risk premia across equities, credit and global market volatility, we can see that a soft landing is what’s priced in.

Earnings growth expectations over the next 12 months look very healthy. Trump tax cuts have already been baked into market prices even though polls have seen his chances of winning slide from 70% to now below 50% since Kamala Harris entered the race.

Exuberant sentiment can never in itself cause a market to turn, just like how valuations are poor timing tools. However, when risky assets are priced for very little downside this means that in the event of a negative catalyst, the downside becomes asymmetrically larger than any upside that can be gained from here.

At the start of every cycle’s softening trend, it’s impossible to discern whether the softening will accelerate – resulting in a hard landing.

The early part of the softening is good for bonds and equities, especially as the world comes off a high inflation problem. The risk is increasing that lower inflation will be engulfed by much lower growth.

Owning bonds at this stage of the cycle makes a lot of sense.

They will pay you a positive income and could deliver capital appreciation if inflation continues to come off – especially if that is accompanied by a worsening growth outlook.

The risk is another inflation shock, but there is sufficient consistency in lower prices and wages to argue for removing higher policy rates for the rest of this cycle.

Not owning equities can feel painful when the tech and AI driven story keeps gaining new legs.

So, owning bonds against this FOMO (fear of missing out) is a no-brainer – not because bonds are there to save us when equities fall, but because the growth speed bump that causes equities to fall is exactly the economic fundamental that will be a boon for bonds.

What is the state of play in China? Head of income strategies AMY XIE PATRICK offers an overview of China’s recent Third Plenum and the implications on world economies. 

• Property fall-out akin to China’s own Global Financial Crisis
• The cyclical picture for China “not going to get better” in near term
• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Browse Pendal’s fixed interest funds

IN China, the Third Plenum ended with little fanfare.

The market didn’t expect much by way of stimulus policies since almost all hopes of that kind have been repeatedly dashed over the past two years.

As a forum focused on the medium term, it addressed structural over cyclical issues facing China’s economy. The overarching message was about prioritising sustainable long-term growth over short-term sugar hits.

The property market fall-out

We’ve written at length in the past about the nature of China’s economy and its intricate ties to the property sector. We won’t rehash those details here.

The economy’s dependency on real estate means that there are significant withdrawal symptoms to be addressed in the aftermath of the massive Chinese housing slump.

The fall-out is akin to China’s own version of the Global Financial Crisis (GFC).

Source: Bloomberg

It took the US economy close to a decade to heal over the wounds from the GFC. During that time, authorities focused on banking sector repair and regulation.

Fiscal policy remained conservative, leaving quantitative easing (QE) to provide indirect support through the financial markets. Private sector businesses and households focused on balance sheet repair. Low interest rates could do little to incentivise demand for borrowing during this repair phase.

China has many of the same constraints today.

Financial sector reforms are vital for ensuring that new excesses don’t build up in place of previous property-related bets.

Fiscal policy is unable to provide much boost because local governments who dish out much of this stimulus are hamstrung by the devastating hit to their revenues as land sales collapsed with the housing slump.

Monetary policy can’t help because lower interest rates threaten the stability of the yuan and ultimately the stock of China’s foreign currency reserves.

With home prices now able to fall as well as rise, households won’t be persuaded to add more property to their portfolios just because mortgage rates fall at the margin. There are bigger capital holes to fill in their existing property portfolios.

Source: Bloomberg

Structural over cyclical

The cyclical picture for China is not going to get better in the near term.

Beijing has been unwavering in its resolve to de-lever and de-risk the property sector. These goals have been in play since after the GFC, but each time something got in the way.

Here’s a timeline:

• In 2013, deleveraging efforts ended with a devaluation experiment which resulted in China losing a quarter of its foreign currency reserves.
• In 2015, deleveraging efforts led to a slowdown in demand that swept across commodities and ignited a wave of defaults in the US energy sector.
• In 2017, deleveraging efforts had to be slowed as fighting Trump’s trade war became a priority.
• In 2020, deleveraging efforts had to swiftly U-turn to offset the pandemic.
• Since 2021, the deleveraging commitment has stuck.

While communication from the Third Plenum renewed the government’s commitment to the growth target, more noise was made about the longer-term transition goals for the economy. The hope is to fill property void with high-tech and innovation.

There was also talk of a smoother mechanism for fiscal transfers between central government and local governments. Fiscal reform is a lengthy process, and the overarching goal would be to ease the pain from anaemic land sales revenues rather than greatly increase local governments’ fiscal firepower.

Structurally, changes are afoot on the technology front in China.

Since 2017, the real estate sector’s contribution to final demand in the Chinese economy has fallen from close to 25% to now under 20%, while contributions from the high-technology sectors have growth from 11% to just under 15% (data from IEA).

Renewables power generation capacity now makes up more than 85% of total annual newly added power capacity whereas thermal power has dwindled to under 5%.

The picture 15 years ago was almost the mirror opposite.

In electric vehicles (EVs), thanks to government subsidies and consumer incentives, sales in China make up close to 40% of total vehicle sales. This compares to only 21% in Europe and 10% in the US.

Thank goodness for asynchronous cycles?

China’s unwavering resolve since 2021 to deleverage the property sector has been successful thanks, in large part, to the strength of the global recovery from the pandemic shock.

This acted as economic immunity for the rest of the world from China’s property crisis and prevented a feedback loop that would have otherwise thwarted Beijing’s efforts again.

Subsequently, China’s domestic deflation and weak demand has helped developed market inflation to normalise via the goods channel.

Source: Bloomberg

But now is where things start to get tricky.

There is little reason to hope for big-bang stimulus from China. The policy focus is about strengthening local institutions, balance sheet repair, and positioning new engines of long-term growth.

At the same time, growth is weak or softening in other parts of the world:

• Europe has been dancing on the precipice of recession for the best part of two years.
• Asia’s recovery from the pandemic was weaker than other areas in the world due to its strong links with China.
• Excess cash and savings from pandemic fiscal stimulus are running out for economies like the US and Australia.

China’s investment focus on technology and renewables will not provide the offset needed to steady the ship of the global economy in the near term.

From inflation to deflation?

Of course, it wasn’t long ago that central banks had the opposite inflation problem to what exists today.

No matter how low they kept interest rates and how hard they engaged in QE, inflation continued to undershoot its target in the pre-pandemic era. Part of the problem was the balance sheet recession caused by the GFC. The other issue was continued price deflation in goods and tradeables.

This deflation can be traced back to China producing more than it could consume and relying on global demand to absorb its excess manufacturing capacity.

With a new investment wave in high-tech sectors coming from China comes risks of more deflation from too much capacity in China. This is already apparent in EVs, where the competitive price pressures from Chinese EV producers have forced companies like Tesla to slash prices to defend market share.

The difference between today and a decade ago is the competitive realm. It has moved on from commoditised manufactured goods to high-tech.

“Good enough” is far harder to achieve in high-performance computer chips than plastic children’s toys. Nevertheless, with global trade partners all trying to “de-risk” from China, alternative hopes for long-term growth are few and far between.

These concerns about overinvestment may be just as valid in the west as it is for China. It has certainly been a feature of the latest US earnings season, with growing market scepticism on the pace and scale of company investments into artificial intelligence.

When overinvestment leads to overcapacity, technological success will have a hard time finding its way into company earnings success. Just look at the Chinese stock market.

What does the recent global market volatility mean for emerging markets investors? Here’s an update from Pendal’s Global Emerging Markets Opportunities team

• Key EM factors: Decline in US yields and expectations of Fed rate cut
• We may see monetary stimulus from Asian EM central banks
• Mexico and Brazil set up for fixed-income inflows and significant rate cuts
• Find out about Pendal Global Emerging Markets Opportunities fund

WE’VE seen significant volatility in global financial markets – including emerging markets – in recent weeks.

The main cause was a combination of softer US economic data coinciding with an increase in policy interest rates in Japan.

As a result, we experienced multiple dislocations in fixed interest and currency markets, as “carry trades” were aggressively unwound. Carry trades involve investors borrowing a low-yielding currency to invest in a higher-yielding currency.

This caused a rapid risk-off move across most global financial markets.

In the emerging markets space, market segments with the highest exposure to international investors saw the greatest volatility and weakness.

In EM equities, the pain was concentrated in the information technology (IT) sector, and across Korea and Taiwan. Among currencies, the high-yielding Brazilian Real and Mexican Peso saw the sharpest sell-offs.

What’s next?

The key question now is: what happens next?

We find it hard to be overly positive about the IT sector, despite a reset in valuations from market weakness.

The entire sector has re-rated substantially in recent years, despite essentially soft demand in important end-demand segments such as PCs and mobile phones.

This optimism has been attributed to a potential demand shift from widespread adoption of generative artificial intelligence.

But beyond some key semiconductor names held in our portfolio, we have not seen sufficient evidence of this opportunity.

From a country view, this translates into ongoing caution towards Korean and Taiwanese equities.

Where the opportunities are

In our view, the last six weeks of price moves create opportunity in emerging market interest rates – especially their role as potential drivers of broad domestic demand and local financial markets.

The sell-off prompted repricing of US policy interest rate expectations.

Yields in the middle part of the US Treasuries yield curve have declined by more than 0.5%.

Meanwhile the 12-months-ahead futures-derived expectation for the US Federal Funds policy interest rate are down nearly 1% since May.

In emerging Asia, some economies have failed to fully close the output gap that the Covid slowdowns created.

This has been accompanied by undershoots in inflation and core inflation. But local central banks have been unable to respond with interest rates cuts in the face of stubbornly high US bond yields and interest rates, and a stronger US dollar.

If the Federal Reserve is now to move to reducing policy interest rates, emerging Asian central banks can respond more directly to domestic growth and inflation conditions.

Some Emerging Asian central banks have local issues that may constrain this effect – notably Bank of Korea’s concerns regarding household leverage and the Reserve Bank of India’s worries about growth in unsecured lending.

But we see output gaps, low core inflation and concerns about currency weakness in Indonesia and China – and both of these markets (which are held as overweight positions in our portfolio) could see significant monetary stimulus in the next few quarters.

Mexico and Brazil

Mexico and Brazil also look well placed in the medium term.

Firstly, despite the currency weakness caused by market volatility, the interest rate gaps that drove bond market inflows remain (Brazilian policy interest rates: 10.5%; Japanese policy interest rates were just hiked from 0.1% to 0.25%), and a period of market stability is likely to see a resumption of inflows.

Secondly, we believe the Peso and Real went into the sell-off with some challenges from weaker export revenues, but in no sense overvalued.

Mexico had a trailing current account surplus in the first quarter of 2024, while Brazil’s trailing deficit to June was only 1.4% of GDP – small by historical standards.

Thirdly, real interest rates in both countries remain very high compared to historical levels, with US rates and yields the dominant constraint on cuts.

The faster the US Fed moves to cuts, the faster Banxico and the Brazil Central Bank can follow – which should be highly stimulative for both economies.

It has been a challenging period in global markets, but we believe the fall-out is ultimately positive for emerging equity markets, and particularly positive for the markets we hold as overweight positions in the portfolio.

About Pendal Global Emerging Markets Opportunities Fund

James Syme, Paul Wimborne and Ada Chan 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 JIM TAYLOR. Reported by investment specialist Chris Adams

• Find out about Pendal Focus Australian Share Fund
• Register now: Crispin Murray’s Beyond the Numbers webinar

MARKETS were volatile last week, driven by the blow-off from a US employment report and Yen carry trade reversal in the previous week.

Thursday’s US jobs data provided a circuit-breaker to last week’s employment data doom.

Ultimately, the US equity market finished flat on the week, with the S&P 500 down 0.02%, the NASDAQ down 0.17%, and Australia’s S&P/ASX 300 falling 2.12%.

The US bond market gave up some of its strong month-to-date gains, while commodities were generally softer.

In the absence of much economic data to guide markets, key insights for the week have been derived from US reporting season messages.

Here, commentary highlighted heightened pressure on lower-income consumers, as all the Covid handout savings are gone and extra income is probably, at the margin, harder to generate.

There was also continued softness in big-ticket and discretionary spending, evidence of consumers “trading-down” to cheaper alternatives, and some spillover to travel and lodging demand.

Here’s how the Disney CFO summed it up: “The lower-income consumer is feeling a little bit of stress and shaving a little bit off their time at the parks. The high-income consumer is traveling internationally a bit more.”

As a broad observation on markets, there are two areas where we are evolving to a new (old) normal:

1. Inflation. This is falling everywhere but the easy wins – like in goods – are behind us. The rate of decline is slowing, meaning progress to a “2%-ish” target has become a little more volatile and lumpier, and positive surprises on inflation aren’t a one-way bet anymore.
2. Earnings. The general state of play in most developed economies is that there are distinct hot and cold parts of the economy, and this gets reflected in the disparity of earnings across stock market sectors. The market may have forgotten this over the last two to three years as the excess savings run down effect has been significant in bolstering activity levels across the board. These have been run down and we now need to readjust to the new environment.

Last week’s stock market volatility was on par with both the GFC and Covid.

This week, we see some genuinely meaningful numbers like PPI, CPI and retail sales – so we expect the volatility to roll on.

That said, some of the panic and calls for emergency rate cuts looks way overcooked.

Central banks

The Fed stepped in quickly to make its position clear amid the market’s fuss.

Chicago Fed President Austan Goolsbee said, “the law doesn’t say anything about the stock market; it’s about the employment and it’s about price stability.”

“As you see jobs numbers come in weaker than expected but not looking yet like recession, I do think you want to be forward-looking at where the economy is headed for (in) making the decisions,” he continued.

San Francisco Fed President Mary Daly made the point that inflation is near the target, that the labour market is slowing and that “it’s to a point where we have to balance those goals”.

She also noted that while rates have been left unchanged, the shift in rhetoric to acknowledge the need to balance between two goals is a policy adjustment in itself.

Elsewhere, Bank of Japan’s Deputy Governor Uchida said it would stick with the current policy setting “for the time being” and “won’t raise interest rates when financial markets are unstable”, in what is seen as a bit of backpedalling following the response to the last rate hike.

US macro and policy

The ISM Services non-manufacturing Purchasing Manager’s Index (PMI) rose from 48.8 in June (its lowest level since May 2020) to 51.4 in July.

The ISM Employment Index also picked up – from 46.1 to 51.1.

This rebound in new orders and a rise in employment helped quell recession fears stoked by the employment report the previous Friday.

Better sentiment on employment was bolstered by initial jobless claims, which came in at 233k versus 240k consensus and the prior week’s upwardly revised 250k.

It is interesting to note that the Bloomberg consensus probability of a US recession in the next twelve months has fallen from 60% this time last year to 30% today.

Goldman Sachs has increased its own recession probability in response to recent data but had been running well below consensus at 15% – now standing at about 25%.

Australia macro and policy

As expected, the RBA held rates steady at 4.35%.

Its statement observed that “momentum in economic activity has been weak, as evidenced by slow growth in GDP, a rise in the unemployment rate, and reports that many businesses are under pressure”.

It also noted that inflation had “fallen substantially” but remains “too high” in underlying terms and with upside risks.

As a result, Governor Bullock struck a decidedly hawkish tone, being very clear that “a near-term reduction in the cash rate does not align with the Board’s current thinking” for the remainder of the year.

She also noted that the Board gave “very serious consideration” to holding rates steady for some time or even to raising.

Australia macro and policy

US reporting season

Beneath all the noise, it has been a positive reporting season.

With 91% of the market having reported, the blended earnings growth rate for Q2 S&P 500 EPS currently stands at 10.8%. This compares to the 8.9% expected at the end of the quarter.

The blended revenue growth rate is 5.2%.

And 78% of the market has beaten consensus EPS expectations, which is level with the 78% one-year average and a bit higher than the five-year average of 77%.

Sales expectations are also being routinely beaten.

Companies are reporting earnings that are 3.5% above expectations, which is below the 6.5% one-year average positive surprise rate and the five-year average of 8.6%.

A significant feature of this reporting season has been the weakness in results and outlook commentary in the leisure sector:

• Airbnb pointed to slowing demand as Q3 guidance for revenue and earnings came in soft, with management calling out “shorter booking lead times globally and some signs of slowing demand from US guests”.
• Lyft’s guidance pointed to a 2-4% deceleration in bookings next quarter.
• Hilton Hotels lowered the top end of its FY guidance amid “softer trends in certain international markets and normalizing leisure growth more broadly”.
• TripAdvisor noted a normalisation of experiences demand, moderating pricing and trading down in travel spend.

It is hard to decompose this trend between normalisation of the post-Covid travel boom and a more cautious consumer.

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About Jim Taylor and Pendal Focus Australian Share Fund

Drawing on more than 25 years of experience investing in top-performing Australian companies and a background in accounting, Jim manages our Long/Short Fund and co-manages our Imputation Fund. He is a Chartered Accountant with membership of the Australian Institute of Chartered Accountants.

Pendal Focus Australian Share Fund is managed by Crispin Murray. The fund has beaten its benchmark in 14 years of its 18-year history (after fees), across a range of market conditions. Find out more about Pendal Focus Australian Share Fund here.

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

Contact a Pendal key account manager here

Pendal’s head of income strategies, AMY XIE PATRICK, explains what the recent market volatility means for fixed-income investors

• Trending ‘unwinds’ contributing to risk-off sentiment
• Volatility expected to stabilise and then fall
• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Browse Pendal’s fixed interest funds

BIG market moves have rocked sentiment since the beginning of August.

The table below shows market moves in equities, credit, volatility and bonds since August 1.

These are classic “risk-off” moves.

Figure 1: Risk off!
Major benchmark moves since market close on Thursday 1 August 2024

Whiplash

For bond investors, it’s not so much the fall in yields that was interesting to witness in the price action of the past few market sessions. It’s the fact they rebounded significantly from the lows seen on Monday, August 5.

US 10-year yields, for example, backed up 19bps from Monday’s session lows and US two-year yields rebounded by more than 30bps.

Perhaps the market remembers the whiplash from early 2024.

Rate markets rushed to over-interpret the Fed’s end to hiking as the start of the next concerted easing cycle. But they were disappointed by an overt “wait-and-see” stance from Fed officials.

In Australia, our markets priced in four rate cuts from the RBA earlier this year, but had to swiftly walk that back when resilient economic and sticky inflation data failed to support those hopes.

Only a few weeks ago, Australian short-end rate markets were pricing in a 50 per cent chance of the August RBA meeting raising the overnight cash rate a further 0.25% to 4.60%.

Following a more benign-than-feared June CPI release, the meeting ended with another hold decision — and an RBA that still “rules nothing in or out”.

Is this an emergency?

In the US, market pricing currently sees a 100% chance of a 0.50% cut in September, followed by consecutive 0.25% cuts in subsequent Federal Open Market Committee meetings.

The argument seems to be that had the Fed seen the full suite of July data at its end-of-July meeting, the central bank would have opted to cut.

On top of this, some big-bank economists are now calling for back-to-back 0.50% cuts – even an inter-meeting emergency cut.

Are things really dire enough to justify a panic to easing?

We argue the data isn’t there yet.

The US labour market report was the main cause of the market’s negative reaction on August 2.

The gain in employment fell well short of market expectations. Unemployment rose from 4.1% to 4.3% while the market anticipated no change.

Employment gains, however, were still gains.

Coupled with a slight fall in average hourly earnings, this is the kind of data that would have had bond and equity markets partying a couple of months ago.

Monday night’s release of a healthier-than-expected set of ISM Services data pointed to no evidence that a recession is waiting on our doorstep.

Similarly, second-quarter earnings season in the US so far shows an earnings beat of 5.2% versus analyst expectations.

This puts total earnings growth from the companies that have reported so far at over 11%.

In recessions, earnings typically fall by 10% or more – so the corporate picture also doesn’t have the US in a recession. Yet.

Various unwinds

A bigger reason for the risk-off market sentiment could be a combination of recent events:

• A “great rotation” away from expensive tech to less expensive small caps, as investors become sceptical that AI-related hype can meet with real results
• The “yen-unwind”, as the Bank of Japan starts to remove the cheapness of yen funding from international carry and risk-seeing trades
• The “great de-grossing”, as risk-parity funds rush to reduce exposures as volatility rises.

By themselves, these trends naturally run out of energy.

The rotation into small caps should end because 40 per cent of Russell 2000 companies are not profitable.

Carry trades should unwind when the excesses in their momentum to the upside have been unwound.

And the risk-shedding of risk-parity funds will end so long as there are not marginally incremental waves of risk-shedding.

Volatility should stabilise, then fall.

Watch the economy

We think fundamentals or a systemic shock are needed to ignite the next recession. Unfortunately, there are a few fundamental developments to worry about.

Over the next year, analyst earnings expectations for the S&P 500 have growth at more than 10% per quarter. That’s not to say it can’t happen — but not even a soft landing seems to be baked in there.

Default rates have continued to climb among US corporates, but even including the moves of the past week, credit spreads are near their cycle lows.

The New York Fed’s recession probability index has climbed to new cycle highs. We know that after a lag, the VIX Index (a gauge of market volatility) also follows.

Vacancy rates in US office real estate have continued to rise and now sit at over 20 per cent. As a result, delinquency rates in US commercial real estate are climbing.

Not just yet

The conclusion of our analysis is that it’s not quite “the big one” just yet.

Following big positive runs in bonds, we need to take a calm breath and ask whether the fundamentals justify the pricing of emergency cuts.

If not, profit-taking comes first. Waiting for the next opportunity to buy bonds comes next.

Zooming out, we’re in the ripe part of the cycle for owning some bonds in portfolios, regardless of your stance on risky assets.

Without a recession, bond yields should continue to fall steadily as central banks around the world normalise their policy settings from restrictive levels.

Some have more work to do than others. Many have already started the journey. That’s because we won’t be talking about inflation as a problem for much longer.

With a recession, bonds will pay for themselves.

Bonds are not guaranteed to perform all the way to the end of a recession, but they’ve always been useful at the start of recessions.

Since the start of recessions are hard to predict, bonds provide great insurance for the unpredictable.

Add to that the 4% types of annual income returns you can currently get on US or Australian 10-year bonds and it basically amounts to being paid to take out insurance.

That’s a nice change from the insurance inflation we’ve all been experiencing for the past two years.

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

• US economy reaches tipping point, unemployment rate triggers “Sahm rule”
• Markets fear the US Federal Reserve is now behind the curve
• Find out about Pendal Focus Australian Share fund
• Coming soon: register to join Crispin’s Beyond the Numbers webinar

LAST week saw a significant shift in sentiment, prompted by signs that the US economy is slowing down faster than previously thought.

The rally in bonds (which saw US ten-year Treausry yields fall 40 basis points), as well as further falls in global equities and a sharp rotation away from tech, banks and cyclicals towards utilities, REITs and gold all suggest that the market was clearly not positioned for this.

The moves were exacerbated by US results, with the tech sector reporting OK but seeing no material upgrades, while other companies indicated some signs of slowing consumers.

Finally, the Bank of Japan (BOJ) surprised everyone with a rate rise, triggering a sharp rise in the Japanese yen and a fall in the Japanese stock market.

The common link with all these developments is that they are leading to the unwinding of crowded trades – this is important given the US market has rallied for eight and a half months and gained more than 35%.

Even if this growth concern proves a head-fake (as others have), there is room for a correction in the S&P 500 to the 5,000-5,100 level – reinforced by the weaker seasonals and election uncertainty. There is also likely to be material rotation as part of this.

We have been bracing for such a correction, with cash levels higher and positions reduced in some of the more economically leveraged stocks.

The S&P 500 fell 2.05% on the week, while the NASDAQ was off 3.34%.

The S&P/ASX 300 was up 0.28% for the week on the back of more benign inflation data, making a new high Thursday.

The move off the October 2023 lows is well below that seen in the US, but still roughly 20%.

The key issue is whether this is a “normal” bull market correction or will we see a more meaningful drawdown.

Two potential drivers of the latter could be:

• Flows and/or liquidity. ETF flows have been strong in recent months and there are no signs of them reversing, but if that happened it would reinforce the sell-off. Liquidity is unpredictable and needs to be watched. There appears no stress in the system at present and US funding requirements should be supportive short term as it gets skewed to the short end and funded from reverse repos.
• More significant economic weakness. Our view is that this will not be the case for several reasons: the global economy is holding up OK, we have not seen an economic shock, there is a lot of scope for rates to be cut (particularly given the stepdown in inflation), and corporate earnings and the AI/semi theme still looks well underpinned. That said, this can change and markets will remain focused here.

US economy: is it weakening more than expected?

Markets reacted to a string of negative data points, with a shift towards the narrative that the Fed may now be behind the curve – having not cut rates in last week’s meeting – and that the risk of recession has risen materially.

US employment data cemented this shift in sentiment, as July non-farm payrolls rose 114k versus the 175k forecast and the prior month was revised 29k lower.

The three-month trend rose from 168k to 170k, however, the underlying components looked soft – with 67k of the rise from healthcare.

Total services employment slowed from 125k to 72k, and the underlying measure of private sector jobs (ex-healthcare) dropped to 75k on a three-month annualised basis.

The 20 basis point rise (bp) in the unemployment rate – from 4.05% to 4.25% (versus the 4.1% expected) – caught the eye.

It is now 60bp higher than its low point and just triggering the “Sahm rule”, which signals that a recession has started when the three-month average unemployment rate rises 50bp off its three-month average low in the prior 12 months.

This increase was driven by the household survey seeing job growth of only 67k (on the payrolls-equivalent basis it fell 15k) and a continued rise in the participation rate from 62.59% to 62.7%, which added 420k to the labour force.

Hours worked data was also weak, declining 0.3% month-on-month. This series is now flat on three-month annualised basis.

Average hourly earnings were only 0.2% month-on-month (versus the 0.3% expected) and fell from 3.8% to 3.6% year-on-year

The fear is that we are at a tipping point in the US economy.

For the bears who have been predicting recession for almost two years, the payrolls data was the signal that validates these concerns, and the market is concerned that the Fed has misread the economy and is behind the curve.

While that may be the case this is only one data point, and there are issues with this month’s payroll figures.

The main caveat is the impact of Hurricane Beryl – the Bureau of Labour Statistics said there was no discernible effect from it, but this weather-related category for not being employed or working fewer hours spiked to 20-year highs suggest that there was an effect.

There is a very wide discrepancy between the payroll data and Household Survey data series, with each giving quite different signals.

There is a view that higher immigration is distorting the numbers. Normalising these numbers suggests that underlying payroll figures are not deteriorating as much as the headline would suggest. For example, Goldman Sachs estimates underlying July payroll growth of 147k, down from 148k in June.  

The rise in the unemployment rate has been driven more by the increase in the labour force, rather than an acceleration of layoffs. This means employment is rising, just slower than the rise in workforce.

This is a different profile to the rise in unemployment that has been seen in previous cycles. That said, ex-FOMC member William Dudley recently pointed out that this labour force supply was the trigger in the 1970s and the Sahm rule proved correct then.

US reporting season company commentary indicates that there has been no deterioration in corporate attitudes to employment and no sign of a step-change in the need to cut costs.

While these caveats indicate that we are not seeing a dramatic shift down in the economy, it does signal that the economy is softer than expected.

Economic risk has risen, with some lead indicators suggest a weakening in labour:

• Jobless claims have deteriorated. While this may also partly reflect some weather factors, it is stepping up and represents the best real-time signal on the labour market.
• The flow data of people losing their jobs versus getting jobs was worse in July than in June. This is first real sign of this changing; up to now, there has been no evidence of a pick-up in layoffs.
• Other lead indicators on employment, such as the ISM Survey outlook for employment, have also deteriorated.

So, the question is: does this signal a more rapid deterioration into a recession, or is a soft landing still more likely?

Our call is still for a soft landing, given:

• we still have job growth
• we are not seeing substantial layoffs
• the Fed has significant room to cut rates.
• commodity prices (particularly oil) are subdued, helping consumer spending
• corporate investment appears reasonably underpinned. 

In conclusion, payroll data and others last week indicate the economy is softening more than expected.

Given these caveats, it is too early to read this as an unambiguous change – but what it does mean is that cracks are appearing, and the Fed may be behind the curve. The August data will be critical to determining what the Fed does in September.

It also puts the market on edge regarding a deterioration in earnings trends. Given the extent of the rally and positioning, this is a catalyst for a further drawdown in equity markets.

Ultimately, our view is that growth can be maintained at reasonable level but could well require lower rates than originally thought.

US rates: what is the impact on policy?

The Fed July meeting came two days before the employment data and – as expected – it left rates on hold at 5.25-5.50%.

The messaging was dovish, with a shift from being “highly attentive to inflation risks” to being “attentive to risks to both sides of the dual mandate” – reflecting the improving inflation data from the most recent Personal Consumption Expenditures (PCE) and the employment cost index.

There is a widespread view that the Fed would have cut if it had seen the employment data and, therefore, it is now behind the curve.

As a result, the market is pricing in 70% chance of a 50bp cut in September.

However, economists are split – with some believing sequential 25bp cuts in the last three meetings of 2024 is more likely.

Whichever way it goes, rate expectations have materially shifted.

The market has shifted from pricing an implied 86bps to 166bps of implied rate cuts over the next 12 months.

Chairman Jerome Powell’s Jackson Hole speech on 24 August will be an opportunity to flag a more aggressive easing – similar to how he used his 2022 speech to warn on inflation.

Other US data

There were two positive data points on inflation, with the June core PCE up 0.2% and Employment cost index up 0.91%.

Unit labour costs are coming down as wages decelerate and productivity holds up. This is a good lead on inflation and gives the Fed plenty of room to cut rates.

The US manufacturing ISM was also sending a weak signal on economy.

It fell from 48.5 to 46.8, versus expectations of 48.8. The composition was poor, with new orders down 1.9 points and production down 2.6pts.

The employment component was the weakest since 2009.

Bank of Japan

A hawkish policy shift from the BOJ fuelled the unwinding of the yen carry trade and triggered de-leveraging of widely owned trades.

Rates were raised from a range of 0.0-0.1% to 0.25%.

The market only had a 30% probability of this, reflecting concerns over consumption.

The BOJ also announced a plan to gradually reduce JGB holdings over the next two years (which was expected) and its statement pointed to further rate hikes.

The hike reflected the broadening of wages growth in the economy as well as the risk to inflation from imports, given the weakness in the Japanese yen.

The market’s reaction was brutal, with the yen continuing its appreciation and the equity market falling 9% in two sessions.

The risk is that the yen was funding other trades and that this unwinding will force investors to shut down other risk – extending the de-risking sell-off.

Australia: inflation data better than feared, marketing swinging back to RBA cut

The headline Consumer Price Index (CPI) for Q2 2024 rose 1.0% quarter-on-quarter and 3.8% year-on-year.

This was in line with expectations. However, the RBA-favoured trimmed mean rose 0.8% versus the 1.0% expected, leaving FY24 at 3.9% versus the 4.0% forecast.

This is still too high, but low enough to leave rates on hold this week.

The monthly core CPI fell from 4.1% to 4.0% year-on-year.

Australia remains unique globally with inflation proving sticky.

Government measures on price relief have probably taken 0.7% off the headline rate, which reflects the greater resilience of our economy and the ongoing issue with rents and wage inflation.

Separately, we had household spending data – which covers two-thirds of GDP consumption – revised higher materially. While slowing, it is still up 3.1% year-over-year.

We also saw strong retail sales for June, with 2.9% growth – the highest since May 2023. Credit data was also firm.

None of this suggests that the economy is slowing sufficiently to allow inflation to fall to levels where rates can be cut. That said, lower global inflation and slowing growth will give the RBA time.

US Q2 earnings: holding up well, but surprises moderating

The challenge this reporting season has been a higher bar, making upside surprise harder.

There have been fewer positive surprises than recent trends, but still more than historical averages.

This suggests that earnings have not been a factor in the market sell-off – rather, they didn’t provide enough offset for the other headwinds of de-grossing and stirring macro fears.

The one negative is that the market is relying more on margin than sales to drive upgrades.

With 77% of the market having reported, revisions are running up 0.2% for FY24, led by financials and communication services. Energy, materials and industrials have been the weakest.

One area of focus has been the outlook for tech capex as this is a large component of overall capex and key to the trends on AI. 

The “hyperscalers” – Meta, Microsoft, Alphabet and Amazon – updated capex spending and guidance, with investments in AI infrastructure driving upside to 2024 expectations. Meta and Microsoft also guided to significant capex growth into 2025. 

This is supportive of the AI/semiconductor investment case over the medium term, but is unlikely to offset the current position unwinding.

Markets

The move in bonds is dramatic and highlights how much the market was caught off-guard.

This reinforces the point that investing is driven by the shift in probabilities of something happening, rather than the event itself.

The break lower in yields takes us back to the levels when rate cut optimism was at its greatest at the end of 2023.

That proved a head-fake – instead, we saw the economy hold up and inflation pressures increase.

Should the US economic growth hold in the 1.5% to 2.0% level – and we get rates falling to 4.0% –it is hard to see bond yields falling from here.

So, the question now is whether we do head into an economic downturn. If so, yields could drop to around 3.0%.

It is interesting that last week’s move led to an unwind of the inverted yield curve. This type of steepening is usually bearish for equities as it can be a lead on earnings risk.

One signal to watch is credit – this has not yet broken down despite the rise in volatility.

Credit as a signal is not as clear as it used to be as it has become more coincident with equities, but a widening of spreads could act as reinforcing factor in an equity selloff.

Another signal to watch on the US economy is the performance of discretionary stocks versus defensives.

This has broken lower, but so far looks like the false signal at the end of last year rather than the more material breakdown which coincided with the 2022 bear market.

The fundamental difference from 2022 is that rates had to rise then; this time, we have a material buffer of rate cuts to shield any slowdown and a very willing Fed.

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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 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 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

Today’s inflation numbers mean the rate-cut window is open in Australia from early next year. Pendal’s head of government bond strategies, TIM HEXT, explains why

• Two easings expected in February and May
• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Browse Pendal’s fixed interest funds

TODAY’S 1% quarterly CPI number would not normally be cause for celebration. After all, that’s 4% annualised – above the RBA target.

But the RBA focuses more on trimmed-mean inflation to avoid high and low swing items like petrol and food.

On this measure, the Q2 CPI number was 0.8% – still not quite in the target band, but comfortably heading that way.

Calls for rate hikes are off, the RBA can again be patient and the inflation picture should improve into year end.

Markets liked it. At the time of writing three-year bonds had fallen from 3.95% to 3.73%.

RBA governor Michele Bullock can avoid the wrath of the government and Anthony Albanese can return to selling his pre-election cost-of-living relief without a rate hike spoiling it.

Key items in the CPI: 1% headline (1% forecast) for Q2

We already had two-thirds of the items from the monthly CPI in April and May, so the headline was no surprise.

There was remarkable consistency across key areas, as food, housing, transport and insurance all went up around 1%.

In the context of these recent moves, housing and insurance were lower than previous outcomes, though there were some seasonal elements for insurance.

Health was up 1.5% as medical and hospital services grew at 2%. This is more structural and recent battles between providers and health insurance show the strains in this sector.

Tobacco was up 3% on tax indexation, which alone added almost 0.1% to CPI. International travel was up 8%, though domestic travel partly offset that – down 5%.

Trimmed (underlying) inflation 0.8% (forecast 1%) – why the forecasting miss?

Given the headline number came in as expected, why did economists miss the trimmed number, which came in at 0.8%?

At the risk of losing readers’ interest, this gets into how “trimmed-mean inflation” works.

Basically, the RBA (or ABS these days) lines up every item from highest to lowest change – weighted for its contribution to the index – and cuts off the top and bottom 15%.

That is, 30% of weighted items are trimmed.

Petrol is nearly always trimmed (it’s 3% of the CPI weight), as are many food and non-alcoholic items (a combined 17% weight).

Volatility in travel prices means they are generally trimmed these days (6% of weight).

This still leaves around 5-10% of weighted items to be trimmed and the extent of their movements feeds back into the trimmed mean.

If I’ve lost you, find your resident mathematician – there’s generally one around in finance.

Rate hikes off, rate cuts on – but not till 2025 despite a potential flat headline CPI in Q3

The RBA releases its forecasts every quarter at its early February, May, August and November meetings.

Given the lack of any guidance from the RBA these days, these forecasts are important.

In May, the RBA expected trimmed mean inflation to be 0.8% in Q2, so it will be pleased with today’s result. The inflation scares from the monthly April and May numbers, which Bullock felt the need to acknowledge at the June RBA meeting, have passed.

When we get the new set of forecasts next week, we think headline CPI will be forecast at 3.2% for year end – down from 3.8% due to electricity subsidies announced in recent Federal and State budgets.

Trimmed mean inflation, however, will likely only be revised down from 3.4% to 3.2%.

That is, trimmed mean inflation will still likely be too high for a rate cut this year, though there should be some probability priced.

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

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

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

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

The team won Lonsec’s Active Fixed Income Fund of the Year award in 2021 and Zenith’s Australian Fixed Interest award in 2020.

Find out more about Pendal’s fixed interest strategies here

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About Pendal

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

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

Contact a Pendal key account manager

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

• The small-cap Russell 2000 gained 3.47% while the NASDAQ fell
• Microsoft, Meta, Apple and Amazon all report this week
• We remain constructive on the medium-term market outlook
• Find out about Pendal Focus Australian Share fund

A CONTINING reversal in global asset markets was the main story last week as hedge fund “de-grossing” of equity exposure led to a broader risk reduction among investors.

This prompted underperformance among large caps and ongoing sector rotations.

The S&P 500 fell 0.82% and the S&P/ASX 300 was down 0.65%. The NASDAQ retreated 2.08%, while the small-cap Russell 2000 gained 3.47%.

Limited economic data tended to maintain support for the soft-landing thesis.

It was a busy week for offshore quarterly results, which reinforced the sell-off in Mag7 stocks and reflected an overall challenging top-line environment for many industries.

We remain constructive on the medium-term market outlook given resilient economic growth and easing inflationary pressures.

But the reversal in market momentum may persist given the stretched positioning and the low likelihood of a positive circuit breaker, with a rate cut from the US Federal Reserve not expected until September.

Market reversal and rotation continues into its second week

Market action was dominated by continued de-grossing and the reversal of previously winning crowded trades originally triggered by June’s softer inflation print.

The Mag7 have had an outsized impact on these trends, with Alphabet down 6% and Tesla down 8% for the week.

The rotation into small caps continued in the US but not in Australia, where weakness in commodities has had an influence.

The sell-off appears to be entering a self-fulfilling phase, with investor sentiment becoming much less bullish and VIX (an index of equity market volatility) picking up.

What was initially a rapid resetting of positions by hedge funds has led to a broader number of investors reducing their risk in response to the pullback.

This has also spread beyond equity markets with reversals seen elsewhere, including the JPY/USD cross, metals and commodities, and even gold.

The pullback and rotation may persist, given that a Fed rate cut is unlikely in August (giving us two months until the policy catalyst of a September cut) and quarterly earnings results seem to be reinforcing some of the dynamics – in particular, Mag7 disappointment.

In addition, positioning still has room to unwind and liquidity conditions are tougher. We note:

• commodity trading adviser (CTA) accounts – which are systematic strategies – still have a very long positioning in equities
• equity markets have pulled back but are still a long way from oversold
• the VIX has increased but remains well below the level of recent selloffs. The second half of calendar years have historically had more volatility and greater drawdown risk.

Given the likelihood that current trends persist, we have slightly reduced our exposures to some of our year-to-date winners.

However, this episode is also offering an opportunity to lighten up in companies where stock-specific fundamentals are deteriorating but are benefiting from the macro-driven rotation.

US macro: a soft landing with some downside risk

June’s US Personal Consumption Expenditures (PCE) Deflator was the week’s most important data point, given its role as an input for the Fed’s decision making.

The PCE deflator was up 0.2% month-on-month, which was in line with consensus. This saw the three-month annualised rate at 2.3% and the year-on-year rate at 2.6%. It further de-risks the prospect of a rate cut in September and also triggered a US share market rally on Friday.

The in-line PCE deflator offset a hotter Core PCE release (up 2.9% versus the 2.0% expected) from earlier in the week, which was released along with better-than-expected US Q2 GDP figures (up 2.8% versus the 2.0% expected).

The GDP data supported the view that the US economy remains resilient overall, which is constructive for the market.

Key drivers of the GDP beat were government spending (up 3.6%) and a build in inventories.

Non-residential fixed investment was also a little stronger, driven by an 11.6% rise in spending on equipment. Weakness in durable goods orders and capex intentions surveys suggests this boost is unlikely to be sustained.

Elsewhere, we saw weaker-than-expected new and existing home sales.

The University of Michigan consumer sentiment survey was in line with expectations but also the weakest reading since November 23.

Durable goods orders and the Richmond Fed manufacturing index were also weak, which comes at a time when investment in new factories in the US is at a record high in response to onshoring.

The upshot is that a slowing, but not concerning economic outlook and easing inflation provides support for rate cuts without requiring a material cut to earnings expectations.

When looking beyond the short-term momentum reversal, this should be supportive to equity markets.

US quarterly reporting: exacerbating negative momentum for market leaders

As we reach one third of the way through US reporting season, earnings have so far beat expectations by 4% in aggregate, driven by margin.

Mag7 share price weakness was boosted by disappointing results.Tesla was down heavily after missing earnings due to price cuts hurting margins.

Alphabetalso sold off despite beating on earnings, as the market decided it was time to start questioning the return on investment on AI spending. Alphabet’s top-line growth in YouTube and Google is slowing sequentially but its capex is up dramatically (up 91% year-over-year).

Microsoft, Meta, Apple and Amazon all report this week.

Staples are showing that the reversal of post-Covid price increases is playing out as hoped, with Unilever and Nestle showing slowing prices but volume growth accelerating in Q224 (after a year of volume declines).

This is supportive of deflationary dynamics globally, taking pressure off the consumer, and is relevant for stocks like Brambles, Amcor, and Orora in our market.

We are also seeing the trade-off of lower prices for higher volume play out in other sectors, including automakers, packaging and homebuilders.

Consumer-exposed stocks are generally seeing softer demand, but in many cases at a slower rate than in Q1. Luxury stocks (e.g. Kering, LVMH) were sold off as a China recovery failed to materialise and the global recovery in luxury spending was pushed out.

Visa also highlighted some weakness in lower income cohorts.

This all suggests that stocks that are more positioned for volume growth, rather than price/revenue, are likely to be relative outperformers.

Any stock that has benefitted quite a lot from higher prices over the past few years probably has margin risk because the slower consumer environment makes it hard to hold price.

Commodities

Slowing macro conditions and no real positive news for China from the Plenum saw another week of declines for commodities, which dragged on the Australian market.

With the Chinese property market continuing to weaken despite policy measures, dragging consumer sentiment and consumption down, the market was hoping for some material policy moves from the Plenum.

These did not eventuate, barring a tiny cut in interest rates, and saw commodity prices continue to slide during the week.

A weak property sector, a soft consumer and declining infrastructure spend means Beijing is increasingly relying on exports and “green” investment to drive economic growth.

This is driving deflation in many global categories, including steel, solar cells, batteries and EVs.

Resources have generally been poor performers this month, but the lack of a catalyst for change in China demand leaves them with poor fundamentals.

The sector may see short-term rallies if the sector/commodity is oversold, but it seems there is a low likelihood of sustained outperformance.

This is arguably a positive for the banks as a “last man standing” among the ASX big-cap sectors.

Commodities

Few sectors were spared declines last week.

Energy (down 5.57%) did the worst after Woodside’s (WDS) poorly received acquisition.

Defensives such as Healthcare (up 0.08%) and Financials (up 0.32%) were the only places to hide.

In contrast to the US, Australian small caps continued to underperform large caps.

At a stock level, the largest underperformers tended to be resources stocks given declining commodity prices and some poor quarterlies, as well as weakness in growth year-to-date winners including Goodman (GMG), Block (SQ2) and NextDC (NXT).

Financials had a good week outside of the big four banks, as did a range of defensives.

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About Anthony Moran

Anthony Moran is an analyst with over 15 years of experience covering a range of Australian and international sectors. His sector coverage has included Australian Industrials and Energy, Building Materials, Capital Goods, Engineering & Construction, Transport, Telcos, REITs, Utilities and Infrastructure.

He has previously worked as an equity analyst for AllianceBernstein and Macquarie Group, spending a further two years as a management consultant at Port Jackson Partners and two years as an institutional research sales executive with Deutsche Bank.

Anthony is a CFA Charterholder and holds bachelor’s degrees in Commerce and Law from the University of Sydney.

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