Late-cycle dynamics can be tricky to navigate. Here are five tactics Pendal’s head of income strategies AMY XIE PATRICK is considering for the path ahead

• Late-cycle dynamics can be vulnerable to shocks
• While growth slows, inflation remains a concern
• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Browse Pendal’s fixed interest funds

EQUITY markets seem to have recovered from their August gyrations for now.  

But investors are left wondering if those moves were a one-hit wonder or a warning shot of more to come.  

The key characteristic of this “late cycle” economy is that growth – while still positive – is slowing down.

This is broadly the case the world over, though some places like China never even lifted off during the good part of the cycle.  

Late-cycle dynamics are tricky to navigate, since they carry the risk of being caught wrong-footed in both directions.  

If we get concerned too early we can miss some impressive late-cycle market rallies. We’ll also miss out on good corporate bond coupons and decent equity dividends along the way.  

Get too greedy, though, and we can be caught in the down-draught with little to no ability to sidestep any of the pain.  

Knowing what to prioritise and staying focused on our investment goals can give us the agility and tenacity we need to navigate uncertain macro environments.  

This article covers the top five things that our team are prioritising for late-cycle trading in our income portfolios.  

1. Conviction in quality

Now is the time to kick the tyres of every corporate bond we own.  

As the economy slows, credit quality will disperse and generally deteriorate. 

Companies that can preserve strong cash positions and demonstrate resilient business models will do well. Those who have few levers to pull against the headwinds of slowing sales and narrowing margins won’t. 

Another feature of late-cycle dynamics is a system more vulnerable to shocks.  

Physical corporate bonds in Australia are usually the first to lose their trading liquidity at any sign of trouble. The most extreme example of this was during the early weeks of Covid, as Australian credit markets ground to a halt.  

Since fundamentals are deteriorating and liquidity events can happen without notice, the only way to prepare is to test our conviction of every issuer we own. Those who can’t pass that conviction test need to leave the portfolio. 

Our portfolios passed our conviction tests with flying colours.  

We have always had a through-the-cycle quality discipline with the assets we buy.

Sure, our tyre-kicking exercise left us with slightly scuffed shoes, but it also meant little need for additional action.  

2. Demand the right pay

It is more recent bond issues from the primary market that tend to fail our conviction test.  

Marginal and first-time issuers have been extending the maturities of new debt and offering to pay very skinny spreads to us investors. 

There are points in the cycle where investors must succumb to these sellers’ markets.  

When most portfolios have stayed on the sidelines for too long, cash levels are high, and bond issuance is measured and high quality, we have no choice but to accept what is on offer to keep our portfolios invested.  

The economic backdrop is usually benign in those times. Growth tends to be stable or accelerating, inflation won’t be in Google’s most-searched items, and global economic cycles will be in sync.  

That is not what the economic stage looks like today.  

While growth is slowing, inflation remains a lingering concern. And while the US economy grows at 2% per annum, Australia is seeing growth at its lowest level in two decades (outside of the pandemic).  

Even if strong issuers come to this market, investors need to be compensated for the likely volatility those businesses could experience economically, or the certain volatility their credit spreads would experience if recession were to hit.   

For inaugural issuers, investors need to be compensated for both of the above, as well as what can’t be known beforehand: how will this bond behave and what will its trading liquidity be like through a prolonged bout of market volatility?  

3. Liquidity is our flex

Notwithstanding the cyclical liquidity of physical corporate bonds in the Australian market, now is the time to make sure we have enough overall liquidity in our portfolios.  

Not only does this mean carrying plenty of cash buffers, it also means making sure that whatever exposures we’re taking in addition to credit is through the most liquid means possible.  

Liquidity allows for agility, and that is a prized asset in late-cycle markets.

The volatility in early August was a glimpse into how the market’s assessment of economic fundamentals can change on a dime.  

One minute, a soft-landing was the received wisdom. The next, the US economy was already in a recession. And a few minutes (or days) after that, a soft-landing was back on the table.  

Our portfolios were exposed to both defensive and risky levers throughout this volatility episode.  

Our implementation was through the most liquid means possible, so that we did not need to rely on the rather clunky and slow functioning of physical bond markets to enact our views.  

As rates market enthusiasm peaked, looking for emergency cuts from central banks, we quickly trimmed our interest rate positions to protect profits.

As equities and global credit indices passed through their lows, we were able to add some exposures for our portfolios so they could join in on the recovery – even though they didn’t participate in the fall.  

4. Good decision-making

This seems superfluous, since investors need to make decisions all the time. But a strong process for decision-making is something to be prioritised in uncertain times.  

The uncertainty that plagues late-cycle market dynamics tend to lead to binary outcomes. Recession, or no recession? Default rates surge or stay benign?  

There is no room for vague decision-making when these are the potential outcomes. Making half a bad decision causes portfolio managers to spend all of their energy dealing with the consequences of that decision.  

It’s important to be clear that a good decision isn’t defined by the outcome.  

Good decisions take into account as accurate and as objective an assessment of the relevant information. They are based on a rational assessment of the risks and rewards.  

Good decisions are made when we are honest about what we know, and what we don’t or can’t know. Good decisions involve taking risks and cutting losses.  

One way to ensure a strong decision-making process is to understand what the markers of success and failure will look like before taking on any exposures for the portfolio. That way, an action plan can be formed with the benefit of rationality.  

This removes the demand for cool-headed decisions to be made in the heat of the moment.

5. Look around the bend

If a recession were to happen, whether it be global or local, the worst thing would be to have held a portfolio of expensive and illiquid assets through a significant market drawdown.  

The second worst thing would be not to have acted on dislocated market opportunities for our portfolios.  

Recession isn’t a done deal – we just know that simply because the momentum for growth is now slowing, it necessarily raises the odds for a hard landing.  

A hard landing looks like accelerating unemployment, drawdowns in house prices and rising rates of debt default.  

In markets, it looks like large drawdowns in equity markets (think 25%+), significant widening of credit spreads (think US high-yield spreads above 1,000bps compared to 320bps currently), and a low in 10-year bond yields below 2.5%.  

The difference between a recession in the real world and how it plays out the markets is that the latter happens far more quickly. Most will remember the V-shaped move in equity markets through the rolling years of the Covid pandemic.  

If recession happens, it’ll be caused by the lagged effects of monetary policy tightening.  

The main reason for the long lags in this cycle has been the magnitude of cash stimulus during and after the pandemic. With cash in pockets, consumers had a lesser need to borrow and hence the economic sensitivity to interest rates was lower.  

Now that much of the excess cash has been spent, the next cycle can only start once the cost of borrowing falls materially. New leverage will be necessary to fuel consumption.  

Failing to look around the bend means waiting for economic activity to recover before adding risk to the portfolio. By then, the opportunity to buy the dip will have come and gone. 

Summary and performance

In summary, our active approach is geared towards prioritising five things to navigate late-cycle dynamics.  

Since growth is slowing, we are staying with only the highest-conviction exposures that we’re happy to hold even through a recession.  

We are demanding to be paid the right spreads for those exposures. And any exposures on top of that, we are prioritising liquidity since it arms us with the flexibility to act as things change.  

As always, we need to ensure that our decision-making processes stay solid. This means we won’t be blinded to future opportunities by any debris that may fall from near-term chaos. 

Total returns* of Pendal’s income strategies 

Fund name	Total return	RBA Cash Index	Active return
Dynamic Income Fund	9.0%	4.3%	4.7%
Monthly Income Plus Fund	8.9%	4.3%	4.6%

*Returns are net of fees, to end of August 2024 

Active small-cap managers are delivering strong returns despite index underperformance. Pendal portfolio managers LEWIS EDGLEY and PATRICK TEODOROWSKI explain why

• Small caps could return to favour as conditions evolve
• Quality earnings the key
• Find out about the Pendal Smaller Companies Fund

IS IT time to invest in ASX-listed small caps?

It’s a question investors are asking ahead of potential global rate cuts which could bring a long period of small-cap underperformance to an end.

But while it’s tempting to focus on timing, the unique nature of small-cap indices means a careful stock-selection approach can outperform regardless of broader market conditions, argue Pendal’s Lewis Edgley and Patrick Teodorowski.

“As a whole, small caps have been a significant underperformer relative to large caps over the last two years and people are asking us ‘is now the right time to be investing?’ says Edgley.

“My answer is the underperformance problem isn’t just a two-year problem – it’s a two-decade problem.

“The Small Ordinaries index has generated a 5.5 per cent compound annual return for 20 years, versus the ASX 100’s 8.8 per cent.

“But the median small-cap manager has returned 9.7 per cent over the same time.

“That tells you what an active small-cap manager can do when they’re able to sift through the maze of good and bad investment opportunities that the Small Ordinaries provides.”

Edgley and Teodorowski co-manage Pendal Smaller Companies Fund, which invests in companies outside the top 100 listed on the Australian and New Zealand stock markets.

Together the pair have 25 years of experience with Pendal Smaller Companies Fund.

Unique opportunities and challenges

The Small Ordinaries index – which includes companies included in the ASX 300, but not in the ASX 100 — presents unique challenges for investors due to a wide array of industries and companies.

The index can often include faddish companies that enter the index with high expectations before underperforming as their popularity wanes.

It can include single-play resources companies that rally and fade as commodity prices fluctuate.

“We get themes that run and components of the index that get significantly exposed to that theme. Then as the theme runs its course, performance ends.

“But despite the fact that the benchmark has only delivered a 5.5 per cent a year over 20 years, by being dynamic and identifying the better-quality companies, we’ve been able to navigate that and find money-making ideas.”

Since inception in 1992, the Pendal Smaller Companies Fund has generated an after-fees return of 11.95 per cent. You can view the fund’s performance over other time frames here.

Rate cuts could spur performance

Small caps are historically correlated to changes in interest rates, argues Edgley.

“We have a blueprint for this in many cycles, whether it’s the GFC or Covid – declining interest rates are usually a tailwind for small caps relative to large caps.

“Over the last two or three years, small caps have essentially been driving with the handbrake on.

“We don’t know when rates are going to start coming off. But when they do, small caps should start to get a tailwind.”

What does that mean for timing?

“We think it actually doesn’t matter – our history shows there are ways of finding money-making opportunities regardless of what rates are doing.

“Small caps have historically traded at about an 8 or 9 per cent premium relative to large caps for the past 10 years – and they are at about that same premium today.

“Most people want to buy small caps when they are cheap. You could argue that as it stands, small caps aren’t cheap.

“In any case, our view is that buying the cheapest small caps generally isn’t the best way to make money.”

Earnings drive performance

“We don’t focus on the price-to-earnings ratio as the starting point – we focus on earnings and earnings quality,” says Teodorowski.

“Through the last two years of a challenging macro and market environment for small caps, we’ve been able to identify two groups of businesses: structural growth businesses that we were able to put more capital in at a better valuation; and businesses with more defensive earnings than the market thought, which have rebounded significantly.”

Edgley adds: “The reason we feel confident that we can continue to do this is due to the composition of our performance over time.

“The value we’ve created hasn’t just come through a very small number of big bets going well, it’s come through a broad combination of lots of things going well.

“That’s much easier to replicate going forward.

“If you can do lots of small things well over time, that can compound to a really great outcome.”

The latest GDP data shows a weak Australian economy, but the numbers should pick up from here, says Pendal’s head of government bonds TIM HEXT

• Commodity boom waning, households going backwards
• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Browse Pendal’s fixed interest funds

TODAY’S June quarter GDP numbers paint a reasonably bleak, but not unexpected, picture of the Australian economy.

Quarterly GDP was 0.2% for the third consecutive quarter, leaving annual growth at 1%. It was the weakest financial year – excluding the Covid hit of 2020/21 – since the recession of 1991/92.

We are avoiding a technical recession overall this time, but the consumer is going backwards – even with 2.5% population growth.

Remember, the main GDP you hear reported is a chain volume, not price measure.

I prefer looking at numbers on a state basis, split into consumption and investment. This gives a better picture of what is going on in the economy.

Source: ABS

Here are five key takeaways from today’s numbers:

1. Government spending remains strong despite government investment tapering off

Government expenditure contributed 0.3% to GDP, government investment 0.1%, while government spending rose by a strong 1.4%.

The main driver is social benefit programs for health services (largely the NDIS).

This also remains a major source of strength for employment and inflation, and is central to the current animated debate between Treasurer Chalmers and the RBA (though Governor Bullock has wisely toned down prior comments, leaving RBA proxies to continue it).

State governments are also major drivers of growth and inflation.

However, NSW has now seen government investment go negative (down 3.8%) as major projects like the Metro are completed. Victoria (up 5.4%) and South Australia (up 5.8%) clearly didn’t get the RBA memo asking for restraint.

---

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

---

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

Despite a cloudy narrative, Pendal’s emerging markets team remains overweight in Chinese equities via a highly selective set of stocks. Here, they explain why

• China bond market moves look rational
• Good results among domestic companies
• Find out about Pendal Global Emerging Markets Opportunities fund

THERE’S been a lot of focus recently on what bond market signals are telling us about the outlook for growth.

This is true for emerging markets such as Brazil and Mexico as well – though investors have tended to overlook some dramatic moves in Chinese bonds.

The US five-year bond yield has fallen slightly this year.

Medium-term bond yields have risen in many emerging markets, amid concerns that a strong US dollar might delay interest rate cuts, or even (as is the case in Indonesia) prompt interest rate hikes.

In China, though, the five-year bond yield has fallen from 2.4% to less than 1.9%.

This has led China’s central bank (also known as the People’s Bank of China or PBoC) to worry about a bubble in Chinese government bond prices.

As a result the PBoC has been gently intervening in markets to try to prevent bond yields falling too far or too fast.

Bond yield moves look rational

Despite the central bank’s concerns, these moves in yields look rational to us.

Inflation in China is low and quite possibly negative. The latest inflation measures are +0.5% for CPI, -0.8% for PPI (both to July) and -0.7% for the GDP deflator.

Deflation increases the real yield on bonds, while real estate and equities are potentially hurt by deflation in a leveraged economy.

As well as the signal from inflation, the credit environment is also signalling an ongoing deflationary economic slowdown.

July lending data shows a contraction in bank loans as corporates and households look to pay down debt.

This is the first contraction in lending in the economy since 2005, including during Covid and the GFC.

Given the historical pattern of a decade-long, debt-driven real-estate boom followed by what looks like a debt-deflationary slowdown, there is a temptation to see China falling into the same kind of balance sheet recession that Japan experienced after its late 1980s boom.

Only just this year has Japan’s Nikkei equity index exceeded its 1989 peak.

Do Chinese equities also face a similar “lost decade” as Japan did in the 1990s?

One group that might be worried are the western multinational companies that have been reporting sharp downturns in their China sales in recent quarters.

From beer to luxury products to cosmetics to cars, a clear pattern has emerged of results commentary warning about Chinese demand.

We feel a more detailed look at company results shows a different, more promising pattern.

Good results among Chinese companies

In the above consumer segments – as well as areas such as travel, tourism and e-commerce – many Chinese domestic companies are reporting good results and earnings growth.

Consensus estimates of future earnings are also being revised up.

We feel this reflects Chinese consumers pivoting to different products and lower price points, as well as a new preference for domestic Chinese brands.

For example, foreign car makers have fallen from 64% market share in China to 38% over the past four years.

A similar pattern is emerging in other products, including beer and cosmetics.

With these companies performing well, China’s broad equity market weakness in recent years (especially for Hong Kong-listed names) has pushed some stocks to attractive valuations – especially compared to falling bond yields.

Yes, China’s economy is struggling for growth.

Its credit environment is particularly difficult and there has so far been no turnaround in the wider real estate market.

Yet there are opportunities to be found in Chinese equities.

We remain overweight Chinese equities in the portfolio, with exposure to a highly selective set of stocks.

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 Aussie equities analyst and portfolio manager ELISE MCKAY. Reported by portfolio specialist Chris Adams

• Markets are pricing in a 33bps Feb cut in September
• The Australian Boomer is continuing to boom
• Register now: join Crispin Murray’s Beyond the Numbers webinar
• Find out about Pendal Focus Australian Share fund

REPORTING season has shown that the consumer is holding up better than expected – helped largely by Baby Boomers – and credit conditions have improved, benefiting the REIT sector. Capital discipline has been rewarded.

The S&P/ASX 300 gained 1.01% last week, but the US market was muted.

The S&P 500 was up 0.27%, while the NASDAQ was down 0.91% as NVIDIA’s (down 7.7%) result was not good enough for the market.

NVIDIA reported strong revenue, with data centre sales up 154% year-over-year (YoY) and ahead of expectations, signalling that AI demand is intact. However, its gross profit margin guidance disappointed, resulting in much more muted EPS upgrades. 

It was a quiet week on the macro front.

US Personal Consumption Expenditures (PCE) inflation data is no longer a major market mover, unlike earlier this year, as the Fed has moved its primary focus from inflation to labour.

With a September rate cut now a given in the US, the labour data released this Friday (6 September) will be key to helping determine the size. 

While the market is pricing a 50% chance of a 50-basis-point (bps) rate cut, the Atlanta Fed GDPNow Tracker is forecasting a robust 2.5% real Gross Domestic Product growth for Q324 – suggesting that we are still on track for a soft landing. 

US policy and macro

PCE data

July’s PCE inflation was in line with expectations on both a headline (up 0.2% month-on-month (MoM) and 2.5% YoY) and core (up 0.16% MoM and 2.6% YoY) basis.

This is the third consecutive month where we have seen the MoM number come in below the Fed’s forecast. As a result, we expect that the Fed committee will need to revise down its Q2 2024 inflation forecast at next month’s meeting, which is currently sitting at 2.6%. 

There was nothing in this print to upend the view that the Fed has moved from being inflation-first to labour market-first. 

The market’s question now is whether the Fed cuts by 25bps or 50bps in September. This Friday’s labour data will be key in this regard.

PCE Core goods inflation is back in deflationary territory, with a MoM print down -0.1%. 

The Fed’s preferred metric, Core services (excluding housing), increased from 0.16% last month to 0.21% MoM. But the trend is in the right direction, with the three-month annualised rate now at +2% YoY. 

Personal consumption

Consumption growth has maintained decent momentum – with real consumption spending coming in at 0.4% MoM (versus consensus at 0.3%), driven primarily by goods expenditure (up 0.7% MoM). 

Spending on autos picked up meaningfully to 4.1% MoM, but even stripping this out, goods expenditure still grew a robust 0.4% MoM.

Consumption appears to have accelerated from the 2.9% annualised rate in Q2. This is at odds with income growth, which is on the weaker side. 

Personal incomes grew 0.3% MoM in July and real after-tax income rose by just 0.1% MoM, with the annualised number only just over 1%. 

With consumption running roughly 2% above income growth, consumers are saving less in order to fund their lifestyles. The savings rate dropped to 2.9% in July – the second lowest rate since 2008 and well below the pre-Covid average of about 6%. 

It is reasonable to assume that, should the labour market continue to soften, we should see people start to save more in precaution, thus dampening consumption growth. However, this is yet to be seen in practice.

US pending homes sales

The strength in consumer spending has not made its way into a stronger housing market. Pending home sales fell 5.5% in July, versus expectations of 0.2% growth. 

This index is now at a new all-time low for its 24-year history. 

Mortgage rates have been dropping and are now, on average, 70bps lower in August than in May, but this has not yet reached levels sufficient to support mortgage demand. 

Unlike in Australia, mortgage rates can be fixed at the outset for the full term in the US. As a result, the differential between existing mortgages and market rates makes it too expensive for many homeowners to move, which should continue to weigh on the supply of homes for sale.   

Upcoming Fed meeting

The next meeting is scheduled for 17-18 September. 

Over the past week, the market has moved to price in a 33bps cut in September (i.e. roughly halfway between a 25bp and a 50bp cut) and about 100bps of cuts by the end of the year.  

We would likely need to see an unemployment rate at 4.3% in this Friday’s labour data to support a 50bp cut. This remains to be seen, though weekly claims data is supportive of an unemployment rate below 4.3%, with the four-week average claims running at 232k. 

Soft landing data After strong 3% growth in GDP for Q224, of which two-thirds was driven by consumption, the Atlanta Fed GDPNow Tracker is looking for a robust 2.5% in Q324. This has ticked up following strong consumption data. 

Australia policy and macro

Australia’s July Consumer Price Index (CPI) fell from 3.8% YoY in June to 3.5% YoY in July.

This was 10bps higher than expected, but the timing of an electricity subsidy accounted for the difference.

The trimmed mean CPI slowed to 3.8% YoY from 4.1% YoY and is trending down broadly in line with the RBA’s most recent forecasts for Q324.

Retail sales were up 2.3% YoY in July but flat month-on-month and below consensus expectations of +0.3%.

This is somewhat surprising given the strong start to FY25, flagged by several consumer discretionary companies during reporting season.

One possible explanation is that the stronger players in each category – think Temple & Webster (TPW), Endeavour (EDV), Universal Stores (UNI) – are taking market share.  

As previously flagged, the Australian Boomer is continuing to boom. 

UBS estimates that the total retirement benefits paid out over FY24 rose to a record high of $160 billion, equivalent to roughly 11% of household income. 

This has been driven by record-high levels of retirement assets, which now total $3.9 trillion (about 147% of annual nominal GDP). 

Retailers that cater for an older demographic (e.g. Nick Scali (NCK)) have benefited in this environment. 

We also saw the latest capex data for Q2 2024.

It suggests that mining companies are becoming more cautious on the outlook for investment in the sector, with FY24 estimates downgraded and forward estimates tracking for a fall in FY25. 

That said, we have seen some companies buck this trend during reporting season, with both Fortescue (FMG) and Mineral Resources (MIN) guiding to increased capex spend. 

Eurozone inflation

The August print was in line with expectations, keeping the European Central Bank on track to cut by 25bps at the September meeting. 

Headline inflation is now running at 2.2%, while core inflation is running at 2.8%.

Services inflation (at 4.2%) remains stubbornly sticky and may have been assisted by one-off factors such as the Olympics. 

NVIDIA result and AI

NVIDIA yet again beat expectations and raised guidance in its quarterly results last week. 

Revenue grew 15% to US$30 billion for the quarter (versus consensus of 10% growth) and guided to US$32.5 billion for Q3 2025 (versus the market at US$31.5 billion). 

Data centre demand remains strong and broad-based across hyperscale, consumer internet and enterprise customers. 

The demand for sovereign AI has strengthened further, with low double-digit billions in sales forecast for FY25 (increased from high-single digits). This reflects sovereign states’ desire to build AI models that are based on local datasets, language and cultures. 

However, the disappointment was on gross profit margin guidance at 75% for 3Q 2024, which was 40bps below expectations and implied guidance for gross profit margins in the low-70s for Q4 2024. 

This reflects the introduction of the new Blackwell family of chips, which start at a higher cost before reaching scale during 2025. 

Revenue upgrades on a bullish outlook for data centre demand were mostly offset by cost upgrades, limited EPS upgrades to low-single digits. 

Valuation does not look unreasonable in our view, with NVDA trading roughly 15% below its five-year average multiple.

NVDA’s 154% YoY growth in data centre revenue is supportive for the local Australian-listed plays, like Goodman (GMG), NextDC (NXT), Macquarie Telecom (MAQ) and Infratil (IFT), of which the first three are held across a variety of Pendal’s Australian equities portfolios.

Australian markets

The final week of reporting season was a good one, though the S&P/ASX Small Ordinaries was a touch softer (down 0.19%). 

Financials (up 2.21%) and REITs (up 2.20%) were the best-performing sectors, while Technology (down 1.65%) and Consumer Discretionary (down 1.30%) were the weakest.  

A few industry-level observations emerged from reporting season, including:

• Bank net-interest-margins (NIMs) surprised on the upside and domestic general insurance trends have strengthened.
• The contractors and services companies have been getting it done – those already in good shape (e.g. Seven Group (SVW) and Ventia (VNT)) have excelled in an easier labour environment, while the tough operating environment in recent years has helped whip the rest of the sector into much better shape (e.g. Downer (DOW) and Worley (WOR)). 
• Consumer discretionary has been a mixed bag, but the highest-quality operators have continued to take share and grow in a challenging retail environment (e.g. Breville Group (BRG), Temple & Webster (TPW), JB Hi-Fi (JBH), Universal Stores (UNI), Super Retail (SUL)).
• Travel has been more challenged and FY25 is likely to be more volatile, particularly for the travel agents and those exposed to hotel bookings (e.g. Flight Centre (FLT), Webjet (WEB), Corporate Travel Management (CTD) and Siteminder (SDR)). On the other hand, Qantas (QAN), continues to trade well.

Our property team of Peter Davison and Julia Forrest note the following regarding the REIT space:

• REITs have broadly seen better rent growth (up 4.1%), with malls particularly strong (up 5.8%) and office still the weakest sub-sector (up 2%). 
• Nearly every REIT is highlighting far better credit conditions, longer tenor and lower margins.
• Debt costs, as measured by the three-year swap rate, have fallen by almost 60-80bps in the past two months – boding well for leveraged names and property fund managers.
• Regional malls are all trading well, with positive leasing spreads, low occupancy and very good demand for regional mall space. Importantly, buying interest for larger property assets is now reaching larger-scale mall assets. There has been very good demand for recent unlisted offerings by Scentre Group for its Tea Tree and Westlakes mall assets in Adelaide. This is a meaningful change in market dynamics.
• Melbourne is the weakest residential market, while Brisbane, Perth and Adelaide are very strong. Retirement living (land-lease communities) is also very weak in Melbourne.
• Apartment markets are all very weak on delivery concerns and affordability issues. Only luxury apartments are making money.
• Industrial assets are still recording high rent growth (about 4.6%).
• Office is still the weakest sector, with 2% rent growth.

---

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

• US economy slows, but no signs of a recession yet
• Green light confirmed for a series of rate cuts in the US
• Find out about Pendal Focus Australian Share fund
• Coming soon: register to join Crispin’s Beyond the Numbers webinar

MARKETS continued trailing back toward their July highs last week, driven by commentary from Federal Reserve Chairman Jay Powell.

Powell expressed confidence that a soft landing is achievable and said that the Fed would focus on keeping the labour market strong as it makes progress towards its inflation target.

The “Fed put” is back in terms of monetary policy, providing important insurance against recession risk.

US bonds rallied and the market is now pricing in a roughly 50% chance of a 50 basis point (bp) rate cut in September.

The US Dollar weakened, which is supportive for risk assets, and crypto rallied, indicating that liquidity is coming back to markets.

The S&P 500 gained 1.47%, while the S&P/ASX 300 finished up 0.90%.

The main check on equities is the fear of September, which is seasonally the weakest month.

Local earnings results remain supportive, albeit with some pockets of weakness which tend to reflect specific industry issues rather than broader economic malaise

US economy: green light confirmed for a series of rate cuts

Two years ago, Powell used his Jackson Hole address to signal that the Fed would risk recession to restore price stability.

His speech at the same venue last week was as close as you get in central bank world to a declaration of victory.

The message was the labour market will not be a source of inflationary pressure. Instead, it is cooling – and the Fed does not want it to cool any further.

Powell noted that “the time has come for policy to adjust” and that “the direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook and the balance of risks”.

There was no specific lead on whether we see a 25bp or 50bp cut in September; this depends on employment data.

However, the key point is that we will see a series of cuts into next year.

This is supportive for equities as it reduces the tail risk of a recession. Should the economy slow quicker than expected, it will still affect the market – but the downside is limited, as it would be mitigated by more accelerated easing.

The more material tail risk is a re-acceleration of inflation as the economy cools, but this looks unlikely for now.

US economy: slowing but no signs of recession

There were a number of data points supporting the notion of an economy which is slowing, but not sliding into recession.

1. US payroll data saw its annual revisions and was adjusted down 818k for the year – this is much larger than normal and gives fuel to bearish arguments. It was expected, to some degree, given the gap between this data set and the Household Survey. The key observation is that the economy wasn’t as strong as previously thought and that cracks in the labour market started earlier. But this does not imply that the odds of recession have risen. We note this data is often revised again and the final estimate has been above the preliminary for the past five years.
2. Jobless claims data remained benign again last week
3. The Flash US composite Purchasing Managers’ Index (PMI) data was solid, falling to 54.1 versus 54.3 the previous month, but above the consensus of 53.2. Services rose to 55.2 from 55.0 and beat expectations of 54.0. Manufacturing was weaker at 48.0 versus 49.6 last month and the 49.5 expected. There was a drop in the employment component to 48.9 from 51.6, which highlights there are still risks to employment data.
4. New home sales were stronger than expected, which could signal that the impact of lower mortgage rates is beginning to flow through. This may help clear the inventory issue holding back new home construction.

The Atlanta Fed GDP Now measure is still hanging in there at 2.0% for Q3. It has dropped from just under 3%, which relates to home construction, which may turn soon.

Europe

Stronger PMI data was put down to a combination of the Euros, Olympics and Taylor Swift.

Underlying growth remains soft, with Germany quite bleak.

The European Central Bank’s (ECB) indicator of negotiated wages fell materially from 4.74% to 3.55%. This should remove one of the barriers to future ECB rate cuts.

Markets

Last week’s weakness in the US Dollar was interesting.

The US Dollar Index (DXY) fell 1.7% – just breaking down through a technical resistance level – and is down 4.9% in the quarter to date.

This reflects the more benign US inflation outlook, allowing the Fed to move faster on rate cuts.

A falling US Dollar, combined with weaker oil and lower bond yields, is typically helpful for equities.

The other potential positive is that a weaker US Dollar may allow Chinese policy to be more stimulative. This remains the key concern for global growth and has weighed on commodity prices and resource stocks.

The oil price is resting on technical support levels. Iraq is making noise about breaking its quotas, so the Saudi reaction will be interesting.

Australia

The ASX continues to grind higher.

Resources didn’t drag last week – the main sector moves were driven by stock-specific factors relating to results, notably Wisetech Global driving tech and Brambles lifting industrials.

Thus far, the take-outs from reporting season are:

• The market is looking for beta – any promise of upside is being enthusiastically embraced rather than being challenged, as seen in Wisetech last week and Pro Medicus the week before. 
• Good industry structures and capital discipline are being rewarded (e.g. insurance).
• Some signs of a turn in industrials which have been navigating a post-covid hangover (e.g. Brambles, Ansell and Reliance Worldwide)
• Consumers are receptive to product innovation and good value propositions (eg Breville Group and Super Retail)
• The steel industry is suffering as a result of China’s over-production and exports
• Earnings volatility and rising capital intensity are being penalised by the market (eg A2 Milk and Ampol).

---

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

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.

---

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

---

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.

---

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.