Australia has joined other sovereign nations in issuing an inaugural Commonwealth green bond. Senior ESG and impact analyst MURRAY ACKMAN explains what it is and why Pendal invested in it

• Australia has joined 30 other sovereign issuers by issuing its own green bond
• Investors willing to pay a premium for the bond, market oversubscribed
• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Browse Pendal’s fixed interest funds

THE Commonwealth Government just issued its first green bond.

It has a June 2034 maturity with $7 billion issued.

The Green Treasury Bond also came with a “greenium” (meaning investors were willing to pay a premium to hold it) of around two basis points, which is roughly consistent with global peers.

Green bonds are meant to finance solutions for climate change and environmental challenges, but not all bonds are equal.

At Pendal — and at our specialist sustainable investing business Regnan — we’ve seen quite a few green-labelled bonds that don’t have any meaningful impact. Some are simply doing business as usual.

For governments, this is a particular risk.

At Pendal we are not interested in green bonds made up of already-completed projects that they were going to work on anyway, such as public transport or other infrastructure projects.

But we were very active in buying this bond – mainly across our sustainable funds, through which investors expect the majority of bonds to finance specific projects in the environmental or social space.

How did we judge this new bond? We asked a few questions:

• Does this green bond fund new things?

We want the first Commonwealth green bond to support new projects.

This is known as additionality – that is, funding something that would not have been funded but for this green bond.

Half the proceeds will go towards existing commitments and half will go towards new commitments.

In our view, this is quite reasonable and is better than some other green bonds from governments.

Ideally, we would like to see completely new projects, but we recognise that there are complications in doing this for a first issuance.

• Does it fund revolutionary projects?

Government has a different risk profile to the private sector and that gives it an opportunity to fund catalytic change — things that lead to a step change.

The list of projects funded include some that will help with the transition to a low-carbon economy – with the focus on renewable energy, clean transport, climate change adaptation, and a circular economy.

Electricity generation is the biggest source of emissions in Australia, so upgrading the grid to allow greater renewable energy connectivity will be essential in reducing emissions.

Electrification using renewable energy will significantly reduce emissions. The green bond includes investments in modernising the electricity grid and developing new transmission infrastructure through concessional financing.

This bond also funds projects that relate to this – from community batteries and electric vehicle charging infrastructure to loans for energy-saving home upgrades.

However, there are some sectors that cannot easily switch to electricity – for instance, industrial activity, which requires certain inputs for chemical reactions.

Taking a page from Joe Biden’s Inflation Reduction Act, which has made hydrogen use and production more viable, this bond will also help fund the development of regional hydrogen hubs.

We would like to see more catalytic change, but for the very first Commonwealth Green Bond, we are pleased with the scope of projects.

• Is clear reporting available?

The Commonwealth’s commitment is to distribute an annual impact report no later than 18 months after first issuance.

This will be reporting at a portfolio level rather than each bond line, which is fairly typical.

The government has also made the commitment to have independent verification of allocation and impact reporting.

This will assist in establishing annual reporting with independent verification as industry standard.

We are hopeful that this bond will demonstrate what the minimum requirements are for clear and transparent reporting for green bonds in Australia.

What else do we know about this bond?

A green bond should be a reflection of an issuer’s philosophy — not an apology for their actions.

Prior to issuing, the government announced funding to progress leadership on climate action in Government operations, which includes financing to support all Commonwealth entities in publicly reporting on their climate risks, opportunities and management.

This bond is consistent with recent government action to respond to climate change as well as engage in environmental repair through this bond.

The government has put in a lot of effort to make sure it got its inaugural green bond right.

The market has agreed, being nearly three times oversubscribed.

We anticipate that there will not be a new green bond for at least a year or two, so we believe it should perform well in the secondary market.

It provides integrity to the Australian green bond market and will provide a clear example of expectations for the market in future.

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

• Equities quiet, may see period of consolidation
• The Fed unlikely to cut rates in June/July
• Find out about Pendal Focus Australian Share fund
• Watch Crispin’s most recent Beyond the Numbers webinar

EQUITY markets have been quiet and were down marginally last week.

Combined with a lack of follow-through on the Nvidia result and weakness in US software, this suggests we may see a period of consolidation.

The S&P 500 fell 0.49% while the S&P/ASX 300 was off 0.34%.

In the US, Personal Consumption Expenditure (PCE) inflation data was marginally lower than expected, which kept the chance of a pre-election rate cut alive.

Economic growth data was a touch softer than expected, but this week’s employment data should provide a clearer picture.

Australian inflation data was worse than expected and – despite softer retail sales – the prospect of rate cuts seems remote.

BHP’s attempt to take over Anglo American has ended for now. UK rules mean it can’t try again for another six months.

US inflation outlook

April’s PCE data was incrementally positive for the inflation outlook, but the Fed remains in “wait and hope” mode.

It is unlikely to cut rates in June or July.

The PCE – the Fed’s preferred measure of inflation – was in line with expectations, with Headline up 0.26% and Core up 0.25% month-on-month (or 2.8% year-on-year), versus a 0.3% run-rate in the last two months.

The market read this as marginally positive as the “super core” data – which adjusts for some of the imputed service components – fell from 0.3% month-on-month in March to 0.17%, which is consistent with 2% inflation.

But it is too soon to be bullish on inflation, as the trend remains too high – with three-month and six-month annualised growth at 3.5% and 3.2%, respectively.

The year-on-year reading is in the high 2% range, and in the past few months the outlook for inflation at the end of 2024 has also shifted there from the sub-2.5% range.

As a result, the Fed remains on hold – waiting for three months of data that indicates inflation is fading again.

We note that the base effect of slowing inflation in the second quarter of 2023 will also work against readings in the second half of 2024.

Digging into the details, core services inflation is moderating again but is still above the trend of late 2023, suggesting it sticks in the 3% range.

Meanwhile, goods deflation has now ended.

The bull case here is that retail margins, which are materially higher than pre-Covid, will be driven lower by competition in a softer economy, which could help bring inflation down.

The upshot of all this for markets is that we are unlikely to see rate cuts in either June or July. The question is, then, whether the Fed will cut ahead of the Presidential election.

The market is currently implying a 4% chance of a cut in June, 17% in July, and 63% in September.

US economic growth

Here, the incremental news was softer, though it remains on trend for somewhere around 2% in 2024.

Headline first-quarter GDP was revised down from 1.6% to 1.3% (as expected) – driven mainly by lower consumption growth and lower net exports and inventory accumulation, while investment was stronger.

However, the drag from inventory and exports overstates economic softness.

Final sales to private domestic purchasers is a better indicator, which rose 2.8% versus 3.1% in the initial estimate.

Data on personal consumption was also softer, with consumer spending up 0.2% in April following 0.7% growth in March.

Personal incomes rose 0.3% and the savings rate was steady at 3.6%.

Real consumer spending – adjusted for inflation – was weaker than expected (-0.1% in April), continuing the signal of a slightly weaker consumer.

Services remains the strongest component, but this is fading. Spending on goods is down 1% on a three-month annualised basis.

This has seen second-quarter GDP forecasts reduced, though this is only the first month of the quarter.

The Atlanta Fed GDPNow estimate has shifted from the 3% range into the high 2% range. Market consensus is at 2%.

Anecdotally, in some sectors, US corporates are still constructive.

Booking.com and Airbnb are saying leisure travel demand is solid, while Uber is seeing no “trade-down” activity in restaurant delivery. Demand for digital advertising is also holding up.

The conclusion at this point is that US economic growth is decelerating at a moderate pace, but still heading for about 2% in 2024.

News of Trump’s conviction has led to a small shift back towards Biden in the betting odds, with the Real Clear Politics Betting Average showing Biden at about 39% and Trump at about 48%.

Europe

The European Central Bank (ECB) is expected to cut rates for the first time in this cycle this week.

The markets are pricing two-to-three rate cuts by the year’s end.

However, growth data, wages and inflation have been stronger than expected in last couple of months, so ECB President Lagarde may be cautious in the press conference and not commit to cut rates again in September.

Australia

The April Consumer Price Index (CPI) rose 0.73% month-on-month, taking it to 3.6% year-on-year, versus 3.4% as expected.

Core CPI rose 0.24% to 3.8% year-on-year.

This pushes out expectations around rate cuts. Inflation is falling, but it remains too high for the RBA’s comfort.

The food, clothing and health components drove the upside surprise.

Construction costs have accelerated in the past few months.

High construction costs are a structural issue for Australian inflation, as it leads to a lack of supply of housing, retail space, distribution centres and other physical capacity.

Subsidies are helping ease some pressure, with the electricity component down 1.9% month-on-month and rent inflation slowing due to higher Commonwealth rent assistance.

Elsewhere, retail sales for April were softer than expected at 0.1% month-on-month and 1.3% year-on-year.

The read-through is messy due to the timing of Easter and school holidays, but the trend is flat-lining and has been reliant on population growth, which is now slowing.

On the positive side, there has been a pick-up in credit growth on the back of rising house prices.

This suggests that the stabilisation in interest rates is feeding through, and policy may no longer be as restrictive as it was.

The takeaway is that Australian inflation looks stickier than most countries and is being held up by structural problems. Even though the consumer is softening, rates look set to stay on hold for some time.

Markets

Markets appear to be consolidating and there are signs of deteriorating breadth.

Despite the S&P 500 being up about 11% calendar-year-to-date, 45% of stocks are down.

Higher bond yields are weighing on equities and ten-year bond yields are rising towards key resistance levels.

Positioning is getting more extended. Cash levels in US equity mutual funds are as low as we have seen in decades, though hedge fund exposure has room to rise further.

At this point, we see markets in something of a holding pattern and we believe liquidity can continue to support them through the September quarter.

The Magnificent Seven have become the “Fab Five” of Amazon, Apple, Microsoft, Google and Nvidia.

Indicators suggest that mutual and hedge fund managers are still underweight these stocks in aggregate, so there is still potential for them to squeeze higher.

When the 27% year-to-date index return of these stocks is removed, the roughly 6% or more return from the rest of the S&P 500 looks closer to a roughly 3% return from the S&P/ASX 300.

The AI thematic helping drive the Fab Five is also seeing bifurcation in the tech sector.

This can be seen in the divergence between the iShares Semiconductor ETF and the Global X Cloud Computing ETF, which have traded largely in tandem in 2022 and 2023.

However, the AI theme has seen semiconductors materially outperform since early 2024 – a trend which has accelerated in the last two weeks.

In this vein, the US Software sector was down 5.4% on Thursday, which was biggest day of underperformance in more than 10 years.

This was on the back of a quarterly result for Salesforce.com, which was in line with expectations but saw softer revenue guidance – leading the stock to drop about 20%.

The key debate is whether slowing revenue is company-specific or a broader macro issue.

We have seen this divergence in an Australian context in the performance of Goodman Group (GMG), which has also decoupled from a previously close correlation with a fellow industrial property company in the US, Prologis.

GMG has outperformed massively since Q3 2023 on the back of GMG’s pivot towards data centres.

Australian market

The S&P/ASX 300 rose 0.85% in May.

The thematic winners included aluminium/alumina names like Alumina and South32, as prices caught up with copper, as well as AI-related names such as Goodman Group and NextDC.

Other good performers such as Aristocrat Leisure, Xero, Technology One, Bendigo & Adelaide Bank, and AGL were driven by stock-related news.

Thematic losers were discretionary retailers such as Super Retail, Bapcor and Nick Scali as anecdotes of softer trading came out.

Some caution around the outlook for corporate travel saw Corporate Travel Management and Flight Centre softer.

The market was relatively quiet in the last week, with limited rotation. A weaker iron ore price saw some of the miners underperform.

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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

Despite a narrative around re-emerging inflation, Australian investors are remarkably relaxed about the outlook. Here Pendal’s head of government bond strategies TIM HEXT explains the latest inflation data

• April CPI came in higher than expected
• Australian market relaxed about inflation outlook
• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Browse Pendal’s fixed interest funds

APRIL’S inflation numbers point to a 3.6% increase in the annual Consumer Price Index.

That’s slightly higher than March (3.5%) and more than the 3.4% the market was hoping for.

Excluding volatile items (food and energy) the CPI was steady at 4.1%.

It bears repeating that the monthly CPI number does not measure all items.

Sixty per cent of items are collected every month, while 30% are collected once a quarter (with roughly 10% in each of the three months), and 10% are collected annually. 

Forecasters are still having to constantly refine their models and learn something new every release.

The ABS is constantly improving that collection and is hoping to release a comprehensive monthly number later next year.

What’s up and down in monthly price moves?

International travel led the way, up 10.6% after sharp falls earlier in the year.

Fruit prices were up 7.3%, fuel prices were up 2.2%, and medical and hospital services were up 2.7%.

Surprisingly, clothes and footwear were up 4% on average – a rare and large rise in goods prices.

What was encouraging, though, was some rent relief – inflation “only” rose 0.5%, which is the lowest increase in a long time.

Electricity and gas prices fell slightly and will obviously collapse as subsidies hit in Q3.

The narrative has been that goods prices (about a third of CPI) should only grow 1-2%, allowing services (the other two-thirds of CPI) to be 3-4% and still get near the inflation target.

However, overriding these concerns are the impacts of upcoming government subsidies.

Electricity subsidies should deduct 0.5% from CPI in Q3 and the RBA will need to reduce its end-of-year (2024) inflation forecast from 3.8% to 3.3%.

Lower oil prices in May should see the monthly CPI start falling again and end the year closer to 3%.

Implied 10-year inflation levels, based off inflation swaps, remain reasonably well anchored at 2.77%.

Over the past 12 months, this level has largely been treading water – between 2.70% and 2.90%.

The market is backing the RBA to do its job.

Implications for investors

Three-year yields in Australia have backed up above 4% once more following this inflation number.

We view this as an opportunity to add duration, as our medium-term view on inflation is positive.

US inflation numbers come out on Friday and should show lower rental outcomes feeding through to lower outcomes.

As mentioned before, the CPI track in Australia should improve into the third quarter.

We will dig around and see if the goods inflation story in this number is temporary or a sign of emerging pressures.

The Pendal Australian equities team’s insights are very useful in this regard.

Unless our concerns ramp up, we will be happy to be long duration into the winter months.

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

• Nvidia delivers blow-out 1Q result
• Pendal Australian equities portfolios positioned to benefit
• Find out about Pendal Focus Australian Share fund

THE global economy appears to have left last decade’s monetary policy era well behind and embraced a far more exciting fiscal policy era.

Kicked off by Covid spending, and quickly bolstered by the energy transition and defence focus, we now see further momentum in a sovereign artificial intelligence race and the generative AI build-out.

This was highlighted by last week’s blow-out Nvidia first-quarter result.

The stock gained 15% over the week, suggesting that investors continue to underestimate the speed, scale and scope of the AI revolution.

Nvidia is perhaps more than just another stock. At present it appears to be a key driver of markets – touching almost every aspect of the global economy.

Its influence is felt everywhere – from the geopolitical need for sovereign AI and the productivity and capex boom affecting economic growth, to increased demand for commodities to help power data centres, and the wealth effect of rising stock markets, which helps consumption.

Our portfolios are positioned to benefit.

In the large-cap portfolios, we have NextDC (NXT) and Goodman Group (GMG), which benefit from increased demand for data centres.

In our midcap fund, we hold NXT and Megaport (MP1), which is exposed to networking, as well as newly listed copper stock Capstone (CSC).

The small-caps team own another data centre play Macquarie Technology Group (MAQ), along with copper miners Sandfire (SFR) and CSC.

In this week’s note we check the pulse of the global consumer – with the European consumer strengthening, the Australian consumer under pressure, and a bifurcation occurring between US consumers who own shares (like higher-income households) and those at the lower end.

On the inflation front, a bounce in May’s Flash S&P Global Composite Purchasing Manager’s Index (PMI) plus more hawkish Federal Reserve speak and minutes resulted in US 10-year Treasury bond yields moving up five basis points (bps) to 4.47%.

Goldman Sachs was prompted to push out its first rate-cut assumption from July to September 2024.

But the PMI sub-components data, plus unemployment claims, were consistent with the narrative that employment and inflation measures are on track to weaken over the coming months.

Confidence remains high that the next move will be down.

The market is now only pricing a 10% chance of the Fed cutting rates in July, while this rises to 50% by the September meeting.

Though last week was very busy in Australia, with a mini-reporting season seeing the likes of Xero (XRO), Technology One (TNE), James Hardie (JHX) and ALS (ALQ) all delivering results, this week looks a little quieter.

The S&P/ASX 300 fell 1.11%, while the S&P 500 returned 0.05% last week.

The US market is closed Monday for the Memorial Day long weekend and then we get personal income and spending data on Friday.

Economics and policy

The Fed

The May FOMC meeting minutes were released and were relatively hawkish. In addition, we had almost 20 statements from various Fed members.

The broad takeaway is that there is no sense of urgency to cut, and it looks as if like the fastest route to a cut would come through an unexpected deterioration in the labour market, rather than inflation alone.

Unemployment claims

The four-week average weekly unemployment claims inched up to 220k, off the lows of 201k earlier this year.

While we haven’t seen a meaningful increase in claims, the slowing rate of hiring (the first step taken by businesses in response to rising borrowing costs and reduced demand) would suggest claims will eventually follow.

S&P Global PMIs

The flash S&P Global Composite PMI survey rose to 54.4 in May – up from 51.3 in April and well above consensus expectations of 51.2.

The market responded negatively, with US 2-year bond yields rising 7bps on the day.

It is worth noting that this index has been a poor indicator of growth in GDP since the COVID pandemic.

More importantly, the sub-components data was consistent with the narrative that employment and inflation data are on track to weaken over the coming months, supporting potential US rate cuts later this year.

Expectations of the first cut have now been pushed back to September.

On the negative side, the composite employment index recovered half of the unexpectedly soft April decline.

However, it remains soft at 49.9 – suggesting equally as many firms are reducing employment as there are those increasing it.

This is consistent with materially weaker jobs growth and signals that businesses expect demand growth to soften.

The output prices indices for both Services and Manufacturing supported the global disinflation story:

• While the services output price index ticked up from 53.7 to 54.0, it suggests that CPI services ex. rents will soon be rising at a 2.5% three-month annualised rate, down from 7.1% in April.
• The manufacturing output price index moderated from 54.9 to 54.5 and also suggested manufacturers built up inventories of finished goods in May, which may prompt price cuts to free up cash flow and be positive for disinflation.

The Nvidia (NVDA) result

Another “beat and raise” print for Nvidia, which reported 1Q24 revenue of $26 billion – beating consensus expectations by 6%.

Earnings per share (EPS) of $5.59 were in line with expectations.

Guidance for 2Q24 is revenue of $28 billion and EPS of $6.30, which are 8% and 3% ahead of consensus expectations, respectively.

A 10:1 stock split was also music to the ears of retail investors.

Incredibly, data centre revenue growth accelerated again from 409% year-on-year in 4Q23 to 427% year-on-year in 1Q24.

The velocity of demand for graphics processing units (GPUs) continues to grow, with demand expected to outstrip supply until at least 2025.

This is not just from the larger cloud service providers (the “hyperscalers”) – individual corporates (“enterprise”) are now the largest incremental buyers in aggregate.

In addition, sovereigns are now coming in and buying to build their own secure infrastructure stacks.

For example, Japan is making a US$740 million investment in a project led by telco KKDI, Skura Internet and Softbank to build up Japan’s AI infrastructure.

NVDA also talked about supplying 100 “AI Factories” – data centres operated independently of the hyperscalers, which may also provide opportunities for companies such as NextDC (NXT).

Amazingly, NVDA now has 81% share of wallet for data centre processors and continues to gain on its peers (Intel and Advanced Micro Devices, or AMD).

It is estimated that there are 15-20k generative AI-related start-up companies.

We are still in the experimental phase of what this new ecosystem will mean for the economy.

Long-term, the AI revolution is expected to drive significant productivity gains, however, the more immediate concern is the inflationary impact the boom in share prices may have on consumer spending.

This was reflected in the FOMC meeting minutes, with at least two participants hawkishly noting that “financial conditions appeared favourable for wealthier households, which account for a large portion of aggregate consumption, with hefty wealth gains resulting from recent equity and house price increases”.

NVDA stock closed up 9% on the day and added about US$275 billion in market cap (equivalent in size to Salesforce, Netflix, and AMD).

To put this in perspective, NVDA made a cyclical low in October 2022 – trading at 25x next-12-month (NTM) price/earnings (P/E) with a US$280 billion market cap.

Since then, earnings have grown roughly ten times and the stock is now trading at 31x NTM P/E with a US$2.5 trillion market cap.

This is supportive for shareholders more broadly; the boom in the US tech sector alone has added about 10% of GDP to US household net worth this year.

According to Fidelity, the number of millionaires in the 401(k)-retirement savings scheme has hit a new record, with 485k in 1Q24 – up 15% for the quarter and 43% for the year.

Fidelity has more than 23 million plan participants with an average balance $126k, which is up 16% year-on-year.

So the rich are getting richer and that’s supportive for the companies skewed at the higher end of the consumer market, as the beneficiaries of such gains are likely to spend a bit more.

We note that households own 39% of the $73 trillion US market in cash equities – that rises to 65% inclusive of mutual funds and ETFs.

The UK

Core CPI inflation came in at 3.9% year-on-year in April, which was down from 4.2% in March but above consensus expectations of 3.6%.

Disappointingly, services inflation only declined by 10bps from 6% to 5.9%, which was well ahead of consensus and Bank of England (BOE) expectations of 5.4%-5.5%.

This has pushed out expectations for a cut from June (with a 10% probability now) to August.

Further, the BOE will not being updating on policy or giving any speeches until after the UK election on 4 July.

Wage pressures remain firm in the UK, with the three-month average private sector regular pay growing at 5.9% year-on-year.

Several leading indicators, such as the Indeed wage tracker and HMRC pay data, are pointing to a potential increase from here.

Europe

The flash S&P Eurozone Composite PMI rose from 51.7 in April to 52.3 in May – its highest reading for twelve months.

This suggests that output across the combined manufacturing and services sector has continued to grow.

This is supportive for Eurozone GDP growth, which should be bolstered further by the expectation that the European Central Bank (ECB) will cut rates in June.

Further optimism came from output prices, which rose at the slowest rate in six months and are rising at a level that is consistent with inflation meeting the ECB’s 2% target.

The data was particularly constructive for Germany, where output rose for a second month running and the pace of growth strengthened and hit a twelve-month high.

Germany has been under pressure for some time, suffering from a range of cyclical problems (like the gas crisis, higher rates, weaker Chinese demand) and structural issues (like its reliance on China imports, the auto industry shift to EVs, and unfavourable demographics).

Real GDP has been flat since 2019, compared with 5% growth for the rest of the Euro area and 9% growth in the US.

A cyclical upswing is underway – with lower inflation boosting real household incomes, which should support consumption growth in coming months.

Combined with lower inflation dynamics allowing the ECB to ease, growth in Germany should pick up over the next twelve months, leaving behind two years of stagnation.

Europe, and Germany in particular, should benefit from the huge wave of liquid natural gas (LNG) supply coming online over the next couple of years. This should result in lower energy prices and act as a tailwind for consumers and the energy-intensive manufacturing industry.

Global consumer pulse-check

This change in Europe is starting to come through in consumption measures.

The Euro area Goldman Sachs Consumer Health Indicator has improved, from the 30th percentile in early 2023 to the 60th percentile more recently.

The US is also around the 60th percentile on the same measure.

It is downbeat in the UK, where it has ranged between the 30th and 40th percentile for 2023 and into 2024.

Australia is also around the 40th percentile.

More broadly, Australian consumer sentiment has continued to decline despite a supportive budget, according to the Westpac Monthly Survey.

The decline was driven by softer perception of personal financials and an increase in unemployment expectations – signalling a softer outlook for the labour market.

Within Australia, those under 40 years old are facing the greatest pressure.

Analysis from CBA on consumer card transactions in 1Q24 showed that cuts to real discretionary and essential spending are skewed to younger cohorts – particularly the average 25–29-year category.

On the other hand, those at or heading into retirement seem well-placed to enjoy it – with a strong propensity to spend.

This is particularly favourable for those consumer companies most exposed to older age cohorts, such as Flight Centre (FLT).

Meanwhile in the US, overall spending remains healthy but bifurcated, with companies increasingly calling out a weaker lower-end consumer.

These consumers are also most exposed to a weakening labour market, with each 1% increase in the overall unemployment rate lowering spending by 1.2% for households in the bottom income quintile but only 0.4% in the top-income quintile.

Of Australian-listed companies, Block (SQ2) is exposed to the lower-end US consumer through its Cash App offering.

Markets

While the NASDAQ had a decent week (up 1.4%) off the back of an exceptional NVDA quarterly, the rest of the market was pretty soggy.

Looking at US large caps, winners are taking more of the spoils – with the largest ten companies now accounting for 26% of S&P 500 earnings, yet 35% of market cap.

While large caps are reporting positive earnings, this is not the case for small caps.

It was interesting to note that the number of companies mentioning AI during quarterly earnings calls has jumped from about 10% in 2022 to 41% in the most recent quarter.

The breadth of sectors that are considered AI beneficiaries has expanded from semiconductors into AI infrastructure plays, such as copper and power.

In particular, utilities have been in focus as a potential AI beneficiary given the substantial energy requirements to power data centres.

Global data centre power demand is expected to more than double by 2030.

This has been reflected in mutual fund positioning, with the smallest underweight to utilities in ten years.

More broadly, hedge and mutual fund positioning has rotated towards cyclicals – with increases across consumer discretionary, financials and energy as investor confidence about economic growth has strengthened.

Copper

Copper dropped 5.5%, giving back some of its 23% year-to-date gains and coming off all-time highs of $5.12/lb reached during the week.

This has been an interesting market, with differences emerging between the two most liquid markets for the metal: the Chicago Metal Exchange (CME) which is largely investor driven, and the London Metal Exchange (LME) which is largely a physically based market.

Pricing between the two is usually within a 2%-3% range, but huge demand from investors has overwhelmed the physical market – pushing the spread by more than 10%.

This huge dislocation has led to risk mitigation as the medium-term speculative positioning is at odds with a lack of physical tightness in the market today.

In fact, the physical market is trading in contango, with spot demand less than current supply.

However, traders are widely expecting that a supply deficit will start building from 2H24 and that long-term structural drivers, such as decarbonisation and AI-related demand, are very supportive for a tight market.

Previously, the ASX had only one sizeable copper player – Sandfire (SFR) – but that has recently been joined by the Australian listing of Capstone (CSC).

Gold

Gold also fell on the week, down 3.3% (but still up 13% in 2024) despite real yields going higher.

Usually, they would trade inversely, reflecting lower demand for inflation-proof assets.

However, this relationship hasn’t held with new buyers emerging from central banks and the Chinese retail market.

Global central bank purchases have increased three times since Russia invaded Ukraine.

Emerging market central banks (like China, Poland, Turkey, India and Qatar) have been big net buyers.

There is further room for this momentum to continue, with only 6% of emerging market official reserves being held in gold versus 12% in developed markets.

About 20% of all gold mined throughout history is sitting in central bank reserves.

Incremental retail demand out of Japan (reflecting the devaluation of the yen) and China (showing movement of wealth out of property) has also been supportive.

While the Chinese government’s recent moves to support the property market are helpful, we don’t think they are yet at a level to disrupt this trend.

Despite the bullishness in gold, the miners have lagged.

This reflects a combination of positioning – and the possibility that western investors are trained to sell gold miners on the move higher in real rates – as well as hiccups in operational performance.

Australia

Within Australia, Tech (+2.45%) performed off the back of some strong results from Xero (XRO, +8.41%) and Technology One (TNE, +12.18%) while Utilities (+2.35%), Energy (+1.19%) and Industrials (+0.80%) were also in the green. Consumer Discretionary (-4.24%) and Communication Services (-3.73%) were the worst sectors, with Wesfarmers (WES, -6.68%) and Telstra (TLS, -5.99%) weighing on the market.

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About Elise McKay and Pendal Australian share funds

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

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

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

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

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

Contact a Pendal key account manager here

Pendal’s head of income strategies AMY XIE PATRICK argued in favour of an active approach to fixed income at this year’s Lonsec Symposium

• Pendal employs AI to analyse “central bank speak”
• Active management matters the most when markets are volatile
• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Browse Pendal’s fixed interest funds

I RECENTLY had the pleasure of participating in a fixed income panel at the Lonsec Symposium.

It was the most engaging panel session I’ve attended in a long time – and if nothing else, it tells me that this asset class has become a hot topic.

In case you weren’t able to attend, here’s a summary of my main observations from the Symposium.

1. What’s better than a rate-cutting cycle for bonds?

In 2022, the Pendal Income and Fixed Interest team embarked on an exercise to see how bonds and equities performed in different parts of the rate cycle.

The motivation?

Being in the middle of the steepest hiking cycle I’d ever witnessed in my career. I wanted to see just how ugly it could get for bonds.

To do this, we needed to look at data going back as far as the 1970s and the era of hyperinflation.

The results gave us a surprise beyond our original curiosity.

Of course, bonds do well when central banks are slashing interest rates, but it turns out that what’s even better for bonds is when central banks come to the end of hikes.

Opinions are divided about whether cuts will come this year, how many and how soon. On the margin, some debate whether another one or two hikes might be necessary.

This first chart cuts through all that noise – what it tells us is that as long as the conviction has shifted away from hikes, then good times lie ahead for bonds.

2. So, is this the post-hike pause?

Yes, I think so. But having an objective way to discern how policymakers are leaning is key.

At Pendal, we employ the AI power of large language models to help us decipher “central bank speak” – be it from their statements, minutes or general speeches.

This thinking is not novel, but our methods are unique.

When you do nothing to the raw language coming out of central bankers’ mouths, generative AI tools have a hard time delivering useful results for investors; ten attempts may well lead to ten different answers.

By design, language models prioritise syntax (language) over logic. Our methods look for ways to clean the raw language to make it as straightforward as possible.

The crucial test for whether our measures are useful is the presence of a relationship to local policy rates and yields.

When Pendal’s hawkishness scores peak, policy rates and front-end yields usually peak as well.

What these charts show is that both the RBA and the Federal Reserve have passed their peak hawkishness. Peak policy rates and yields won’t be far away, if not already behind us.

This is most likely the post-hike pause where bonds do their best work.

3. Don’t just close your eyes and buy

Yes, bonds are back. Yes, the time is now. But the road for fixed income has been bumpy.

Active management matters the most when markets are volatile.

As the above chart shows, when volatility spikes, the dispersion between active managers’ performance in fixed income really stretches out.

What you can’t see from the chart is that first-quartile managers during the calmer times are rarely able to keep their positions in more volatile times. This makes sense because you need different active tools in different volatility regimes.

Volatility today is about as low as it has ever been in the last three decades.

Now is the time to ensure that not only is your fixed interest exposure allocated to an active manager, but that the managers you choose have what it takes to weather the next spike in volatility.

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

• Economic data points to a slowing US economy
• Australia’s Budget is increasingly stimulatory
• Find out about Pendal Focus Australian Share fund

IT WAS a bullish few days for assets last week as the US monthly consumer price index broke its run of hawkish surprises.

Instead, the inflation print delivered in line with expectations, validating a recent decline in bond yields and the US Dollar Index.

We also saw a continuation in the run of softer, but not disastrous, economic news – reinforcing the narrative’s switch back from “no landing” to “soft landing”.

In response, US equity markets hit fresh highs; the S&P500 gained 1.60%, the S&P/ASX 300 rose 0.98%, while commodities and bonds also moved higher over the week.

As a result of recent data, the market is now pricing 45 basis points (bps) of rate cuts in the US this year – with an 85% chance of a first cut by September.

At the same time, the Atlanta Fed GDPNow tracker estimates that the US economy will grow 3.6% in Q2 2024.

On balance, this combination is positive for markets and – given the slower pace of change in the data – may support this environment through the Northern summer.

However, Federal Reserve Chairman Jay Powell noted that while he expects inflation to come down, his confidence is not as high as it had been and that it may take longer than expected for restrictive policy to help bring inflation down to target.

So, bond yields overshot in mid-April, but it is hard to see them moving much lower from here in the short term given the large pullback from peak.

We also need to keep a close watch on company earnings for any sign of impact from a slowing economy.

US macro

Inflation

The monthly US CPI provided the week’s marquee data point.

The upshot is that the print was reassuring, but it needs to ease further to allow rate cuts.

The backdrop was concerning as the April core Producer Price Index (PPI) had come in at 0.5% month-on-month versus the 0.2% expected.

However, the market’s reaction was muted given that:

1. March was revised down from 0.2% to -0.1%, leaving year-on-year core at 2.37%, which was in-line with consensus
2. There was slower growth in components of the PPI that fed into the core Personal Consumption Expenditures (PCE) deflator – the Federal Reserve’s preferred measure of inflation – such as insurance and airfares.

The University of Michigan’s monthly survey of inflation expectations data had also seen an uptick in one-year-forward expectations from 3.2% to 3.5%.

However, core CPI came in at 0.29% month-on-month in April, which was in line with consensus.

Importantly, it slowed from March – breaking the sequence of upside surprises that has been causing market anxiety this year.

The market also liked seeing year-on-year core CPI slowing to 3.6% – the lowest reading since April 2021. This helped take the risk of a rate hike off the table and gave some support for rate cuts this year.

Digging into the data, we can see that the deflationary impulse from Goods remains but is shrinking.

Core Goods inflation was down 0.11% month-on-month, but up 0.4% once used cars and trucks were excluded.

The big change was a healthy deceleration in core Services (excluding rent/owners-equivalent-rent or OER) from 0.65% month-on-month in March to 0.42% in April.

This is the lowest reading since December, but still well above target.

Rent/OER continued to trend lower.

Looking forward, on the positive side, gasoline pricing may have peaked and insurance repricing has largely occurred, possibly reducing their upwards pressure on inflation.

On the downside, rent growth appears to have stopped slowing.

Shelter cost is particularly important; if it is stripped out, CPI has been largely in line with the Fed’s target since June last year.

The concern is that this has flattened out and the deflationary impulse from rent will start to ease off.

There are some encouraging signs in the housing market, which may flow into rental availability: single family housing inventory is increasing and the year-on-year price growth in housing appears to be slower.

As a result, the Fed may want to keep rates on hold until a loosening housing market is more entrenched.

Economic data

Other data pointed to a slowing economy, but not one falling off a cliff.

This reinforced the notion of a soft landing and so, in this case, bad news was good news.

US retail sales were flat during the month, with higher gasoline spending draining consumer wallets. We note this follows a couple of strong months of spending, so cannot yet call it a trend. 

Softer retail sales were perhaps not a surprise, given real average hourly earnings fell 0.2% month-on-month in April.

Initial jobless claims are increasing but, again, it is too early to call this a convincing trend – particularly as it is not showing up in continuing jobless claims data yet.

The NAHB Index (a measure of homebuilder sentiment) fell to 45 in May, but this is likely to reflect the recent rise in mortgage rates, which has since unwound.

Industrial production is going sideways and manufacturing output fell 0.3% month-on-month. Both the Philadelphia Fed and Empire Manufacturing surveys were also softer.

China

Recent data suggests that the Chinese property market is not healing.

Macquarie Macro Strategy research suggests that existing home prices in 70 major cities fell 6.8% year-on-year in April – the fastest decline on record.

A sharp fall in mortgage interest rates is not supporting the market.

Beijing announced a number of supportive measures, including:

• removal of mortgage floor rate 
• lowering of minimum downpayment requirements
• directives for local governments to acquire homes at “reasonable” prices and turn them into affordable housing.

There is some market debate about this.

It is incrementally positive on the policy side, but there is also concern that the actual size of this stimulus will not be enough to make a material difference.

What we can see is further evidence of a twin-track economy emerging, with industrial production strong but consumption weak.

Industrial production grew ahead of expectations at 6.7% in April – with Autos (up 15%), semiconductors (up 32%) and solar panels (up 11%) all strong, while steel, cement and coal were all weaker.

On the other hand, fixed asset investment (FAI) grew 3.6% and retail sales grew 2.3% year-on-year, both weaker than expected.

So exports – and possibly inventory builds – are currently underpinning Chinese growth.

For example, Chinese exports of autos grew 34% year-on-year in the period January to April, driven by electric vehicles (EVs).

The issue is that the Biden Administration has just announced a 100% tariff on imported EVs, as well as increased tariffs on semiconductors, batteries and solar cells.

This only affects 4% of Chinese exports to the US, but it does set a protectionist precedent for other countries; the EU is also reportedly looking to introduce protective tariffs in some areas.

This potential threat to exports – and possible implication for the resource sector – needs to be watched closely given the current state of the Chinese economy. 

Australia

Our key takeaway from the Federal Budget is that it was increasingly stimulatory.

The $300 per household energy subsidy, rental subsidies and additional spending all adds up to healthy stimulus for households, coming in on top of the Stage 3 tax cuts in July. 

But might this stimulus be needed?

Unemployment surprised, with a jump from 3.9% to 4.1% in April.

There was a big jump in part-time employment (up 44.6k new jobs) while full-time employment fell 6.1k roles.

The key issue was the participation rate, which was up 0.1% to 66.7%, while the number of hours worked remained flat.

Employment is now growing slower than the population (ex-children and non-residents).

The government is looking to cut net migration, from 528k in FY23 to 395k in FY24 (upgraded from 375k) and then to 260k in FY25. That would take some pressure off housing, which should be deflationary.

The question is – will it be enough?

Commodities

Copper was up 7.7% for the week.

The catalyst may have been the combination of China property support measures, a weaker US Dollar, and trade measures which hinder movement of Russian and Chinese physical copper to US.

But short-dated contracts traded at a record high to longer-dated futures, indicating a physical shortage due to shorts being squeezed.

Short copper positions are at record highs, as are long positions.

One thing to note is that Chinese copper indices are depressed and inventories are at record highs.

There are many potential moving parts here, but it is a disconnection from normal copper markets which needs to be watched, given China consumes about 55% of the world’s copper.

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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.

Find out more about Pendal Focus Australian Share Fund  

Contact a Pendal key account manager

The allure of higher interest rates and certainty of returns from term deposits is strong, but the income advantage of bonds over term deposits remains clear, writes head of income strategies AMY XIE PATRICK

• Higher interest rates in 2023 made term deposits seem attractive
• Active income strategies have a role to play
• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Browse Pendal’s fixed interest funds

THE RESERVE BANK held the Overnight Cash Rate steady at 4.35% on May 7 for the fourth consecutive meeting.

At first look, this makes 12-month term deposits seem attractive.

The 2022 “everything sell-off” still haunts many investors, while the allure of higher interest rates and certainty of returns is hard to turn down.

At the margin, however, investors we speak to are starting to wonder whether there is more to life than term deposits — even in a higher interest rate environment.

Our answer? Yes!

Term deposit returns in 2023

Since 2022 was such a volatile and disappointing year for both defensive and risky assets, many investors found it better for their peace of mind to leave their capital in cash products at the start of 2023.

After all, one of the reasons bonds and equities had sold off together in 2022 was because inflation had been a problem and so interest rates had been raised across the globe.

In Australia, the RBA raised the Overnight Cash Rate from 0.1% to 3.1% in the space of six months.
This meant that at the start of 2023, 12-month term deposit rates on offer with the major banks exceeded 3.5%.

Since the economic backdrop looked far from straightforward, one-year return rates of between 3.5%–4% looked pretty attractive to lock in.

Indeed, last year was eventful and volatile.

US regional banks threatened to bring another credit crunch into the global financial system. Chinese property developers continued to be in dire straits with no sign of rescue from Beijing. Inflation continued to be a concern despite passing its peak. And at one point in the year, it seemed like the rise in bond yields was about to bring a repeat of 2022.

Yet, what we see below was the final scorecard of asset class performance in 2023, including 12-month Australian term deposits.

What Figure 1 highlights is that while the decision to turn to term deposits made complete sense following the market chaos of 2022, it is one you then have to stick with for the whole year – even as you see opportunities unfold again.

In short, locking in certainty isn’t a bad thing in certain environments, but it’s good to understand that this would also lock out opportunity along the way.

In today’s environment, what else should investors consider instead of term deposits?

It might be helpful to separate the market environment into four simple regimes, as depicted in Figure 2.

These regimes can be either high or low in volatility, as well as high or low in the interest rate backdrop.

The top-left quadrant of the diagram was a lot like the post-GFC period, where interest rates were low and headed ever lower. Most of that period was benign in terms of market volatility, minus a few short and sharp events.

Term deposits were unattractive in that regime and most investors went searching for yield in riskier assets.

In such a regime, high-quality (investment-grade) floating rate corporate bonds are likely to do a better job at generating income than term deposits.

Not only does a low-volatility backdrop support asset classes such as credit, but a floating rate bond will also not be hurt by interest rate rises should the RBA start to tighten monetary policy.

The bottom-left quadrant of the diagram is like the Covid crisis of 2020, even though it was relatively short-lived. Interest rates were low at the start of the pandemic, but they were slashed further as global central banks tried to provide economic stimulus.

Government bonds were useful to own back then, even if it seemed pointless to own them before the volatility hit since the interest they carried was so low. It seems that no matter how low interest rates get, government bonds still rally when the economy comes under stress.

Term deposits were also not a bad option if capital preservation was all that was required, but they could not have delivered the capital gains that government bonds did during that troubled period.

In the bottom-right quadrant, we see a period of both high interest rates and high volatility. This is a lot like 2022, where being in cash or term deposits would have at least saved you from the drawdowns in other major asset classes.

However, high volatility can set in because of concerns about growth as well, which would prompt central banks to cut interest rates in a hurry. Here again, term deposits cannot offer that upside.

The last quadrant is on the top-right and is probably closest to where we are right now. Interest rates are high, but volatility is low.

Term deposits are easily beaten by fixed-rate corporate bonds in such an environment because not only will yields be higher, but the fixed-rate nature of those bonds will also help to deliver capital gains should rates and yields fall from here.

Figure 3 is a stylised illustration* of how a 12-month rolling term deposit, a five-year floating rate corporate bond, and a five-year fixed rate corporate bond are all likely to perform in a gentle RBA easing cycle.

For simplicity, let’s assume that each of these investments are taken on in a passive way.

For the bonds, the investor holds them to maturity and for the term deposit, they are simply rolled at the end of every year into a new 12-month deposit.

The income advantage of bonds over term deposits is clear.

Even at today’s higher interest rates, the higher yield from corporate bonds (the credit spread) helps bonds generate a better income stream for investors.

At lower interest rates, only the fixed-rate five-year bond can continue to deliver a consistent income stream.

By years two or three, that income stream will look very generous compared to market interest rates that will be on offer.

What is an “active income strategy”?

In each of the four quadrants illustrated in Figure 2, active income strategies have a role to play. Let’s first define what an active income strategy is.

In the first instance, the role of any income strategy is to deliver income. Therefore, the “income engine” of these strategies needs to be made up of assets that pay regular income.

You might think of shares that pay a dividend, but those dividends are at the discretion of the company which is not contractually obliged to pay dividends (or any set level of dividends).

That’s why Pendal’s income strategies like to rely on corporate bonds for their income engine.

Here, we mean high-quality corporate bonds with defined coupons. Hybrids don’t count because once again, they have a provision that allows issuers to skip coupon payments should certain conditions arise.

The income engine itself ought to be actively managed – a high-volatility regime calls for a more cautious approach to taking on more corporate exposures and vice versa.

But other levers are needed on top of that.

When yields are low and volatility is high, government bond exposures are beneficial, but only up to a point. As the reflationary episode after the pandemic showed, you don’t want to overstay your welcome in government bonds when yields are super low.

Equally, higher yields are not a shoo-in for government bonds either, as the last two years have shown.

Active portfolio management to help time when and how much government bond exposure to take should be a key feature of active income strategies. After all, government bond exposures serve different purposes for income funds (as seen in the different quadrants of Figure 2).

In some cases, it is to provide diversification and defensiveness to the credit risk in the portfolio. In other cases, it is to help boost income returns on top of what the income engine is able to generate.

Lastly, we believe an active income strategy should offer investors a compelling way to chase returns when there is more upside on offer.

Rather than adding on more credit exposures to the portfolio, which will have negative quality and liquidity consequences down the road, active income strategies ought to be able to stay liquid while participating in more of the upside.

That liquidity is not only beneficial to investors who may want constant access to their capital, but also beneficial to the agile positioning of the portfolio.

An income strategy that pursues additional exposures only by piling on more corporate bonds will find it hard to dial that back if the market takes a sudden turn for the worse.

That’s not a big problem if it’s only a short-term hiccup, but it could be difficult to resolve should a longer-term bear market set in.

On the other hand, an active income strategy that pursues the addition of exposures through only liquid means will be able to switch off that exposure very quickly and efficiently should there be an unexpected shock.

If it turns out to be only a short-term hiccup, the liquidity of those exposures permits a quick restoring of exposures. If it’s something more fundamentally negative, then those timely risk-reductions would have been hugely beneficial for preserving capital for investors.

Conclusions

Higher interest rates in 2023 made term deposits seem attractive. But despite a volatile year for markets, term deposit returns looked disappointing versus bonds and equities.

Term deposits are great for capital preservation, but by locking in your rate of return, you may also be locking out a lot of upside opportunity.

It may be helpful to consider active income strategies as an alternative to term deposits.

Their income engines comprise corporate bonds offering a compelling yield advantage to term deposits, even if interest rates stay where they are for a long time.

The other active levers within Pendal’s income strategies are also designed to mitigate risk and improve returns regardless of the market backdrop.

Best of all, unlike term deposits, investors won’t be locked in if better opportunities present themselves along the way.

The Australian government has unveiled its Budget. TIM HEXT, Pendal’s head of government bond strategies, looks beyond the noise at what it really means

• The government has unveiled its latest Budget
• As the dust settles, yields are sharply unchanged 
• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Browse Pendal’s fixed interest funds

WHEN you’ve watched enough federal Budgets (this was my 35th in markets), you start to see familiar patterns across commentaries.

Every vested interest or ideological bent comes out bleating about the Budget being irresponsible or reckless, that there’s too much spending or not enough major reform.

What worries me more is when people view the government as no more than a large corporation and when they speak of the budget like a profit and loss statement.

Looking through the noise and self-interest is what really matters for bond markets in the year ahead.

I have narrowed it down to three impacts.

Inflation

There are a number of direct measures that reduce inflation, one of which is electricity subsidies.

Every household gets $300 off their electricity bill, by way of quarterly $75 payments directly off the bill. Businesses receive $325.

The average household bill is $2,000 a year, so that’s 15% off.

Electricity is 2.4% of the CPI basket, so this equates to 0.36% off inflation in direct impact. The government is quoting 0.5% overall impact.

Queensland has already announced a $1,000 subsidy while Western Australia has announced a $400 subsidy, again not means tested.

It will be interesting to see what upcoming state budgets keep rolling existing subsidies (no impact to inflation), let them roll off (inflationary) or, like Queensland, increase them (deflationary).

If we assume modest subsidies coming up from other states, then the electricity impact on lower CPI could be 0.8% or even higher.

Other measures in rental assistance and cheaper medicines are slightly deflationary.

Overall, federal Treasury is forecasting inflation of 2.75% in 2024/25, which is below the current Reserve Bank (RBA) forecast of 3.2%.

We expect an upcoming downward revision of the RBA forecast of 3.8% CPI for 2024, which looked too high anyway. This could also see its 2024/25 forecast moderated lower, though still near 3%.

Tax cuts and spending

Against the direct impact of the Budget on lower inflation, markets ask the question of whether the extra money in people’s pockets may cause higher inflation if and when it is spent.

There is around $20 billion of new spending measures (the Stage 3 tax cuts have been locked in since 2019) in this Budget, with the majority in the next two years.

The Budget will return to deficit, with a forecast of $28.3 billion for 2024/25 and $42.8 billion in 2025/26.

While still low by international standards, the main question is whether or not deficits are appropriate at this point of the cycle.
It must also be noted that it also is based on the usual conservative commodity price forecasts.

For example, an iron ore price of US$60 is assumed, despite a current price nearer US$110 and a five-year average of US$120.

This opens up potential upside surprises as we have seen in the past few years.

This has really excited Budget hawks and has some calling for higher rates as all this money is supposedly spent, stoking inflation.

The question I would ask is whether or not this money is being injected into an economy at full capacity.

On this, my view is that we are sufficiently past the pandemic that supply chains can handle the modest rise in consumer spending without stoking inflation.

Consumers will be spending more in the year ahead. Tax cuts, subsidies and lower inflation should finally see some growth in real incomes – however, this is from a base of real incomes having for the past few years.

Bond issuance

We will see an update on the 2024/25 program from the AOFM shortly.

Given high refinancing (two benchmark maturities totalling $83 billion) the borrowing task is expected to be around $90 billion, as the RBA has borrowed much more than needed this year.

It is important to remember that when determining yields, bond demand and supply dynamics are largely outweighed by economics.

As a bond manager, I only view supply and demand as a short-term impact around supply events.

Ignore the booming debt rhetoric from some commentators and self-styled bond vigilantes – Australian debt will remain AAA for at least the medium term, and with the RBA moving to an “ample liquidity” framework, demand for bonds will remain robust.

So, what does this mean for bonds?

Well, the market always votes straight away, and has already made a half-hearted attempt to run with the higher spending higher inflation narrative.

However, as the dust settles (to quote the cliché), yields are “sharply unchanged”.

I think the RBA will see the Budget for what it is – a mixed bag of measures that will leave it hopeful of further inflation relief but wary of whether the 2%-3% band can be achieved and then sustained.

I would also make the observation that the “Future Made in Australia” spending is an overdue response to the global game-changing US Inflation Reduction Act.

By comparison, our government’s measures are modest for now, but can be expected to increase in the future.

We are in a very different world to the last decade and governments must respond.

For now, a more detailed breakdown of the domestic economy is below.

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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

• Equities continued moving higher last week
• Australian inflation remains key to market performance
• Find out about Pendal Focus Australian Share fund
• Watch Crispin’s most recent Beyond the Numbers webinar

EQUITY markets continued moving higher last week, triggered by the drop in bond yields.

Macro news flow, while limited, supported the signal that US growth is slowing at the margin. This is good for markets, as it brings rate cuts back into play.

The S&P 500 gained 1.89%.

The ASX 300 was up 1.78%, supported by bank results, which noted that the economy is holding up and margin pressures are abating.

A series of updates from other companies generally painted a picture of a solid economy, particularly on the industrials side – with upgrades from AUB Group (AUB) and AGL (AGL), good results from Orica (ORI) and Goodman (GMG), and an absence of material downgrades at the annual Macquarie conference.

The one area of potential weakness is in consumer discretionary stocks, which have underperformed the market.

We’ve also seen a significant shift in government energy policy ahead of this week’s Federal Budget.

The Federal Government is now embracing gas as a transition fuel and recognising the risk of a shortfall in gas supply from 2028, unless more development occurs or import facilities are built.

US economy

Credit

The senior loan officer opinion survey (SLOOS) – a quarterly update on the credit environment – suggested banks are still in credit-tightening mode, but the extent of that is flattening to slightly diminishing.

The US Federal Reserve pays attention to the SLOOS.

This result is consistent with its perception that policy is still somewhat restrictive but not deteriorating. Given the economy has been able to grow despite tighter standards, it suggests nothing should change.

Employment

Following softer payrolls data, we saw a spike in jobless claims last week.

However, half of this came from New York, suggesting it was a not a signal of broad-based deterioration.

Consumer expectations

The University of Michigan’s survey on consumer sentiment deteriorated while inflation expectations rose, which is at face value a negative signal.

The issue is that surveys in general have not given great signals.

For example, consumer sentiment fell in late 2023 despite a strong economy. There is a view that the heightened political tensions in the US may be having an impact on the measure.

Inflation expectations have been volatile, but they are important as it points to more persistent wage pressures. On a more positive note, the Conference Board surveys for CEO Confidence are improving, mirroring the better-than-expected economy and earnings.

US market update

Around 85% of the US market has reported quarterly earnings.

In summary, it has been a good season, with EPS up 6% year-on-year, versus 3% expected when results started.

This has been driven by margin improvement rather than revenue growth, which highlights both the issue of industry structure, and that economic resilience enables more pricing power.

The other observation is that the better earnings tended to be concentrated in the larger stocks rather than the median.

The rally in bond yields has put a floor under the market’s recent correction, and it seems likely we’ll see a test of the prior high.

Volatility has eased off, which is supportive, and we have seen key sectors like the banks already back at their highs.

There is an interesting signal in European equity markets – these have performed well recently, reflecting a more benign inflation outlook than the US and greater scope for rates to fall.

This is also reflected in European bond markets, where yields are rolling over.

The relevance for Australia is that our inflation performance is key to how well the market does. This week’s Budget will be important to see the level of restraint in fiscal spend, which can impact rates.

Australian equities

The combination of results for March-end reporting companies and the Macquarie conference meant there was a lot of stock news.

Banks saw earnings fall but signalled that they were not seeing any signs of economic deterioration, with asset quality good, a steady pipeline of business loans and margins stabilising.

Orica (ORI) offered a good example of an industrial company managing sluggish volumes with more value-added products, helping improve margins.

Consumer trends are divergent.

Some retailers are seeing a slight slowing of sales; combined with cost growth, this triggered market concerns on margins.

However, Qantas (QAN) is seeing no slowdown in travel demand, with some small improvement in the corporate travel market. The upshot is we remain of the view that the market can continue to move higher, with individual stock stories – rather than macro factors – re-emerging as the key driver of performance.

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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

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

• Environment may signal equities pushing higher
• Find out about Pendal Focus Australian Share fund
• Watch Crispin’s most recent Beyond the Numbers webinar

WE saw a reversal in recent trends last week.

After rising 47bps in April, US 10-year government bond yields fell 16bp last week, triggering a continued bounce in equities.

The S&P 500 gained 0.56% and the NASDAQ lifted 1.44%.

This followed dovish comments from US Federal Reserve chair Jerome Powell after US interest rates were left unchanged.

Powell clearly indicated rate hikes were not on the agenda and the Fed did not expect a recent jump in inflation to be sustained.

A subsequently softer payroll report and moderating average hourly earnings data lent credibility to his comments.

The fall in bonds yields was reinforced by a 7.3% drop in Brent crude oil on higher weekly inventories.

The key question is whether this is the beginning of a larger reversal in bond yields as inflation momentum begins to wane.

We suspect this will happen, though we anticipate a relatively moderate bonds rally given resilience in economic growth and recognition of structural factors supporting inflation. 

Trends also reversed in currency markets (with a potential near-term top in the US dollar/Japanese yen trade) and Chinese equities (where internet stocks have made strong gains this month).

Such an environment may signal the equity market is going to push higher.

US earnings have been supportive. Apple was the latest tech name to surprise on earnings and capital management.

In Australia the S&P/ASX 300 rose 0.74%, supported by tech and banks stocks. National Australia Bank’s half-yearly results were largely as expected and the CEO struck a positive tone.

In contrast, Woolworths delivered another disappointing sales update, indicating they were seeing consumers “trade down”.

US inflation and policy outlook

The Fed left rates on hold, as expected.

The focus was on Powell’s press conference and the potential for rates to rise after recent disappointing inflation data.

The market was pricing a 30 per cent chance of a hike by year’s end.

Powell firmly knocked this back.

He acknowledged a set-back on the path to 2 per cent inflation and the need for rates to stay on hold for longer.

But he also noted policy was already restrictive and the question was therefore how long rates should be kept at current settings.

Powell noted the criteria which could allow rates to fall – such as unexpected easing of the labour market – rather than the factors that could lead to a rate rise.

This was likely a deliberate signal on where the Fed is focused.

He also indicated that the Fed expected inflation to move back down this year, noting recent pressure was tied more to lagging factors built into the inflation-measuring process (eg healthcare and rents) as well as confidence in a supply response to support disinflation.

Our conclusion remains that while the Fed retains its current “hold” bias, there is a skew towards looking for reasons to cut rather than reasons to raise rates.

The market’s implied expectations of a rate hike this year have fallen back below 10 per cent.

Liquidity a key factor

Market liquidity has been a key factor driving the equity rally from November 2023.

After the FOMC meeting, the Fed announced a relatively dovish slowdown in Quantitative Tightening (QT) from US$60 billion per month in US Treasury bonds to US$25 billion, effective from June.

This is important as it supports the liquidity environment for markets – and extends that support well into the northern summer. 

Elsewhere, the US Treasury announced its projected financing requirements for the September quarter. This is watched carefully since it also affects market liquidity.

Last year more financing was shifted to the short end of the yield curve, which supported liquidity and helped turn markets around.

This time the plan is a moderate reduction in the Treasury General Account (ie their cash on hand) from US$940 billion to US$850 billion. This is not as aggressive as some looked for, but still partly offsets bond issuance.

The mix of issuance remains largely unchanged, retaining the relative skew to the short end of the curve.

The reverse repo market can also serve as a source of further funding for Treasury issuance in coming months.

US economic outlook

The economy continues to hold up well, but there are signs employment growth is slowing.

US employment

April non-farm payrolls rose 175k, well below a three-month average of 269k and 240k consensus expectations. There were also net revisions of -22k for February and March.

The government sector drove the downside surprise, adding just 8k jobs versus a 60k average over the past six months.

The private sector held up at 153k new jobs, with healthcare and social assistance representing half the rise.

The forward signals are mixed. The NFIB small business survey indicates a material slowdown over the next few months, while jobless claims data is more benign.

The average US work week fell marginally to 33.7 hours — another sign the labour market could be weakening.

Average hourly earnings also softened from 4.1% year-on-year in March to 3.9% in April. There was weakness in leisure, hospitality, construction and government.

This reinforces the signal that wage growth is slowing towards a level consistent with low inflation in the low 2 per cent range.

A household survey saw unemployment rise from 3.83% to 3.86% – not quite as large as some were expecting.

We have crossed a threshold for the “Sahm Rule” – which indicates that a 0.5% increase in unemployment signals a recession will follow.

We have some reservations about this rule and do not read too much into it.

The outlook for lower wages was supported by the latest Job Openings and Labor Turnover Survey from the US Bureau of Labor Statistics.

Notably, the favoured “Quits” rate – a decent lead indicator on wages – continued to move lower. Its current level is consistent with 4.5% unemployment based on historic data.

While we note there are still structural factors underpinning inflation, this is all supportive of easing inflationary pressure in the near term.

US service sector activity

There was some focus on the US services sector after an April ISM survey showed a fall of two points to 49.4 – its lowest point since the pandemic.

The data suggested the worst of all combinations: business activity down materially and new orders also lower, while pricing expectations were higher.

We note this is a volatile series, where weather can play a part. But it does provide a warning shot, particularly in the context of a series of consumer facing companies such as McDonalds and Starbucks signalling weaker demand.

The April S&P Global US Services PMI remains above 50 – and the ISM had been running above it for some time.

We may be seeing a convergence of these series, rather than a material change in trend.

Markets

US earnings season

First-quarter US earnings have been positive, partly reflecting a low bar of only 3 per cent expected earnings growth.

The response to beats is also much more muted than normal, suggesting the market was positioned for good news.

Apple provided a boost to both the tech sector and overall market, with earnings coming in better than many had feared.

There is also a shift in sentiment towards the potential impact of AI – from concerns that it posed a risk to Apple’s outlook, to speculation it may drive a handset upgrade cycle.

Looking across the tech sector, several trends have been supportive:

1. Demand is strengthening and prices are increasing, supporting revenue growth
2. Capital returns picking up; Alphabet and Meta both announced their first dividends in 2024, alongside share buy-backs
3. Rising profitability; margins are up in 80% of internet companies as a result of greater focus on costs
4. The AI cycle; AI use cases are increasing the focus on cutting costs and improving services.

Market signals

There has been some notable price action, likely tied to the reversal in bond yields.

Technology stocks and gold miners represent two ends of the thematic spectrum.

The former’s surge in outperformance from October to February (measured by the Technology Select Sector SPDR Fund versus the VanEck Gold Miners ETFs) reversed entirely in March and April —  but now may have turned higher again.

This may be supportive for equities given tech’s weight in global indices.

There are a couple of other reversals to watch, which are potentially positive signals for the market:

1. The USD/JPY currency cross rate, which has seen a material reversal off sentiment extremes.
   This may be a catalyst for the US dollar trade-weighted index to start easing. This is positive for markets as it supports liquidity.
2. A potential shift in sentiment towards Chinese equities. This may be seen in the KraneShares CSI China Internet sector ETF, which has been in extended bear market. There has been a material break higher in recent weeks — on short-term time frames at least. This reflects changing sentiment on the Chinese market combined with very low exposure to it. Allocation to China in active global equity funds is at it record lows — and in the first decile of historical allocation by one measure.

What does this all mean?

We think it means markets are probably supported at current levels and we could see rotation back to higher beta sectors — those stocks with rate exposure such as telcos and REITs, as well as China consumer-related names.

Australian market

National Australia Bank (NAB) delivered the first bank result — which seemed good enough to sustain the sector’s premium valuation rating — with a surprisingly positive message from the new CEO.

Consumer anecdotes were softer, notably from Bapcor (BAP), Ampol (ALD) and Woolworths (WOW).

Gold stocks rolled over reflecting the bond reversal, while lithium names ran higher on a clean-out of IGO’s (IGO) inventory by its Chinese partner.

High-quality growth names began to run again (eg Goodman (GMG), Xero (XRO), Pro Medicus (PME)), reflecting more positive sentiment on rates.

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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