Aussie small caps are once again outperforming large caps. Pendal portfolio managers LEWIS EDGLEY and PATRICK TEODOROWSKI explain why

• ASX small caps are back in favour with investors
• Earnings holding up better than expected
• Find out about Pendal Smaller Companies Fund

AUSSIE small caps are once again outperforming their large-cap counterparts after a period of underperformance in recent years.

Conditions have turned in favour of ASX-listed small caps in recent months and Pendal portfolio managers Lewis Edgley and Patrick Teodorowski believe that trend will continue.

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. (Teodorowski has been with the fund for 14 years and Edgley for 11.)

In this article, the pair explain why small caps underperformed, how conditions have changed and what they’re doing to take advantage.

Why small caps under-performed in recent years

Small caps underperformed large caps in 2022 and 2023 as higher rates and recession fears pushed investors towards larger, more established companies.

When markets first anticipated a rapid post-pandemic rate-rise cycle, that precipitated a significant underperformance of small caps, relative to large caps, says Edgley.

Many companies in the large cap index — such as banks and insurers — were natural beneficiaries of a rising interest rate environment.

“In the small-cap universe, the composition was quite different,” Edgely says. “For example, we’ve got a large proportion of real estate trusts where rising rates hurt their valuations.”

“We’ve also got a high degree of economically-sensitive businesses.

“When you have a fear of recession these businesses are typically sold off. That happens in advance of any earnings impact as sentiment weighs on those types of businesses.”

At the start of that period small caps had a significant premium compared to large caps, which also exacerbated their relative underperformance.

How conditions changed in favour of smalls

This year, as recession fears dissipated and inflation began moderating, investors regained interest in smaller companies.

“We’ve had the US Fed on hold and the Australian RBA on hold, and in that environment the market starts to anticipate things improving and a shift to the other side of the interest rate cycle, which is rate cuts,” Teodorowski says.

“We’ve also subsequently seen earnings hold up significantly better than investors feared.

“We’ve seen a re-rating of companies that were most likely to feel the pain of higher interest rates.

“More fundamentally, over the past two earnings seasons we’ve seen greater resilience out of the more cyclical companies within our index.

“They’ve been able to manage their earnings far better than the market expected.”

Materially lower valuations and a low Australian dollar has prompted more merger and acquisition activity in the last six months, says Teodorowski.

An expected flurry of “new and bigger Initial Public Offerings” should also see increased demand and investment opportunities.

What sets Pendal’s small caps team apart

“We believe a few things set us apart as quality small-cap investors,” says Edgley.

“The key driver is the breadth and depth of the team.

“We’re a team of five. That would be one of the largest, dedicated small cap teams in the market.

“We’re also supported by the broader Pendal Aussie equities team. So in total there’s 19 of us.“

A larger team allows Pendal to cover a lot of ground — which is very important in small-cap investing, Edgley says.

“The small-cap universe is very diverse by sector. There are always new moving parts. The refresh within the universe is significant.

“With sectoral responsibility across all areas we’re able to make active decisions in certain sectors, and we think we’re able to make the best investment decisions.”

Active management important

“The process has always revolved around going out and wearing out boot leather,” says Teodorowki.

“We do a lot of direct meetings with the management of companies. We meet with other industry participants, whether customers or competitors.

“That’s always been a big part of the process in coming up with a view on a business.

“Another big part of our process is peer review. Lewis and I are not only portfolio managers, we’re analysts.

“When any idea gets brought to the team, we all sit around as a group and debate the merits of that investment as a team.

“The five people in the team are very experienced. This brings a different lens into analysing the business. It normally raises additional questions and drives deeper research into the investment idea.”

Says Edgley: “It’s very much style-agnostic, bottom-up idea generation. “We take a pragmatic view of the opportunities in front of us and converting those opportunities.

Here are the main factors driving the ASX this week according to Pendal portfolio manager JULIA FORREST. Reported by portfolio specialist Chris Adams.

• Underlying inflation in Australia remained well above the RBA’s target in Q1
• The GDP print in the US suggested ongoing economic strength
• Find out about Pendal Focus Australian Share fund

LAST week was a big one for macro data.

In the US, headline Q1 2024 Gross Domestic Product (GDP) growth came in relatively soft at 1.6%, versus 3.4% in the prior quarter and the 2.5% expected.

At the same time, the Q1 Core Personal Consumption Expenditure (PCE) deflator – a measure of inflation – accelerated to 3.7% annualised, versus 2% in Q4 2023 and the 3.4% expected.

As a result, US bond yields continued their climb, with ten-year Treasury yields ending up five basis points (bps) for the week at 4.67% and the market increasingly implying a first rate cut by the Fed in December. 

Chicago Federal Reserve President Austan Goolsbee said that the Federal Open Market Committee needs to “recalibrate” its stance – noting that “progress on inflation has stalled” in 2024 and that after three months, this signal “cannot be dismissed”.

While it was a bumpy week for data, there was an underlying tone of resilience, with the market finding comfort in US Q1 earnings.

The Nasdaq and SP500 ended up by having their best week since November, returning 4.23% and 2.68%, respectively.

AI optimism lifted Alphabet (+10%) across the US$2 trillion market cap threshold, while Nvidia (+6%) and Microsoft (+2%) also gained.

The S&P/ASX 300 was up 0.12%.

The Australian Q1 2024 consumer price index (CPI) came in at 3.6% year-on-year versus the 3.5% expected, slowing from 4.1% in the previous quarter.

The “trimmed mean” measure preferred by the RBA rose 1.0%, again above forecasts of a 0.8% gain.

Following the data release, the Aussie Dollar jumped 0.7% to $0.6530 versus the US Dollar before settling at $0.6517, while yields on the 2-year (up 31bps) and 10-year government bonds (up 27bps) moved higher to trade at 4.18% and 4.52%, respectively.

The two things that the RBA focusses on – employment and inflation – are both above target, with the recent unemployment rate 20bp below the RBA’s forecast (3.9% vs 4.1%) and the trimmed mean inflation now 20bp above (1.01% vs 0.8%).

US macro

Headline GDP growth of 1.6% for the first quarter was softer than the 2.5% expected and the 2.7% forecast by the Atlanta GDPNow measure.

However, the breakdown was quite constructive, as final domestic demand remained solid (up 2.8%) for the quarter – with robust contributions from consumer spending, business fixed investment and residential investment.

The drag came from net exports (down 0.86%), driven by strong import growth apparently related to technology (computers, parts, semiconductors and telecommunications equipment).

In sum, the GDP print suggested ongoing economic strength in the US.

The Atlanta Fed GDPNow estimate for Q2 GDP growth is near 4%, which further fortifies upside risks to the inflation outlook.

The annualised Q1 Core CPI growth of 3.7% was the strongest quarter since the early 1990s, excluding the immediate post-pandemic period.

Core services ex-housing is the key driver, growing at a three-month-on-three-month annualised rate of 5.2%.

This is largely driven in turn by wage growth, where there are some possible early signs of cooling in measures of labour market hiring plans, the quits rate, and the Atlanta Fed wage growth tracker.

However, the US macro backdrop remains strong, with the ISM Manufacturing index showing a big uptick in 2024 and – importantly for markets – earnings fears as reflected in 12-month forward earnings-per-share estimates seeming to have passed.

The combination of sticky inflation and economic resilience raises the question of whether the neutral rate is as low as the Fed and market previously thought and, by extension, whether policy settings are as restrictive as assumed.

Financial conditions are now looser by the Chicago Fed’s own metric than at the beginning of 2022, when rates were effectively at zero and the Fed was still officially saying that inflation was transitory.

The Fed significantly eased financial conditions late last year via its “dovish pivot”, which reduced the global cost of both equity and debt capital.

Fiscal policy is working against the Fed’s rate settings.

The economy is resilient, unemployment is at 3.8% (too low to reduce inflation), and wage growth is strong (albeit slowing).

However, the US fiscal deficit is -6.2% and it is unusual for large deficits in boom times – normally it is the result of recession.

We are a little over six months out from the US Presidential Election and a balanced budget is probably the farthest thing from the mind of either candidate.

As such, the Fed is likely to continue to lean against the continued fiscal dominance.

The problem for the stock market is that rates seem too high to allow equities to push through to higher levels, but not high enough to create the kind of economic slowdown that forces the Fed to ease.

Australia macro

The Q1 3.6% twelve-month growth in Australian CPI slowed from 4.1% in Q4 2023, but by less than the 3.5% expected.

Nearly half of Australia’s CPI basket rose at an annualised rate of more than 3% in the March quarter.

The trimmed mean measure rose 1.0% in Q1, versus the 0.8% seen in Q4 2023 and expected again. The twelve-month rate dropped from 4.2% to 4.0%.

Several components appear to be sticky, notably in domestic market services lifted by rents, insurance and education costs.

Rental prices rose 2.1% for the quarter, in line with low vacancy rates across the capital cities. Rents continue to increase at the fastest rate in 15 years.

On any measure, underlying inflation in Australia remained well above the RBA’s target in Q1.

There are some signs that the labour market is beginning to soften, but wage rates remain too high to be consistent with the RBA’s targets.

Monetary policy is working its way through the system, lifting debt service costs and reducing household disposable income.

However, the Stage 3 tax cuts are likely to see an uptick in retail spending from July, with a possible additional $23 billion in spending capacity in FY24/25.

If 75% of this is spent, this could see a 4.1% lift in retail sales.

Europe/UK macro

The Euro area Composite Purchasing Managers’ Index (PMI) came in at 51.4 versus the 50.7 expected, while the Services PMI was at 52.9 versus the 51.8 expected.

The UK Composite PMI was at 54.0 versus the 52.6 expected. Recent data has been solid and picking up, suggesting that economic activity – having initially been shocked by a shift from zero rates – is now adjusting.

US earnings season

With the US market near its most concentrated in history, earnings for the “Magnificent 7” were crucial to markets.

Three of the four that reported were well received (Tesla, Microsoft, Alphabet), with only Meta disappointing – here’s more:

• Alphabet beat expectations for revenue, operating income and EPS. It also announced its first ever dividend and an additional US$70 billion buyback.
• Microsoft beat consensus EPS expectations and highlighted the growth of its cloud computing business and its efforts to bring AI technology to clients.
• Tesla missed on revenue ($21.3 billion versus expectations for $22.3 billion) and earnings estimates for Q1, noting that “vehicle volume growth rate may be notably lower” in 2024 than in 2023. However, investors were upbeat on the company’s strategy going forward, with a focus on “accelerating” the rollout of new, cheaper models. There are some interesting potential parallels between EVs and today’s enthusiasm for AI. Three years ago, EVs – and Tesla in particular – were expected to take over the world. However, competition has been intense in the sector (especially from China) and demand disappointing in some regions.
• Meta saw lighter revenues and higher expenses and capex as it looks to spend more on AI. 2Q24 revenue guidance was below consensus. There is a concern being that advertising revenue is slowing due to geopolitical events.

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PENDAL has been named as a finalist in three categories of the 2024 Money Management / Lonsec Fund Manager of the Year awards.

OUR investment teams were recognised in:

• Australian Property Securities Fund of the Year – Pendal Property Securities Fund
• Global Emerging Market Equity Fund of the Year – Pendal Global Emerging Markets Opportunities Fund
• Australian Fixed Income Fund of the Year – Pendal Short Term Income Securities Fund

Each nominee is thoroughly reviewed by respected investment research house Lonsec.

“The Fund Manager of the Year Awards are a celebration of the very best of the funds management industry and we are again thrilled to partner with Money Management to showcase this year’s finest and brightest,” said Lonsec research executive director Lorraine Robinson.

“We have applied the same rigorous approach we take to researching and rating funds, to evaluating the nominees and choosing winners in each of the group award categories and we congratulate all the finalists announced today.”

Finalists are shortlisted following a meticulous judging process, with winners revealed on June 13.

To view the full list of 2024 finalists, visit the event page.

Here are the main factors driving the ASX this week according to portfolio manager JIM TAYLOR. Reported by investment specialist Jonathan Choong

• Find out about Pendal Focus Australian Share Fund
• On-demand: tune into Crispin Murray’s bi-annual Beyond the Numbers webinar

THE stock market fell for the third week in a row last week, as investors grappled with rising geopolitical tensions in the Middle East.

This overshadowed positive economic data that previously fuelled expectations of an interest rate cut by the US Federal Reserve.

Fed officials commented frequently throughout the week, but their remarks had little impact on those expectations, which are now firmly entrenched.

Bond yields rose across the board and the US dollar strengthened.

Gold prices continued to climb, along with copper and iron ore.

Oil prices, however, have retraced back to pre-strike levels following the Israeli attack in Syria.

The S&P 500 Index suffered its first six-day losing streak in 18 months, and the NASDAQ took a major hit on Friday night – closing down more than 2 per cent.

The Dow Jones Industrial Average, however, managed a small gain as investors shifted their focus from technology stocks to industrial and financial sectors.

Over the course of the week, the Magnificent Seven lost a collective $950 billion.

Fedspeak

Fed officials hinted at potential interest rate cuts this year, but ongoing inflation concerns are causing some hesitation.

John Williams, president of the Federal Reserve Bank of New York, expressed confidence in the economy and said: “we will likely start bringing rates back to normal levels this year.”

However, Chairman Jerome Powell indicated inflation remains a hurdle.

“The recent data suggests it may take longer than expected” to achieve its goals, he said, adding that the Fed believed its policies were “well-positioned to handle the risks”.

Powell emphasised the Fed’s flexibility, saying it can maintain current restrictions “as long as needed” or ease them if the labour market weakens.

Ultimately, Powell concluded, the central bank would “let the data guide our decisions”.

In other Fed commentary, Fed Vice Chair Jefferson said the economy remains strong and he raised possibility of holding if inflation remains more persistent than expected.

Goolsbee noted that “progress on inflation has stalled”.

Richmond’s Barkin repeated the hawkish messaging, saying CPI data has not been supportive of a soft landing and that the Fed should be patient.

Elsewhere, Mester and Bowman also highlighted there is no rush to cut, with Bowman saying only time will tell if rates are “sufficiently restrictive.”

And Kashkari said rate cuts may need to be delayed until after 2024. Ultimately, notwithstanding the volume of the rhetoric, this week’s Fedspeak did little to move the needle on the market expectations for just two 2024 cuts, likely beginning in September.

Macro and policy

Australia and NZ

Australia’s March labour data was generally in line with expectations – not much of a retreat after the exceptionally strong February print of 118,000 and notwithstanding job ads showing some loosening.

The data remains indicative of a labour market that probably remains tighter than would have been expected a few months ago.

Total employment was down 6,600, with the decline in part-time employment more than offsetting the rise in full-time employment.

Unemployment ticked up to 3.84% but was below expectations of 3.9%, and the participation rate was down more or less in line with consensus.

Hours worked rebounded strongly over the month, up 0.9% month on month.

New Zealand’s headline CPU increased 0.6% quarter-on-quarter in Q1 2024, with the year-end rate easing down to +4.0% year on year.

The outcome was broadly in line with consensus expectations, albeit somewhat above the RBNZ’s standing forecasts from February’s Modern Policy Statement.

Compositionally, tradables inflation was somewhat softer than expected, while non-tradables inflation was somewhat firmer than expected.

Likewise, goods inflation was a bit softer than expected, while services inflation was firmer than expected.

US 

US consumer spending surprised to the upside, rising 0.7% in March.

This strength outpaced forecasts and comes with upward revisions to prior months.

Even excluding volatile items, consumer spending remained robust, climbing 1.1% vs consensus expectations of 0.4%.

Over the last few quarters, consumption has been a consistent contributor to GDP growth and there does not appear to be any sign of weakening in the near future.

This resilience can be attributed to a couple of factors, including a strong rise in real incomes and stock market strength in the first quarter of 2024.

There are some underlying signs of increasing levels of stress on the consumer, with accounts relying on minimum payments increasing past pre-pandemic levels.

Initial jobless claims met expectations and held steady at 212,000, while continuing claims remained relatively flat – suggesting the environment is still stable.

The EVRISI survey of companies in corporate America shows that the aggregate is still in “solid” business conditions.

EU

UK inflation surprised the market, with core CPI dipping slightly to 4.2% but remaining above forecasts.

Headline inflation also came in higher than expected at 3.2%, while Services inflation displayed some resilience – falling only to 6.0%.

While inflation showed some deceleration, it is still front of mind for the Bank of England.

China

There were some signs of stabilisation in China, as Q1 GDP growth beat expectations at 5.3%.

In contrast, retail sales and industrial production missed forecasts.

Despite this, fixed asset investment exceeded estimates, with strong growth in manufacturing and infrastructure.

This suggests targeted policy support is having an effect, however, continued weakness in the real estate market presents a risk.

The EU is expected to announce an investigation into Chinese medical device procurement, raising concerns over future trade relations as it could result in the bloc curtailing Chinese access to its public contracts.

In response to trade practices, President Biden proposed new 25% tariffs on certain Chinese steel and aluminium products.

He also announced an investigation into China’s shipbuilding industry and is considering reinstating tariffs on solar panels.

China’s auto industry has also undergone a dramatic shift, transforming from a net importer to a net exporter in 2023. This rapid rise has sparked anxieties in Western economies.

By facing domestic weakness, China is offloading excess car production through exports at competitive prices.

This aggressive strategy has fuelled trade tensions, with the emergence of the aforementioned tariffs as a potential response.

Australian and US housing

Australia is facing signs of a growing housing crisis.

Record migration is boosting demand, but completions are falling short.

This underbuilding, estimated at a 120,000 annual gap, has been driven by affordability issues.

We are reaching a point where developers cannot make money at current prices and buyers cannot afford more.

This lack of profitability, combined with a shortage of creditworthy contracts, is squeezing supply.

Anecdotally, companies like Mirvac have been keeping sub-contractors on credit support to ensure completions.

In the US, the housing market presents a mixed picture.

March housing starts dropped unexpectedly by 14.7%, while building permits also fell significantly below consensus.

Despite the decline, single family construction continues to trend upwards.

Conversely, apartment starts have plunged 50% from their highs, dragging down overall construction activity which is still at peak levels.

Markets

US earnings season brought some disappointment as positive surprises were below historical trends.

The S&P 500 reported weaker-than-expected earnings for Q1 2024.

The blended earnings growth rate came in at just 0.5%, far below the 3.4% anticipated at the end of the quarter.

While 74% of companies beat earnings estimates, this falls short of historical averages.

Revenue growth also missed expectations.

Some analysts pointed to the strong performance of the Magnificent Seven early in the quarter potentially inflating initial forecasts, but as more companies report, this early boost may start to fade.

In Australian markets it was a sea of red, with losses consistently seen across the market cap spectrum.

Plenty of sectors lost ground by 2% to 3%, with REITs and healthcare suffering the most.

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About Jim Taylor and Pendal Focus Australian Share Fund

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

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

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

Contact a Pendal key account manager here

It will be a bumpy last mile for inflation, but volatility provides fertile ground for opportunistic trades, argues Pendal deputy portfolio manager, insurance and rates, ANNA HONG

• Jobs data indicates a continued bumpy last mile for inflation
• Volatility provides fertile ground for opportunistic trades
• Why bonds, why now? Find out more from Pendal’s income and fixed interest team

THE jobless rate rose only slightly from 3.7% to 3.8% for March – still well below the Reserve Bank’s expectation of 4.2% by June.

Taken in isolation, the number could suggest the economy has not slowed down significantly.

But that’s not the case. The Australian economy grew at a misery 0.2% in the fourth quarter of 2023.

Employment fell by 6,600.

That’s a small reversal to February’s employment gains, but it’s significant against a backdrop of 60,000 working-age adults joining the labour market every month. More on that below.

Reading the unemployment tea leaves

With three months to go, it is unlikely unemployment will reach the RBA’s 4.2% June forecast.

Will that worry the RBA, potentially delaying local rate cuts? Not necessarily.

Firstly, the RBA is not opposed to low unemployment. High unemployment is not a stated objective.

The Reserve Bank will only be troubled by low unemployment if it feeds through to inflation via strong household consumption.

Right now real household consumption is in negative territory and card-spending data shows little sign of a bounce.

It’s unlikely inflation will catch a second wind from the demand side.

The unemployment number does not need to reach 4.2% before the RBA achieves sufficient disinflation to cut rates.

Furthermore, the headline number does not tell the full story.

Net arrivals into Australia picked up pace again in 2024, adding more labour supply.

Some 60,000 working-age adults are joining the labour market every month and hiring intentions have reduced significantly.

The labour market is loosening and will continue to moderate from here.

What does this mean for investors?

It will be a bumpy last mile for inflation as notoriously laggy indicators like unemployment generate noise.

That volatility provides fertile ground for opportunistic trades, however.

At current valuations, we believe fixed-income investors should be positioning now for lower rates later this year.

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About Anna Hong and Pendal’s Income and Fixed Interest team

Anna Hong is Deputy Portfolio Manager, Insurance and Rates, with Pendal’s Income and Fixed Interest team.

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

With the goal of building the most defensive line of funds in Australia, the team oversees some $20 billion invested across income, composite, pure alpha, global and Australian government strategies.

Find out more about Pendal’s fixed interest strategies here

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About Pendal Group

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

Pendal’s emerging markets team expects significant interest rate cuts in Mexico and Brazil, increasing their attractiveness. Pendal Global Emerging Markets Opportunities fund co-manager JAMES SYME explains

• Our EM team remains overweight in Mexico and Brazil
• Significant rate cuts expected in both countries
• Find out about Pendal Global Emerging Markets Opportunities fund

ONE of the reasons we maintained overweight positions in Mexico and Brazil was the expectation of big interest rate cuts when disinflation was achieved.

When disinflation did arrive after a strict monetary orthodoxy from their respective central banks in 2021 and 2022, rate cuts were initially slow to follow.

(Though this didn’t prevent MSCI Mexico and MSCI Brazil comfortably outperforming the MSCI EM Index over the last three years.)

With Mexico’s central bank Banxico finally cutting policy rates this month, this piece aims to review the current prospects for policies, economies and equities in the two big Latin American markets.

A broad rate-cutting cycle

Although many developed and emerging market central banks have been cautious on lowering policy interest rates, Latin America has seen a broad rate-cutting cycle that expanded this month to include Mexico.

It’s true that some Latin American central banks that were quick to cut are now turning more cautious – notably Chile and Peru.

But we believe Mexico and Brazil should both be able to deliver hundreds of basis points of cuts in policy interest rates over the next 24 months.

Mexico’s outlook

After inflation rose to 7.6%, Banxico hiked Mexico’s official overnight rate to 11.25% in March 2023. Rates remained at that level until February, pushing inflation down to 4.4%.

In March, Banxico confirmed the beginning of an easing cycle with a broadly anticipated 25-point cut to 11%.

A supporting statement suggested easing would continue through the bank’s next few meetings, which was a positive surprise for markets.

At the time of writing, the consensus holds that Mexican policy rates will decline to 9.5% this year and 7.5% by the end of 2025.

Mexican economic data has softened in recent months, due to a slow in service activity and expectations of reduce agricultural production due to drought.

But overall the Mexican economy continues to do well, supported by a strong US economy.

Mexico’s Purchasing Managers Index (PMI) – a measure of business activity – is well above 50, which indicates manufacturing is expanding.

Fourth-quarter (2023) GDP growth of 2.5% was above expectations and unemployment has declined to near record-low levels.

In addition, we can expect some stimulus ahead of Mexico’s general election, scheduled for June 2.

This economic success comes despite a very high level of real interest rates. A rate-cutting cycle should prove supportive of domestic demand growth and corporate earnings growth.

Brazil outlook

Meanwhile, the rate-setting committee of Brazil’s Banco Central do Brasil unanimously voted for a sixth cut of 50 basis points, bringing rates to 10.75%. (CPI inflation is at 4.5%). A BCB statement shortened the horizon of guidance to only a 50-point cut in May. After this, policy decisions would be data dependent.

Consensus foresees policy rates at 9% this year and 8.5% by the end of next year.

The central bank’s more cautious guidance reflects strong economic growth in the first part of this year.

PMIs look very strong, retail sales and services output have surprised to the upside, and January’s economic activity index rose 0.6%, following an increase of 0.82% in December.

As in Mexico, drought may reduce agricultural output, but not enough to drag down the broader economy.

Lower-than-expected rates

So both countries are experiencing significant rate cuts amid growing economies.

But the Pendal Global Emerging Markets Opportunities team expects a significant positive surprise in the quantum of cuts.

Our model for the interaction between emerging economics and financial markets emphasises reflexivity, where each feeds the other.

We believe the history of booms and busts in individual emerging markets is driven by a process where, generally, everything goes right at the same time, or everything goes wrong at the same time.

In Latin America that tends to mean interest rates overshoot expectations (up or down) through the cycle.

We do not expect this cycle to be any different.

We think interest rates in both Mexico and Brazil will come in much lower than consensus expectations in coming quarters.

This should bring an even more-positive boost to economies, corporate earnings and equity market returns.

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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

Consumer inflation accelerated faster expected in the US this week, while wholesale price rises were more moderate. Pendal’s head of government bonds TIM HEXT explains what it means for investors

• US inflation looks sticky at around 3%
• Bonds are nearing the buy zone
• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Browse Pendal’s fixed interest funds

THIS week’s hotter-than-expected US inflation numbers would be disappointing — but not alarming — for the US Federal Reserve. 

Late last year the Fed glimpsed core annualised quarterly inflation nearing its 2% target. That’s now given way to a pulse above 4%.

In other words, 0.2% monthly results have been replaced by 0.4% results.

Jumps in rent, car insurance and health

What’s driving this jump in US consumer inflation?

Firstly, rents have remained stubbornly high, ignoring lead indicators that suggest some relief.

Rents and “owners-equivalent rents” (an estimation of what homeowners would pay if they were renting their own home) are both growing at 0.4% a month, rather than the 0.2% suggested by the Zillow rent index.

The direction of these numbers is important, since they represent almost a third of US CPI.

We still expect moderation ahead.

Secondly, a number of services have shown unexpected price spikes.

Car insurance and hospital services jumped sharply in March. The former looks strange, but the latter reflects a surge in medical wages over the past year. Either way service prices are drifting up not down.

Finally, oil prices have shown a slow-but-steady rise since the start of the year, now up 20%.

Although this is excluded directly from core inflation, second-round impacts do matter.

Wholesale prices look better

This week we also saw data from the US producer price index, a measure of inflation at the wholesale level.

The PPI numbers showed a more positive story, reflecting ongoing moderation of price pressures in goods markets.

This is partly a commodity price story (oil aside) and also a falling margin story.

But after almost flat-lining late last year, the data is now showing a steady 0.2% pulse, again showing that disinflation is no longer the main story.

On ANZAC Day we will see new data from the Fed’s preferred inflation reading — the broader core Personal Consumption Expenditures Price Index (excluding food and energy).

(This will arrive two days after Australia’s first-quarter CPI numbers.)

We expect a number around 0.3%, the same as last month.

This means 1% for Q1, or 4% annualised — a meaningful pick up from last year.

This all suggests US inflation will be sticky around 3% for a while.

The Fed needs to see 0.2% outcomes on average before starting any meaningful easing.

US Inflation medium-term outlook

Where does all this leave the medium-term picture? 

We are not drifting back into high-inflation territory. For that we would need to see new supply shocks.

Supply chains are normal, wage growth is moderating and margins are still falling.

Even the US fiscal pulse, which remains very strong, is showing some small moderation. So patience is required — and the US Fed has plenty of that.

Economic commentators can choose from a variety of recent Fed speaker quotes to fit their own outlook.

But the one I like best is from New York Federal Reserve governor John Williams.

There was no need to adjust rates in the “very near term” Williams said on Thursday.

“I expect inflation to continue its gradual return to 2%, although there will likely be bumps along the way, as we’ve seen in some recent inflation readings.”

This would allow rate cuts later this year.

Bonds nearing the buy zone

A move higher in yields is seeing opportunities to look at duration once again.

In Australia, the US sell-off has seen our 10-year government bonds near the cash rate and semi governments once again above 5%.

While the US won’t be easing near term, the European Central Bank still looks disposed towards a June rate cut.

Inflation will be sticky above targets for some time. Our core view is inflation over the next five years will average 2.5% in the US and 3% in Australia.

However, this is not consistent with 5.5% and 4.35% cash rates medium term.

In our view, investors should position now for lower rates later this year.

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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 ELISE MCKAY. Reported by portfolio specialist Chris Adams

• WATCH NOW: Crispin Murray’s latest bi-annual Beyond The Numbers webinar
• Find out about Pendal Focus Australian Share fund

A NUMBER of new data points show the economy is holding up just fine.

Surveys of manufacturing purchasing managers are heading higher globally.  This is supportive for global growth and strength in commodities, particularly in a tighter supply environment. 

In the US, the Institute for Supply Management (ISM) manufacturing PMI index entered expansionary territory for the first time since September 2022. A similar manufacturing survey in China also delivered its highest reading in 12 months. 

Initially this manufacturing strength was taken negatively. But as we received ISM services and labour data, the market changed its tune. 

Payrolls were a big beat, but this was offset by a rise in labour force participation and moderation in wages. This points to an economy with big supply-side tailwinds, supporting the ability to grow strongly while keeping inflation in check and avoiding overheating. 

Progress on inflation should keep the US Federal Reserve on track to cut rates this year, though good economic data may limit the pace of the cutting cycle. This scenario remains positive for equities.

There seems to be differing opinions emerging at the Fed, with a lack of consensus on whether the strength of the economy being supply or demand driven. Recent data suggests the former.

Consensus has historically been important. There have been very few dissenting votes during Powell’s tenure.

The market is now pricing a 53% probability for a June cut. The total of implied expected cuts for 2024 has fallen to 67bps.

This week we will see US CPI data, minutes from the rate-setting Federal Open Market Committee (FOMC), European Central Bank (ECB) policy decisions and the start of US first-quarter earnings season.

The ECB is expected to start rate easing cycle in June rather than this month.  

The S&P 500 fell 0.93% last week while the S&P/ASX 300 was down 1.55%.

US economics and policy

Fed speak

Since Fed chair Jay Powell’s last dovish speech on March 20 we’ve heard differing opinions in comments from several FOMC members. 

There are three key areas of focus:

1. A lack of consensus on whether (disinflationary) supply or (inflationary) demand are driving economic strength. 
2. Differing views on how to balance the dual mandate of maximising employment and keeping inflation stable. The question is whether the Fed should accept a longer path back to 2 per cent inflation to ensure a soft landing.
3. Timing risk: If the Fed can’t justify cutting rates in June, it may have to wait until March 2023 — after the US presidential election.

Does a decision to cut rates need to be unanimous?  No, but reaching a consensus is desirable and Fed has a track record of bridging the gap between those who want to move versus those who prefer to wait. 

In 2015 when moving off zero rates, the Fed managed to reach consensus when its promise of “gradualism” was enough to get all members on board.

US payroll data

March non-farm payrolls beat expectations by a huge margin, rising 303k versus 214k expected. The three-month average gain of 276k / month is the highest level since March 2023. 

However, a rapid rise in US immigration has reduced the effectiveness of non-farm payroll growth as a historical indicator, with an estimated 200k / month increase in labour supply versus a historical growth rate of 100k / month.

It’s more relevant to look at other measures to determine whether the labour market is tightening or not. 

On such measures, the unemployment rate down 3bps to 3.83% and average hourly earnings (AHE) were largely in-line with expectations. 

The unemployment rate benefited from a 498k surge in the number of employed people. The labour force participation rate increased to 62.7% with prime age sitting at 83.4%. 

AHE increased 0.3% month-on-month and 4.1% year-on-year, continuing its downwards trend. Though it is still running ahead of the 3.5% rate estimated to be compatible with the Fed’s 2% inflation target. 

US manufacturing health

The ISM services index — a survey that gauges how busy factories are and how confident purchasing managers are about the future — fell to 51.4 in March. That was below expectations of 52.8 and down from 52.6 last month.

Typically a score of above 50 indicates manufacturing is expanding and the economy might be growing, while scores below 50 suggest a slowdown, with fewer orders and production.

About three quarters of the decline came from lower supplier delivery times. Business activity improved slightly from 57.2 to 57.4 — its highest level in six months. 

Importantly, we did see “prices paid” drop to a four-year low of 53.4 (down from 58.6) suggesting upward pressure on prices from labour cost is easing further. 

This has also been a good lead indicator for underlying core personal spending (excluding housing), suggesting a return to pre-Covid inflation levels are on the way.

Bond yields

Bonds moved 19bps higher last week off the back of strong payrolls. They are up 52bps in 2024.

This move has been driven almost exclusively by better growth expectations in 2024. 

US prices back on track

The Fed’s preferred read on inflation is the Personal Consumption Expenditures index, which tracks the prices Americans pay for everything from groceries and petrol to rent and haircuts.

The latest data was released on Good Friday.

Core PCE (which excludes volatile measures such as food and energy prices) rose by 0.26% in February — which was in line with consensus expectations of 0.3%, and up 2.8% year-on-year. 

January data was revised up from +0.42% to +0.45%, driven by medical services inflation from the Producer Price Index, which tracks business costs.

This brings annualised inflation for the last 3 months to 3.52%. 

Core goods inflation accelerated 0.31% after three consecutive negative prints, primarily driven by a jump in prices for video and IT equipment. 

Core services (excluding rent) increased 0.18%, but three-month annualised is now tracking at 3.7% due to the big January print.   

US consumer spending

Personal income grew 0.3% in February — slightly weaker than expected. 

Consumer spending rose 0.8% (versus consensus of +0.5%) in February, with much stronger services consumption (+0.9% in February and +1% in January).

Airfares, recreational services (such as gambling) and financial services were the biggest drivers of services spending. In contrast, goods consumption only increased 0.5%.

US economic growth

The Atlanta GDPnow index monitors a range of economic data such as manufacturing figures, consumer spending and trade numbers, to create a real-time estimate of GDP growth.

The latest data from the Federal Reserve Bank of Atlanta estimates US GDP growth is tracking towards 2.5% for the first quarter of 2024 (at April 4).  

Meanwhile the Evercore ISI Trucking survey has improved to the highest level since October 2022 and is showing signs of stabilisation, although still depressed levels by historical standard. There is usually good correlation between trucking survey and US real GDP growth.

Destocking of inventories by retailers appears mostly in the rear-view mirror although, there are not signs of significant restocking activity either.

Surveys of US companies by researcher Evercore ISI are now back in the “solid” 50-55 range on a 100-point scale, having rebounded from the “struggling” 45-50 band.

Global growth

Inflation is coming down in most economies around the world.

Eurozone inflation, having peaked at 10.6%, is now back to 2.4% and within its “normal” historical range.

As mentioned above, surveys of purchasing managers (PMIs) have been heading higher, which is supportive for global growth and strength in commodities, particularly when combined with a tighter supply environment. 

• In the US, the ISM manufacturing index was 50.3 for March 2024 (versus consensus of 48.3) and was in expansionary territory the first time in since September 2022.
• China’s NBS manufacturing PMI picked up to 50.8 in March 2024 from 49.1 in February, the highest reading in 12 months and ahead of consensus.  This was well received by the market with the Hang Seng Index rallying 3%. 

Historically, copper is the biggest metal beneficiary of re-accelerating global manufacturing PMIs, with an average 25% move over the 12 months following a PMI trough, slightly ahead of zinc and nickel. 

Unemployment rates in most major economies have also remained low and in check, with some signs they are beginning to rise.

Australia

Inflation data for February came in below expectations, moderating to 3.4% (consensus at 3.5%) and unchanged from January. This is the equal slowest since November 2021. 

Goods inflation eased to 2.9% year-on-year (from 3.1%) but services lifted to 4.2% (from 3.7%). 

Markets

It was a generally soft week for markets with bright spots among some commodities such as oil, copper and gold. 

Consumer discretionary (-2.8%) was one of the worst-performing sectors in the US. Trading updates caused concern despite strength in recent consumer spending and labour-market data.

Investors are concerned that recent management commentary from consumer-facing companies suggests some signs of weakness.

Luxury goods house Ermenegildo Zegna was down 15% on Friday as they guided first-quarter revenues lower.

Costco missed consensus US sales estimates for February. Lulu Lemon, Nike and Ulta have all recently issued disappointing forward guidance.

Last month, McDonalds called out a “challenging consumer environment” while Darden Restaurants recently missed on revenues.  

Oil was up 4% last week and over 18% for the year, after an Israeli strike escalated worries of a broader Iran-Israel war. This is feeding into gasoline futures which are up 80c this year — not helpful for inflation.

Global supply of public equities is getting smaller, with a net decline of $120 billion so far this year, compared with a total net decline of $40 billion in 2023.

The number of listed companies in the US has fallen from >7k in 2000 to <4k today. 

US earnings season is due to start next week and expectations are set for a bullish 2024.

Consensus expects 3% year-on-year EPS growth for the aggregate S&P 500 index, a deceleration from the 8% growth posted in 4Q23 earnings season.

This quarter’s expected growth rate is the highest pre-season bar set by consensus since Q2 2022.

Notably, aggregate results have exceeded pre-season EPS growth estimates in each of the previous four quarters by an average of 4%.

Bottom-up consensus expects the S&P 500 will post 10.9% net margins in Q1, a 28bps quarter-on-quarter contraction but a 2bps year-on-year expansion.

Energy, materials, and health care are expected to post year-on-year margin contractions >100bps.

The 10 S&P 500 stocks with the largest market caps are expected to expand margins by nearly 400bps year-on-year while the remaining 490 firms in the index will see margins fall by 57bps.

Looking back at Q1 2024 performance, areas like AI, copper and obesity drugs all performed well and are expected to continue to be focus areas for the remainder of the year.

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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

The RBA looks set to re-build our financial system’s plumbing. Pendal’s head of government bond strategies, TIM HEXT, explains what it could mean for investors

• The RBA has announced the “Ample Reserves” system
• It will set a price for Open Market Operations and offer unlimited quantity 
• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Browse Pendal’s fixed interest funds

THE plumbing of Australia’s financial system is a bit like the plumbing in your house – of little interest until something goes wrong.

For those few who do take an interest in the RBA and our financial system’s plumbing, the Assistant Governor Chris Kent gave a speech on Tuesday: “The Future of Monetary Policy Implementation”.

By the end of this year, he explained, Australia will have a new system called “Ample Reserves”.

In short, the central bank will set a price for “Open Market Operations” (repos) and offer unlimited quantity – instead of setting the quantity and letting the market determine the price, as was the previous system.

Banks have been flush (so to speak) with liquidity since early 2020, courtesy of RBA quantitative easing and the term funding facility over the pandemic.

These are now slowly rolling off, reducing excess reserves in the system.

The RBA is worried that the pre-pandemic “corridor and low reserve” system may not work so well.

That system relied on the RBA accurately forecasting government inflows and outflows into the system (think taxes and welfare payments) and offsetting them by adding or draining the cash back into the system through repos and reverse repos.

READ NEXT: Private credit has its place in portfolios. So do bonds. In her latest article, Pendal head of income strategies Amy Xie Patrick explains why, as rates normalise, investors should remember that those roles are different. 

You lend them securities and they give you cash that you then pay interest on or vice versa.

The corridor meant banks could always borrow or lend unlimited funds with the RBA at 0.25% above or below target cash, but hardly ever did.

With Ample Reserves, banks can go to the RBA and offer unlimited securities to repo in return for cash (OMOs) at a pre-set margin to the official cash rate.

The price and frequency of these operations are yet to be determined but look like at least weekly and something like the target cash rate plus five basis points (currently 4.40%).

The RBA will release more details later in the year after market consultations.

So, what does this mean for investors?

The good news for leveraged portfolios is that there is now an “ample” supply of central bank liquidity at a reasonable price.

For investors, the good news is that overnight cash should eventually drift back towards target cash levels rather than sit at the ES level.

This would mean closer to 4.35% than 4.25% at current cash targets.

The bad news for investors, however, is that bank bills are less likely to drift too far above cash again.

Also, for relative value funds, government bond baskets (where bonds trade to futures) are less likely to get too cheap again.

Overall, it is a new era for the RBA.

It is not only temporarily moving out of the asbestos-ridden 65 Martin Place while expensive and long overdue renovations are undertaken, but it now has a new way of ensuring system liquidity is always rock solid.

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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

Pendal assistant portfolio manager ANNA HONG unpacks the latest monthly CPI data and highlights some of the key takeaways for investors

• The last mile will not be a smooth run
• There remains optimism that inflation will fall closer to 3% by mid-year
• Why bonds, why now? Find out more from Pendal’s income and fixed interest team

AUSTRALIAN monthly CPI of 3.4% year-on-year (YoY) came in a touch lower than market consensus.

Meanwhile, trimmed mean CPI (with the top and bottom 15% cut off) came in at 3.9%.

Though the monthly CPI shows clear signs of disinflation, it appears that the last mile will not be a smooth run.

The Reserve Bank of Australia references the quarterly CPI measure in its decision-making, and February’s numbers update the quarterly CPI basket.

We expect headline and underlying inflation, released in late April, to be around 0.8% for Q1.

It is evident that the rate hikes have taken a toll on the Australian consumer, with real consumption in negative territory.

Goods inflation is back below 2%, while services remains sticky – above 5%.

The table below highlights improvements over the past six months along with the need for further falls.

We have also had important updates in a few key service areas this month.

Housing

Rents remain elevated at 7.6% (YoY), which is not a surprise given the apartment supply challenges driven, in part, by the current immigration wave.

Adding to this is the 4.9% (YoY) increase in new dwelling prices (the cost of building) in February.

Builders have been able to pass higher labour and material costs onto homeowners.

Education

Education prices are measured only once a year (in February) and represent 4.4% of the CPI basket.

Education prices rose 5.9% (YoY) over February, with the main contributor being primary and secondary schools passing on the high wage rises for teachers announced in late 2023.

Teachers’ wages will show more moderate growth in 2024, however, so next year’s number should be lower.

Looking ahead, tertiary education inflation remains high, as lags in indexation came through this February.

Health

The news on the health front (which is 6.2% of the CPI basket) was better than education.

Health fund rises approved for April (also measured once a year in the CPI) were set at an average of 3.1%.

The RBA needs services inflation at or below 4% before it will be comfortable with inflation.

What does this mean for investors?

It was unlikely that the RBA was going to cut in the first half of 2024 – these numbers and the slowing of the disinflation impulse all back this up.

However, there remains optimism that inflation will fall closer to 3% by mid-year, which would allow rate cuts from August.

In the meantime, movements from the US Federal Reserve in between will also play a role in the last mile.

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About Anna Hong and Pendal’s Income and Fixed Interest team

Anna Hong is an assistant portfolio manager with Pendal’s Income and Fixed Interest team.

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

With the goal of building the most defensive line of funds in Australia, the team oversees some $20 billion invested across income, composite, pure alpha, global and Australian government strategies.

Find out more about Pendal’s fixed interest strategies here

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About Pendal Group

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