Markets are pricing in a soft landing, but in a new Bloomberg webinar, Pendal’s head of income strategies AMY XIE PATRICK argues a US recession is not off the table

• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Browse Pendal’s fixed interest funds
• Watch the full Bloomberg 2024 Market Outlook webinar featuring Amy Xie Patrick

THIS week I was asked about my highest conviction call for 2024 in a Bloomberg webinar discussing key market views for the coming year.

While markets are pricing in a soft landing, I argued there would likely be a US recession in 2024.

A lag in the impact of policy tightening has been evident in the slowdown of inflation and wages in recent months.

This can be seen particularly in shifting trends in the labour market.

The most obvious signal is a falling “quits rate”, signalling workers are becoming less confident about alternative job prospects.

In my view, lagged effects will continue to appear in the data next year — and as we all know from history, recessions happen slowly, then suddenly.

We will likely find a moment in the second half of next year where markets realise disinflation is no longer immaculate — and is being caused by recessionary forces.

A non-consensus view

When asked about my most non-consensus view, I can’t resist pointing out clear signals that the Fed’s Senior Loan Officer survey has been sending.

This survey asks US loan officers if they are tightening or loosening lending standards.

The data points to US default rates likely hitting double digits by the second half of 2024.

Unlike the interest rate charged on borrowings, lending standards refer to the criteria and restrictions placed on borrowers seeking finance.

The tighter those standards, the harder it is for marginal borrowers to access funding.

When small businesses can no longer access funding for every-day business needs, bankruptcies and defaults start to happen.

Rising default rates are already evident, yet high-yield credit spreads are still glued to the floor.

Even if my default rate outlook is overly pessimistic, the risk-reward doesn’t seem to be there for continuing to stretch down the quality ladder for that extra bit of yield.

Especially not when considering two-year US government bonds are now yielding almost 5%.

Listen to the full Bloomberg webinar featuring Amy Xie Patrick

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

• Find out about Pendal Focus Australian Share fund

IT WAS a Thanksgiving feast for the bulls in the US last week, with the S&P 500 up 1% (and 8.9% month-to-date) following the latest CPI print.  

A combination of factors — dovish minutes from the US Fed, seasonality, rampant “big tech”, and systematic investors (like commodity trading advisers) being underweight equities — all pushed the market to one of its strongest-ever Novembers. The week closed out near year-to-date highs.  

While higher-than-expected consumer inflation expectations provided a small note of caution, expectations remain high that the Fed is done hiking rates and will cut by mid-2024. 

Unfortunately, the same can’t be said of Australia, with the ASX falling 0.1% last week.  

If it’s “job done” for the Fed, it’s clearly not for the RBA – with comments from Governor Michelle Bullock underscoring a gulf in inflation and interest rate outlooks between Australia and the US.   

US treasuries were little changed given the Thanksgiving public holiday.  

The yield curve did push further into inverted territory, though it has been there for some time (and just how reliable this is as an increased indicator for a recession remains open to debate).  

The Fed and US rates

The implied probability of a Fed rate cut by mid-2024 has risen 15 percentage points over November and is now sitting above 60%. 

Central bank minutes published during the week provided little new information but were generally viewed as slightly dovish, given united caution on further rate hikes.  

There was a 50-basis point reduction in forecast headline PCE inflation to 3% by year end (with the core PCE forecast at 3.5%). 

By 2026, core and headline inflation rates are expected to be close to 2%. Officials also noted credit standards tightening in many sectors and some concern over rising consumer loan delinquencies.  

US economy

Most US data continues to support a dovish Fed outlook.  

For example, durable goods orders were down 5.4% in October – mostly on softer aircraft orders. Excluding aircraft, orders for non-defence capital goods still fell 0.1% and September’s order growth was revised to a decline.  

The outlier was the University of Michigan inflation expectations survey, where median year-ahead inflation expectations rose to 4.5% – the highest since April. Long-term expectations rose to a 12-year high of just above 3%. 

Where to for the US?

It’s clearly been a positive November for global equities and momentum suggests the rally has further room to run.  

Amid declining core inflation and rising rate cut expectations, US markets appear well supported, particularly as data continues to point to a mild slowdown rather than a recession.  

The Conference Board Leading Indicators index is a case in point. It is now showing signs of a possible bottom.  

Historically, this has occurred at a median of 61 days before the end of every recession since the 1969-70 downturn, with stocks gaining a median 23.4% in the year following a trough. 

Initial signs from Black Friday sales were also positive.  

Expectations heading into the traditional start of the holiday shopping period were relatively muted, with the first three weeks of November essentially flat year-on-year.  

However, Adobe Analytics estimated that Black Friday sales were up 7.5% year-on-year, while Salesforce estimated that spending in the US and across Australia and New Zealand was up 9% and 5%, respectively.  

Finally, S&P earnings expectations also continue to be revised higher, having bottomed in Q1 and Q2.  

It can be helpful to also remember that 2024 is an election year, which has historically tended to be positive for equity markets. An average annual return of 10.2% dates back to Roosevelt’s win in 1932. 

So, what could go wrong?

1. Possibility of recession: The current 7.6% fall on the Leading Indicators index would be the largest ever year-on-year decline without a recession. The yield curve remains inverted and the economy is slowing, with data for inputs like durable goods showing meaningful declines. If inflation expectations are correct, rates could stay higher for longer and risk more significantly lagging effects. We note that if the Fed cuts because of a recession, the equity outlook will be very different.  
   
2. Seasonality: This factor is undeniably less supportive in the near term. December, February and March have been softer for the S&P 500 over the past few years. 
   
3. Positioning is no longer as supportive. November has seen a shift in underweight equity positions. Commodity trading advisers have reduced 80% of their shorts in global equities in the past two weeks, buying $60-70 billion worth of shares. The pace of purchases is now expected to slow, though there is still potentially $30-40 billion to buy over the next fortnight. The S&P is also technically overbought (RSI >70). Over the past 12 months, the S&P 500 ETF has crossed this level six times and then, on average, fallen 1% in the following 20 days. Finally, measures of options pricing suggest that demand for downside and tail risk hedging have fallen materially.  

The RBA and Australian rates

In contrast to the US, expectations for a February rate hike in Australia have nearly doubled since its last meeting.  

Governor Bullock’s speech was interpreted as laying down hawkish credentials, arguing that the inflation problem facing Australia is largely domestically driven – not the global problem that many have believed.  

As such, we are arguably not on the same path as others.   

Inflation is seen as broad-based, with 66% of the CPI basket running at greater than 3%. It is only lower than average for a few items, such as fresh food and holiday travel.  

More generally, services demand is continuing to exceed supply, and with limited labour market spare capacity, inflation is expected to take longer to come back down to target.  

We note that the next CPI print is Wednesday, with consensus expecting a 5.2% annualised increase versus 5.6% in the last reading.   

It is also worth noting the impact of rent. According to SQM (a residential property research group), rental inflation is set to grow 7-10% in 2024, down from 15.5% in the year to mid-November but still at high levels.  

Eurozone

Inflation data due on Thursday is expected to show CPI dropping to 2.7%, which is the lowest since July 2021. However, officials have cautioned that it may pick up again in the short term due to statistical effects. 

According to European Central Bank President Christine Lagarde, rates are at a level that will help bring inflation back to the 2% target if maintained for long enough. That target is expected to be hit in 2H 2025.  

However, the economy is already showing stress, with GDP down 0.1% in Q3. Data on PPI during the week also showed a contraction to 47.1 – the sixth consecutive month below 50.   European bonds also slid on concerns of higher supply, with Germany announcing the suspension of its constitutional limit on net new borrowing for a fourth consecutive year.                          

China

Over the past few months, there has been a renewed focus by authorities on growth, with a range of measures announced to support construction in China.  

Last week, it was revealed that authorities would allow Chinese banks to offer unsecured short-term loans to qualified developers for the first time – a major push to ease the property crisis.  

The previous funding shortfall has been estimated at US$446 billion.  

Time will tell whether this latest measure is sufficient to turn the tide when previous efforts have failed. But over the short term, the impact has been positive for developer shares and bonds, as well as iron ore.    

Commodities wrap

Iron ore: The lack of material Chinese steel production curbs this half – on contrast to previous years – have seen demand remain strong. Coupled with inventories, which are at a five-year low for this season, prices have been driven up 6.4% month-to-date. With further regulatory moves to boost the property sector and strong seasonality ahead of Chinese New Year, our view is that demand and pricing will remain well supported into early next year.  

Oil: It was a quieter week for oil, which remains 7.8% lower month-to-date. Uncertainty continues to cloud the upcoming OPEC+ meeting, which has been delayed until 30 November while US stockpiles continue to grow.  

Lithium: Prices continue to decline on weak demand and rising inventories, with the latter now accruing more at upstream producers rather than at converters and battery manufacturers. Chinese carbonate futures are down 37% over three months to 125,000 RMB/t, but they remain above marginal cost at about 80,000 RMB/t. Given the ongoing inventory build and that we’re heading into a typically weaker period for demand, there remains a high risk that prices continue to decline unless, or until, we see production or project curtailments.   

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About Jack Gabb and Pendal Focus Australian Share Fund

Jack is an investment analyst with Pendal’s Australian equities team. He has more than 14 years of industry experience across European, Canadian and Australian markets.

Prior to joining Pendal, Jack worked at Bank of America Merrill Lynch where he co-led the firm’s research coverage of Australian mining companies.

Pendal’s Focus Australian Share Fund has an 18-year track record across varying market conditions. It features our highest conviction ideas and drives alpha from stock insight over style or thematic exposures.

The fund is led by Pendal’s head of equities, Crispin Murray. Crispin has more than 27 years of investment experience and leads one of the largest equities teams in Australia.

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

In 2023, Pendal became part of Perpetual Limited (ASX:PPT), bringing together two of Australia’s most respected active asset management brands.

Find out more about Pendal Focus Australian Share Fund  

Contact a Pendal key account manager

 

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Emerging markets investors should take a close look at United Arab Emirates right now. Senior fund manager JAMES SYME explains why

• UAE has made a powerful post-Covid recovery
• Significance of structural reforms ‘underestimated’
• Find out about Pendal Global Emerging Markets Opportunities fund

FOR YEARS, the United Arab Emirates was the building site of the Middle East.

Originally largely desert, the cranes took over a few decades ago – and today the UAE boasts some of the most exciting architecture in the world.

Sophisticated transport networks and sprawling shopping malls put the country firmly on the tourist map — though it’s taken a little longer to win over investors.

A recent boom — following a series of economic reforms and a powerful recovery in oil production — has caught the attention of emerging market investors.

Now, the UAE looks almost as bright and shiny as the Burj Khalifa after dark.  

The return of oil and tourists

The UAE was hit badly by Covid, reporting with the most confirmed cases compared to its neighbouring Arabian gulf states.

Transportation revenues fell and aviation plummeted, leading to a variety of issues including a tumble in the profitability of real estate and a rise in unemployment.

The Covid travel ban – which stopped flights into and out of the UAE — prompted an 83% drop in visitors compared to pre-Covid.

But the country has made a powerful recovery and tourists are back.

In 2022 the UAE welcomed some 14.4 million overnight visitors, a 97% increase from 2021. The numbers so far for 2023 are also extremely encouraging.

Dubai and Abu Dhabi revised some tax policies, including those related to alcohol, in a successful effort to boost tourism for business and leisure. 

There’s also been a full recovery in oil production, which took a significant tumble during Covid.

The country has the seventh-biggest oil and natural gas reserves globally, equivalent to 97.8 billion barrels per year or about 30% of its GDP.

Covid caused huge delays in production and output fell below expectations, taking a toll on the economy.

But supportive government policies and increasing investment have boosted the industry which now expects compound annualised growth of 8.4% in daily barrel numbers over the next five years

Structural changes for good

But it’s the structural changes implemented by the president, Abu Dhabi’s Sheikh Mohamed bin Zayed Al Nahyan, that have lent the region the greatest support.

Although this Sheikh does not operate a democracy, he is leading with sensitivity to the needs of his citizens – and in a way that’s supportive of growth. 

His many reforms include the creation of a new visa category for non-nationals which allows longer residency of up to 10 years.

Abu Dhabi has also introduced a freehold law which allows foreign investors to buy property (previously restricted to UAE and Gulf Cooperation Council nationals).

These changes mean foreign nationals can now live and work in the country for a decade and buy property there, rather than just moving transiently through.

This is really helping support the movement of foreign nationals into the region. 

Other successful reforms have targeted the development of Abu Dhabi and Dubai as financial centres. In 2022 the region hosted roughly a quarter of all global IPO volume.

This boost has driven a rise in financial services firms opening local offices, which has firmly put it on the industry’s map.

Geography helps too. The UAE is in a similar time zone to London, with a working day that overlaps with Asia and the US.

Strong travel and transport links seal the deal.

Overweight UAE

In the Pendal Global Emerging Markets Opportunities strategy, we follow a top-down, country-level approach.

We believe analysis of the asset class should always start at a national level.

After taking a thorough look at the UAE’s recovering tourism, trade and oil sectors in the context of the Sheikh’s deep structural reforms, we moved our position to overweight.

Our strategy is now exposed to domestic sectors in retail, commercial and residential real estate, and the commodity side of the economy in Dubai and Abu Dhabi. 

Despite all the bright lights, we think the region has perhaps previously flown under the radar, and the significance of the structural reforms has been underestimated.

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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

Here are the latest insights on the fixed interest landscape from Pendal’s head of government bond strategies TIM HEXT

• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Browse Pendal’s fixed interest funds

EACH quarter the Reserve Bank releases its economic forecasts as part of a monetary policy statement.

Most investors are happy to see a few headlines and take the rest as given.

For bond investors, though, these forecasts are very important.

They tell us what the RBA expects – and sets parameters for what might trigger a rate move over the next quarter.

In May, inflation was forecast to finish the year at 4.5%. 

In August this was revised to 3.9%. Now it is back at 4.5%.

Why the revision in August? Well, the Q2 CPI had just come out at 0.8%, helped by falling oil prices.

Prices then turned around in Q3, pushing inflation up to 1.2%. 

We could smooth it out and call it 1% on average – but the RBA is currently in the business of fine tuning, and keen to regain its damaged inflation credentials.  

So up goes the forecast and up go cash rates.

Rates outlook

For what it’s worth, we see Q4 inflation at around 0.7% to 0.8%, meaning inflation will end the year at 4.2%, rather than 4.5%. 

If we are right, then the rate hike was not needed.

More importantly, this makes the chance of a February hike very low.

Beyond February, inflation should remain sticky around 0.8% to 0.9% a quarter, meaning rate cuts are off the table for most of 2024.

By the middle of next year, US rate cuts may well be on the table, helping bonds find more support.

The RBA expects inflation to hit 3.6% by mid-2024, a forecast we roughly agree with.

That’s still above their preferred 2-3% band, but would reclassify inflation as “high to uncomfortably high” – though manageable. (We don’t expect the RBA to be quite so explicit, however).

The next few months will reveal what kind of damage this pre-Christmas hike has had on the economy.

As always, we will be watching leading indicators and leaning heavily on our equities team to get an insight into retailers this Christmas.

For now though, our models and our macro outlook are bond friendly.

Yields, despite their comeback this month, remain attractive on a medium-term basis.

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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

• Find out about Pendal Focus Australian Share Fund

DATA on the macro front continues to support the soft-landing (or “goldilocks”) scenario.  

Inflation data came in lower than expected in the US and UK last week. 

The US print was accompanied by stronger-than-expected retail sales, emphasising there are no signs of a slowdown in US growth just yet.  

The Atlanta Fed GDPNow model is estimating fourth quarter (Q4) GDP growth of 2%, which is above the consensus expectations of less than 1%.   

This suggests the Fed hiking cycle is now well and truly done. Risk is now to the downside (ie rate cuts) should we see any real signs of a growth slowdown.   

This is consistent with the bull case for markets we outlined last Monday (and drove a “risk-on” rally in equities last week). The S&P 500 rose 2.31%, the NASDAQ lifted 2.42%, while the S&P/ASX 300 was up 1.35%. 

Bonds were also quick to adjust, with US 10-year yields dropping 22 basis points (bps). The market moved to price in more rate hikes, with a 78% chance of a cut by May and four cuts priced in for 2024.     

In Australia we had some meaningful economic data, with wages accelerating to above 4% year-on-year (in line with expectations), a 55,000 rise in employment, and a 0.2% increase in the unemployment rate to 3.7%.   

While this suggests a resilient labour force, some leading signs suggest pockets of weakness are emerging – for instance, an increasing share of part-time work, number of hours worked stalling and youth unemployment increasing to 9.2%.  

US economics and policy

CPI inflation 

Headline CPI came in higher at 0.045% month-on-month for October, which was below consensus expectations of 0.1% growth. Core CPI rose 0.227% on the month.   

On an annual basis, headline inflation declined to 3.2% while core CPI declined to 4%.   

This positive outcome was due partly to a 2.5% decline in energy prices, with softer demand and increased supply contributing to a 4.9% decline in energy goods (largely gasoline).  

This decline is likely to continue into November, with retail petrol prices continuing to fall through the first few weeks of the month.   

However, there was some offset from an acceleration in food prices to 0.3% in October – up from a three-month average of 0.2% monthly – which was driven by an uptick in the “food at home” category.   

For core CPI, there was a 0.3% increase in core services inflation and a 0.1% decrease in core goods inflation.  

Pleasingly, core services inflation decelerated to the second lowest print in CY23. This was the result of shelter inflation cooling from 0.6% in September to 0.3% in October, with owners’ equivalent rent declining from 0.6% to 0.4%.   

While core CPI is running at 4% year-on-year, core inflation (excluding rents) is now back to 2% – down from 8% at the peak in February 2022.   

This is supportive for the core personal consumption expenditure (PCE) numbers (the Fed’s preferred inflation measure), which have less weighting to rent inflation.   

Rents should also continue to come down in line with the forward-looking Zillow rent numbers.   

Much of the downward pressure on core CPI inflation (excluding rents) has been driven by the ongoing decline in used vehicle prices, which fell a further 7.1% year-on-year in October. These lag auction prices, which are generally supporting further downside pressure.   

PPI inflation 

PPI data was also lower than expected. Core PPI (excluding food, energy and trade services) was 0.14% month-on-month in October, versus the 0.2% consensus and is running at 2.9% year-on-year.   

Headline PPI was also depressed by energy prices (down 7.4%, driven by gasoline and lower electricity prices), coming in significantly lower than expected at -0.5% month-on-month versus consensus growth of 0.1% and down from 0.4% in September.   

Combined with the CPI data, this suggests that core PCE continues to soften for October. This report is due on 30 November.  

Retail sales 

October retail sales were stronger than expected, but confirmed a slowdown in consumption into Q4.   

Headline sales were down 0.1% month-on-month versus the consensus expectation of a 0.3% decline, and down from 0.9% in September. Most categories (8/13) were negative.  

It’s likely there will be a more sustained step-down in consumer spending in Q4, driven by softer consumption (the student loan moratorium ended in October), labour markets softening, and tighter credit conditions weighing on consumer spending.  

Australian economics and policy

Australian wage growth accelerated to 4% year-on-year, which was in line with expectations. 

There was a 55,000-person rise in employment and a small 0.2% increase in the unemployment rate to 3.7%.   

This suggests labour-force resilience, though there are softer pockets emerging, such as an increased share of part-time work, hours worked stalling and the youth unemployment rate increasing to 9.2%.   

Wages 

Wages accelerated by a record 1.3% in September, lifting annual growth to 4% (from 3.6% in Q2).  

But this was as expected given the 5.8% increase in award wages (accounting for some 20-25% of employees) and a lift in EBA wages growth.   

However, wages growth under individual agreements was up only 0.01%, which is encouraging given this is the sector most sensitive to underlying labour market conditions.   

Looking forward, third-party data is providing a mixed read on non-award/EBA wages growth.   

The slower individual agreements data is supported by Xero’s Small Business Insights, which show wages rose only 1.9% year-on-year in September and are growing below the pre-COVID average of 3%.   

However, Seek data supports current strength while EBA data suggests stabilisation around 4%.   

Employment data 

Of the 55,000 new jobs, 38,000 were part-time – contributing to a mix shift, with 31% of employment now part-time. As a result, hours worked grew only 1.7% year-on-year versus employment figures up 3%.   

A slow-down in hours worked can be a leading indicator, as companies may find it easier to reduce hours rather than lay-off their employees.   

The youth unemployment rate also lifted materially to 9.2%, which is the highest rate since December 2021 and a good indicator of the strength of the overall market given the low-skilled and young tend to fare the worst when conditions get tough.   

Labour market outcomes should ease in the near term with surging migration contributing to strong population growth (roughly 3% year-on-year in the working age population) and softer labour demand. 

UK economics and policy

Both UK retail sales and inflation came in below consensus.  

Retail sales fell 2.7% year-on-year, with October sales down 0.3% month-on-month versus consensus expectations of a 0.3% increase. 

October’s headline CPI came in lower than expected, down from 6.7% year-on-year to 4.6%, and core CPI decelerated to 5.7%.  

While most of the decline in core inflation has stemmed from goods (driven by lower energy prices and easing supply chain bottlenecks), services inflation has also started to decelerate, albeit from a much higher level. 

Services inflation is closely tied to wages growth, which has remained strong at about 7% year-on-year, but there are signs that this is cooling.   

Private sector regular pay decelerated from 8.1% year-on-year in August to 7.8% in September (below the Bank of England’s forecast), while a number of other metrics show data consistent with the moderation story.   

The UK rates market has moved quickly to price earlier cuts, reflecting this data. Bond yields have declined as well, with the two-year down 46bps and the five-year down 58bps from the recent October peak.

Markets

We note that demand for US government debt from foreign buyers is decreasing, with foreigners now owning an estimated 30% of all outstanding US Treasury securities, down from 43% a decade ago.   

The US Treasury has shifted to issuing more shorter-dated debt in response. This has helped restore market stability but is resulting in material changes in supply and demand dynamics.   

As flagged last week, positioning by systematic strategies going into November was very underweight equities, particularly CTAs, which had the lowest exposure since 2018.   

Over the last ten days, CTAs have bought nearly $70 billion in US equities – the largest ten-day buying volume that Goldman Sachs has on record. 

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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

With moderating inflation as the trend of the year, investors can be more assured in their bond allocation, argues Pendal assistant PM ANNA HONG  

• Why bonds, why now? Find out more from Pendal’s income and fixed interest team

MODERATING inflation is the trend of the year. 

Across the globe, economies are seeing inflation come down as the resumption of supply chains eased price pressure on goods. 

Central banks have taken the fight to services inflation — which has held on even as goods inflation eased. 

In 2023, markets whipsawed on inflation and unemployment data releases, as investors try to pick the end of the rate-hiking cycle. 

The latest US Consumer Price Index data came in much weaker than expected on Wednesday, sparking a Wall Street rally. 

The US CPI increased 3.2% in the year to October — down from 3.7% annualised in September.

We can now see the light at the end of the tunnel. 

US inflation cools 

US inflation for October came in at a cool 3.2% year-on-year.  

On a monthly basis, October was flat — the slowest since July 2022 — with core services handing out the biggest downside surprise.  

Markets welcomed the news that this time around the inflation slowdown is much more broad-based, rather than just a goods-fuelled moderation.  

With the US Federal Reserve’s July rate hike still working its way through the economy in the months ahead, markets swiftly took out most of the pricing for any future US rate hikes. 

Investors now seem convinced that the last rate hike by US Fed is behind us. 

The story back home 

Back here in Australia, the picture does not look quite the same.  

The most recent CPI (Q3, 2023) surprised to the upside instead, printing at 5.4% year-on-year. 

Australia economic strength was confirmed with business conditions continuing to improve in the latest NAB business survey. 

Headline capacity utilisation moderated to 84% but remains well above long-run average. Price pressure eased on business inputs but remains elevated at 1%. 

We are probably six months behind the US. 

US CPI last had a five-handle on it back in March. 

Australian capacity utilisation remains stubborn at 84% while the US has dropped below 80%. 

The US Fed has been on pause since its July rate hike while the RBA just raised ours. 

Even though we may be lagging the US in the disinflation journey, inflation is on the same trajectory here. 

Elsewhere, the UK CPI dropped from 6.7% to 4.6% this week. 

What it means for bonds 

Bond investors can be more assured that we are seeing the light at the end of the tunnel. 

The gap between Australian and US front-end rates should narrow as US Fed starts a rate-cutting cycle ahead of the RBA.  

That should buoy short-end US treasuries and weaken the USD against AUD. 

For Australian investors, any gain in short-end treasuries should be largely offset by foreign exchange losses. 

For long-end bonds, we believe the risk-reward of Aussie government bonds outweighs the US treasuries. 

Why?  

Firstly, Australian 10-year yields at 4.56% are more attractive than US 10-year treasuries at 4.45%. 

Secondly, the steepness of the Australian yield curve gives investors good carry-and-roll versus the inverted US yield curve. 

Finally, the supply-demand dynamics work in Australia’s favour. 

Australia is running a budget surplus while the US is running a budget deficit.  

This means that on the supply side, the Australian government does not need to issue more bonds.  

On the other hand, the US has raised its planned 10-year issuance size by US$2 billion to US$40 billion. 

On the demand side, the number of captive audiences for US treasuries has dwindled. 

US Fed — the biggest buyer — is now a seller, not a buyer.  

The reliable Japanese have shied away due to the weakness of the Yen.  

And US commercial bank — having learnt from the mistakes of Silicon Valley Bank — are rebalancing away from long-end US treasuries. 

With moderating inflation as the trend of the year, investors can be more assured in their bond allocation. 

On balance, we believe Australian bonds should provide better risk-reward ahead. 

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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

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

• Find out about Crispin’s Pendal Focus Australian Share fund

MOST equity markets held their recent gains or advanced incrementally last week, despite bond yields rising after a big move lower the previous week. 

The S&P/ASX 300 gained 0.1% and the S&P 500 lifted 1.35%.

Recent equity market resilience has been driven by a combination of:

• A slower-than-expected bond issuance calendar for the December quarter
• A dovish Federal Open Market Committee (with chair Jerome Powell highlighting the work done by bond yields on tightening financial conditions)
• Softer data from the US Institute for Supply Management manufacturing index
• Jobs data sitting in the “goldilocks zone”

However, these factors were offset last week by:

• Powell adopting a sterner tone in an IMF speech, perhaps with an eye on an easing financial conditions index
• A disappointing US Treasury auction, reminding the market that supply is a risk to bond yields
• Worse-than-expected inflation expectations, which highlights Powell’s mantra that there is “a long way to go” to get inflation sustainably back to 2%

Despite this more negative tone, there was resilience in equities. This can be attributed to short-covering by systematic funds which were bearishly positioned and caught out by the prior positive reversal.

Investors were also possibly mindful of the market moving into what has historically been a positive part of the year for equities.

Due to the technical nature of the bounce, it was concentrated in the mega cap “magnificent seven” of the S&P 500, with breadth not as supportive.

This could suggest price action from here will be more subdued. Though we expect to see a continued grind higher given prior bearish positioning, unless fundamentals change.

Oil continued lower with Brent crude down 5.7% last week, which also supported equities.

The rate hike in Australia was well anticipated and therefore had limited market impact.

Dovish RBA commentary helped support equities and led to a sell-off in the Australian dollar.

Markets

We have often referenced the importance of positioning both at a stock and market level. This has been recently demonstrated again.

Systematic strategies such as commodity trading advisor (CTA), risk parity and volatility-controlled funds are often the marginal dollar in the market.

Going into November they were very underweight US equities with CTAs at their lowest exposure since 2018.

This coincided with historically the most positive seasonal period of the year, encouraged by reduced tax loss selling and the resumption of buy-backs.

A reversal in bond yields provided the catalyst for systematic strategies to cover their position in equities. The rush to cover led to an initial sharp move which has subsided.

But the current equity exposure is still low and vulnerable to any squeeze into market, which is why it could be supportive.

From here, there are two disparate views on the medium-term outlook:

• The bear case

The bears expect material weakening or recession in the US in 2024.

This view points to the effects of monetary tightening lagging more than usual due to longer debt duration, though still flowing through.

Recent weakening in economic data and continued tightening in credit conditions are taken as early signs of this.

In this scenario unemployment might rise materially, affecting consumption.

This could result in rate cuts sooner than expected in response to economic weakness. Though lingering inflation concerns could still cause delays.

In this scenario we could see a fall in corporate earnings and a de-rating in equity markets.

• The bull case

The bulls believe the peak in tighter financial conditions has passed and presents a lighter headwind going forward.

In this scenario, core inflation has fallen more quickly than feared. Unemployment has stayed low and GDP growth resilient, reflecting a different kind of cycle tied to the distortions of the pandemic rather than a classic ‘overheating’ cycle which requires a recession.

This view sees the recovery in labour force participation enabling wages to ease off, consumption to remain supported and real disposable income growth improving.

Should inflation continue to fall, this could facilitate potential rate cuts, providing protection against a slowdown.

The global picture

The global picture on current market valuations is mixed.

The US looks expensive at 18.5x 12-month forward price/earnings versus a 20-year median of just under 16x.

However this is distorted by mega-cap tech. Without these stocks, the market is at 16x, versus a median of around 15x.

Asia and Australia are around the 20-year median point while the UK and Europe are looking cheap by historical standards.

With almost 90 per cent of the US index having reported quarterly earnings, EPS growth is coming in at 4% year-on-year, versus 0% in Q2 2023. That reflects a stronger economy. (Ex-energy EPS is +10%.)

Despite this, expected earnings have fallen 4% for Q4 and 1% for the calendar year so far.

Q4 expectations indicate margins are set to fall, suggesting the market is reasonably cautious in terms of outlook.

US policy and economics

There were four factors to take note of in the US last week:

• Powell comments – a shift in tone from the previous week

Powell’s IMF speech struck a more hawkish tone than a week earlier. This was likely due to the risk of prompting too much optimism and becoming counter-productive. He said there was still a long way to go to get inflation sustainably down to 2%, while also noting previous “head fakes” on inflation. 

Powell also toned down comments on the impact of improved supply chains versus. The benefits from supply might now wane, requiring tighter financial conditions to reduce inflation.

He also didn’t cite the impact of higher bond yields as a counter to recent strong growth, effectively recognising the rapid fall in bond yields has diminished this economic brake.

• Conditions remain tight in Senior Loan Officer Opinion Survey

A lot of the bears focus on this Federal Reserve quarterly series. The latest survey reinforced the idea that conditions remain as restrictive as they were in the prior release — which usually signals slowing credit growth.

This is understandable given the cost of debt has risen close to 10 per cent for small-to-medium enterprises.

The US relies less on bank lending than any other economy given alternatives such credit and private credit. So it may not be as negative a signal as in previous years.

• Inflation expectations deteriorating

US consumer sentiment deteriorated for second consecutive month, according to the latest University of Michigan survey on inflation expectations.

Expectations one-year forward shifted from 4.2% to 4.4%, having risen from 3.2% in September’s survey.

Five-year forward expectations rose from 3% to 3.2% — a 12-month high.

While an important signal for the Fed, this series has some caveats given a smallish sample and the historic influence of energy prices.

That said, it reinforces the Fed’s need to strike a balanced line on policy messaging and ensure expectations remain anchored.

• Atlanta Fed’s wage growth tracker slightly lower

There was no major shift in this signal on US wages. The three-month moving average of median wage growth was at 5.2%, but it did validate a recent move lower.

This measure is typically about 1% ahead of other measures of wage growth, which suggests they may be in the low-4% to mid-3% range.

This is closer to being consistent with 2% inflation.

China

There was little newsworthy from China last week. But it’s worth noting some of the real-time trackers of the economy deteriorated again in October, reinforcing the need for ongoing stimulus. 

Property is still not bouncing off depressed levels and confidence remains weak.

Australia

The Reserve Bank raised rates 25bp to 4.35% but softened its language regarding the need for further hikes — perhaps to dampen down reaction to the hike.

The RBA is effectively indicating it will not raise rates again unless the data demands it.

The RBA’s updated forecasts for inflation suggest why it remains more benign on the outlook for rates.

The actual rise in CPI forced it to raise forecasts. But it’s now expecting CPI to return to a previous forecast by mid-2024 — so it’s seen as six-to-12-month phenomenon.

A lower CPI forecast comes despite higher GDP growth, driven by stronger net exports and private and public investment.

Higher employment growth and lower unemployment is expected. But wage growth is anticipated to fall as higher award wages partly offset moderating wage growth in IT, professional services and construction. 

The RBA therefore seems optimistic on inflation fixing itself, as has been the case in US.

The logic is that we may be just beginning to see the first signs of consumer slowing, while falling global inflation should also help.

The RBA’s six-month stability report and quarterly monetary statement highlighted the resilience of households and businesses.

Households have taken on extra work, reduced discretionary spend and drawn on savings. Businesses have been helped by large cash buffers.

Employment income growth has been strong, particularly at the lower-income levels, even as real base wages have declined. This reflects household ability to add extra sources of income.

For the lowest quintile of households by wage real (ie inflation-adjusted) employment income has grown more than 10 per cent.  

Spending remains supported by savings buffers, which are only being run down slowly and still represent more than 15 per cent of household disposable income.

The RBA stability report noted some early signs of emerging financial stress. For example:

• The National Debt Helpline has seen demand for services rising 25%, albeit off a very low base.
• Another metric uses baseline household expenditure measure (HEM) for essential expenses. The proportion of households with variable-rate mortgages where baseline HEM plus-mortgage repayments is greater than income has risen from 1% to 5% since April. If rates went to 4.6% this 5% would rise to 7%, of which 30% are at risk of depleting buffers within six months (2% of all mortgages).
• Using a broader HEM (including some discretionary expenses), the proportion of mortgage holders where HEM plus mortgages is higher than income has risen from 3% to13% since April. 
• Around 25% of households have less than a three-month buffer on their mortgage.

We are approaching the end of the fixed rate re-pricing peak, with two of the eight peak months left to go.

Mortgage principal plus interest payments is now reaching the threshold of percentage of disposable income that households have historically paid, when they were making voluntary payments over and above principal and interest.

This means mortgages are now starting to eat into disposable income.

Negative equity is not near to being an issue given the loan-to-value ratio distribution.

This shows that in the event of a 10% fall in house prices there would be almost no losses for the lender — even if a portion of borrowers could no longer service mortgages.

This all highlights that the economy, households and the financial system are under strain, but have so far absorbed the rise in interest rates and the headwind of tighter financial conditions.

These headwinds may begin to fade and we may see some support from higher real disposable incomes as inflation falls relative to wages.

 

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About Crispin Murray and 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

Pendal equities analyst ELISE MCKAY is bullish on data centre stocks. But some are better positioned than others. Here’s why.

• Generative AI putting pressure on data centres
• Power and water major constraints on sector
• Find out about Pendal Focus Australian Share fund

“I’M very bullish on the outlook for data centres,” says Pendal Aussie equities analyst Elise McKay, who’s just returned from a US trip where she met with participants across the “DC” supply chain.

Data centres are facilities which house heavy-duty computer systems and components used to support resource-intensive applications such cloud computing, artificial intelligence training and data storage.

In Australia an example would be NEXTDC (ASX: NXT), which is held in a number of Pendal Aussie equity portfolios. 

The accelerating shift to cloud computing (on-demand access to computing resources over the internet) is driving demand, along with “generative AI” applications such as ChatGPT.

But some data centre stocks are better positioned than others, cautions McKay.

She prefers established DC owners with existing capacity — due to the time it takes to acquire land, undertake construction and manage power requirement and other complexities.

“There’s strengthening demand for DCs and supply is tightening,” McKay says.

“In some major DC locations, such as Northern Virgina in the US, vacancy rates are at one per cent. In Australia it’s closer to 17 per cent.”

Demand for energy and water

Strong demand and tight supply are conditions ripe for data centre owners to outperform — though there is a potential emerging constraint.

“There is not enough power available, especially for artificial intelligence (AI) applications,” Elise says.

Data centres use huge amounts of energy, estimated to be more than one per cent of global energy markets — and power requirements will grow demand is expcted to grow iline with DC footprints.

Access to power will a significant constraint for some players, particularly as the world focuses on the energy transition.

“It means that providers of data centres with available capacity will benefit while new entrants will be constrained by access to power,” she says.

“Power constraints are very material and data centre players need to be planning five to ten years out.

“They are now looking for solutions that go behind the meter. They are thinking about self-generation – in the future can they do small scale nuclear reactors to power data centres?

“US data centre giant Equinix is powering two Dublin two facilities with gas. This is a complex issue that needs to be solved.”

Data centres also need large amounts of water. The energy used in data centres produce heat, and the servers need to be cooled.

Technology is addressing some of the water challenges in data centres.

“New cooling technologies are being deployed with limited need to retrofit. While this is slightly more expensive, I don’t expect it to change return targets.” 

“Because data centres are both power and water hungry, sustainability is now an increasing focus,” Elise says.

Elise believes it will ultimately result in stronger pricing and better returns for data centres with capacity.

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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

China equities are not about to outperform the broader emerging markets benchmark. But there are opportunities if you know where to look, argues Pendal’s JAMES SYME

• Over-reaction in some parts of China market
• ‘Real opportunities at these price levels’
• Find out about Pendal Global Emerging Markets Opportunities fund

PARTS of the Chinese equity market are showing opportunities at current price levels, argues Pendal emerging markets portfolio manager James Syme.

Syme and his team members — who manage Pendal Global Emerging Markets Opportunities fund — believe the EM equities asset class is dominated by bottom-up investors who, in the aggregate, alternatively underreact and then overreact to top-down developments.

“Sometimes over-reaction can occur to the downside, when groups of stocks within markets sell-off indiscriminately to unjustified levels on top-down concerns,” says Syme.

“We believe that’s happening in parts of the Chinese equity market — and that real opportunities are being presented at these price levels.”

Does that mean China equities are set to outperform the broader emerging market benchmark?

No, he cautions. “The property sector continues to struggle and the loss of market share in US imports will not easily be regained.”

But there are opportunities if you know where to look, argues Syme.

Chinese retail sales in September were up 5.5% year-on-year, but that broad measure hides greater strength in particular segments, he says.

For example restaurant and catering sales were up 13.8% annually, while tobacco and alcohol sales gained 23.1%.

Stock examples

Below Syme outlines three stock examples which are held in Pendal Global Emerging Markets Opportunities fund:

Tsingtao Brewery is China’s second biggest brewer, with a 15% domestic market share.

As well as benefiting from the cyclical recovery, Tsingtao is a beneficiary of the down-shifting of Chinese consumers away from more expensive foreign brands into the company’s own premium brands, and also of a political preference for domestic brands, Syme says.

“In recent results the company showed strong growth in average selling prices and margins.

“In the first nine months of 2023, the consensus forecast for the company’s forward earnings rose 30.5%, but the stock itself declined 16.8%, putting it at an all-time low P/E ratio.”

Trip.com

Trip.com is China’s dominant domestic online travel agency providing full travel booking services domestically and internationally.

Again, the company is performing very strongly, says Syme.

“Chinese Valentine’s Day in late August saw booked hotel room nights reach a record high.

“The third quarter of 2023 saw profitable results from all listed Chinese airlines and revenue per room reach a record high for Chinese hotels.

“The shift online was hugely accelerated during the pandemic, helping Trip.com gain market share and achieve economies of scale reflected in rising margins.

“As well as domestic and international tourism, recovery in China in music festivals, business conferences and exhibitions should remain supportive.

“Yet, in the first nine months of 2023, the consensus forecast for the company’s forward earnings more than doubled but the stock itself declined slightly.”

Meituan and Tencent

Elsewhere in the consumer e-commerce space, Meituan’s continued success as a business seems to be ignored by equity markets. 

The pattern is the same at online giant Tencent, Syme says.

“Tencent’s under-performance is particularly stark given the current global investor enthusiasm for stocks with AI exposure.

“Tencent is likely to be a global leader in the space, combining its existing technological strengths with a major investment program in a Chat-GPT-style artificial intelligence ‘Large Language Model’.

“You wouldn’t know that from the share price though.”

What it means for investors

This is not a ‘buy-the-dip’ argument, stresses Syme.

“It is not a deep value argument — we remain growth-at-reasonable-price investors.

“But what we are seeing within the Chinese equity market are stocks with supportive top-down conditions, strong and steady earnings growth, upbeat results and guidance from management –  and valuations that look attractive relative to peers and to the stocks’ own valuation histories.

“As always with our process, it is crucial for the top-down and bottom-up investment cases to align.”

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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

Equities investors have focused on operating cost inflation in recent years. Now it’s time to think more about capital expenditure, argues Pendal equities analyst ANTHONY MORAN

• Investors should focus on capex cost inflation
• Risk of blowouts in some sectors
• Find out about Pendal Focus Australian Share fund
• Watch Crispin Murray’s bi-annual Beyond The Numbers webinar

EQUITIES investors have rightly kept a close eye on company operating costs during the recent period of high inflation.

Now it’s time to pay greater attention to capital expenditure, says Anthony Moran, an analyst with Pendal’s Aussie equities team.

Operating cost inflation refers to increases in the price of goods and services a company needs to operate its business. Higher costs for raw materials, labour, energy and the like can squeeze profit margins.

Capital expenditure inflation refers to rising costs associated with long-term assets like buildings, machinery or technology, which can affect a company’s ability to grow, expand, or modernise.

“We’ve obviously gone through a period of very high inflation and spent time figuring out which stocks can pass that on to their customers through higher prices — and which stocks are exposed to the worst of the cost rises,” Moran says.

“While the market has focused on the operating cost side, it’s time to give more focus to the capital expenditure side. Any company with a fair bit of capital intensity will be exposed to price rises in coming periods.”

Price rises have occurred across the board, from gas turbines and other hard equipment to construction costs, Moran says.

“If you’re a capital-intensive company, capex inflation is going to erode returns, especially if you don’t have pricing power,” he explains.

“If you’re in an industry where there are just a few manufacturers and they all have the same cost base, maybe they can pass through the higher costs.

“But if it’s an industry like steel, which is a globally traded commodity, there is no pricing power.”

Capital intensive stocks

Moran highlights ASX-listed BlueScope Steel (ASX: BSL), which is undertaking a $1 billion reline of its blast furnace in Port Kembla, NSW.

It’s also considering increasing capacity in North America and building a coating facility in western Sydney.

“They are going through a very capital-intensive phase and it’s something BlueScope must be wary of because capex blowouts could eat into the cash flow of the company,” he says.

Other examples of companies needing to maintain a strong focus on capital expenditure inflation include Star Entertainment (ASX: SGR) which is finishing off a multi-billion-dollar development in Brisbane and toll road operator Transurban (ASX: TCL).

“The revenue side of Transurban is very attractive because it rises with the CPI.

“But the company has no incremental pricing power, and it is still building its West Gate Tunnel Project in Melbourne.

“What will catch people out is when there is irregular, bumpy capex – something like replacing a plant every five years when the price of the plant has gone up considerably in that period.”

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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