Economic weakness in China is affecting emerging markets commodity exporters. That means the key to success is looking instead for domestic growth stories, argues Pendal’s JAMES SYME

• China’s weakness affects EM exports
• Focus instead on domestic growth
• Find out about Pendal Global Emerging Markets Opportunities fund
• Watch a recent Emerging Markets overview webinar with James Syme

EMERGING markets investors often focus on commodity-intensive countries – many of which rely on China as one of the world’s top importers.

That may not be an attractive angle right now due to China’s weaker economy.

But it doesn’t mean there isn’t opportunity in the EM space, says Pendal PM James Syme.

Look instead for domestic growth stories that do not depend on exporting to China, argues Syme, who co-manages Pendal Global Emerging Markets Opportunities Fund.

“It’s been very good for the portfolio having the overweight positions in Mexico and Brazil — but we’re cautious on metals, cautious on China, and cautious on Latin American commodity stocks,” says Syme.

Why domestic demand matters in emerging markets

Emerging markets naturally go through business cycles where growth leads to inflation and pressure on the trade balance, which eventually leads to higher interest rates and a downturn, says Syme.

“Then eventually at some point inflation is very low, there’s loads of capacity in the economy, and the economy naturally grows. That’s the cycle that happening now in emerging markets.

“It tends to be boosted by what happens with global financial conditions and the US dollar. One of the big patterns we see at the moment is that after a decade of a strong US dollar, we may now be seeing a weaker dollar.

“That really opens the way for strong domestic growth booms in some of these emerging markets.”

Opportunity in Latin America

Some of the markets best-placed to benefit from this change are found in Latin America, argues Syme.

Brazil and Mexico should see significant interest rate cuts over the second half of 2023 and into 2024, further stimulating what is already quite robust domestic demand, he says.

“We’re very positive on Brazil and Mexico. They’re two of the largest overweights in the portfolio.”

Typically, Latin American GDP growth and equity market returns are highly correlated with commodity prices — especially metals.

Latin America is a large producer of oil, with Brazil, Colombia and Mexico all being major producers. It is also a big exporter of soft commodities which are filling supply gaps created by the Russia-Ukraine conflict.

But it is the metals part of the commodity cycle that tends to correlate with growth most strongly, says Syme.

“We’re very positive on the outlook for the domestic economies of Brazil and Mexico, but this is not because we’ve got a particularly positive view on metals.

“Although there are some significant supply constraints, particularly around copper, the world’s largest demand source for industrial metals continues to be China, the Chinese economy looks very weak and within the Chinese economy, it’s the most commodity intensive sectors that look the weakest.

“So, we have no copper, we have no Latin American gold miners, we have no Latin American iron ore miners. Generally, our exposure to the commodity complex in Latin America is very low.”

Instead, emerging markets portfolios need to be positioned to capture the beneficiaries of domestic growth, says Syme.

Leading opportunities include banks and financial stocks, alcohol producers and brewers, domestic airlines, fast food and building materials like cement, he says.

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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

A new signal from China caused excitement among investors this week. AMY XIE PATRICK explains what it means

• Take caution with China’s latest property signal
• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Browse Pendal’s fixed interest funds

THE latest message from China’s top decision-making body caused a stir this week when investors noted softer language on property.

For the first time since 2016, President Xi Jinping’s signature slogan that “houses are for living, not for speculation” was missing from a note that followed the Politburo’s July meeting.

That caused excitement in the market about the potential for a meaningful stimulus push via the property sector.

China’s property industry accounts for up to 20 per cent of GDP once related sectors are added.

But the market is getting ahead of itself.

The line has likely been dropped because it’s simply no longer needed.

Buyers are no longer speculating. They are actively selling in an attempt to exit the property game altogether.

In fact, one of our investment themes here in Pendal’s Income and Fixed Interest team, is that there will be no silver bullet from China to turn around its economy.

Deleveraging leads to fire sales

Beijing’s attempts to de-leverage property developers effectively shut them out from official channels of funding in 2020.

The unofficial channel relied on off-the-plan pre-payments from buyers – but relying on this channel alone is a bit like a Ponzi scheme.

Developers need to keep selling properties they promise to build in the future, to secure the funds to finish what they’ve already pre-sold.

As defaults among Chinese property developers started to snowball last year, buyers soon came to the realisation that they may never get delivery of properties they’d made down payments on.

To cut their losses, owners of partially completed apartments started to list them at discounts on the secondary market.

Indicators suggest property prices are now falling as fast as they did during the initial outbreak of the pandemic, with no relief in sight.

Breaking bad

It is impossible to understate the extent of this shock to the Chinese psyche.

The economic model has had property at its core for the best part of a generation.

Every crisis has been met with property sector stimulus. This spurred consumer spending on all things related to buying a new home.

It gave local governments revenue from selling plots of land.

It spurred borrowing from Chinese households to get on the property ladder because as far as they knew, Chinese house prices only ever went up.

Confidence in the property sector has now been shaken to the core.

It forces Chinese households to recognise the real state of their balance sheets. At the margin, income will be directed towards balance sheet repair rather than new consumption.

I have some sympathy with commentary that draws parallels between Japan’s bubble bursting in the late ’80s.

In the long run, this is a good story for China.

It allows the economy to break away from its addiction to building endless apartments and move on to find healthier alternatives. What those alternatives might be is yet to be determined.

Economic debris

The bad news right now is that the debris from the current property carnage is clogging up China’s economic engine.

Policy response has so far been limited.

Interest rates and reserve ratios have been cut. But what use is making the price of borrowing cheaper in a system where there is no appetite to borrow because of shattered confidence?

Clearing this debris requires either allowing developers to borrow again or someone to absorb losses.

The former is unlikely given the pain endured to come this far down the deleveraging path. The latter is unpalatable given the sheer extent of losses that potentially exist.

As an example, Chinese property developer Evergrande recently wrote down US$52 billion of losses on the value of its assets – and faces a $44bn funding gap for completing its construction pipeline.

If that funding gap can’t be bridged, further write-downs will follow.

The extent of unrealised losses sitting within this sector may simply be too big for the private sector to bear.

But the state also faces a moral hazard dilemma if it tries to share the burden.

Against this backdrop, it is easier to understand why stimulus efforts have been so lacklustre to date.

What it means for markets and investors

Chinese asset prices have largely priced in a soggy growth story from here.

The rest of the world has had the luxury of ignoring China’s woes because strong consumption supported by excess savings has more than offset China’s drag.

What happens when those savings run out has most certainly not been priced into global asset prices.

The Politburo meeting also highlights a renewed focus on currency.

Beijing dislikes extreme moves over a short period of time. But in the absence of a property-driven growth engine, Beijing probably doesn’t mind a weaker currency.

Since domestic demand is hard to lift, a weaker yuan should at least help to channel some international demand in China’s direction.

Here are some broad-brush implications for positioning:

• Lean against yuan strength. Volatility can be smoothed but the trend can’t be stopped. A cheaper currency would help Chinese growth at the margin by lifting exports.

• Avoid betting on lower Chinese yields. Slashing interest rates won’t work to stimulate the economy when no one wants to borrow. Near term, the Chinese rates market may have priced peak pessimism.

• Maintain a long duration bias in global duration. When excess savings run out, China’s drag will become more evident on global growth.

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 Pendal Focus Australian Share fund

EQUITY and bond markets trod water last week after well-received inflation data – and ahead of more US quarterly earnings reports, plus meetings at the Fed, European Central Bank and Bank of Japan this week.

The S&P 600 gained 0.7% while the S&P/ASX 300 was up 0.13%.

In US equities we saw a rotation from tech to banks.

There was some wariness of tech stocks ahead of results, given their big recent runs. Bank results are so far better than many feared. This rotation provided breadth to the market.

Positive surprises on inflation and economic resilience – combined with the AI thematic – have driven markets in 2023.

We now appear to be entering a phase of consolidation, rather than a major correction.

The improvement in market breadth is a constructive signal, as is an economy with little tangible sign of deterioration.

In Australia, strong employment data is a reminder of domestic economic resilience. It is hard to see how inflation falls sufficiently in this environment – but the market is waiting for this week’s inflation data before worrying too much about rates again.

Key market issues

At the start of the year we outlined six issues we thought most important for markets going into 2023.

It’s worth revisiting now to see how they’ve transpired.

In short, the key issues have evolved, but there haven’t been any definitive developments.

It’s worth noting the miracle of a soft-landing is now a real possibility – something no-one really believed six months ago.

Since then we’ve also added two new issues to keep tabs on:

• Artificial Intelligence: To what extent is AI a material driver of long-term earnings and will it continue to fuel a re-rating of tech?
  
• The US-dollar index (DXY): It’s off 2.4% since the start of 2023, which has supported markets and commodities. But is this the beginning of a more material move or a period of consolidation?

Here’s a look-back at the original six issues:

1. The persistence of inflation – which will determine how tight financial conditions should be

Inflation has proven more persistent than expected for much of 2023, though in recent weeks it’s started to surprise on the downside.

Importantly, this recent change has begun without the economy showing material signs of weakness.

Despite the rise in two-year bond yields – US government bonds are up 42bps in 2023 and Australian yields up 61bps – 10-year bond yields have remained flat (down 4bps in the US and Australia so far this year).

Lower commodity and input prices along with improved supply chains have eased inflationary pressures.

The key area of contention remains services inflation, which is tied to wage growth and productivity.

Wages are trending lower.

Forward indicators such as the Indeed Wage Tracker are slowing materially, down from about 9% annual growth in late 2021 to 4.8% by June.

The Atlanta Fed wage tracker has seen the gap between overall wage growth and wage growth for job switchers narrow materially, as the latter has decelerated faster.

This suggests the worker shortage is dissipating.

The remaining concern is the continued strength of the labour market, which may make the Fed question whether wages will fall back as far as they need to.

Weak productivity is another reason to be wary of how quickly services inflation falls back.

The upshot is that there is still more to do.

Wages need to reduce to 3% or below to be consistent with 2% inflation. The latter is heading in the right direction and offering hope.

2. The scale of the economic slowdown in the US and other developed markets

The economy has clearly held up better than most expected.

The market was pricing a 65% chance of recession at the start of the year. We remain at the same level some seven months later.

Higher rates have not wreaked havoc as many feared. The debate has shifted to how long the potential lags in effect may be.

Bulls point to “total financial conditions” – a measure of changes in key indicators such as mortgage rates, credit spreads, equity markets and currency moves – having already tightened to a peak. Lead sectors such as housing are turning the corner and an inventory de-stocking phase is now slowing.

Combined with the better inflation data, confidence is building of a soft landing.

Bears continue to point to yield curves and other lead indicators as signs the economy will roll over.

The Fed has now released its own “total financial conditions” index (alongside others from the likes of Goldman Sachs, Bloomberg and regional Federal reserves).

The Fed’s index – which measures the expected impact on growth – shows total conditions as more restrictive than indicated by other indices, suggesting we may see a weaker economy by the year’s end.

That said, even the Fed’s measure of total financial condition tightening has peaked – and the expected impact on growth is waning.

The March banking crisis was seen as evidence of how tightening can affect the economy in unpredictable ways.

But it’s increasingly looking like the “all-in” policy response from the Fed and US Treasury has successfully stemmed second-order consequences. 

The question remains: will we defy the “laws of economics” this cycle and avoid a recession?

The accumulated stimulus from the pandmic – combined with green investment, re-shoring and a deflationary China – may help pull off a soft-landing miracle. But there is still no clarity emerging.

3. The leverage of earnings to that downturn

With no sign of recession, there is no insight on the degree of operating leverage.

Earnings have proven more resilient than many expected, particularly in tech.

4. Whether markets have already priced in the downturn

In hindsight a lot of bad news was priced in at the start of the year.

Markets have done much better than expected, squeezing higher on cautious positioning and resilient outlooks for the economy and earnings.

The S&P 500 is up 19.24%, the NASDAQ 34.69% and the S&P/ASX 300 a more subdued 6.03%.

The bulk of this move is valuation re-rating. The S&P 500 has gone from 16.8x P/E to 19.6x.

This suggests less pessimism – but also less buffer in the case of an economic downturn.

5. How China’s economy performs as it exits Covid-zero

China has been a material disappointment.

Q1 saw a strong re-opening bounce, but it faded far more quickly than expected.

Housing has been weak. At best, it can be expected to stabilise.

Exports have suffered on slowing global growth – particularly in goods – although there are some signs of stabilisation.

Consumers remain cautious and this is more likely to be structural factors at play.

Q2 weakness was exacerbated by inventory de-stocking, so there should be some improvement in Q3 even without stimulus.

July’s Politburo meeting is usually focused on the economy. But the mail we are getting is not to expect too much.

The growth rate, while slower than expected, is still consistent with Beijing’s target. It is also unclear how effective stimulus would be.

So any measures are more likely to be specific industry-orientated actions, rather than a “big bang” type of stimulus.

6. Can the RBA engineer a soft landing in Australia?

Australia’s relative appeal has deteriorated.

When it looked like the rest of the world was facing a recession, our immigration-driven resilience was a relative positive.

Now with the rest of the world seemingly more likely to pull off the soft landing, the Australian economy is seeing more stubborn inflation due to higher population growth, combined with rising wage growth and weak productivity.

At the same time the much-anticipated mortgage cliff has not yet had a meaningful impact.

The latest employment data reinforced the strength in the economy.

The politicisation of the rate-setting process and an RBA flip-flopping between inflation hawkishness and social concerns also runs the risk of undermining confidence in policy making and de-anchoring inflation expectations.

So the risks here have risen.

Central bank policy

The Fed, ECB and BOJ meet this week. To summarise:

• The Fed is widely expected to hike for the last time, with rates up 25bp to a 5.25% to 5.5% range. They will probably look to maintain the expectation of one more hike, but may signal that it won’t be in September. The reason for this is they will not want the market bringing forward the first rate cut which is now priced for March 2024.
• The ECB is also expected to hike, but again, this could be the last. The Dutch central bank noted there was no certainty of hikes beyond July. Awareness of the monetary lag could also lead to a less hawkish message.
• The key issue for the Bank of Japan is whether to move the targeted cap on government bond yields from 50bp to 75bp. If they do, we could see a continued rise in yields and a stronger yen. If nothing changes we may see a re-test of the calendar year to date highs.

Markets

US earnings season kicked off with a focus on banks – where results were not as bad as feared.

One of the key issues was margins, which did deteriorate but not as much as expected. Big banks retain strong liquidity and haven’t chased deposits, which seems to have helped.

The other concern was around exposure to commercial real estate, particularly office.

The positive news here was that reserves against this exposure had stepped up from 3-4% to 8-9% – but without a hit to capital, providing more of a buffer.

Heading into the main phase of earnings, revisions have been at the weaker end of the historic range. Clearly if this persists it will add to the argument for market consolidation, or even a pull-back, given the recent run. 

It is also worth noting how low stock correlations have been in 2023.

They are now probably as low as they go, which would indicate macro factors may begin to re-emerge.

 

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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

The unemployment rate remains low. Pendal assistant PM ANNA HONG explains what that means for rates and bonds

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

TODAY’S jobs data shows the headline unemployment rate stuck around 3.5% and the participation rate falling by only 0.1%.

The good news is, we’ve got jobs.

But does it mean more rate hikes are on the cards?

Yes and no.

The unemployment rate is a slow-moving indicator, reflecting what has already happened rather than what will happen.

People tighten their belts, which results in a slowdown in economic activity way before we lose our jobs.

This can be observed through spending habits, retail sales and the inflation trend which clearly shows disinflation flowing through in the Australia CPI number.

Australia’s CPI peaked at 7.8% in December 2022 and continued to slow down to 5.6% in May.

That’s despite our unemployment rate tracking sideways at 3.5% since reaching a low of 3.4% in October 2022.

Furthermore, high net migration has already materially reduced the number job openings in Australia.

Job advertisements in NSW, VIC and ACT have weakened, especially in the segments such as hospitality, tourism and retail which are most sensitive to the inflow of foreign workers.

What does this mean for bond investors?

It’s not yet time to raise the “mission accomplished” flag, but we are closer to the end of the rate hiking cycle.

There may be one or two more rate hikes, though much of the market pricing already reflects than.

This is especially evident in Australian three-year and ten-year government bonds price moves after the release of the unemployment data – it moved in about a 0.06% range.

Is there a risk of over-hiking by the central banks? Yes.

In that scenario, something will break and we favour duration protection at around 4% yield to deliver capital gains for the portfolio.

What if we get a soft-landing?

That means that the RBA can chart a path back down towards neutral, which should give long bonds a nice capital kick.

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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 portfolio manager JIM TAYLOR. Reported by portfolio specialist Chris Adams

• Find out about Pendal Focus Australian Share Fund

MARKETS strengthened last week ahead of the US June CPI report and surged again when the cooler inflation data met with approval.

There was some consolidation on Friday as second-quarter US company results started to come through, though things were okay on that front.

The CPI print, bolstered by a supportive and instructive Producer Price Index (PPI) print, means the market now has peak Fed rates firmly in its sights.

Investors are pricing in one more 25bp rise in July. Some are even saying that would be one hike too many. 

The notion of a soft landing in the US gained further traction with a good labour market print and stronger consumer sentiment.

As a result, there was a notable improvement in the breadth of the equity market rally, though mega-cap tech performed strongly as well.

Commodities rose, notwithstanding some poor economic data out of China. The DXY — a trade-weighted index of US dollar strength — headed to 12-month lows.

The S&P 500 rose 2.44% and the S&P/ASX 300 was up 3.73%.

Central bank watch

Fed commentary last week was mostly hawkish, persisting with the line that there is more to be done.

Mary Daly of the San Francisco Fed noted that “we are likely to need a couple more rate hikes this year”.

Fellow non-voting FOMC member Loretta Mester, of the Cleveland Fed, agreed there was “more tightening needed”.

The market, though, was not buying this line. Scepticism may have been bolstered by the resignation of St Louis Fed president James Bullard.

Bullard had been among the most hawkish members of the FOMC, pushing for stronger moves to fight inflation over the past two years. He leaves to take up an academic post.

There was a slightly softer line from Atlanta Fed president Raphael Bostic (another non-voting member), who said policy makers “can be patient” given that we are “in restrictive territory”.

Michael Barr (who is on the Fed board of governors and was the only voting member to speak), noted the Fed had made progress and was “close” to a sufficiently restrictive level — but “still have a bit of work to do”.

Elsewhere the Reserve Bank of New Zealand left the official cash rate unchanged at 5.5%, as expected.

This was its first pause since it started lifting rates in October 2021.

US macro

June’s CPI came in 0.2% higher than May — below the +0.3% consensus expectation.

On an annualised basis it was 3% — also below the consensus of 3.1% and the lowest rate since March 2021.

Core CPI (which excludes food and energy), was up 0.2%. This was down from 0.4% in May and below the expected 0.3%.

Annualised Core CPI is running at 4.8%, versus 5% expected. It is at its lowest since October 2021.

Importantly, the shelter component has now fallen from a peak of 9.5% down to 5.5%. Based on effective rents, this will continue to fall for the rest of the year.

Used car prices fell 4.2% — the biggest monthly drop since the pandemic’s early days. This component accounts for about 4% of the CPI basket.

This well-received reading was supported by the PPI which rose 0.1% in June on a headline and core basis. This was below consensus expectations of 0.2% and the third straight month of a 0.1% gain.

Core PPI is running at 2.4% versus 2.6% in May. But the annualised three-month rate is 1.0% — its slowest rate since early 2020.

It is expected to be at 1.5% in August and may turn negative given leading indicators of downward pressure on prices.

All this was seen as a signal of further weaking pressure on the CPI.

As inflation falls, there was some resilient economic data prints, which fed the narrative of a soft landing.

• Consumer sentiment measured by the University of Michigan’s index rose from 64.4 in June to 72.6 in July — well above the consensus of 65.5. That said, it’s worth noting that 5-to-10-year inflation expectations remain elevated versus pre-pandemic levels.
• Initial jobless claims fell to 237K from 248K, well below the 250K consensus

Australian macro

The Westpac-Melbourne Institute consumer sentiment index improved by 2.7% in July, up from a 0.2% in June.

However it remains in “deeply pessimistic” territory.

Underlying sub-indices were mixed.

Perception of family finances have fallen to new cycle lows, but perceptions around the broader economy and the housing market have seen something of a rebound.

China macro

Beijing is grappling with a deflationary problem, which bodes poorly for growth.

Its CPI was flat at 0% year-on-year for June — the lowest print since February 2021.

The PPI is deflationary, running at -5.4% year-on-year versus -4.6% in May.

This suggests already-weak domestic demand continues to soften. Services consumption is recovering, albeit slowly, while housing demand remains subdued.

There were some signs of life in credit.

Aggregate financing — a broad measure of total credit — was CNY 4.2 trillion higher in June, versus CNY 3.1 trillion expected.

There were CNY 3.02 trillion in new loans. This should eventually feed through to increased new activity.

Deputy Governor Liu Guoqiang of the People’s Bank of China (PBOC) sought to calm concerns over the economy.

The bank retained “ample policy room to deal with unexpected challenges and changes”, he said. There was a need “to be patient and confident in the economy’s continued and steady growth”.

There are also signs Beijing is easing pressure on China’s tech sector. The PBOC noted that most of the issues at Ant Group and Tencent had been dealt with.

Earnings expectations

As we move into US quarterly reporting season, the market is expecting a 7.1% year-on-year decline in earnings for the second quarter of 2023.

This is slightly worse than the -7% expected on June 30.

If this transpires, it would be the biggest quarterly earnings decline since Q2 2020, when earnings fell 31.6%.

It would also be the third straight quarter of declining earnings.

So far 6% of S&P 500 companies have reported, with 80% delivering a positive EPS surprise and 63% a positive revenue surprise.

JP Morgan, Citigroup, Wells Fargo and Delta Airlines kicked off the season with decent results.

Leading into the Australian reporting season in August, the market is expecting 0.7% aggregate EPS growth for FY23. This is down from more than 10% a year ago.

Banks are expected to deliver 15.1% EPS growth on the back of higher margins, though this is expected to fall 5.3% in FY24 as those tailwinds recede.

Resources are the drag, with expected EPS down 17.4% in FY23.

Industrials (excluding resources, banks and listed property trusts) are expected to see 19.5% EPS growth for FY23.

Markets

A perceived end to the US hiking cycle saw technology-related stocks go on a tear last week.

The S&P 500 is now 3% higher than when the Fed started hiking rates in March 2022.

In Australia the IT sector rose 6.25%, led by Square (SQ2, +15.54%).

Materials (+5.76%) were also strong despite ongoing Chinese economic weakness. Part of this was strength in the gold miners on a weaker US dollar.

Evolution Mining (EVN, +17.08%) was the best performer in the ASX 100. Generally stronger commodity prices also buoyed Alumina (AWC, +9.33%) and South32 (S32, +7.63%).

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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

Among emerging markets, Brazil is providing investors with opportunities, argues Pendal senior fund manager JAMES SYME

• Brazil took its medicine and is now reaping rewards
• Growing investor opportunities in emerging markets
• Find out about Pendal Global Emerging Markets Opportunities fund
• Watch a short Emerging Markets overview webinar with James Syme

BRAZIL’S central bank, Banco Central do Brasil, was one of the first global monetary authorities to start lifting interest rates.

It was tough medicine but now the top-ten economy is reaping rewards earlier than its peers,” argues James Syme, co-manager of Pendal Global Emerging Markets Opportunities fund.

Syme and his London-based team EM take a top-down, country-level approach to the asset class.

“Brazil’s central bank has run orthodox monetary policy for three or four years, more so than most other central banks,” Syme says.

“When they started hiking rates in the first quarter of 2021, Covid was still a huge problem in Brazil. But inflation expectations pushed above target, and they ultimately pushed rates to 13.75 per cent.”

The early shift is now paying dividends.

“Brazil took the medicine and on the back of that it got anchored inflationary expectations and a strong currency,” Symes says.

“First-quarter 2023 GDP came in at 4 per cent, and consensus was 3.1 per cent. The May inflation number was expected to come in above 4 per cent but came in below 4 per cent.

“There has been very significant disinflation in the economy and inflation is now around the central bank’s target range.”

Banco Central do Brasil will cut rates at some point in the next year, Syme says, though they will do it cautiously.

He expects rate cuts, ultimately, will exceed 300 basis points.

“When these rate cuts come through, they will happen in an economy that’s already, on the domestic front, growing quite strongly,” he explains.

“Across the domestic economy there are strong positive numbers and beats relative to consensus, despite there being no rate cuts yet. And that’s a really exciting environment.”

Stable currency

A reason why Brazil will keep growing, according to Syme, is the stable currency, the Brazilian real.

It was sold off during Covid, losing nearly 50 per cent of its value against the US dollar. More recently it has appreciated against the greenback.

“That strength in currency reduces the cost of imported goods, which are a meaningful part of the inflation basket,” Syme says.

“So in economies like Brazil, a strong currency reduces inflation which enables more rate cuts..

“In emerging markets, typically everything goes wrong, or everything goes right.

“If things go right, you typically get capital inflows, a stronger currency, a better inflation outlook, the prospect for yields to fall, equities going up along with economic growth, and that eases any political stresses.

“And we think that is where Brazil is now.”

EM stand-outs

Brazil is the stand-out example of a number of emerging economies that pre-Covid struggled economically but are now providing investors’ with opportunity, Syme argues.

“We are seeing broadly similar patterns in India, Indonesia and Mexico.

“Long, deep downswings tend to be followed by long upswings and that’s broadly what we expect will happen with these economies.

“Brazil really has been the surprise. We thought rate cuts would be needed to really get the economy going.

“But it seems that through what higher commodities and prices are doing to the economy and through the natural tendency for the domestic economy to recover, Brazil is doing well already with the potential for more good news when the cuts come through.”

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

• Find out about Pendal Focus Australian Share fund

EQUITIES continue to rally even as bond yields rise on the back of the Fed’s “hawkish pause” which held rates steady but added in a second rate rise by the year’s end to the “dot plot”.

The market is not convinced of the need for that hike, with CPI data indicating inflation is coming down.

There has been some good news recently.

While it has been a relatively narrow cohort driving the market’s momentum, we have seen some broadening in recent weeks. For example, the Russell 3000 index of US small caps is up 5.8% in June.

The S&P 500 gained 2.6% last week and has broken through the 4350 resistance level, with technical investors suggesting it could now retest the highs of January 2022 at about 4800.

The economy also looks to be holding up, with industrial companies like Honeywell signalling things are not as dire as some would suggest.

All that said, complacency is high.

Markets can enter the doldrums in the Northern Hemisphere summer. The liquidity environment may turn negative as the US Treasury rapidly refill their coffers, having run them down during the debt ceiling stand-off.

This could prompt a decent retracement in equities.

The S&P/ASX 300 gained 1.8% for the week, helped by a 3.06% gain in the resource sector as people hope that Beijing will blink and pull the traditional property and infrastructure stimulus lever in response to a disappointing economic recovery. 

US inflation

While there are myriad ways to measure inflation, the overall trend is one of incremental improvement on signs that underlying inflation is falling.

The headline US Consumer Price Index (CPI) rose 0.1% in May and is running at 4.0% annualised. This was broadly in line with expectations.

The impact of food and energy has swung about from driving about 4% of inflation in mid-2022, to now having zero impact in aggregate.

The breadth of inflation across different categories is also moving in the right direction. The number of categories growing at greater than 5% has fallen from almost 75% in mid-2022 to roughly 40% now.

Core CPI rose 0.4% month-on-month and on a three month-moving-average basis remains stuck in the low 0.4% range.

This is still higher than the Fed wants to see.

However the market is taking a sanguine view, expressing confidence that inflation will head lower in coming months, driven by:

1. Used car prices falling back. These added 15bp in May, but auction prices are falling. Auto assembly is also ramping up, which means more new car inventory, more competition and reduced margins, helping inflation.

2. Rents are set to drop. Owner Equivalent Rent is stuck at 0.5% month-on-month on the lagged effect of previous rent rises. But this has largely played out now, according to Cleveland Fed. Owner equivalent rent should fall materially based on leading indicators.

In combination, there is a view that these trends can shift annual core CPI from 5.3% to 4.2% by the end of 2023.

As an indication, inflation ex-rents and used vehicles is running at a three month annualised rate of 2.8%.

Personal Consumption Expenditure (PCE), which the Fed place emphasis on, could fall from 4.7% to 3.7%. It is declining more slowly due to the effect of higher health care and financial services representation in the basket. 

Finally, the University of Michigan survey of inflation expectations showed that the median expectation of inflation in one year had dropped by 0.9% — more than was expected — to 3.35%.

The ten-year median fell by 0.1% to 3%, which was in line with expectations.

Fed meeting

The Fed’s meeting was described as a hawkish pause.

Chair Powell kept rates unchanged, as previously flagged, but simultaneously sent a more cautious message via the commentary and dot plots.

The FOMC is now signalling two more hikes this year, versus only one back in March.

In his commentary, Powell suggested he is considering moving to hikes in alternate meetings. This is relevant because it would mean a hike in July – as the market expects – but then a second in November.

This is a long time away and a lot could change by then. So while the market moved, two year yields only rose by 12bps. 

The Fed’s statements and actions appear to be at odds. Why pause when you are also raising the amount of hikes you believe are required to bring inflation into range?

The logic could be:

1. Having pre-committed to a pause, they didn’t want to do an about-face

2. With inflation falling, the Fed may see risk-reward as more balanced between inflation and recession, so can be more patient

3. The Committee may be more hawkish than Powell and this statement was the quid pro quo for a pause

4. The Fed is concerned the market would react too positively to the pause, leading to looser financial conditions

US bonds have rallied from March, fuelled in part by concern over the economic impact of the banking crisis. However the economy has held up better than feared and, while inflation is falling, it remains sticky at around 3.5-4.0%.

So the current yield curve suggests the market is no longer looking for rapid easing in 2H 2023.

The reason the Fed remain wary is that while the momentum of the economy is slowing, the absolute level of activity remains high.

This is reflected in a tight labour market and stubbornly high wage pressure, manifesting in unit labour costs and wage expectations.

The Fed’s six-monthly monetary policy report (MPR) was released to Congress.

It noted the labour market remains “very tight”, despite some signs of easing, versus the “extremely tight” of the previous report.

They therefore believe that core services inflation “remains elevated and has not shown signs of easing”.

It does indicate that they still expect some impact from credit tightening post the bank failures. It also included the imputed level of rates based on the Taylor Rule, which would be 6%.

Rest of the world

The European Central Bank raised rates 25bp to 3.5% and signalled another hike in July, blaming resilience in employment and inflation signals surprising to the upside.

The market is pricing in an 80% chance of a further hike in September.

There is a lot of chatter around potential stimulus in China, which did see a small rate cut in its seven-day reverse repo rate last week, signalling the direction of policy.

Issues such as youth unemployment rising to 20% are seen as driving the requirement for Beijing to act, with commodity plays strengthening in response.

Australia

Good employment data validated the message from the RBA that more rate hikes are needed.

Australia is in a different place to the US, reflecting accelerating wage increases, poor productivity, rising house prices and strong immigration underpinning the economy.

The domestic bond market woke up to this last week with some big moves in yields.

• Two year bond yields rose 19bps to a new cycle high of 4.2%. This is the highest level since 2011 and we have now seen yields move 136bp higher since the lows of the US bank crisis. This has had no impact on equities.
• Five year yields also broke out to new cycle highs of 3.95%. This is also the highest since 2011.  
• Ten-year yields are holding in better at 4.03% — not yet back to the 4.2% seen in October.

The net result is that the ten year versus two-year yield curve has inverted for the first time since 2008.

This is a negative signal for the economy, although we note that the curve first inverted in mid-2006 and equities continued to rally through to late 2007.

So this is not necessarily a flag for near-term falls in equities.

Markets

The S&P/ASX 300 continues to rally and is up 4.89% CYTD, versus 15.78% for the S&P 500 and 31.35% for the NASDAQ.

Miners led the market last week on hopes of China stimulus, with Resources up 3.06%. They are now outperforming the S&P/ASX 300 over CYTD, up 7.19% despite the price of iron ore being flat and lithium  falling about 30%.

Information Technology continues to run, up 4.26% for the week, following the US lead.

Healthcare (-5.69%) was a laggard, largely down to a downgrade from CSL.

 

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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

Investors must collaborate on policy advocacy to protect biodiversity, because individual investor efforts are less likely to succeed, argues Regnan’s OSHADEE SIYAGUNA

• Conservation efforts failing to protect biodiversity
• Policy intervention required
• Download Regnan’s Beyond Biodiversity guide
• Find out about Regnan Global Equity Impact Solutions fund
• Find out about Regnan Credit Impact Trust

Investors should collaboratively prioritise policy advocacy to protect biodiversity, because individual investor efforts are less likely to succeed, says Regnan’s Oshadee Siyaguna.

Siyaguna’s new research paper Beyond Biodiversity sets out six guiding principles for investors to guide the stewardship of ecological and social — or “biocultural” — systems.

Most of the world’s GDP is dependent in some way on nature, but historical efforts at protecting biodiversity, nature and ecosystems have repeatedly failed to achieve their goals.

Siyaguna says a deep interconnectedness between natural systems and thousands of years of human intervention complicate stewardship efforts — meaning a holistic and inclusive policy approach is needed to drive results.

“Advocacy has to be top of the list for investors,” says Siyaguna, a thematic analyst at sustainable investing leader Regnan.

“Essentially, that means investors standing up and saying policy has not been adequate.

“It’s very clear that it needs to be policy led, because as soon as policy changes, everything else will start to fall in line.

“In the absence of holistic regulations, issuers are likely to consider biocultural issues as an externality, which makes it difficult for investors to engage with them.”

Siyaguna says most conservation efforts fail because of a lack of appreciation that natural systems are complex adaptive systems coupled with a flawed framing of “nature” as separate from people.

“We’ve got to stop thinking of ‘nature’ — pristine forests and animals and so on — as a separate system and start thinking of it as a system that constantly interacts with people, economic and political activity.

“People have been transforming landscapes for at least 12,000 years. Nature as we see it now is a product of that transformation. People and nature are inseparable.”

The implication is that traditional conservation actions like fencing off pieces of land is sub-optimal and in some instances counterproductive.

“It is fundamentally impossible to go back — the system has evolved,” says Siyaguna.

“People evolve, environments evolve, economies evolve. Everything constantly changes.

“You are trying to revert to a year in the past without asking yourself ‘why?’”

Siyaguna says preserving the integrity of biocultural systems should be high on investors’ agenda because the deterioration of these systems undermines the stability of our economic, social and political systems.

But he says a new approach needs to be built that takes a systems view that includes both nature and people.

“Distinctions that separate humans and nature are somewhat artificial.

“The planet does not care how it survives — but we care because we need to live on it.

“Our goal should be to keep nature operating within thresholds that are productive to us.”

Siyaguna’s research aims to look at biodiversity in a new way.

Instead of trying to save and protect each ecosystem on its own, the approach is to focus on ‘biocultural resilience’, to make nature, society, and culture stronger and more adaptable.

Here are the main factors driving the ASX this week according to portfolio manager JIM TAYLOR. Reported by portfolio specialist Chris Adams

• Find out about Pendal Focus Australian Share Fund

THE domestic market seems to be awakening to the realisation that Australia and the US are at appreciably different stages of this rate-raising cycle.

It will be interesting to observe the extent to which domestic equity sectors begin to de-sync from global momentum trends, reflecting the heavy lifting still required to tame inflation domestically.

Last week the S&P/ASX 300 shed 0.33%.

On a brighter note, the S&P 500’s +0.41% weekly gain meant it technically entered a bull market; up 20% from the 52-week low (Oct 22).

The NASDAQ gained 0.15% — it’s seventh consecutive weekly rise.

US small caps are rebounding and market leadership is broadening from the “mega-tech” names to autos, airlines, energy, machinery, building products and banks.

RBA hikes rates

The RBA increased the cash rate +25bp to 4.1% at June’s board meeting.

The outcome was a hawkish surprise relative to consensus expectations.

Two-thirds of 30 economists surveyed by Bloomberg were expecting a pause, while financial markets had only around +8bp priced ahead of the meeting.

The RBA noted they were looking “to provide greater confidence that inflation will return to target within a reasonable timeframe”.

They also referenced rising house prices and accelerating public sector and administered wages.

Some key observations of the RBA’s release:

• The RBA retains a bias towards further tightening, noting “some further tightening of monetary policy may be required to ensure that inflation returns to target in a reasonable timeframe, but that will depend upon how the economy and inflation evolve”.
• Inflation: “While goods price inflation is slowing, services price inflation is still very high and is proving to be very persistent overseas.”
• Wages: “Growth in public sector wages is expected to pick up further and the annual increase in award wages was higher than it was last year”. The RBA reiterated that “unit labour costs were also rising briskly, with productivity growth remaining subdued”. The latter point was confirmed by subsequent data.
• Labour: “Conditions in the labour market have eased” but “remain very tight”. The unemployment rate, which has “increased slightly” to 3.7% in April, is “still very low”.
• Housing: “Housing prices are rising again”. While “some households have substantial savings buffers, others are experiencing a painful squeeze on their finances”.

Governor Lowe reiterated these points at a subsequent conference.

Now that house prices were rising again, they had shifted from a headwind to a tailwind for consumer spending, he emphasised.

He also noted that labour productivity remained poor, public sector wages were going up and services inflation remained sticky elsewhere in the world.

Lowe wanted to “make it clear … that the desire to preserve the gains in the labour market does not mean that the board will tolerate higher inflation persisting”.

The board couldn’t just “sit idle” given these risks and there was a limit to their patience on inflation.

The “unevenness” of the effect of higher rates across the community was “not a reason to avoid using the tool that we have”. 

The sum effect was that the three-month interest rate implied by bank bill futures had shifted from a peak of about 4.1% in September to a touch under 4.5% by December.

There have also been nearly three more hikes priced into the outlook in the past month.

Australian Q1 GDP and other data

The punchline is that the GDP data release painted a picture of an economy slowing materially.

GDP grew 0.2% sequentially in the first quarter — a touch softer than the +0.3% consensus forecast.

This was the third quarter in a row in which growth slowed. Annual growth now sits at 2.3%.

There were a couple of bright points. Business investment (3.4%) and public investment (4%) accelerated in the quarter, reflecting eased supply constraints to a degree.

On the negative side:

• Consumer spending increased only 0.2% for the quarter (3.5% annual). Spending on essentials rose 1.1% for the quarter, but discretionary spending fell 1.0%. This is an important trend to monitor.
• The savings rate fell to 3.7%, below its pre-Covid average.
• Disposable income fell 4% year-on-year in real terms, the biggest annual decline since 1983. While wage income has been strong, the effect of higher taxes (+15% yearly) and interest costs (+107% yearly) are providing a material drag.
• Labour costs are still accelerating. Total Compensation of Employees (COE) has risen 10.8% for the year – the strongest rate since 2007 – given the still tight labour market and rising wages. Productivity continued to decline. GDP per hour worked fell 0.2% quarterly and -4.5% over the past year. This meant that unit labour costs (wages adjusted for output) accelerated in Q1, up 2% for the quarter and 7.9% for the year.

On the housing market, data from CoreLogic showed 11.7% annual rent growth in Australian capital cities in May — a record high. The national vacancy rate is near a record low at 1.2%. New listings are a third below the long-term average.

This suggests little relief for Australian renters through to the end of the year.

US economy

Headline initial jobless claims rose to a cycle high of 261k, ahead of 235k consensus expectations.

The next few data points are likely to be a little messy given auto makers re-tool over summer. 

The May ISM services index from 51.9 to 50.3. There is a clear shift down following a period in which services remained resilient compared to manufacturing.

At a sub-sector level, declines in the employment and prices indicate slower growth in payrolls and wages. This is good news for the Fed.

Other snippets to note:

• The NY Federal reserve Global Supply Chain Pressure index has hit a record low point extending back to 1998.
• The prime age workforce participation rate moved up to 83.4% in May. This represents 65% of the total workforce. Participation among workers aged 55+ was unchanged at 38.4%.
• The RealPage rent measure came in at 2.3% year-on-year in May, down from 15.6% a year earlier. This is a lead indicator of the rent component of the PCE, which was still at 8.4% for April and is likely to see a substantial fall. This highlights an aspect of the difference between Australia and the US at the moment.
• The three-month moving average Service PMI for prices has fallen sharply this year. It leads the core PCE for services, which is likely to slow significantly for the rest of 2023 and into 2024.

Rest of the World

The Bank of Canada raised rates 25bps to 4.75%. This followed a pause, and was contrary to most expectations.

China’s exports declined 7.5% yearly in May, versus consensus expectations of -1.8%. Exports to the US (-18.2% yearly) and the European Union (-7%) and ASEAN (-15.9%) declined sharply.

The EU slid into technical recession with GDP for the three months to March 23 at -0.4%. The

ECB remains on track for its eighth consecutive rate rise.

Markets

Markets remained gripped by AI mania.

Last week was the biggest weekly inflow in listed technology companies in history at about $9 billion, according to market analysts EPFR. That’s about 40% more than the next biggest inflow in 2021.

The Bureau of Meteorology has announced that the El Niño-Southern Oscillation (ENSO) had shifted from “watch” to “alert.”

This means about a 70% chance of El Niño forming in 2023 — roughly three times the normal chance of an El Niño in any given year. After three years of high rainfall, the “weather ate my homework” excuse may be taken off the table for many companies. 

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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

With interest rates rising and the risk of a recession rising, it’s time to look for a safe harbour, says Pendal’s ANNA HONG 

• Rate rise risks triggering a recession
• Fixed income provides safe option

RECESSION talk increased in Australia this week after the RBA’s decision to lift rates for the 12th time in just over a year.

It means investors need to think about safer assets, argues Anna Hong, assistant portfolio manager with Pendal’s Income and Fixed Interest team. 

“That’s government bonds, cash and high-grade investment credit,” Hong explains. “But it’s important that it’s Australian fixed income and cash.” 

That’s because Australia is one of just a handful of countries to record a budget surplus this financial year and — not withstanding the threat of recession — the economy remains in very good shape, Hong says. 

“From an economic perspective, even if things go wrong, the government is in a good position to support the Australian economy.

“As a result assets within Australian shores should be safer than almost any other part of the world,” Hong says. 

The risk of recession in Australia is very real, Hong says.

While the government can tighten fiscal policy by increasing taxes, that often isn’t politically palatable.

It means much of the heavy lifting in controlling aggregate demand falls to the Reserve Bank. 

“The Reserve Bank hasn’t yet been able to reduce inflation enough with the interest rates increases they have already done,” Hong says.

“There are a lot of factors out of their control and they can only affect aggregate demand using interest rates.

“They are in a position where they almost have to break something to contain inflation, which they don’t really want to do.” 

The “something” is the economy.  It means investors should consider safer assets, she says. 

“Anything related to government — federal or state — is backstopped by the federal government and an investor will likely get their money back. 

“The RBA regards our major banks as ‘unquestionably strong’ and are well placed to weather any storms. This makes major bank credit a relatively safe place for investors.” 

“If you go into high-risk assets, even high-growth stocks, you might invest $100 today and not have $100 in six months because company outlooks can change very quickly now the risk of recession is higher.” 

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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 A$22 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