Fixed interest investors should get their portfolio settings right now, before US inflation tops out and starts falling in the second half, says Pendal’s TIM HEXT
- Markets set to trade in narrow range
- Inflation to move quickly lower in second half
- Find out about Pendal fixed interest funds
FEELING moody? It’s understandable says our head of government bond strategies Tim Hext.
Right now, US inflation reports are resetting the mood of investment markets every month, says Hext.
“The mood runs for about a month or so until the next set of numbers.
“Central bank officials in the US and Australia come out and express concern if the numbers are too high. Then they warn they’ll have to do a lot more.”
On the other hand, when inflation data is lower – like late last year in the United States – investors start thinking the rising interest rate cycle is nearer the end.
“We’re going to be in this environment for the first half of this year and we are going to be range-trading as the narrative goes backwards and forwards,” Hext explains.
But the uncertainty won’t last – and investors should be ready, says Hext.
“By the second half of the year, we are going to get a much clearer picture and we are going to see that inflation hasn’t just topped out but is coming down.
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“Inflation could head back towards central bank target ranges faster than they think.”
Inflation to fall this year
Pendal’s income and fixed interest team estimates inflation will fall towards 4 per cent by the end of 2023. That compares to the Reserve Bank’s forecast of 4.75 per cent.
“The Reserve Bank is going to be pleasantly surprised by inflation,” Hext says.
“In this current March quarter, the number will still be higher because of utility charges, but then in the second, third and fourth quarters, there’s a chance we get readings below one per cent.”
Goods inflation is weakening, in large part because supply chain disruptions during COVID is broadly over. Services inflation continues – about two-thirds of the way through, Hext says. That’s why the inflation data remains elevated, and choppy.
“Investors will start believing the soft landing story,” Hext says, whereby the economy slows bringing inflation down, but doesn’t go into a recession.
“There is a risk though. Central banks might feel they haven’t done enough, particularly the US Federal Reserve.”
Hext believes there will be a couple more interest rate hikes in Australia in coming months, starting next week at the Reserve Bank board meeting.
As to how far the official cash rate set by the Reserve Bank goes, Hext says ten-year bond rates normally top out around the same level as the cash rates peaks.
“That’s where we are now. We are around about 385 basis points for ten-year bonds.
“The big message is that investors have a bit of time on their hands now, but things will start to move quite quickly by the middle of the year.
“So investors should be getting their duration sorted.”
That means checking the duration of your fixed income investments and their sensitivity to interest rate changes.
“Investors should be getting back to at least where their model portfolios tells them they need to be in the medium-to-long term.”
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.
Find out more about Pendal’s fixed interest strategies here
About Pendal
Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management.
In 2023, Pendal became part of Perpetual Limited (ASX:PPT), bringing together two of Australia’s most respected active asset management brands to create a global leader in multi-boutique asset management with autonomous, world-class investment capabilities and a growing leadership position in ESG.
As markets absorb the impact of central bank tightening, it’s important to maintain a high-quality, balanced portfolio, says Pendal’s ANNA HONG
INVESTORS need two things in 2023 – protection and patience.
Today’s Australian monthly CPI shows the Reserve Bank’s tightening – which started in the second quarter of 2022 – is starting to have an impact.
The monthly CPI indicator rose 7.4% for the year to January – an easing from 8.4% in December.
Monetary policy works with a lag – but it does work.
This can be observed through the two key components of the CPI number: new dwelling prices and rents.
Compared to December, there is moderation in the growth of new dwelling prices and rents – which accounts for almost a fifth of the basket.
The January data also shows price increases have slowed more broadly.
We may have passed peak inflation.
This will be welcome news for the RBA.
But their job is not done.
While price rises are moderating, inflation can be sticky. That’s something the Reserve Bank is alert to.
Globally, we are still in a tightening cycle as central banks race to contain inflation by unwinding the easy money of the last couple of decades.
As the markets absorb the impact of coordinated central bank tightening, it’s important to maintain a high-quality, balanced portfolio.
Defensive assets can play an important role as a shock absorber when risk assets wobble.
The effects of central bank tightening will continue to flow into economies and markets in 2023.
Investors should add protection to their portfolio, but may need patience to reap rewards.
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
About Pendal Group
Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management.
Corporate Australia is looking robust as macro forces work their way through, says Pendal’s OLIVER RENTON
- Earnings season surprisingly conventional
- Five big themes in reporting season
- Find out about Pendal Focus Australian Share fund
ASX earnings season — which wound up at the end of February — delivered a more robust-than-expected picture of the economic backdrop.
Earnings upgrades and downgrades were broadly in line with historical averages despite higher inflation and a tight labour market.
But a closer look at the half-year results shows signs that increasing prices, higher rates and energy prices are at different stages of working their way through corporate Australia.
Investors should be a little wiser as to how this all plays out — without yet having the full picture.
As always there are opportunities and risks over the remainder of 2023, says Oliver Renton, an analyst and co-portfolio manager with Pendal’s Australian equities team.
“If you look top-down at how the reporting season played out, it was pretty normal in terms of the mix of revisions, upgrades and downgrades,” says Renton.
“That’s illustrative, because it wasn’t expected to be a normal reporting season with all the fears around the consumer, home-owners, interest rates and macro-economic forces more broadly.
“So, to come out of the reporting season relatively unscathed in terms of earnings shows the economy is probably holding up better than was feared.”
Here are Renton’s five big themes from this reporting season:
Interest Rates
The effect of higher interest rates is generally well understood. There is a lag, however, as companies adjust decision making to reflect higher costs of capital, says Renton.
Also, with some companies locked in to fixed rates or hedging, the impacts are yet to fully flow through company P&Ls.
“A few companies hit expectations at an operating level but missed at a net profit level.
Alot of that can be attributed to interest costs.”.
Labour cost pressures
Early signs of higher wages are starting to show in company results.
But the full effect could take to two-to-three years to flow through in countries like Australia, he says.
“Even as some of the heat comes out of the headline employment and wages statistics, we continue to be cautious on labour pressures coming through and pressuring margins.
“Labour pressures come through with a lag and we see that persisting for some companies over the forecast horizon.”
Inflation
“In an inflationary environment, we favour companies with a degree of pricing power, strong margins and control of their cost base.
“The online classifieds companies, CSL and COH have these attributes, for example, and they held up relatively robustly.”
Consumer confidence
The earnings season has not resolved concerns about the outlook for household spending and consumer confidence, says Renton.
“This was not the sort of reporting season that washed those concerns out.
“Ultimately, the economy does need to cool, rates probably need to go up or stay higher for longer and the outlook is for a more cautious consumer.”
Energy
This reporting season, energy stocks had exceptional periods for revenue off the back of high commodity prices.
That largely flowed through to bottom-line results and strong dividend outcomes.
“Ampol had revenue up 78 per cent, Viva was up 66 per cent, Santos was up 65 per cent and Woodside up 142 per cent boosted by the BHP transaction,” said Renton.
“Of course, if they’re making those sort of revenues, then that’s inflation which is coming through the rest of the economy.”
Share price performance
ASX-listed stocks dropped about 3 per cent over February through the company reporting season, giving back some of the strong gains in January.
“At a headline level reporting season appeared quite normal, but there is a lot going on under the surface and much-discussed macro drivers are only just starting to come through in actual company earnings,” says Renton.
“This reporting season was not a widespread cleansing event.
The same pressures we’ve been speaking about for the past 12 months are not in the rear-view mirror yet.
“The good thing is that the intersection of those macro forces with company specifics continues to create opportunities to add value.”
About Oliver Renton and Pendal Focus Australian Share Fund
Oliver is an analyst and co-portfolio manager with Pendal’s Australian equities team. He has more than 15 years of industry experience.
Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management.
Here are the main factors driving the ASX this week according to our head of equities Crispin Murray. Reported by portfolio specialist Chris Adams.
GLOBAL markets remain weak as the US and European economies continue to show greater strength than expected.
Last week’s US personal consumption expenditures (PCE) data – a measure of inflation – also came in higher than expected.
Bond yields continue to climb in response. US two-year yields broke to new cycle highs of 4.8% while 10-year yields are at 3.95% – 30 bps off their cycle highs.
The same is true in Europe, with German two-year yields at new cycle highs of 3% versus -0.5% this time last year.
Australian bonds yields haven’t quite broken to new highs. But we suspect it’s a matter of time until we test 4%.
Higher yields are a headwind to equity markets. The S&P 500 fell 2.66% last week and has now given back about 60% of the year’s gains.
The Australian market (S&P/ASX 300 was down 0.29%) held up better than the US. Reporting season is broadly signalling earnings resilience for the time being.
A firming bid for Origin (ORG, +15.4%) also helped. The Australian market has now given back about half of its 2023 gains.
Higher rates are driving the US dollar higher. Resulting tighter global liquidity adds an additional market headwind.
The S&P 500 has fallen back to its 200-day moving average support level, so this week’s payroll data will be important.
There is debate as to whether the mild winter is playing havoc with seasonal adjustments and the underlying economy is in fact slowing.
The downside risk comes with sticky inflation forcing the Fed to be tougher, ultimately exacerbating a second-half slowdown or recession.
US Economics and policy
Last week’s jobless claims data, PMI surveys and personal consumption all reinforced the trend of stronger-than-expected economic conditions.
In combination with the PCE reading, this has prompted the market to shift rate expectations to a peak of 5.25% to 5.5% and a slower descent from the peak.
The PCE rose 0.62% month-on-month and 5.38% year-on-year.
Core PCE rose +0.57% month-on-month, its strongest monthly gains since June 2022. It is up 4.71% year-on-year. We also saw upward revisions to recent months.
Core services PCE is the key battleground determining how quickly inflation will fall. It had its largest three-month moving-average increase for the cycle.
The bottom line is that these numbers are too hot for the market’s liking and leave the Fed in a challenging place.
At this point a return to a 50bp hike in the next meeting remains unlikely. But the bar for a pause in hikes has been lifted.
This is all underpinned by an economy holding up better than expected.
The Atlanta Fed’s GDPNow indicator remains materially higher than market forecasts for Q1 – and is still rising, driven by non-residential investment and consumption.
High-profile job cuts that have come with US reporting season are not reflected in US Initial Unemployment Claims, which remains at historical lows.
Clearly there is a direct effect of unemployment on wage inflation.
In addition, low unemployment and concern around job security have a significant bearing on propensity to spend and the savings rate. Last week’s personal consumption data highlighted the continued use of excess savings to support spending, despite the low savings rate.
We also saw more data revisions, raising the current savings rate from 3.4% to 4.7% (which is not as low as feared).
This inferred that excess savings have been run down less than thought. The potential size of excess savings also ranges widely depending on the calculation methodology.
The upshot is that it could continue to support spending anywhere between six and 12 months. This will also be tied to confidence around employment prospects.
Markets
This week’s US payroll data – and the inference for inflation and economic conditions – will be important with the S&P 500 falling back near a technical support level.
A bounce off the 200-day moving average would be a clear positive. If the support level fails, the December low of 3800 – or even potentially a cycle low of 3600 – could be tested. The US dollar index has risen back to resistance levels.
If these are broken, it would remove a prior tailwind for equities.
Finally, the US 30-yr bond yield is approaching a key resistance point at 4%. Concern over housing will build if it breaks through.
In the oil market, we are seeing counter-seasonal increases in crude and product inventories. This can no longer be blamed on the release of the US strategic petroleum reserve.
This is inconsistent with what you would expect, given stronger US economic data and the re-opening of China. Nevertheless, it is occurring and is downward putting pressure on oil prices.
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Brent crude currently looks range-bound between US$70 to US$86 a barrel. With spot at $US83, the near-term risk is to the downside.
Australia
Resources (-2.28%) fell as sentiment around China’s economy continue to deteriorate.
Any signs of continued recovery after the Chinese New Year have been limited, though this may simply be due to the winter.
The National People’s Congress which began yesterday will see the official announcement of new government positions and economic targets.
Utilities (+6.22%) outperformed as the Brookfield consortium’s re-cut bid for Origin Energy (ORG, +15.43%) was more favourable than the market expected.
ASX half-year reporting season
With only two days left we have a clear read on reporting season.
The broad theme has been stronger revenue offset by weaker margins
December-half revenue has risen 12% at an index level. About 38% of companies have beaten expectations while 18% have missed.
However this has not translated into operating leverage, since costs have risen 15% at the index level.
A margin squeeze has seen 49% of companies miss EPS expectations, versus a historical average of 30%.
Companies have signalled that costs are decelerating – though they will need to, since revenue can’t continue at this pace.
The net effect is that the misses have not flowed through to a spike in negative forward-year earnings revisions.
The mix of upgrades and downgrades to forward-year EPS was in line with historical trends.
Interest costs are beginning to build as a headwind to EPS, but still remain at relatively low levels.
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 an independent, global investment management business focused on delivering superior investment returns for our clients through active management.
Here are the main factors driving the ASX this week according to portfolio manager Jim Taylor. Reported by portfolio specialist Chris Adams
JOB cuts and Fed rate hikes have not curbed the animal spirits of the US consumer.
The consumer is employed, enjoying strong wage growth, unworried about job loss – and still has some savings left over from the lockdowns.
Net lenders to the system are enjoying rates that were not expected for many years. That’s basically free money in the pocket right now.
The net effect is the assured deflation story is being called into question. The market has reacted by pushing up peak rates and removing a large portion of cuts that were priced in for this year.
The complicating factor in this seemingly straightforward trade is the magnitude of the violent market melt-up we saw a few weeks ago.
This is keeping the bears at bay – and seemingly reluctant to put the potential-end-of-deflation trade on.
Reporting season results are mixed.
There are plenty of misses, but some big moves where results are better than expected or where stocks were excessively discounted in anticipation of a poor result.
The S&P 500 was essentially flat last week (-0.2%) while the S&P/ASX 300 shed 1.1%.
Australian macro conditions
RBA governor Phil Lowe’s address to parliament reiterated the recent hawkish shift and the RBA’s “tightening bias”.
“The board expects that further increases will be needed over the months ahead to ensure that inflation returns to target and that this period of high inflation is only temporary,” he said.
“How much further interest rates need to increase will depend on developments in the global economy, how household spending evolves and the outlook for inflation and the labour market.”
He did caveat that the RBA was “conscious that there are risks in both directions”.
He also noted the RBA “meets every month, which gives it frequent opportunities to evaluate how these various risks are evolving and to respond flexibly as appropriate”.
Consumer sentiment fell 6.9% to 78.5pts in February, retracing a bump from the last few months and taking the reading back to November 2022 levels.
The decline was broad based, but perceptions of family finance and economic conditions over the next 12 months were particularly weak.
On the other hand, trading conditions for businesses remain near all-time highs, according to the latest NAB survey.
January’s ABS Labour Force Survey was weaker than expected, with total employment falling 11.5k versus +20k expected. The unemployment rate rose 15bp to 3.67% and hours worked fell to 2.1% month-on-month.
However, the Bureau flagged caveats to January’s data linked to difficulties in post-Covid seasonal adjustment; a larger-than-usual number of people ‘waiting to start work’ (but registered as unemployed or not in the labour force); and a higher-than-usual uptake of annual leave.
US macro conditions
There were mixed messages from the Fed last week.
Federal Open Market Committee voting member Lorie Logan warned the Fed may need to raise rates more than expected to ensure prices moderate.
Thomas Barkin, a non-voting member, said much the same thing: “Inflation is normalising but it’s coming down slowly.”
Patrick Harker, a voting member, took a more dovish line, noting that “we are not done yet… but we are likely close.”
January’s CPI data was in line with consensus at 0.5% month-on-month. The yearly figure of 6.4% was a touch ahead of expectations, though down from 6.5% the previous month.
Services excluding energy and housing – the Fed’s favourite core measure – was +0.4% on a monthly basis and +5.6% year-on-year.
In the core, primary rents and owners-equivalent-rent both rose at the slowest monthly pace in three months.
The 3m/3m annualised rate is now at 4.5%, down from 5.3% in December.
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That’s the slowest rate of increase on this basis since January last year, but it’s unlikely to slow further unless the monthly prints soften.
Vehicle repair prices were up 2.7%, lifting the yearly rate to 23.1%. Car insurance prices jumped 1.4%, well above the recent trend.
These two components together accounted for half the increase in January CPI services (excluding energy and housing).
The January PPI rose 0.7%, above a consensus expectation of 0.4%. The core rose 0.5% above a 0.3% consensus.
The headline PPI was lifted by higher electricity, natural gas and petrol prices, which should subside in February.
Initial jobless claims dipped to 194K from 195K, slightly below the 200K consensus expectation.
US retail sales rose 3% in January, versus 2% expected. This reflected very low unemployment and growing wages.
It is worth noting that the EVRISI Pricing Power survey – having fallen sharply in recent months – is now moving sideways at a still-elevated level. This reflects the strong consumption data noted above.
Overall, a resilient economy has resulted in a step-up in expectations of peak rates. A significant chunk of 2023 rate cuts – which had previously been priced in – have now been removed.
Markets
ASX results season dominated returns last week.
Good results
The market had been worried about the impact of claims inflation and reinsurance costs for QBE Insurance (QBE, +8.8%). But it delivered on 2022 expectations and issued confident guidance for 2023. The CEO believes volatility has been taken out of the business. This was further supported by a transaction removing 1.9bn of problematic US reserves. The message was reduced risk plus expanding earnings – an attractive combination that should help the multiple recover.
Endeavour (EDV, -0.6%) beat earnings expectations by about 8% as lower-than-expected cost growth buoyed margins. The company continues to lose market share in retail. Gross margins are elevated, up 242bp versus pre-covid levels. This is a risk to future earnings.
Wesfarmers (WES, +3.6%) delivered a solid result, helped by improved retail trading in November and December. Kmart is delivering near 10% margins. Bunnings was weaker with incremental margins at about 4% versus an overall margin of 13.4%. Retail continues to hold up, but is still a looming risk for the company. Chemicals earnings have also been boosted by ammonia and DAP prices, though that earnings leverage has now largely played out.
Seven Group (SVW) had good results with Westrac EBIT +21% and Coates +25% year-on-year EBIT growth. Management upgraded guidance from low double-digit for both Westrac and Coates to mid-teen and high-teen growth respectively. This seems conservative given the first-half strength, giving SVW room for another update or upgrade later in the year.
Indifferent results
Commonwealth Bank (CBA, -8.2%) delivered a solid result with sequential growth of 12% revenue and 25% pre-provision profit. But the market focused on a cautious outlook, which suggested margins had peaked as a result of intense mortgage competition and emerging deposit competition.
Telstra’s (TLS, +3.4%) EBITDA for the half came in just above consensus. It looks on track for the high end of guidance and everything is going well operationally. There are a few items that will probably result in the second half being sequentially better than the first. International roaming is also coming back, with $100m of revenue growth. This takes it to 70% of pre-Covid levels.
Computershare (CPU, -3.4%) reiterated strong guidance for margin income given rising rates. But EBIT ex-margin income fell 40%. CPU needs a sharp recovery in transactional activity (corporate actions, share plans activity) to meet guidance.
National Australia Bank’s (NAB, -5.8%) quarterly update ran counter to CBA with continued margin expansion of 15bp (ex-markets). NAB is potentially best placed in the short term given its skew to small-to-medium enterprises (SME). NAB would also have benefited from running below system growth in mortgages, though it will likely start to re-engage in this market.
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JB Hi-Fi (JBH, -2.3%) had a positive (pre-announced) result with earnings up 15% vs pcp. The surprise came in the form of margin drivers. The cost of doing business is up 24% versus pre-Covid for both the JB Hi-Fi and The Good Guys divisions. This was the first period where the cost base was unaffected by Covid-trading disruptions. Revenue growth rates are now falling behind cost-growth numbers. This creates a scenario for earnings to fall below pre-Covid levels if revenues continue to normalise along with gross margins.
Newcrest’s (NCM, -4.8%) half-year result was largely in-line with expectations. The board has formally rejected Newmont’s takeover offer, but granted limited due diligence. Any increase in the offer price arguably leads a decline in Newmont’s share price, negating any increase. Newmont will no doubt incorporate NCM’s 20cps special dividend plus 15cps interim dividend into their calculations.
South32’s (S32, -1.1%) half-year result was largely as expected with production guidance unchanged. As expected, free cash flow was muted given a few one-offs and a working capital build. S32 nevertheless extended its share buy-back program. Outlook commentary was positive, particularly with respect to current free cash flow generation and project development in the US.
Fortescue’s (FMG, +1.2%) financials were in-line with expectations. The dividend was 3% ahead of consensus despite a drop in the payout ratio to 65% vs 70% a year ago. The market’s focus remains on Fortescue Future Industries. FMG says five projects will go to final investment decision this year. But there is no incremental news on project scale or economics, or detail of funding. This remains a key concern, despite recent headlines on job cuts.
Evolution (EVN, -7.4%) came in slightly weaker than expected for the half, with net debt now at $1,455m and gearing at 31% versus an internal limit of 35%. However EVN surprised positively on the dividend, flagging confidence in its balance sheet and reiterating an equity raise is not needed. Net debt should peak this quarter, with deleveraging the focus from here. Commentary on Red Lake was positive, but capex uncertainty remains around Ernest Henry and the economics of the proposed Mungari expansion.
Challenger (CGF, +2.6%) had an in-line result with higher rates driving strong annuity growth. There had been some hope product margins would also expand given rising credit spreads. But management instead said it wanted to pass the benefit of base rates and spreads onto customers, to drive growth. This potentially limits further multiple expansion.
Whitehaven Coal (WHC, -2.5%) had pre-guided on EBITDA and net cash so it was all about the dividend, which came in at 32cps vs. consensus 48cps. WHC has said there would be more at year end, but we note it underspent on capex in the first half and a decision on Vickery is due imminently. Revenues are also expected to be lower, given a decline in thermal coal pricing.
Disappointing results
Aurizon (AZJ, -7.3%) missed expectations and downgraded full year guidance by 4%. Exposure to weather events surprised on the downside. Further capex of 215m announced for growth in bulk rail operations, ahead of any contract wins creates new uncertainty. Not a great deal to get excited about as the company continues with the challenges of transitioning away from reliance on Coal earnings.
The market had been looking for positive developments on costs and capital for AMP (AMP,-14.8%). But they did not materialise. Management recognised costs were too high and said they’d be flat in 2023 while a strategy is formed. Capital management was reiterated at $1.1bn but will take time to deploy and now appears to be inclusive of 2022 and 2023 dividends.
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.
Here are the main factors driving the ASX this week according to our head of equities Crispin Murray. Reported by portfolio specialist Chris Adams.
STRONG US payroll data and consumer expectation surveys last week painted a picture of an economy that continues to hold up well.
Bond yields rose in response and equities gave back some of their recent gains.
US two-year government bond yields rose 23bps and saw the largest spike since September. At 4.52%, the two-year yield is 46bp above the January lows and is 21bp off its cycle highs.
This led to rotation away from yield-sensitive technology and REIT stocks.
The S&P 500 fell 1.7% last week and the NASDAQ lost 2.4%. They remain up 6.7% and 12% for the year, respectively.
The sell-down was not broad-based and looks more like a consolidation than start of a sharp reversal.
In Australia we saw a sharper reversal in the short end of the bond curve. Two-year government bond yields were up 41bps, as the RBA pushed a more hawkish line on inflation than expected.
The S&P/ASX 300 fell 1.7% and is up 5.6% for the year.
Trends and potential scenarios
It’s too early in reporting season to identify trends, though domestic stocks appear to be holding up better so far. This year’s rally has been driven by signs of inflation and wages easing without a sharp economic slowdown.
This “soft landing” (or ”narrow path” or ”immaculate disinflation”) scenario is the most bullish of the three broad outcomes.
The market likes the idea of a limited earnings downturn combined with falling rates.
There are two other, more bearish, scenarios:
- Structural inflation: Some combination of limited commodity supply, structural constraints on labour, re-arming of nations, re-shoring of supply chains and de-carbonising power and energy infrastructure all contribute to inflation remaining higher for longer.
- Policy is already too tight: A lagged effect – currently hidden – will prompt a recession in the second half of 2023.
We are in a better place than we were three months ago, but material risks remain.
We need to regularly gauge the scale and direction of economic data to get a better read on which scenario is playing out.
US Economics and Policy
Rates
A strong labour market – plus signs of housing pressures easing and improvement in consumer sentiment – contributed to the market adding back in an expected rate hike.
This takes the peak to between 5% and 5.25% and means a pause after the May hike, rather than March.
Revisions to historic CPI (following the annual recalculation of seasonal adjustment factors) show the decline in core services inflation (excluding housing) may not have been as material as originally reported.
This means the three-month seasonally adjusted annual rate over the last three months is 3.5% rather than 2.6%. This helped support a shift higher in expected rates.
Labour markets and the economy
Economic contradictions are evident in a number of areas. Lead indicators such as the Conference Board Leading Economic Index (LEI) suggest forthcoming recession.
Meanwhile jobless claims are at historical lows.
The number of employed people is above pre-Covid levels, while the number of job openings is far higher. This all highlights the strength of the labour market.
The Fed is focused on the labour market becoming more entrenched as the transmission mechanism for inflation.
One possible reason for its ongoing resilience – and that of the economy more broadly – is that the lagged effect of tightening is longer in this instance.
Another is that other factors such as “labour hoarding” are working against the traditional transmission mechanism.
There have been a lot of headlines about job cuts in the US.
Last week Disney announced 7000 job cuts, NewsCorp 1250, Yahoo 1600, Dell 3500, Boeing 2000, Zoom 1300 and Affirm 485.
However aggregate data indicates overall layoffs are still relatively limited and well below levels consistent with recession.
Job cuts are concentrated in the technology sector, where average employee numbers have risen by 40% in recent years. Jobless claims data suggest people are still able to find roles elsewhere.
All this begs the question whether the recent down-trend in wages will continue.
The US economy remains strong. The latest Atlanta Fed GDPNow signal is well above consensus market forecasts for Q1.
Consumption remains a key driver.
Aggregate excess household savings are running down at a rate of $80-90 billion per month. But with $1.1 trillion remaining it could support the economy for another five to six months.
That said, there are some negative signals on the economy:
- The yield curve hit new lows in terms of inversion last week. History suggests a recession within 12 months of yield curve inversion.
- Money supply is running at -7.8% year-on-year in January.
The risk of recession remains. But history indicates that once rates peak they reverse relatively quickly.
Whether that happens this time depends on the stickiness of inflation.
Australia
There was an important shift in the RBA’s stance last week. The messaging became more hawkish, in response to December’s stronger-than-expected inflation data.
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This led to a step up in short-term rate expectations. Rates are now expected to peak around 4%.
The RBA has noted that while housing construction and house prices have reacted as expected to higher rates, consumption and investment are holding up more than expected.
The reason why is critical to the path of rates – and whether we see only another 50bps to 75bps of hikes, or if a more sizeable increase is required.
The benign case is that strong consumption reflected a one-off “celebration Christmas” post-Covid and that spending falls away quickly.
As it stands there is no data supporting this theory. However the impending step-up in rates for those with fixed mortgages may quickly change that.
The RBA is indicating it needs to jolt consumers into worrying more about the future. This would help contain consumption and would mean fewer rate increases.
The challenge is the RBA’s policy setting is looser than other central banks.
There are several reasons why this may not be logical:
- Inflation in Australia is still rising, even in durable goods. There is hope that the latter reverses sharply.
- Unlike the US, rents here are still rising thanks to immigration. Household formation rose through the pandemic. The RBA will be looking for this to reverse to ease pressure.
- We need to hope that Australia’s current terms of trade boost does not translate into more investment spend. So far it has not.
- We need the government’s support for inflation-linked wage increases for low-paid workers not to flow through into higher income groups.
There is a lot on the line.
In the near term the market gets the benefit of earnings holding up better than feared.
The risk will be if this ends up requiring much tighter policy.
Markets
The US equity market is not giving the same signals we saw in April, August and November last year, which led to more significant corrections.
The Australian market saw weakness in REITs and technology, which had been leading the market in 2023. Thematic rotation continued to play a major role in stock performance, but stock specifics also started to come through as results begin.
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 an independent, global investment management business focused on delivering superior investment returns for our clients through active management.
The RBA’s hawkish tone could mean a hard landing with a fast turnaround on rates later this year. That means fixed interest investors should be eyeing longer-dated bonds.
In Pendal’s latest webinar, Commbank chief economist STEPHEN HALMARICK reviews the latest economic data while Pendal head of bond strategies TIM HEXT outlines the impact on fixed interest investors. Here’s a summary.
WITH higher rates on their minds, Aussies have begun reining in spending in the past two weeks, says Commbank chief economist Stephen Halmarick in a new Pendal webinar.
Halmarick, who has a unique, real-time view of the spending habits of CBA’s 16 million customers, says consumer spending continued during the summer holidays, but is now slowing down.
The economist was speaking alongside Pendal’s head of bonds Tim Hext in Wednesday’s Why bonds, why now? webinar. (You can watch a replay here).
“People were saying: ‘I know interest rates are going up and I know inflation is high, but what the heck, I need to have a holiday’,” says Halmarick.
“That was pretty clear in the data. Things like eating out and recreation and travel were very strong.
“In the first week of February, things have definitely softened again.
“I’ve seen a turn-down in spending in the last two weeks on the CBA credit and debit cards.” (Halmarick stresses the data analysis is anonymous).
That will be good news for the RBA, but it’s unlikely to change its hawkish approach to inflation in coming months.
Why bonds, why now
Ausbiz’s Nadine Blayney interviews CBA chief economist Stephen Halmarick and Pendal head of bonds Tim Hext
ON-DEMAND WEBINAR
That’s partly because of strong wage growth – another area Halmarick has excellent real-time insights via the salaries deposited into savings accounts.
“The annual rate of wages growth is heading towards 3.5 per cent,” he says. That’s against official ABS data showing 3.1 per cent growth.
“If it gets too much north of 3.5 per cent towards 4 per cent, the RBA will be quite worried about the inflationary impact of that and then maybe you get more rate hikes.
“So, we’re definitely watching wages go up very closely.”
Odds increase on hard landing
While a soft landing is still likely, the chance of a hard landing in Australia is rising as the RBA takes a more aggressive approach to inflation, Halmarick says.
The strong tone taken by the RBA this week has narrowed the path for the bank to get control of inflation, with the official cash rate now expected to hit 3.85 per cent by April, up from 3.35 per cent today.
“We would describe that as very restrictive monetary policy,” he says.
“The RBA has been talking about a narrow path forward to get inflation back towards target while also having the economy grow.
“I think that path is getting narrower and narrower. The risks of a hard landing are growing.”
A short cycle?
Halmarick reckons the cycle will be short and rates could still fall this year.
He is forecasting “inflation declining at a much faster rate than the Reserve Bank’s forecasts”.
That means rates are likely to peak this year, he says.
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“We’re currently forecasting GDP growth this calendar year of 1.6 per cent but the risks are now on the downside for that.
“We think the RBA will need to start cutting interest rates before the end of this year. So, we’ve got a fairly quick turnaround in that cycle.”
What it means for investors
The upshot for fixed interest investors?
Pendal’s Tim Hext says it’s time to consider longer-dated bonds as insurance while locking in a decent income.
Bonds play two important roles in a portfolio: acting as an insurance policy against a downturn and providing income.
“It’s certainly not a time to be underweight bonds,” says Hext. “A 3.7 per cent triple-A government guaranteed return for the next 10 years is pretty decent income.”
But investors need to consider the duration of bonds as the economic picture changes, he says.
Take care with bond duration
Duration is a measure of the sensitivity of a bond’s price to changes in interest rates.
The longer the duration of a bond (for example ten years compared to two years), the more sensitive the bond’s price is to changes in market interest rates.
“Duration is the period you are locking in current rates for,” says Hext.
“If you buy a 10-year bond, you’re locking in for 10 years. If you buy a two-year bond, it’s only for two years.
“Bond prices are far more sensitive to interest rate changes the further out you go.
“If you think rates are going up, you should keep your investments as short as possible so you can take advantage of the higher rates down the track.
“But if you think rates are going to fall, you want to lock them in for as long as possible.
“Our advice to clients is if you’ve got quite short duration, you should be looking to lengthen that.
“With 10-year bonds around 4 per cent, we don’t think cash rates are going to be able to get that high. If they do, they’ll only be there very briefly.
“Therefore, you’re going to get a better income locking in for a longer term.”
Watch a short webinar with Stephen Halmarick and Tim Hext
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.
Find out more about Pendal’s fixed interest strategies here
About Pendal
Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management.
In 2023, Pendal became part of Perpetual Limited (ASX:PPT), bringing together two of Australia’s most respected active asset management brands to create a global leader in multi-boutique asset management with autonomous, world-class investment capabilities and a growing leadership position in ESG.
Here are the main factors driving the ASX this week according to portfolio manager Brenton Saunders. Reported by portfolio specialist Chris Adams
MARKETS continue to rally hard, helped by dovish Fed commentary following last week’s 25bps rate rise in the US.
We’ve also seen notable US economic data.
The Nasdaq lifted 3.3% last week while the S&P500 was up 1.6%. The S&P/ASX 300 gained 1.1%.
The NYSE FANG+ index – which tracks tech companies such as Amazon, Google and Facebook-owner Meta – is up about 30 per cent this year. Meta jumped 23% last week.
US bond yields and the US dollar rose moderately by the week’s end. Most of the moves came on Friday in response to very strong non-farm payrolls data, which raises expectations for further rate increases.
A stronger US dollar weighed on most commodities, though iron ore continued to make good gains.
Elsewhere, the European Central Bank raised rates by 50 basis points. Another 50 points is likely in March.
Commentary suggested the ECB was heartened by falling inflation, helped by a mild winter and a fall in natural gas prices.
US economy and the Fed
The US economy is so strong that some are wondering if it’s less about a hard or soft landing – and more about whether there is a landing at all.
Inflation continues to cool in many areas. But strong labour markets are confounding the more bearish economic forecasts.
The Federal Open Market Committee – which is responsible for setting US monetary policy – raised rates 25 basis points to 4.75%, in line with expectations.
Fed chair Jay Powell noted greater optimism around inflation and the start of a disinflationary process.
However, he also said the FOMC “anticipates ongoing increases in the target range would be appropriate” and there was “more work to do” on raising rates.
If the US economy performed as the Fed expected, it would not be appropriate to cut rates in 2023, Powell noted. This is in keeping with recent signals.
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But if inflation slowed faster than expected, this would be incorporated into their thinking, he said.
On balance, markets took this nod to data-dependency as dovish – particularly since Powell down-played improvement in total “financial conditions” in response to a question.
Financial conditions tries to capture the cost and availability of funding, which impacts spending, saving and investing for businesses and households. Indicators include corporate borrowing rates, US equities and even the US dollar.
While the language was softer, there is a risk that the market’s interpretation is overly dovish in the face of continued strength in the US economy and labour market.
The latter was emphasised by Friday’s non-farm payroll data.
By Friday the short end of the US yield curve had more than retraced a bond rally that came after the Fed’s press release.
Some analysts are raising the possibility that the Fed may be raising rates by 50 points in March or May, rather than the currently expected 25 points.
The market continues to price Fed rate cuts in late 2023. This expectation may have to shift if labour markets remain strong.
The market is also implying rate cuts in Australia by the end of the year, but from a high point of about 3.6%, versus about 5% in the US.
The US dollar is down about 10% from its late September high (as measured by the DXY).
Some degree of consolidation – or even reversal – is now likely, which may be a headwind to commodities and markets in the near term.
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Pendal Horizon Sustainable Australian Share Fund
We are likely to see a partial reversal of the 70-point decline in US 10-year bond yields since October 2022, as the market digests the impact of strong jobs data on the interest rate trajectory.
The yield curve remains inverted on most measures.
Bears still point to this as the most reliable recession predictor.
US employment data
The cost of employment – measured by the Employment Cost index (ECI) and Average Hourly Earnings – is trending in the right direction. But other employment data has been surprisingly strong in direction and magnitude.
The market was looking for 188,000 new jobs in the non-farm payrolls last week – and got 517,000 instead.
Unemployment fell to 3.4%, down from 3.5% and below a consensus expectation of 3.6%.
The return of 36,000 workers from strike – and seasonal effects such as relatively warm weather – played a role.
Nevertheless this was a strong print which may result in some re-thinking of the rates trajectory.
This strength was also reflected the latest Job Openings and Labor Turnover Survey and initial claims for unemployment insurance.
US quarterly earnings
Just over half the S&P 500 by number (and roughly two-thirds by weight) have now reported December-quarter earnings.
The proportion of companies beating eps estimates remains at 69% – below the long-term average.
Aggregate consensus earnings estimates for FY23 have bounced from their lows on February 1, but are still down 2.3% since the start of major earnings releases this season.
Markets
The S&P 500 next-12-months (NTM) PE is 18.3x, up from lows of 15.5x. The market is forecasting 9% EPS growth for the NTM.
The ASX200 NTM PE is 14.9x, up from lows of 12.6x. The market is forecasting 1.8% EPS growth for the NTM. Technical indicators suggest the ASX 200 is fairly over-bought, with resistance at the 7600-7650 level.
About Brenton Saunders and Pendal MidCap Fund
Brenton is a portfolio manager with Pendal’s Australian equities team. He manages Pendal MidCap Fund, drawing on more than 25 years of expertise. He is a member of the CFA Institute.
Pendal MidCap Fund features 40-60 Australian midcap shares. The fund leverages insights and experience gained from Pendal’s access to senior executives and directors at ASX-listed companies. Pendal operates one of Australia’s biggest Aussie equities teams under the experienced leadership of Crispin Murray.
Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management.
Fed chair Jerome Powell today gave the green light to the market’s move to risk-on investing. But it may not last, writes Pendal’s TIM HEXT
JANUARY was a great month for risk. Equities and bonds had strong rallies. Credit spreads contracted.
As we entered February all eyes were on Jerome Powell and the US Fed to see if they would push back on the easing of “financial conditions”.
Here we’re talking about overall financial conditions for the real economy – not just where the Fed Funds rate is.
Financial conditions tries to capture the cost and availability of funding, which impacts spending, saving and investing for businesses and households. Indicators include corporate borrowing rates, US equities and even the US dollar.
Below you can see the Goldman Sachs US Financial Conditions Index, which suggests it’s becoming cheaper to access money or credit.
The Fed’s response?
This morning the US central bank announced a rate rise of 25 percentage points after a year of bigger hikes.
As always, we look to changes in phrasing in the official Fed statement. Today we saw the phrase “extent of future increases” replace “pace of future increases”.
This is interpreted as the debate shifting from last year’s theme of “25bp, 50bp or even 75bp” to “25bp or nothing”.
The Fed is keeping a few more hikes in its “dot plot”, but it’s now distinctly less hawkish.
All this was not unexpected.
Markets really did not react immediately after the statement.
Rather it was Powell’s press conference that saw equities and bonds get a boost.
The first question asked about the recent easing of financial conditions.
Many would have expected Powell to call this out as unwelcome in the fight against inflation.
He did not.
The Fed, like many central banks caught flat-footed a year ago, is now happy to react to data rather than predict it.
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Of course, inflation is a lagging indicator meaning central banks, including the RBA, are happy to sit back and observe these long and variable lags.
Two of the three planks of high US inflation are now in a downtrend. Goods and rents price should ease further in the months ahead and disinflation will be the trend.
However, the third area of services prices remains high. Easing of wages and employment will be need to return to 2 per cent.
Overall though Powell has given the green light to January’s moves to risk-on investing.
February should see that trend continue although at a more modest rate given current levels.
By the middle of the year though, weakness in the economy and falling business margins may see pressures go the other way.
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.
Find out more about Pendal’s fixed interest strategies here
About Pendal
Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management.
In 2023, Pendal became part of Perpetual Limited (ASX:PPT), bringing together two of Australia’s most respected active asset management brands to create a global leader in multi-boutique asset management with autonomous, world-class investment capabilities and a growing leadership position in ESG.
Here are the main factors driving the ASX this week according to portfolio manager Jim Taylor. Reported by portfolio specialist Chris Adams
THE market is still waiting for a clear indication of how much the global economy will slow this year.
Last week’s economic data didn’t provide a strong signal one way or the other.
European data continued to be better than many feared. US data told the story of moderating inflation and slowing consumer activity as higher rates began to bite.
US reporting season has been mixed from an earnings perspective.
About 100 S&P 500 companies report this week – including Apple, Amazon, Meta, Alphabet, McDonalds, Caterpillar, Merck and Exxon Mobil – which could provide a clearer picture.
Job cuts, which started in tech, have now spread to a broader cross-section of sectors.
The US Federal Reserve meets this week and is expected to hike 25bps, perhaps with some jawboning around “we are not done yet” to keep the bulls at bay.
The S&P 500 gained 2.48% last week. The NASDAQ was up 4.32% and the S&P/ASX 300 rose 0.56%.
North America macro and policy
The Bank of Canada became the first G10 nation to pause its hiking cycle after a 25bp increase to 4.5%.
The Canadians cited “growing evidence that restrictive monetary policy is slowing activity – especially household spending”.
Though they also noted economic growth was “stronger than expected and the economy remains in excess demand”.
This bolstered a growing view that the risk of central banks dogmatically driving the economy into deep recession may have fallen. Instead, a growing chorus of voices suggest the US can achieve a soft landing – in stark contrast to consensus views just a couple of months ago.
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In addition to Fed hawk Christopher Waller’s recent “case for cautious optimism”, prominent economist Larry Summers has said economic figures are looking better than he expected three months ago.
Summers had previously been bearish on the Fed’s ability to avoid a hard landing.
International Monetary Fund managing director Kristalina Georgieva also noted the global economic situation was “less bad than we feared a couple of months ago”.
Elsewhere, there was a slew of data released last week, none of which was individually significant or market moving.
December’s Core Personal Consumption Expenditures (PCE) index (a measure of inflation that excludes more volatile categories such as food and energy) increased by4.4% annually.
This is down from November’s annual rate of 4.7%.
On a monthly basis it was up 0.3%, in line with consensus. It is now at its lowest level since October 2021.
The deflator rose at 3.1% (annualised) in Q4, slowing from 4.5% in Q3 and 5.4% in Q2. Most of the downshift is in the goods component, with rents expected to begin slowing.
Data shows consumers pulled back in December, with spending falling by 0.2% from the month before. Personal income rose 0.2% last month, the smallest increase since April.
Personal saving rate as a percentage of disposable income increased to 3.4% from 2.9% in November.
The savings rate is now up one percentage point from its September low. This is all possible evidence of belts tightening.
Headline US GDP growth of 2.9% looks positive, but strength was driven by inventories.
Domestic demand was relatively modest and likely further weakens in the March quarter.
December new home sales rose 2.3% to 616K, marginally below the consensus of 617K. It’s likely a lack of existing homes for sale is pushing people to buy new homes.
Initial jobless claims are extremely low at 186k, well below the four-week average of 198k.
Employment agencies continue to indicate that wage pressures are subsiding.
Australia
Australia bucked the trend of moderating inflation, with the December quarter’s CPI print coming in hotter than expected.
Inflation rose 7.8% year-on-year, its highest rate since 1990 and ahead of 7.6% expected. It was up 1.9% over the quarter versus 1.8% expected.
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The RBA’s preferred measure – the trimmed mean CPI – lifted 1.7% in the quarter to 6.9% year-on-year, versus consensus expectations of +1.5% and +6.5% respectively.
This is well above the central bank’s 2-3% target and ahead of its 6.5% end-of-2022 forecast.
A 25bp hike in February is now baked in.
Consensus still expects rates to peak at about 3.75% somewhere in the middle of the year.
Digging into the numbers, 87% of categories in the inflation basket are now exceeding 2.5% annualised growth.
Services inflation is now at the highest level since 2008, at 5.5% annualised. This was driven by travel-related categories including domestic airfares and accommodation (+19.8%).
Rents continued to rise in the quarter with the annual pace of increase now at 4%.
Given the current rental crisis across Australia it is hard to see any abatement in this area soon. Food and grocery inflation remains high and broad-based.
One bright spot is that the rate of growth in business input costs, including labour, have been falling across all industries since the mid 2022 peaks
Europe
The outlook for economic activity in the European Union continues to look less dire.
The Euro area composite flash PMI – a measure of economic activity – increased 0.9pts to 50.2.
The gain was broad-based across sectors as the services sector surpassed 50 for the first time since July 22. New orders, employment and backlogs all showed improvement.
US Reporting Season
About 30% of S&P 500 companies have so far reported actual results for the December quarter.
Of these, 69% have reported actual EPS above estimates. This is an improvement on 67% at the end of last week. But the five-year and ten-year averages are 77% and 73% respectively.
At an index level, aggregate Q4 earnings are 5% lower than the previous quarter. If this figure holds, it will be the first time the S&P 500 has seen a decline in annual earnings since Q3 2020, when earnings fell 5.7%.
Four of the GICS 11 sectors are reporting year-over-year earnings growth, led by the energy and industrials sectors.
On the other hand, seven sectors are reporting a year-over-year decline in earnings, led by materials, consumer discretionary, communication services and financials.
Financials have been the biggest contributor to the decline in earnings estimates since December 31.
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.