A monthly insight from James Syme, Paul Wimborne and Ada Chan, co-managers of Pendal’s Global Emerging Markets Opportunities Fund
ONE of the main drivers of global financial markets in 2022 has been the strength of the US dollar (and the weakness of other global currencies), driven by tightening US financial conditions.
The dollar is the preferred currency for international trade invoices and cross-border financial claims.
The global financial cycle is essentially a dollar cycle – and an aggressively tightening Federal Reserve has a chilling effect on non-US economies and non-US financial markets.
Emerging markets can generally be divided into two broad groups:
- Net exporters that tend to run current account surpluses (such as China, Korea and Taiwan, but also UAE and Saudi Arabia)
- Net importers that tend to run current account deficits (such as Brazil, Mexico, South Africa and India).
Historically, the first group have broadly tended towards high sensitivity to global growth and the second to global financial liquidity.
So it’s normally been the second group that has the worst currency and equity market performance in strong dollar/tight liquidity environments.
In 2013 the Fed announced an intention to reduce the buying of US treasuries.
The hardest-hit emerging markets were Brazil, India, Indonesia, South Africa and Turkey. They were dubbed the “fragile five” by one market participant.
This time it’s different
This year has decidedly not followed that pattern.
In the first nine months of 2022, the only major EM currencies to strengthen against the dollar were the Brazilian real and the Mexican peso.
The Indian rupee and Indonesian rupiah were also relatively strong, declining 6.8% and 9.4% respectively.
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By comparison, the Korean won fell 20.4%, the Taiwanese dollar 14.7% and the Chinese renminbi 12%, despite those economies running big current account surpluses.
This pattern is very interesting and points to a real change in leadership in the asset class.
We have previously commented on the positive effect high commodity prices have on commodity economies such as Brazil – and to a lesser extent Mexico and Indonesia.
This continues to play out in economic data. Recent PMI surveys are 51.1 in Brazil and 47.3 in Korea, for example.
Other drivers at play
The explanation is that there are other drivers at play.
One is the Japanese yen.
With ongoing monetisation of debt and low inflation, Japanese monetary policy remains very loose, leading to about a 25% depreciation of the yen against the dollar year-to-date.
Given the tight trade relationships between the four big East Asian economies (both as partners and as competitors), this has put significant downward pressure on the currencies of China, Korea and Taiwan.
Another driver is energy balances.
The huge moves in oil, gas and coal prices in the last two years have been a boost for energy exporters (or large consumers who also have large domestic production).
The value of Indonesia’s exports of oil and gas in the last three months were $US4.6 billion, compared with $US3 billion for the same period in 2019.
By comparison, the cost of Korea’s crude oil imports in the third quarter of 2022 was $US31 billion, compared to $US17 billion in the third quarter of 2019.
At a broad regional level, North America and the Arab Gulf are in extremely strong positions, while Europe and East Asia face a powerful drag on their external balances and their growth.
Although all four East Asian economies have very substantial ability to use their large foreign exchange reserves to support their currencies, their desire to support exports has meant this has been limited.
Japan did intervene last month, but the ongoing economic weakness in China and Japan mean major intervention was unlikely.
By comparison, both India and Indonesia have intervened, supporting their currencies, reducing imported inflation and facilitating economic growth.
Sign of change
We think 2022 is a sign of a change in market leadership in emerging markets.
The markets that might be expected to underperform instead may be the best performers.
We believe that can continue with either a stronger or weaker US dollar.
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 an independent, global investment management business focused on delivering superior investment returns for our clients through active management.
In the current environment tightening must come from a big reduction in government spending to support private sector growth, says assistant portfolio manager Anna Hong
THE RBA’s Financial Stability Review sheds light on last week’s decision to limit the cash rate rise to 25bps.
It shows the Reserve Bank is keeping a close eye on the ability of households to absorb the impact of rate rises instead of blindly following other central banks.
In this world of instant gratification the effect of monetary policy is no different. If inflation has not reversed since the last hike, let’s go again, more this time.
Our collective impatience meant the Reserve Bank’s decision to hike 25bps stuck out like a sore thumb in a sea of 50bps and 75bps rate hikes from other central banks.
These consecutive rate hikes ignore the fact that the cash rate target is a blunt instrument that requires time to trickle into the economy.
Its ability to control demand in a supply-shocked environment is made even harder by large-scale Covid stimulus programs we’ve seen in most of developed economies.
In Australia, the fiscal stimulus – JobKeeper, JobSeeker – was effective because it skipped part one of the song and went straight to part two – the household balance sheet.
Interest rates alone will not be sufficient to unwind demand supported by the lingering effects of the stimulus.
The federal government will need to deliver a sensible budget to help the RBA keep the Australian economy on track.
Despite signs of a roaring economy – real GDP growth, low unemployment, strong business conditions – household nerves about the future have led to near-historic lows in consumer confidence.
A never-ending increase to interest debt-servicing costs will only make consumers more pessimistic, eventually hurting business profitability in the form of lower consumer demand and higher cost of credit.
Fiscal policy is the circuit breaker required to stop that trajectory.
Productivity drives real growth. That comes from private sector growth.
In the current environment, tightening must also come from a large reduction in government spending so the private sector can take over.
A productivity-driven expansion will ensure the economy stays on the right track with a lift in real wages, ultimately creating sustainable growth.
Are we still the lucky country? The upcoming federal budget will paint a better picture of what’s ahead.
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About Anna Hong and Pendal’s Income and Fixed Interest team
Anna Hong is an assistant portfolio manager with Pendal’s Income and Fixed Interest team.
Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia. In 2020 the team won the Australian Fixed Interest category in the Zenith awards.
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
About Pendal Group
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.
THE sharp equity market rally last week was fuelled by very bearish positioning and ignited by weak job opening and manufacturing data. There were also hopes that emerging financial strain would prompt a Fed pivot.
But the “good is bad” phase proved short-lived. Solid US employment data emphasised a tight labour market, while OPEC+ quota cuts sent the price of oil higher.
The S&P 500 ended the week up 1.56% and sitting at a key technical support level of 3500-3600.
There is scope for the bear market bounce to continue back to the next technical level of 3900-4000, but data trends are not supportive.
The US economy remains resilient with insufficient signs of weakness. Meanwhile inflation remains stubbornly high – with the additional risk that fuel prices are rising again.
The S&P/ASX 300 was up 4.5% last week and continues to outperform. It’s down 6% for 2022, while the S&P 500 has lost 22.7%.
This is due to currency moves, the index sector mix and a defiant RBA.
Our central bank raised rates only 25bps. It’s crossing fingers and toes that the rest of the world fixes the inflation problem and it won’t have to induce a recession here.
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Economics and policy
US job openings were a lot weaker than expected, which is good for markets. The ratio of openings to unemployed remains very high, but the quarterly downward trend is encouraging.
There was also a fall in job “quits” which is a signal people see less opportunity to move.
Job layoffs remain low, which is also constructive. The best scenario is one where the job market loosens via less hiring (ie less labour demand) but layoffs remain limited (ie more supply). A big increase in layoffs is more likely to trigger a recession.
The US is now 50% of the way to reducing the gap between jobs and workers to a level where wages should slow sufficiently, according to a Goldman Sachs indicator.
Wage growth appears to be running over 5% annualised on most measures and needs to drop below 4%.
However the relief on this data was short-lived. Payroll and employment data reinforced the tight labour market.
This is the Fed’s key policy problem, since they risk recession in bringing this down.
There is much focus on the lessons of the 1970s, where the Fed heeded political pressure and loosened too soon. This meant it had to go through three phases of tightening to finally solve the problem.
US payroll data was in line with expectations (+263k jobs). The household survey was a bit stronger than consensus, with the unemployment rate falling to 3.5% due to a 0.1% drop in the participation rate.
The market did not like this because:
- Other data points had been weaker – and the market was hoping for more of that
- A tight labour market supports wage growth, reinforcing the Fed’s need to tighten rates further and potentially risk recession
- The participation rate looked to be increasing, but it fell this month as hopes of greater labour supply faded. The gap in participation compared to pre-Covid levels is mainly in older people and this is unlikely to return
Payrolls need to get down to 50-75k per month to be at a level where wages may slow to the target level.
The household survey of wage growth among production and non-supervisory workers is seen as a better proxy of underlying wage growth. It was stable month-on-month, landing at 5.8% year-on-year. This is consistent with inflation running between 4 and 4.5%.
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Mixed signs on the state of the economy are another challenge for markets.
The bears can point to measures such as housing and trucking as signs the economy is slowing sharply. But consumers continue to hold up – as do hiring intentions.
One of the signals from the employment report is that nominal incomes continue to grow – and in fact are picking up in real terms as inflation slows. This makes the Fed’s job harder.
Underlying resilience in the US economy is also evident in a pick-up in the Atlanta Fed GDP Now tracker. It’s re-accelerated in the last couple of weeks, driven by net exports and the consumer.
The Cleveland Fed inflation tracker is another real-time indicator not helping the case for a pivot. It continues to indicate inflation running at 0.4-0.5% month-on-month.
We will see the CPI print released on Wednesday. This will be a key determinate of market direction.
Oil
OPEC+ surprised the market with a bigger-than-expected quota cut of 2 million barrels per day.
It is worth bearing in mind that many members are already producing below their quotas. By a rough estimate the real production impact would be about half of that announced. The market is expect 0.8 to 1.2m barrels to be taken out of the market.
There will be another meeting in early December to review the impact, so this will be in place for at least two more months.
This was not designed as a direct attack on the US, despite the latter’s reaction.
Instead, OPEC is concerned about the impact of recession on demand – and also that the oil price appears to have disconnected from fundamentals.
When you compare the oil price to inventory levels there is probably a US$20 gap.
OPEC also believes the inability to reach production quotas shows a lot of countries are not investing in capacity – which will make the oil supply-and-demand balance more precarious in the future.
This requires higher prices to incentivise investment. In response to rhetoric from the US, OPEC is also pointing to factors such as levies, carbon taxes and fuel standards as reasons why petrol prices are so high in the west. These, they say, are in the hands of western governments to resolve – if they want to.
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There is now upside risk to the oil price because:
1. Chinese refinery production is ramping up (counter to OPEC’s concern over recession)
2. Another round of sanctions on Russian oil will start in the next few months, creating more friction in oil markets
3. SPR releases will slow from 1m barrels per day to about 500k through to the year’s end.
In combination, these could have an impact of 1.5m to 2m barrels a day on oil supply-and-demand balance, more than offsetting any slowdown.
Australia
The Reserve Bank got global attention last week as people thought the lower-than-expected 25bp hike might signal the beginning of a small pivot from central banks.
We find it hard to draw any broader global conclusions from the RBA’s move.
It could be slowing rate rises to gather more information and gauge the effect of tightening to avoid a policy mistake and recession. The likely rationale includes the notions that:
1. Australian wages have not risen as quickly as other nations, so the RBA has less to do at the moment in loosening the labour market
2. Australia has more short-rate sensitivity due to floating-rate mortgages
3. The RBA has more meetings than the Fed, so they will get the opportunity to re-appraise in early November with more data.
4. They are probably anticipating a reasonably tight federal budget, ie no fiscal stimulus, unlike the UK
5. They will be expecting the tightening in the ROW to help contain inflationary pressures
Also, the RBA has already tightened more than other regions in Europe and Canada, though not as much as the US.
There is some risk to the RBA stance.
While wages growth is slower than the US, surveys indicate it is still rising, unlike the US.
Should this continue – and the Australian dollar weakens – we could see inflationary pressures build, forcing the RBA to go harder again.
For now the ASX can take comfort from the more benign approach from the RBA, with strength across all sectors and resources and domestic cyclicals running. Consumer staples was the laggard.
Markets
The trifecta of higher bond yields, oil prices and the USD is a challenge for equities.
Friday’s sell-off leaves the US market in a finely balanced position in the near term.
The bounce earlier in the week had all the hallmarks of the start of at least a bear market rally, with some extremes in terms of buying / selling ratios.
On average, these rallies are 15% over 32 days, so the 6% in 4 days looked like it should have had legs.
Wednesday’s CPI print is likely to have a large bearing on whether the S&P 500 gets back to 3900 in the near term.
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.
Pendal’s Tim Hext, head of government bond strategies and Steve Campbell, head of cash strategies explain why.
The Reserve Bank of Australia (RBA) surprised the market yesterday when raising the cash rate by 25 basis points to 2.60%.
The market had assigned an 85% probability of the RBA hiking by 50 basis points.
Governor Lowe dropped a hint last month that the pace of tightening would slow when he commented that “the case for a slower pace of increase in interest rates becomes stronger as the level of the cash rate rises”.
The market rallied following this comment which indicated 25 rather than 50 was more likely to happen in the nearer term.
Yesterday’s 25bp hike means the RBA has now raised rates from 0.1% to 2.6% in 5 months. This is now seen as the bottom end of neutral territory.
Markets were looking for a 50bp hike given the hawkish party happening globally, led by Jerome Powell and his recent 75bp hike.
It was a case of a rising tide lifts all boats. As the following graph shows, central banks globally continued to tighten monetary policy aggressively in September.
In Sweden the Riksbank tightened by a more than expected 100 basis points.
The Federal Reserve, Bank of Canada, European Central Bank and Swiss National Bank (the last remaining member of the negative interest rate policy club) all raised their rates by 75 basis points.
The RBA, Bank of England and Norges Bank were all in the 50 basis point hike camp last month.
However, unlike other central banks, the RBA has shown some patience with this move. Rate hikes normally take 2 to 3 months to show up in any data given lags between the RBA hikes and the higher rates hitting mortgages.
One of the key lines out of the statement yesterday was “One source of uncertainty is the outlook for the global economy, which has deteriorated recently”.
The UK Government’s mini budget released last month was the source of much financial turmoil last month, the moves (and lack of liquidity) were astonishing late in the month.
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The RBA is also acutely aware of the large amount of fixed rate mortgages that roll off over 2023.
The national accounts also reflected a drop in the household savings rate, indicating that the large savings buffers that households have built over the past 2 years may start to be called upon as cost of living pressures rise.
The decision to raise by a less than expected 25 basis points yesterday resulted in the market pricing in a terminal cash rate of 3.6% in 1 years time. At the end of September this was around 4.1%.
Back around neutral the RBA now thinks it has time on its side.
Their hope will be for better behaved CPI numbers in the quarters ahead.
The Sep Quarter CPI, due out later this month, should show elevated yet slowing CPI.
Our initial forecast is for a 1.4% increase, although electricity subsidies in WA and Victoria, and a lesser extent Queensland, could mean a lower number.
1.4% would be no cause for celebration but after a 2.1% and a 1.8% in recent quarters it is in the right direction.
Governor Lowe will likely take his next round of speeches reiterating their preparedness to tackle inflation with above neutral rates if needed.
“The Board remains resolute in its determination to return inflation to target and will do what is necessary to achieve that” was the final line of yesterday’s decision.
For now though, reopening of supply chains, anchored inflation expectations and falling commodity prices are working in their favour.
The key domestically will be how tight labour markets feed into wage outcomes over the next year.
The RBA is prepared for 3.5% to 4% increases to wages, as many agreements are now showing, but will be alert for any trend higher.
Immigration is making a welcome comeback and may well impact enough in the next 12 months for the RBA to get their way.
However, the jobs market is unlikely to be back at pre COVID conditions until 2024 so the RBA patience, although welcome, may be tested again.
About Tim Hext and Pendal’s Income & Fixed Interest boutique
Tim Hext is a Pendal portfolio manager and head of government bond strategies in our Income and Fixed Interest team.
Tim has extensive experience in banking, financial markets and funding including senior positions with NSW Treasury Corporation (TCorp), Westpac Treasury, Commonwealth Bank of Australia, Deutsche Bank, Bain & Co and Swiss Bank Corporation.
Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.
The team won Lonsec’s Active Fixed Income Fund of the Year award in 2021 and Zenith’s Australian Fixed Interest award in 2020.
Find out more about Pendal’s fixed interest strategies here
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 Pendal’s Head of Equities, Crispin Murray. Reported by portfolio specialist Chris Adams
Higher bond yields, a stronger US dollar and the expectation of a US recession before the end of 2023 continued to weigh on markets last week.
A bout of panic in the UK bond market added some spice. A government ‘mini’ budget triggered the rout and demonstrated the currently fragile state of the financial system. The Bank of England was forced to buy long-dated bonds to maintain solvency in the pension fund system.
Finally, geopolitical risk remains elevated. Sabotage of the Nordstream pipelines and Putin’s speech signalled the potential for the conflict with Russia to escalate.
The S&P 500 shed -2.9% for the week. The S&P/ASX 300 continues to outperform. It was down -1.6% for the week, helped by a weaker AUD, which broke down versus other currencies.
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US economy and policy.
The Core Personal Consumption Expenditure (PCE) index – which is the Fed’s preferred measure of inflation – came in a little higher than expected for August.
A headline of 0.6% growth versus 0.4% expected caused some alarm, although the actual number of 0.56% versus 0.44% made for better reading. July was also revised down from 0.1% to 0.0%.
Rent increases, which comprise 17% of the index, drove the increase. There is some debate about whether the lagged effect is giving the Fed a false signal as lead indicators of PCE rents – such as the Zillow Home Price index – may have rolled over. However these lead indicators also suggest that inflation in rents is much stronger than is being reflected in the PCE measure. So it probably is not right to discount this component.
Core Services PCE remains resilient, up 0.6% month on month and 4.7% year on year.
All told, this data likely cements in the 75bp November rate increase.
Consumer spending on autos and services continues to hold up and is expected to support 1% growth in real consumption in Q3 2022, helped by a fall in the savings rate. This demonstrates the current resilience in the US economy, given the headwinds from energy and other prices rises.
With real incomes on the rise again, savings rates are likely to rebound higher in Q4. Current estimates have US households running down US$63bn of their excess saving so far, around 30% of the total. This leaves US$1.5tr remaining – around 5.5% of GDP. This helps explains the Fed’s challenge in slowing the economy.
Finally, it is worth noting the downgrade from Nike, which pointed to substantial excess inventories in North America. This will lead to discounting; another sign of easing prices for goods.
Australia
The ASX fell 1.6% and is now -10% in 2022.
The more rate-sensitive sectors led the market lower last week, reflecting concerns over financial stability and rising credit spreads. Financials were down -3.1% and Real Estate -2.9%.
Resources (-1.0%) held up better, helped by a weaker currency and also gold beginning to rally.
Traditional defensives did best, with Health care (1.6%) and Communication Services (0.7%) up on the week.
UK bond market chaos
The fiscal largesse of the UK mini-budget shook confidence and triggered a selling loop in UK bonds, sending the market into tailspin.
The issue is many UK pension funds hold their long-dated exposure via synthetic 30-yr government bonds. This theoretically matches their long-dated liabilities. The problem is that there is a liquidity mismatch. When the bonds start falling, the funds are forced sellers of bonds to raise the liquidity to meet the margin call. This was reinforced by broader positioning in the market.
At one point the UK 30 year bond had fallen almost 50% in value since August, with the yield rising from 2.5% to north of 5.0%.
The Bank of England (BOE) intervened, promising to buy bonds to ensure the market was functioning. Their quantitative easing (QE) did the job, with UK 30-yr yields rallying back to 3.8% by the end of week.
It also saw the British pound bounce back from 1.05 to 1.11 versus the US dollar. This coincided with a broader fall in the latter.
The BOE has said they will continue to buy bonds through to mid-October, which buys time for the pension funds to raise liquidity.
This highlights the current risk of forced liquidations from some market players – another headwind for equities.
The challenge is that the interest rate the BOE should target, given fiscal policy, is likely to be too high for many households to service their mortgages. This could trigger a housing bust.
So the expectation is that they will tolerate higher inflation to hold rates lower and probably sacrifice the GBP.
The BOE’s intervention and Whitehall’s decision to reverse tax cuts may help calm the bond market.
Extreme risk aversion saw money parked in US dollars. With this crisis seemingly averted, this may reverse and we may have seen a near-term top in the US dollar and bond yields.
These signs of financial strain may have a perverse silver lining for markets, in that it may prompt a less severe tone from the Fed.
We may have seen this on Friday where Fed Vice Chair Brainard noted the need to consider time lags with monetary policy. She also noted how the spill-over impact of rate hikes can amplify the tightening of conditions, which appears to be a nod to the risk of some form of financial contagion.
We see three scenarios which could lead to a Fed Pivot:
- Inflation looks to be under control,
- The economy falls into a major downturn, or
- A major financial shock.
At this point the latter two appear more likely but would result in further equity market falls before bouncing back once the Fed pivots.
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Australia
We continue to see the Australian market as more defensive. It trades on a P/E of 12x, versus the S&P 500 at 17x, while the economy is supported by higher savings, a less aggressive central bank, supportive terms of trade and immigration.
The issue for Australia is as much as the RBA may want to limit rate rise, there may be a limit to the gap between our short-term rates and those in the US, before it creates issues with the currency which would exacerbate inflationary pressures.
About Crispin Murray and Pendal Focus Australian Share Fund
Crispin Murray is Pendal’s Head of Equities. He has more than 30 years of investment experience (including 28 years at Pendal) and leads one of the country’s biggest equities teams.
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 Great British Sell Off: The fiscal support package announced in the UK on the weekend could make inflation even harder to control, TIM HEXT explains.
CENTRAL Banks, led by the Fed, have spent the last few months pushing hard their hawkish credentials.
We have been told that combating inflation is priority one and if it means a recession then so be it. Markets have reacted by selling off risk but also moving rate expectations a lot higher.
However, the new UK Prime Minister Liz Truss and her Treasurer Kwasi Kwarteng have taken a more unconventional approach.
They seem to be focused on avoiding recession and hoping that somehow inflation will sort itself out.
Inflation is at its heart a demand versus supply problem. Central banks can’t control supply so they try to impact demand through rates. Fiscal policy can impact supply but it needs to be very targeted.
As a large energy importer the UK has little control over energy supply, at least short to medium term.
The fiscal support package announced on the weekend is partly an attempt to help address supply problems, but markets have taken it as merely propping up demand that is already too high.
GBP 72 billion of tax cuts were made across national insurance, corporate taxes, stamp duty and income taxes. Much of it will find its way to the wealthy, with more of a propensity to save than spend.
All this is on top of energy price caps that at current rates are worth GBP 160 billion over the next three years. They at least will keep headline inflation in single digits.
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The Bank of England is now faced with an even harder job to rein in inflation.
Markets have taken it that way, now pricing terminal rates above 5%. This was nearer 4% last week.
However, it is the extra supply that the bond market and currency market are struggling to assess.
At an extreme the price of 30yr UK Debt fell 10% after the mini budget. So far in 2022 UK 30 year debt has halved in price.
This all impacted on global bond markets in another tough week.
UK investors will potentially move money back onshore as their currency and rates become relatively more attractive.
Terminal rates in Australia are now back to pushing near 4.5%. Whilst domestically this looks very restrictive, global investors are not hanging around to find out.
Time will tell whether this huge gamble by Liz Truss pays off.
If global energy prices plummet, then they may get away with it. As it stands now though, markets are taking the view that the UK is falling deeper into a hole.
About Tim Hext and Pendal’s Income & Fixed Interest boutique
Tim Hext is a Pendal portfolio manager and head of government bond strategies in our Income and Fixed Interest team.
Tim has extensive experience in banking, financial markets and funding including senior positions with NSW Treasury Corporation (TCorp), Westpac Treasury, Commonwealth Bank of Australia, Deutsche Bank, Bain & Co and Swiss Bank Corporation.
Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.
The team won Lonsec’s Active Fixed Income Fund of the Year award in 2021 and Zenith’s Australian Fixed Interest award in 2020.
Find out more about Pendal’s fixed interest strategies here
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 Pendal’s Head of Equities, Crispin Murray. Reported by portfolio specialist Chris Adams
CHAIR Powell reiterated his message that the Fed will continue to tighten quickly, even if that threatens to trigger a recession.
This prompted market pain last week. The S&P 500 fell -4.63%, through a previous support level, and is now retesting year-to-date lows. So too are high yield credit spreads, the copper price and Australian equities (which fell -2.48%).
Elsewhere the US dollar index rose to year-to-date and twenty-year highs, US bond yields hit year-to-date and twelve-year highs, the oil price fell to its lowest point since the invasion of Ukraine, and both French and German equities broke to new lows for the year.
In the US, commodity prices, freight rates and used car prices are all falling. But service sector inflation continues to rise and the labour market has not cooled enough.
The market fears the Fed will break the economy, with rates rising too quickly. As a result, we appear to be entering the capitulation / liquidation phase of this bear market, where the orderly sell-off gives way to fear and more indiscriminate selling.
Currency appears to be at the nexus of this sell-off. There is less confidence in the British Pound and the Japanese Yen due to fiscal and monetary policies. This is driving strong flows into the US dollar, which causes stress on risk assets generally.
There is a circularity in FX markets. As the US dollar rises it increases inflationary pressure in other countries, forcing them to consider more rate hikes. The on-going sell-off in bonds, despite growing concerns on recession, also points to liquidity issues.
Bulls are pointing to extremely weak sentiment, that we are at peak inflation hawkishness and the belief that the support levels currently being tested can hold. It is also possible that the Fed may send some small signal to prevent the market becoming disorderly.
Overall, we remain cautious in the near term. However we are mindful that these episodes can present attractive opportunities on a medium-term view.
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Policy and economics
US
While the 75bp hike in rates to a 3.0-3.25% range was largely expected, the Fed’s hawkish stance weighed on markets.
Powell’s comments that there “isn’t a painless way to get inflation down,” that “the housing market may have to go through a correction,” and that there will “very likely be some softening in the labour market” all point to a clear effort to change the market’s mindset and flush out any hope of pivoting.
This rhetoric, combined with the shift in “dot plots” of future hikes moved the expected rate profile higher. November is now expected to see another 75bp hike, with 50bps more in December and 25bps in February. This implies rates peak at 4.5% to 4.75%.
The Fed also increased their expected unemployment rate at the end of 2023 from 3.9% to 4.4%. Such a move would be consistent with a recession, suggesting that they are prepared to keep hiking rates into a recession.
The 2 year government bond yield rose 34bps to a cycle high of 4.21% in response.
One challenge for the Fed – and the market – is that the economic data is not looking that soft. It may also remain supported by the fiscal drag easing off and by pent-up demand in autos and services, while the backlog of unfinished homes will underpin construction in the short term.
In addition, the labour market remains tight. The difference between job openings and unemployed peaked at 5.9m, which is the highest ever as a percentage of the workforce. This creates pressure on wages.
Goldman Sachs estimate this has to fall to 2m to loosen the labour market enough to get to back to 3.5% wage growth, which is consistent with 2% inflation. So far, this has only dropped to 5.2m. This makes it difficult for the Fed to signal a significant pivot in approach.
The market’s fear is that the pace of hikes is too quick to be able to assess their impact and the Fed is therefore making a significant policy mistake that sends the economy into recession and may trigger some form of financial shock.
In response, the Fed is saying this is not a mistake. Rather, it is what needs to happen to solve the inflation problem.
Either way creates risk to corporate earnings.
UK
The scale of fiscal stimulus in the new UK Chancellor’s “mini” budget went beyond most expectations.
The government will spend GBP45bn, equivalent to 1% of GDP. Most expected something in the order of GBP30bn. This comes on the heels of the energy pricing policy, which is expected to cost at least GBP60bn in its first year.
This largesse has been widely condemned on the premise that such strong fiscal expansion in an inflationary environment will only force the Bank of England to raise rates more aggressively.
UK government bond yields surged 35-50bps across yield curve in short order. The UK 5 year bond was yielding below 2% on 15th August and is now 4.15%.
The broader fear is loss of confidence in the UK. This is reflected in currency markets, where the GBP fell 5% against the USD over the week to reach record lows.
The Bank of England raised rates 50bps during the week, but would not have anticipated this degree of fiscal stimulus. The market is now pricing in a potential intra-meeting rate hike by the BOE, to try to protect the pound.
Japan
Intervention by the Bank of Japan on behalf of the Ministry of Finance to support the yen – for the first time in twenty four years – shows another source of stress in forex markets.
It came in response to the BOJ’s continued commitment to yield curve control and comments that there would likely be no need to raise rates for two years. While providing short-term relief for the yen, the market remains sceptical that it will ultimately prove successful, with Japan the only buyer. There is also the question of how deep are Japan’s pockets. It has US$1.3 trillion of forex reserves, but much of this is in US Treasuries, which it is unlikely to liquidate to fund intervention – although it does highlight some concerns regarding liquidity in the treasury market.
Markets
Both the S&P 500 and the NASDAQ look set to test their year-to-date lows. There are plenty of negative signals at present, including:
- Bond yields hitting new highs for the cycle. The ten year yield is at decade highs for the first time in forty years, perhaps signalling a regime shift. Higher rates means lower valuation ratings and the US equity market is still sitting at higher-than-average P/E ratios. This means valuation is not a supportive factor.
- Key equity markets in Europe have already broken to new lows and may potentially lead the US.
- Major stocks such as Microsoft and Google – and key sectors such as semis and software are hitting new lows. Although at this point stocks such as Apple and Tesla haven’t broken to new lows and are helping prop the index up.
- Sectors such as energy which have held the market up are now seeing significant selling.
- Market breadth remains wide as the index falls. Typically trend shifts are preceded by narrowing markets, which we are yet to see.
- Volatility hasn’t yet spiked to levels normally seen near a market bottom.
- The option market – as measured by the put / call spread – is not positioned at extremes.
- Real rates (nominal rates minus inflation) have risen sharply, which has been required to anchor breakeven inflation expectations. One thing to note is that real yields have been the driver of the relative performance of growth versus value in recent years, which would indicate there is risk of further rotation away from growth.
Overall, this feels like the capitulation phase is beginning to kick in. This will present opportunities, but the lesson of prior bear markets is to be careful not to jump in too soon.
There is a risk the moves we are seeing trigger forced selling. We note that US households still have high holdings in equities and some foreign central banks may liquidate to get access to their reserves. There is also now a decent carry on cash and fixed income, offering an alternative to equities. The counter-risk, mentioned above, is that the Fed steps in with some signal to calm markets.
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Australia
We continue to see the Australian market as more defensive. It trades on a P/E of 12x, versus the S&P 500 at 17x, while the economy is supported by higher savings, a less aggressive central bank, supportive terms of trade and immigration.
The issue for Australia is as much as the RBA may want to limit rate rise, there may be a limit to the gap between our short-term rates and those in the US, before it creates issues with the currency which would exacerbate inflationary pressures.
About Crispin Murray and Pendal Focus Australian Share Fund
Crispin Murray is Pendal’s Head of Equities. He has more than 30 years of investment experience (including 28 years at Pendal) and leads one of the country’s biggest equities teams.
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
THE market was positioned for good news on the US inflation front – and took a hit when the CPI came in slightly stronger than expected.
A strong inflationary pulse across a broad range of categories ran contrary to a prevailing narrative of softer inflation.
In an environment where the Fed is driven by data – rather than by its own forecasts – sentiment on the monetary policy path shifted quickly.
The Fed funds rate is now expected to reach 4.2% in December 2022, up from 3.9%.
Equity markets took a hit. The NASDAQ fell 5.54% on the day of the data print – its worst fall since March 2020. The S&P 500 was off 4.3%, its worst since June 2020.
Poor sentiment was compounded by pre-released earnings from Fedex, which saw quarterly EPS at $3.44 versus $5.15 consensus expectations and an even bigger shortfall on next-quarter guidance.
Management cited softer demand, weakening further into the quarter’s end, both in the US and internationally. This exacerbated concerns around the economic backdrop.
The S&P 500 fell 4.7% for the week. The S&P/ASX 300 was down 2.2%.
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US inflation
Headline CPI rose 0.1% month-on-month in August, against an expected decline of 0.1%. On an annualised basis inflation is running at 8.3% versus 8.5% last month – again higher than the expected 8.1%.
Core CPI rose 0.3% to 0.6%, higher than 0.35% forecast. Annualised, it is running at 6.3% m/m, versus 6.1% expected – the highest print since March.
The key concern was the breadth of disappointing numbers across multiple buckets including shelter (34% component), new and used cars (8%), medical services (7%), food away from home (5%), apparel (2%), utility gas service (1%) and motor vehicle repair (1%).
Inflation is no longer driven by energy and food.
Housing inflation is a slow-moving part of the US CPI data. Landlord rent expectations have fallen recently but will take a while to flow through into the data.
The next biggest segment is new and used car prices. These have definitely turned down, which is helpful.
Wage pressure in healthcare is a global phenomenon and is likely to continue ticking up as wage demands are met.
More positively, airline fares fell by 4.6% in August – less than expected. This should continue to fall as airfares follow jet fuel prices quite closely, and they have reversed most of the spike triggered by the war in Ukraine.
Food inflation is finally moderating. The 0.7% increase in food-at-home prices was the smallest since December, after seven straight 1%-plus increases.
Lower global food commodity prices are starting to work through, with more to come.
Petrol pump prices are down to $3.69/gallon – 26% below an all-time high in June and the lowest level in six months.
The “peak inflation” narrative is probably still intact, but the core components remain stubbornly sticky.
Producer Price Index data (see below) suggests some relief is on the way. But it won’t matter this week.
Fed officials have made it very clear they will not slow the pace of rate hikes until they see convincing evidence that core inflation pressure is easing on a sequential basis.
The chance of a 50bp hike this week has gone.
The market has wavered between a 20%-30% chance of a 100bp hike.
The chance of a soft economic landing has fallen for two key reasons:
- Strength and stickiness in both goods and services inflation indicate meaningful reductions toward 2% are impossible without a recession and a big fall in employment
- The risk of a Fed overshoot has increased, meaning a recession gets induced almost regardless of what the data does from here.
US PPI
The Producer Price Index data was more reassuring than the CPI print.
Headline PPI fell 0.1%, in line with consensus, helped by falling energy prices. Annualised, it is 8.7%. This is down from 9.8% in July and 11.2% in June.
The key message here is that Core PPI inflation is now falling across both goods and services.
Core goods rose at a 6.1% annualised rate in the three months to August, exactly half the peak pace in the three months to May.
Core services rose 3.9% in the three months to August. This was an even bigger slowing from the 10.8% peak in the three months to March.
Consumer inflation expectations have plunged for both the three and five-year time horizons.
Other US data
The Atlanta Fed Wage Tracker grew to 6.7%.
Companies that have high turnover of low-paid workers are feeling the full force of wage pressures in the economy. Wage growth for job switchers far exceeds that for people staying with their current employer.
Retail sales were slightly disappointing with core sales down 0.3% versus flat expectations.
But they haven’t fallen off a cliff and may reflect higher petrol prices over the past few months, which have now reversed.
Australia
GDP data in the second quarter showed continued strength in consumer spending, driven by a rebound in services. This included a quarter-on-quarter rise of about 30 per cent in tourism-related spending.
It seems likely that the consumer hangs in there for another few months, before feeling the pinch in the December quarter as increased mortgage rates flow through to household cash flows.
Employment increased 33,000 in August. This was in line with consensus but only partially reversed the prior month’s 41,000 decline.
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At the same time, labour participation moved back close to its record highs (66.6%) and unemployment ticked up to 3.5% (consensus expected 3.4%).
Hours worked also recovered most of the prior month’s losses (0.8%) and the under-employment rate fell to 5.9%.
It’s notable that the number of workers affected by sickness remains nearly double its usual amount (about 750,000).
The data hasn’t moved expectations for another 100bps of tightening across Q4, taking rates to about 3.35%.
Europe
The EU has proposed a redistribution of excess profits from energy companies and non-gas-power generators (nuclear and renewables), totalling an estimated EUR 140 billion.
This would involve a price cap of 180 euros per megawatt hour, which would raise about EUR120 billion.
The balance would come from energy companies contributing a third of any profit more than 20% over the last three-year average.
The plan is complex and will take time to put into practice. Each member state would have jurisdiction over key aspects.
The plan includes a binding agreement to get winter peak electricity use down by 5% – and overall 10%.
Markets
Australia held up better than other markets last week due to index composition.
Large caps did better than small caps. Small resources and REITs bore the brunt of the sell-off. Interestingly, consumer staples did not prove to be defensive in the weak market and we saw a clean sweep of negative returns across all sectors.
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.
US rates are heading for 4% after inflation remained high in August. But the RBA may have more patience. Pendal’s TIM HEXT explains why
ALONG with many other observers, we expected US inflation to moderate more than it did in August.
Headline CPI came in overnight at 0.1% (8.3% annual) and underlying at 0.6% (6.3% annual).
A new group of unrelated components (including vehicle repair, dental charges and tobacco) showed fresh signs of inflation, pushing the rate positive for the month.
We still expect goods deflation in the months ahead. Oil prices and most other commodities are weak.
But US wage growth is spreading inflation wider into services. Services inflation is now the battleground and labour supply lines are normalising far slower than goods.
What little patience the US Federal Reserve may have had is running out.
Fed funds now seem destined for 4% or higher. As little as six weeks ago the market was expecting terminal rates closer to 3%.
RBA may be more patient
As always, Australian bonds will follow the US. But the RBA seems prepared to show a bit more patience.
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This is due to a number of factors — but the two main ones are wages and our floating rate mortgage market.
The NAB business survey showed that rate hikes are yet to have any impact.
This is not surprising as the economy is now almost fully open, many have pent-up savings to spend and fixed rates are protecting 40 per cent of mortgage holders.
The RBA remain on course for 3% cash rates by year end (either 2.85% or 3.1%).
It will likely rely on the fixed rate mortgage cliff and immigration to do the heavy lifting to combat inflation in 2023.
Bond markets are caught in the loop of pushing rates up with the Fed but also with one eye on increasing recession risks.
Flatter curves seems to be the favoured way of reconciling these two outcomes.
Credit and equity markets were hit by the high inflation numbers, but for now look to be range-trading rather than breaking down.
The only certainty for now is volatility is here for a while yet.
About Tim Hext and Pendal’s Income & Fixed Interest boutique
Tim Hext is a Pendal portfolio manager and head of government bond strategies in our Income and Fixed Interest team.
Tim has extensive experience in banking, financial markets and funding including senior positions with NSW Treasury Corporation (TCorp), Westpac Treasury, Commonwealth Bank of Australia, Deutsche Bank, Bain & Co and Swiss Bank Corporation.
Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.
The team won Lonsec’s Active Fixed Income Fund of the Year award in 2021 and Zenith’s Australian Fixed Interest award in 2020.
Find out more about Pendal’s fixed interest strategies here
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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.
Energy security and workplace relations were the big ESG themes in this year’s ASX reporting season, says Pendal’s RAJINDER SINGH
- Labour and energy were key ESG themes this year
- Investors should scrutinise capital spending
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ENERGY security and workplace relations were among the big ESG themes to emerge from this year’s annual reporting season, says Pendal’s Rajinder Singh.
The volatility of energy supply amid disruption in energy markets has become abundantly clear in the last six months, leaving companies with real challenges on how to respond, says Singh, who manages sustainable Australian share funds for Pendal.
And the emerging theme of labour shortages and industrial action by workers is starting to show up as a key risk for Australian companies.
“This reporting season was quite interesting because we have this ongoing bounce-back out of Covid, while at the same time there are top-down geopolitical issues and the bogeyman of inflation and interest rates,” says Singh.
“And we’re seeing ESG perspectives play out as well.
“A lot of companies have momentum on planning for net zero and building out renewable energy targets. But at the same time they are getting hit by massive volatility in energy prices.”
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“My one-liner to clients has been this: there’s plenty we don’t know about the energy transition, but what we do know is that there’s going to be increased volatility.
“That is the real challenge for companies on how they respond to that.”
Energy is a material input for many companies, meaning the cost of electricity, gas and fuel can be important factors affecting profitability.
Singh says this reporting season saw companies weathering energy volatility on the back of fixed price energy contracts entered before price rises.
“The question will be what happens when those contracts reset.
“Perhaps ironically, the companies that signed power purchase agreements using renewables are beneficiaries of this environment.
“Even though they may have signed their agreements at a higher-than-prevailing electricity prices a year ago, that’s a fraction of what the spot prices are now so they’re effectively hedged.”
Energy security issues and supply chain problems are playing out against the backdrop of decarbonisation across industry.
“Companies are scrambling to solve today’s supply chain and energy problems, but they are also in the medium to long-term grappling with decarbonisation goals.
“Previously, signing up to renewable energy, putting solar panels in and making your vehicle fleet a bit more efficient by buying EVs was easy. Now there’s a problem.
“You can’t get EVs, electricity prices are moving all over the place, and you can’t back it up with gas.
“There’s a lot more considerations that companies need to make because of this energy volatility.”
Industrial relations back on investor radar
Another ESG theme that emerged from reporting season related to labour supply, from COVID-related absenteeism to industrial action and wages.
“The federal government’s recent Jobs Summit elevated industrial relations back onto the national agenda, but it was already showing as an issue in reporting season,” says Singh.
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“What we’re seeing is the importance of how companies do their human capital management – labour was taken as given but that’s changed. Labour has become harder to find.”
What does it mean for investors?
For labour, Singh says investors should seek to understand the nature of companies’ agreements with workers.
“When strikes in Sydney mean the trains aren’t working every second day, it provides a precedent for how things will get resolved going forward.
“If you’ve got an agreement that’s due for renegotiation in the next 12 months versus one that was signed for five years, that could have a material impact on your forecast growth of your labour costs.”
Look for energy security
For energy, security of supply is critical, says Singh.
Partly this can be solved simply through dealing with larger companies – “there’s security in size,” says Singh.
But it’s also important to seek security in geography, he says, using battery mineral lithium as an example.
“The two biggest sources of lithium are hard rock in WA and brine at altitude in the Andes in South America. The regulatory environment is a lot different.”
Singh says investors should seek out companies that are clearly facing up their energy problems no before the problems become more acute.
“That could be contingency plans in the short to medium term, but you also want to see evidence that the plans will enhance their transition in terms of energy efficiency, replacement of vehicles and investment in technology.
“The other thing that matters for investors is understanding the required capital expenditure.
“What’s the capital allocation to these initiatives? And is there an actual measurable benefit for the amount they are planning to spend?”
About Rajinder Singh and Pendal’s responsible investing strategies
Rajinder is a portfolio manager with Pendal’s Australian equities team. He has more than 18 years of experience in Australian equities.
Rajinder manages Pendal sustainable and ethical funds including Pendal Sustainable Australian Share Fund.
Pendal offers a range of responsible investing strategies including:
- Pendal Sustainable Australian Share Fund
- Crispin Murray’s Pendal Horizon Fund
- Pendal Sustainable Australian Fixed Interest Fund
- Pendal Sustainable Balanced Fund
- Regnan Credit Impact Trust
- Regnan Global Equity Impact Solutions Fund
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Responsible investing leader Regnan is part of Pendal Group.