What is the neutral cash rate in Australia? The debate rages on. Pendal assistant portfolio manager ANNA HONG explains

Today’s RBA minutes provide insights into the central bank’s decision making in its last policy meeting on July 5.

The minutes clearly lay out the uncertainty around price risks due to the continued war in Ukraine and China’s Covid-zero policy.

One thing is certain however. There will be another rate hike in August — most probably 50 basis points and a chance it could be higher.

The Reserve Bank expects inflation to peak late in 2022. We are merely a few weeks into the second half.

This means the RBA believes the inflation problem will worsen in the months ahead.

With only one blunt instrument in the monetary toolkit, there is no other option but to raise rates again in August.

How much? The case is much stronger for a rate hike of 50bps or more.

Why? The Australian June Labour report obliterated any lingering doubts that we are in in full employment.

Employment gains almost tripled expectations, leading to an unemployment rate of 3.5% — even accounting for the improvement in participation rate.

There is now one unemployed person per job vacancy in Australia. In other words, filling all our job vacancies will require every single unemployed person.

The economy is running red hot and the tightest labour market in almost 50 years is driving consumption demand on an upward trajectory.

The only way to cool off is to slam the brakes hard.

With other central banks raising the hawkishness stakes by hiking rates 0.75% to 1% in each board meeting, it will come as no surprise if the RBA raises cash rates by more than 50bps.

Despite earlier “guidance” indicating the most likely rate hike scenarios are 25bps and 50bps, Dr Lowe may once again have to correct himself.

The RBA governor is well practised on backflips — most notably Yield Curve Control and no rate rises til 2024.

Not surprisingly short rates drifted higher this week.

Longer rates are caught between expectations of higher cash rates and the damage to the economy and potential recession those higher rates may cause.

For now, 10-year Australian government bonds are holding around 3.5% but are vulnerable to drifting back towards 4%, where they were only a month ago.

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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

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About Pendal Group

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

Contact a Pendal key account manager

Here are the main factors driving the ASX this week according to Pendal investment analyst ANTHONY MORAN

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INFLATION continues to be hotter than expected, as last week’s monthly US Consumer Price Index print shows.

Core CPI grew 5.9% year-on-year. It was down from 6% in May, but the market was expecting it to decelerate to 5.7%.

Meanwhile headline CPI (which includes energy and food) stayed high at 9.1%.

Despite this, the market’s reaction was relatively muted. The S&P500 fell 0.9% last week, following a solid rebound on Friday. US 10-year bond yields fell 16bps, with the inversion tightening from -3bps to -21bps.

This suggests the narrative of central bank over-tightening — followed by recession and the need for rate cuts in CY23 — remains in control.

In this context, the market is focusing on the current recession in US manufacturing and sees CPI as a lagging indicator.

The role of the consumer will be critical in determining the scale of a slowdown and needs to be watched carefully.

Locally, the S&P/ASX 300 fell 1.1% last week.

US inflation

We are seeing broad-ranging price declines in a number of areas, suggesting flat or negative month-on-month CPI figures in the next couple of months.

Some key factors:

1. Commodity prices are generally weaker due to a combination of disappointing Chinese economic data, slowing global manufacturing and a stronger US dollar. Action in the oil futures market suggests a deteriorating outlook for oil fundamentals, bringing it closer to an already negative view in financial markets. Weakness in oil prices is now flowing through to gasoline.
2. Global supply chain indices are showing material declines.
3. The outlook for food inflation is improving as soft commodity prices continue to decline. Corn, wheat and milk prices are all down materially from their highs. Better harvests and some easing of Ukrainian supply constraints are helping here.
4. In the US, used car and house prices are also finally rolling over, though they remain at historical highs.
5. Wage/price spiral concerns are easing at the margin. The labour market remains tight, but weekly jobless claims are now rising, taking some pressure out of the market. There are no signs of wage pressures growing in measures such as private sector average weekly earnings.
6. A third of CPI comes from shelter and “rent of primary residence” which accelerated from 5.2% in May to 5.8% in June. There are indications that growth in asking rents has peaked, which points to a slow-down in the rent component of CPI as well.

Gas remains the outlier to easing commodities. European gas prices are rising on Russian supply curtailment. Hot weather is seeing the same in the US.

However in aggregate these movements in price indices are starting to feed through to inflation expectations. Long-run inflation expectations fell to 2.8% in July (down from 3.3% in June) according to the latest University of Michigan survey.

US breakeven inflation rates have also fallen markedly over the past month. The two-year breakeven rate has fallen from about 4.5% to about 3%, for example.

The US consumer: not going down without a fight?

Compared to the end of June the expected peak in the Fed funds rate has been brought forward from Apr 23 to Feb 23, but the peak rate is at a higher level.

This reflects a view that the economy will deteriorate faster and deeper than previously thought — and that short term inflation remains too high.

There is a recession in global manufacturing driven by the effects of higher interest rates, energy prices and US dollar, combined with the roll-off of stimulus and normalisation of spending patterns post-Covid.

New orders are dropping and earnings are being revised down. This is not a positive for markets.

But it’s important to note we still don’t know the degree to which ongoing strength in US consumption can offset the manufacturing downturn.

We note:

1. Consumer confidence remains stronger than expected. The University of Michigan June survey had the index at 51.1 in June, versus 50 in May and 49.8 expected. Retail sales numbers for June grew 1% month-on-month, versus +0.9% expected.
2. Quarterly commentary from the big US banks, while wary on the longer-term, noted that current conditions remain positive. JPMorgan Chase CEO Jamie Dimon said: “Consumers are in good shape. Jobs are plentiful. They’re spending 10% more than last year. Businesses, you talk to them, they are in good shape… We’ve never seen business credit better — ever — like in our lifetimes”. Citi CEO Jane Fraser said: “Little of the data I see tells me the US is on the cusp of a recession”. Bank CFOs are saying consumer spending remains resilient, with a mix shift to travel and entertainment. They are seeing low levels of credit losses.
3. Jobless claims are deteriorating, but not at a scary rate.

The upshot is that the consumer may be more resilient than expected due to strong initial savings balances, a still-tight employment market, good wages growth and a softening in short-term inflationary pressures.

The question is whether this relative strength in the consumer will partly offset the recession in global manufacturing, leading to an overall economic outcome that is better than currently feared.

The current consensus view is that resilience in consumer spending is simply a head-fake and a summer splurge, with the hangover coming in 2H22.

This needs to be watched closely. We could be facing a scenario where the savings buffer for consumers is sufficient to see them through the peak in inflation and we see a slowdown, but not a material consumer recession.

We note markets are already very bearish. The ratio of consensus US upgrades to downgrades and changes in target prices has not reached the lows of previous market downturns. But it is in a very pessimistic range by historical standards.

Measures of shorting are already at the low points of previous cycles. The S&P 500 P/E has retraced to the Covid low point and is close to pricing in a recession.

This means it does not take much to beat very depressed expectations.

Energy crisis ongoing

There are a number of ongoing market concerns, including the fact that Covid remains disruptive and the outlook for manufacturing is deteriorating.

The energy situation remains the wildcard and could deteriorate further.

US gas prices are up on hotter weather. European prices have risen in response to tighter supply due to scheduled maintenance on the Nordstream pipeline. The latter will be closely watched — it is due to reopen this week. The risk is it becomes a geopolitical bargaining tool.

Higher energy prices are seeing Europe enter a recession much deeper than expected in other regions. The bearish European economic outlook was reflected in the very brief EUR-USD parity party this week.

Meanwhile, winter is coming.

Germany needs to be at 80% gas storage level by October to be ready for colder weather. Current storage levels are 64.7%. They need to add 0.19% a day to get there.

This was not a problem prior to Nordstream maintenance, but there will be serious issues if it doesn’t come back online in a timely fashion.

China macro weaker

China continues to struggle with impact of the zero-Covid strategy, adding to current market concerns.

Beijing has announced new financial stimulus measures. Packages put in place last year are seeing some benefit in infrastructure investment.

But the real estate sector remains a mess.

New home sales and starts are down dramatically. This is a large proportion of the Chinese economy. It is feeding through to broader economic softness, with weakness in steel production and prices. It is also an additional drag on global commodity prices.

Retail sales recovery post the partial reopening has also disappointed.

The silver lining for Australia is that Beijing is looking to resume Australian coal imports to avoid its own energy crisis.

Markets

Metals & Mining (-6.6%) led the S&P/ASX 300 lower last week, driven by weaker global industrial data and a stronger USD.

Staples (+1.3%) and Healthcare (+3.4%) were pockets of strength, benefiting from a pull-back in bond yields and an uncertain economic outlook. The rest of the market was flattish.

As it has been for a while, the market is grappling with uncertainty over how bad the upcoming recession will be. It was quiet week on news flow as we move towards reporting season.

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About Crispin Murray’s Pendal Focus Australian Share Fund

Pendal’s head of equities Crispin Murray 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. 

Find out more about Pendal Focus Australian Share Fund  

Contact a Pendal key account manager

Here are the main factors driving the ASX this week according to Pendal investment analyst ELISE MCKAY

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THE markets endured another volatile week as we entered the second half of 2022.

Overall they were positive: the S&P 500 and S&P/ASX 300 gained 2% each and the NASDAQ lifted 4.6%.

Macro themes continued to lead sentiment — everything that worked in the first half of the year not working now and vice versa.

We saw growth outperform and commodities underperform last week as the case for peak inflation/near-term recession strengthened. This is supportive of long-duration plays.

Bond markets remain confused. Different yield curves are giving positive and negative signals as to the odds of a recession.

When averaged, however, the yield curve remains in positive territory.

We saw a 20bps increase to US 10-year bonds, bringing them up to 3.08%. Note the market is now pricing around 75bps of cuts in 2023.

The Atlanta Fed’s GDPNow tracker suggests the US is already in a technical recession, though this is challenged by positive payroll data.

Wages appear to be cooling off across many sectors which suggests Covid disruptions and re-openings have been the primary driver in the past, rather than linkages to structural inflation.

Looking forward, the next US CPI report on July 13 will be a key test for the market.

If it’s hotter than expected the thesis around peak inflation will be tested. Yields will likely increase and long-duration growth will once again underperform.

Economics and policy

The case for peak inflation continues to build with commodity prices softening, inventory de-stocking, supply chains recovering and labour market conditions easing.

Commodity prices rolled off again this week on the back of a strong USD.

There was a slight bounce at the end of the week after reports China would provide a US$220 billion stimulus package.

Retail gasoline prices were off peak levels and futures suggest prices will further decline over the next six weeks.

Anecdotal feedback implies retail inventory levels remain elevated. But it’s still unclear if this signals consumer weakening or a shift of spending towards services and travel.

June BAML credit card data supports the former with real spending declining for a second consecutive month. Spending on travel and restaurants fell for the first time since the Omicron peak.

Supply chain pressures continue to ease with the Global Supply Chain Pressure Index declining consistently.

The index is still however largely positive (2.41) meaning it is still elevated compared to pre-Covid levels.

We saw confusing data in the manufacturing industry with the ISM Services index increasing while the ISM Manufacturing index for new component orders slipped to a two-year low.

Global container trade volumes tracked negatively in May. Though on an annual basis volumes are flat versus long-term average growth of 3%.

On the employment front layoffs are still rising. June was a particularly tough month for the tech sector. We have seen general hiring freezes across sectors.

Zooming out, jobs data is holding up better than expected, with 70% of industries seeing job gains.

Unemployment is at 3.6%, average weekly hours are back to pre-Covid averages, and the three-month annualised average hourly earnings is up 4.3%.

Bonds

There is a lot of uncertainty in the bond market about the timing of a potential recession.

Usually the spread between the US 10-year and the Fed Fund rate moves in tandem with that of the 10yr – 2yr. But there has been a divergence on recent timing.

We saw the 10yr – 2yr spread invert on a daily basis last week, while the 10yr Fed Fund rate spread remained in positive territory.

This contradiction suggests the elevated volatility is likely to continue for some time.

It is worth noting we typically need to see the 10yr – 2yr inversion averaged over a month to suggest a future recession.

Markets

Confusing macro data leads to a somewhat confused market.

Despite bond yields rising, technology was the best performing sector last week.

Commodities fell with Brent crude oil down 4.1%, iron ore off 1.5% and gold losing 3.2%.

Reflecting on the first half of 2022, the US 60/40 “world retirement portfolio” had its second-worst start to the year since 1900, returning -17%. Once this result is reflected in retail investor’s report cards there could be structural outflows in the near term.

This would likely dampen the market’s positive start to 2H22 and affect broader performance.

In Australia performance was positive last week despite resources retreating.

The RBA’s 50bps rate hike was in line with expectations and had minimal impact  on the ASX. In fact, there was a slight rally in long-duration growth, suggesting some relief in expectations.

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About Crispin Murray’s Pendal Focus Australian Share Fund

Pendal’s head of equities Crispin Murray 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. 

Find out more about Pendal Focus Australian Share Fund  

Contact a Pendal key account manager

What does the RBA’s latest interest rate hike mean for investors? Pendal assistant portfolio manager ANNA HONG explains

TODAY’S RBA rate hike of 50 basis points is no surprise – it’s coming off a low base.

The delay in lifting rates at the start of the year means we have a lot of ground to cover, just get back to neutral.

This month’s hike – which takes Australia’s official cash rate to 1.35% — is about tackling actual inflation.

Further hikes in coming months will be about tackling inflation expectations which are just as important to get under control.

This time last year we might have thought inflation was something that happened to others, but not here in Australia.

It’s now apparent that we are not different – just delayed. The delay has some upside though, since other developed economies can provide some guidance of what’s in store:

	New Zealand	US	Canada	UK	Australia
Policy rates	2%	1.75%	1.5%	1.25%	1.35%

How high can this go?

Guidance aside, what everyone wants to know is: “How high can this go?”

Australians have more say in the answer than we may realise.

While tackling inflation is now the number one priority, the RBA has no desire to send us into recession just for the sake of it.

That’s why the central bank is doing this delicate dance of 0.5% hike-and-see instead of breaking the economy with a one-off 2%-3% sledgehammer hit.

The Reserve Bank is trying for a soft landing. To achieve that, a few things need to dovetail for demand and supply to reach stable prices:

• A pick-up in the global supply chain: This inflation cycle is supply induced. The faster the supply chain issues ease, the more the inflationary pressures will ease.

• Evolution of household spending: Consumption growth is dragging prices higher while supply bottlenecks make it hard to keep up. Australian households can slow rate hikes by reducing consumption. That would allow time for supply to catch up without the RBA hiking rates by an ever-increasing amount. Recent NAB data shows we are already starting to adapt and evolve.

• Prevent a wage-price spiral: If workers are fully compensated for the increased cost of living, no personal consumption belt-tightening will be required. A merry-go-round of ever-increasing money chasing limited goods and services will lead to sustained higher inflation requiring more hikes. Counterintuitively, accepting a real wage cut will lead to long-term gains for the greater good.

No pain, no gain. It is unpleasant to cut consumption, and no one wants a cut in real wages.

But a protracted rate hike cycle will send the Australian economy into a recession, which is no good for anyone. We have a say in how high RBA’s Cash Rate Target will be. It’s time to exercise that power.

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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.

Contact a Pendal key account manager

Here are the main factors driving the ASX this week according to Pendal investment analyst Sondal Bensan

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Find out about Pendal Horizon Sustainable Australian Share Fund

THE Australian market outperformed peers again last week as fears of a 2023 US recession started to increase.

We saw large drawdowns early in the week but they were partially recovered by Friday. The S&P/ASX 300 ended down 0.46% while the S&P 500 retreated 2.2% and the Nasdaq fell 4.13%.

Positive returns late in the week were driven by China finally beginning to reopen along with theories on peak inflation — which gathered momentum and resulted in a fall in bond yields globally. Despite this, recession fears remain.

Speculation about a smaller-than-expected 50bps rate rise at the Fed’s upcoming July meeting influenced sentiment — following weeks of a consensus view at 75bps.

A smaller rise could prove calming for markets. But it is still very much an outside chance considering recent rhetoric from the Fed.

China

After months under a zero-covid policy Shanghai is officially moving out of lockdown. China is also reducing quarantine for inbound travellers to ten days — which is seen as a small positive step.

China believes the spread of the virus will have far greater consequences than the lockdowns themselves, so there is caution on any change of course.

Unlike Australia, there has been no unemployment safety net for China’s workers. This will be the greatest challenge to overcome in restoring confidence.

China has talked up monetary support for the economy with 300 billion yuan ($A 65.6 billion) in extra funding for infrastructure projects, though nothing else has been confirmed.

Beijing is still optimistically targeting an annual GDP growth of 5.5%, so it’s expected further funding will be provided.

As we’ve seen around the world, activity accelerates rapidly after exiting lockdown — and we saw that in the latest Chinese PMI data.

The likelihood that China will shift from a zero-covid policy to living with covid remains very low even as the rest of the world moves forward.

One reason is that vaccination rates among the elderly are still comparatively quite low. Unlike Australia, China has not committed to a policy on Covid-linked vaccination rates so we are unlikely to see vaccinations increase quickly.

Full vaccinations among Chinese nationals aged 60 and over have risen to 64.8% (up 8.3 percentage points) over the past two months.

If the rate continued steadily at 0.6 points per week it would hit 90% in April 2023. But in recent weeks vaccination rates have slowed, which could further delay a complete reopening.

We will likely see in China a continuation of the stop/start mentality which lowers confidence and makes it incredibly difficult for economic growth and unemployment to be restored.

On top of a global growth slowdown and strengthening US dollar, this likely means means headwinds for commodity prices.

The good news for markets with China’s reopening is easing of supply chain pressures which will create some relief from rising inflation.

Inflation

Inflation — and inflation expectations — remain a key driver of markets.

There are no short-term signs confirming inflation has peaked, but there is an emerging sentiment it may top out sooner rather than later.

Fed rhetoric may have been too strong, since the market is starting to consider the prospect of rate cuts in 2023.

Calls around peak inflation are not left of field given the current magnitude and base effects.

The economy was expected to return to normality after a post-covid, bubble year. But it’s important that the speed and magnitude of rate rises does not break the economy before then.

The pace at which inflation subsides will be key. We’ve seen signs of this already.

There have been significant falls in many hard and soft commodities as well as swelling inventories which can absorb some inflation within corporate margins as demand fades.

However, for inflation to come under control, demand must fall and supply constraints must ease.

Covid created a world of free money to support consumption, but at the same time it severely restricted the world’s ability to produce and transport goods. Add in the turmoil in energy and commodity markets spurred from Russia’s invasion of Ukraine, and we have the ultimate recipe for inflation.

Consumer confidence in the US continues to slide to a near decade low as inflation concerns weigh heavily on households.

Despite 3.5% unemployment in the US, the number of job vacancies is about twice that. This indicates that right now consumer confidence is not too bad at the aggregate level, though it is likely to worsen.

Rapidly falling consumer confidence will be a problem for markets and must be watched closely.

There are theories that household savings generated throughout the pandemic will act as a buffer for consumption. Using Australia as an example, household savings average around 11% compared to the 5% from the pre-pandemic days.

It is possible that a collapse in confidence within an inflationary and rising rate environment that most societies haven’t seen before will result in the savings rate rising before it helps to buffer inflation.

This would lead to a much faster fall in demand/consumption than many might expect.

On a more positive note, the supply side continues to improve — helped recently by China’s reopening. This is a positive indicator for inflation peaking.

The other factor giving hope for a near-term inflation peak is the rapid reversal in many commodities from their previous high. Notable examples include sell-offs across the board in soft commodities as well as iron ore.

While weakening commodity prices are good news for inflation easing, we must remember most of the inflation to date has come from food, energy and other core goods. Services inflation has yet to filter through. How wages evolve will be also key.

There are headlines around the world about wages chasing inflation — with step ups of 4-6% under consideration.

Some companies such as Qantas and Nine are offering tactical cash bonuses to stave off a permanent wage increase. This will not be the norm as wage pressures increase by the week.

Bonds

Bond yields fell as market pessimism drove the market last week. US and Australia 10-years fell 23bps and 12bps respectively.

The US 30-year mortgage rate has also retraced back to 5.61%.

This week’s RBA announcement should be largely uneventful. A 50bps increase is expected to bring the cash rate up to 135bps.

Australian Markets

The markets are becoming quite narrow considering the broad themes discussed above.

Last week the markets performed better than expected as recession fears grew and bond yields retraced.

Utilities (2.6%), Consumer Staples (0.68%) and Financials (0.36%) saw gains throughout the week. In contrast, Resources (-1.58%), Tech (-2.35%) and REITS (-1.8%) fell.

Stocks

Resources suffered another rough week. Evolution (EVN, -29.59%), Northern Star (NST, -14.77%) and Newcrest (NCM, -12.02%) were the biggest detractors.

Evolution saw downgrades largely based on increased costs. Costs for gold miners have historically been highly correlated to oil, with knock-on effects from the squeeze on diesel refining. On top of that the labour disruption impacting many industrial companies is now affecting Evolution.

Companies deemed less sensitive to economic weaknesses such as Computershare (CPU, +5.07%) continued to eke out gains. Some non-REIT bond sensitives such as Transurban (TCL, +3.74%) and APA (APA, 3.30%) also saw positive performance.

Elsewhere we saw Metcash (MTS, +2.42%) report well ahead of the market at all levels including EBIT at $472m and NPAT at $300m. With strong sales momentum Metcash continues to grow revenue at the fastest clip in all segments versus peers. It remains a key position for many of our portfolios.

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About Crispin Murray and Pendal Focus Australian Share Fund

Crispin Murray is Pendal’s Head of Equities. He has more than 27 years of investment experience and leads one of the largest equities teams in Australia. Crispin’s Pendal Focus Australian Share Fund has beaten the benchmark in 12 years of its 16-year history (after fees), across a range of market conditions.

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

Find out more about Pendal Focus Australian Share Fund  

Contact a Pendal key account manager

State government debt is becoming increasingly higher in yield against Commonwealth debt. Pendal’s Tim HEXT explains what that means for investors

AUSTRALIA is slowly re-emerging as a federation of states after the disunity of the past few years.

Governments such as Queensland and WA are running big ad campaigns to lure tourists back — barely months after they were threatening jail for interstate interlopers.

Though we are again a single nation, the financial status of the states has diverged in the post-pandemic world.

The recent round of State budgets revealed a number of things:

1. Total State debt will net increase by $67 billion in FY22-23.  Commonwealth debt will likely net increase by $40 billion. Both have downside risks but the Commonwealth more so. There is now twice as much Commonwealth debt as semi-government debt outstanding and usually their programs are at least double. This will be the first time in over a decade that State issuance exceeds Commonwealth.
2. WA (and to a lesser extent Queensland) are at or near a budget surplus courtesy of booming commodity prices and royalties. S&P this week upgraded WA to AAA, joining the ACT as the only AAA state or territory.
3. NSW and Victoria are now the laggard states on debt — unlike most of the past decade. NSW will be borrowing about $24 billion of new money, Victoria $16 billion and Queensland only $8 billion. WA is flat.

NSW has an election next March… Hence a State budget that continued to act like NSW is an economy with excess capacity needing help from the government. Or as The Australian Financial Review described it — a “gobsmacking spendathon.”

NSW is the only State reporting more borrowing not less since the mid-year update, despite a better than forecast economy. Vouchers and handouts seem to be here to stay — not just as emergency measures.

NSW, and to a lesser extent Victoria, may cause the RBA to go harder than previously thought.

We are yet to see where the new federal government lands with its budget, but the whole point of rate hikes is to reduce demand in a supply-constrained economy.

State budgets are leaning the other way, adding to demand and therefore increasing inflation pressures.  And unlike the federal government, the States cannot print money to finance it all.

This all leads to the fact that State government debt is becoming increasingly higher in yield against Commonwealth debt. 

As a fund manager we don’t worry about getting our money back from States. After all, the federal government has shown on numerous occasions it effectively stands behind the credit.

But we do have to worry about how that debt performs.

For now, the supply and demand dynamics suggest State debt will continue to underperform.

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About Tim Hext and Pendal’s Income & Fixed Interest boutique

Tim Hext is a Pendal portfolio manager and head of government bond strategies in our Income and Fixed Interest team.

Tim has extensive experience in banking, financial markets and funding including senior positions with NSW Treasury Corporation (TCorp), Westpac Treasury, Commonwealth Bank of Australia, Deutsche Bank, Bain & Co and Swiss Bank Corporation.

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

The team won Lonsec’s Active Fixed Income Fund of the Year award in 2021 and Zenith’s Australian Fixed Interest award in 2020.

Find out more about Pendal’s fixed interest strategies here

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About Pendal

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

In 2023, Pendal became part of Perpetual Limited (ASX:PPT), bringing together two of Australia’s most respected active asset management brands to create a global leader in multi-boutique asset management with autonomous, world-class investment capabilities and a growing leadership position in ESG.

Contact a Pendal key account manager

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

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WE SAW some relief for equity markets last week following a tough period. The S&P 500 gained 6.5%, the NASDAQ added 7.5% and the S&P/ASX 300 put on 1.6%.

There was a notable rotation in performance on the ASX. The year’s bottom-three sectors — information technology, real estate and consumer discretionary — were the best performers for the week, up 7.9%, 6.9% and 5.5% respectively.

Resources — which had been a lone bright spot in the market — fell 5.6%.

US Fed rhetoric continues to emphasise commitment to the fight against inflation. Increasingly, investors are trying to work out what this means for commodity demand. This helps explain market moves over the week.

We also saw this in volatility among commodity markets. Brent crude fell 2.6%, iron ore was down 5.4% and copper lost 6.4%.

Economics and policy

US

Fed sound bites indicate it will raise hard and fast, with seemingly very little prospect for a soft landing. 

Several members of the Fed’s Open Market Committee signaled that another 75bps move was very much on the cards next month. Fed governor Christopher Waller noted “the central bank is ‘all in’ on re-establishing price stability”.

Chair Jay Powell noted the Fed was “acutely focused” on returning inflation to 2 per cent and commitment to reining in inflation was “unconditional.” He warned a recession was “certainly a possibility” and it would be “very challenging” to achieve a soft landing.

In this vein, Philadelphia Fed president Patrick Harker noted the US could very well see a couple of quarters of negative growth.

The rate trajectory is well understood, but the market is still grappling with the possible implications. This is driving much of the volatility in markets.

China

President Xi noted last week that Beijing would “strengthen macro-policy adjustment and adopt more effective measures to strive to meet the social and economic development targets for 2022 and minimise the impacts of Covid-19”.

China should be a net positive contributor to the global economy in the second half of 2022, compared to the first half. That said, there is skepticism over the strength of the outlook given competing policy constraints.

Australia

RBA governor Phil Lowe noted the path of rate hikes currently implied by market pricing was too aggressive and not likely. But here, too, markets remain sceptical and are looking for evidence that the RBA has a handle on inflation. 

Markets

There is a lot of bearishness priced into current markets. At this point the S&P 500 is sitting at the third-worst, first-half return since 1928 (after 1932 and 1940).

Historically, the worst first halves have resulted in a positive second half — though usually not enough to return a positive full year. It remains to be seen if we follow that historical path this time around.

We are also mindful of bear market bounces.

Selling the rally has been a consensus trade in recent times. For example the ARK Innovation ETF — a proxy for the long-duration growth names — has undergone more than 15 rallies of 10 per cent or more over the past 15 months, but it’s still down some 70% from its highs.

Similarly, the NASDAQ had 19 rallies of more than 10% in the three years of the tech crash from 2000 to 2003.

Nevertheless this market has had a lot thrown at it in a historical context. So, too, in bonds, where the total return of a 10-year US treasury bond over the past year has been among the worst ever — albeit with a strong base effect.

We have also seen a large and sharp drawdown in high-yield bonds in a historical context.

At this point the relative forward P/E of defensives is at a historically extreme premium to cyclicals.

That said, current operating conditions remain fine. When we start to see earnings downgrades come through this may shift the “E” in the cyclical P/E — so they no longer look as cheap versus defensives.

Pessimism is showing up all over the place.

• The pace of rising US bond yields has exceeded even the 1994 experience.
• The US homebuilder index has fallen about 40 per cent. Historically moves of this scale have usually — but not always — been followed by decent rebound. In this instance, the scale of mortgage-rate increases continues to pose a material risk.
• Sentiment indicators around commodities are near extreme bearish levels in a historical context. The copper price continues to come under pressure over demand concerns.

There is a lot of chatter about private equity activity in the current environment.

With this backdrop and in this type of market it can be dangerous to get too bearish on certain stocks and sectors. Private equity has lots of liquidity and public market valuations are relatively cheap.

For example, we have seen a recent bid for Ramsay Health Care (RHC). The infrastructure space has also been very active.

Finally, it is worth noting Covid is not going away.

Combined with this season’s flu, Covid is leading to ongoing societal disruption. This is showing up as a real cost to businesses where working from home is not an option — such as supermarkets, hospitals and airlines.

The duration of this impost remains to be seen.

Energy

Energy came under pressure last week. 

With the Fed talking tough, people are questioning how oil can escape the maelstrom. Energy is a key component of inflation, which needs to be brought under control.

From a fundamental point of view demand remains stubbornly inelastic, while supply constraints remain an issue.

It is also worth remembering the oil price is not particularly extended from a historical point of view. This is all mitigation against the risk of a material fall in the oil price.

We also remember how strangely oil traded during the GFC. It literally peaked 12 months after the market peaked.

Oil, though, is also very macro-driven and is part of a broader trade expressing concern over the pace of US tightening. Thematic trades can prove to go way deeper and last way longer than the fundamentals justify.

All that said, it would probably take a recession to materially affect oil demand and prices enough to start helping tame inflation.

It is also important to note that refined oil product prices locally continue to rise even as crude has fallen, due to high regional refining margins.

This, in turn, could be driven by China which has spare capacity but may be holding it back.

Russian production remains stronger than many expected and is finding a home in China and India.

Sanctions are about to get tighter, but it seems people find ways of working around these impediments. The upshot is that the effect of trying to remove Russian volumes is not contributing as much to the price as some think.

Oil and refining is becoming very political in the US. There is not much the Biden administration can do about refining because the additional capacity doesn’t exist and has a long lead time. Meanwhile utilisation of existing capacity is already very high. If the US government sought to ban exports then regional refining spreads would go higher again.

Stocks

The rotation back to growth saw Block (SQ2, +21.6%), REA (REA, +19.7%), Xero (XRO, +11.7%) and Next DC (NXT, +10.6%) among last week’s market leaders.

Resources fared worst, led by Whitehaven (WHC, -9.6%), Evolution (EVN, -8.4%) and Santos (STO, -7.3%)

Elsewhere an update from Qantas (QAN, +2.1%) reiterated guidance but flagged some one-off costs, which equates to an upgrade for the underlying operations. Demand remains strong. Capacity has been trimmed to 110% of pre-Covid levels in response to higher fuel costs. Importantly net debt continues to improve, down $500 million since April to $4 billion.

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About Crispin Murray’s Pendal Focus Australian Share Fund

Pendal’s head of equities Crispin Murray 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. 

Find out more about Pendal Focus Australian Share Fund  

Contact a Pendal key account manager

Are bonds a buy? Our head of government bonds Tim Hext offers his view in Pendal’s weekly Income & Fixed Interest snaphot

RATE HIKE expectations turned up another notch last week after a higher-than-expected US CPI and a 75bp lift from the US Fed.

Three-year bonds in Australia rose from 3.12% to 3.62% — another 50bp move. 

To put this in perspective that was more than the entire market range in 2018.

By the end of last week terminal cash rates were priced at 4.25% in mid-2023 and 3.8% by the end of this year.

This is well ahead of even a hawkish RBA’s expectations. Comments from Phil Lowe suggested they were too high even with the expectation of inflation hitting 7% late this year. This saw a small rally today (Tuesday).

Clearly the near-term mission of the RBA is to get back to a neutral 2.5% cash rate over the coming months.

Very little will stop them.

However, the broader debate is just how resilient the household sector — and to a lesser extent the business sector — is to these higher rates.

The RBA quotes higher savings as an important buffer. But it will not be the median household in trouble when mortgage rates hit 5-6%. Mortgage stress will fall on young families with a high propensity to spend — families without any savings buffer.

Bonds a buy?

The question of whether bonds are a buy at 4% is being increasingly asked.

Let’s break it down into inflation and real yields. 

For all the panic and commentary on inflation this last week, market expectations of longer-term inflation have not moved.

In fact a 10-year inflation swap is still at 2.5% — a vote of confidence that the RBA will hit its inflation target across the decade.

The rising nominal yields were all driven by rising real yields. This is not consistent with the view building increasingly in risk markets of a US recession in 2023.

In Australia 10-year real yields are now around 1.65%. This is your risk-free return above inflation… That is, you are protected for inflation plus you get an extra 1.65% and no credit risk.

Sounds quite compelling and real yields are at levels not seen since 2014.

Real yields are supposed to represent the productive capacity of the economy to generate more return from existing resources, meaning borrowers are happy to pay a return above inflation.

Maybe there is a surge in productivity building. There have been some encouraging signs in business investment recently, though higher rates may temper that.

The other factor that drives real yields is simply the level of cash rates versus inflation, or the real cash rate.

These are still sharply negative, though on future expectations markets are looking for Fed Funds around 3.5% in a year and forward inflation expectations suggest an inflation rate at a similar level.

In Australia it is harder to see a cash rate well above inflation for at least the next two years, though they may also eventually converge around 3.5% in early 2024.

This all makes real rates look like good medium-term value.

If you buy the market’s medium-term view that inflation will come back into the RBA band, it means bonds above 4% are cheap.

Given moves like the last week of trading this may be hard. But for asset allocators and portfolios underweight bonds it does suggest it’s time to get back to neutral.

If you buy into the whole recession view then clearly it is time to go overweight. But for us, momentum is still problematic in the short term.

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About Tim Hext and Pendal’s Income & Fixed Interest boutique

Tim Hext is a Pendal portfolio manager and head of government bond strategies in our Income and Fixed Interest team.

Tim has extensive experience in banking, financial markets and funding including senior positions with NSW Treasury Corporation (TCorp), Westpac Treasury, Commonwealth Bank of Australia, Deutsche Bank, Bain & Co and Swiss Bank Corporation.

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

The team won Lonsec’s Active Fixed Income Fund of the Year award in 2021 and Zenith’s Australian Fixed Interest award in 2020.

Find out more about Pendal’s fixed interest strategies here

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About Pendal

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

In 2023, Pendal became part of Perpetual Limited (ASX:PPT), bringing together two of Australia’s most respected active asset management brands to create a global leader in multi-boutique asset management with autonomous, world-class investment capabilities and a growing leadership position in ESG.

Contact a Pendal key account manager

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

Find out about Crispin’s Pendal Focus Australian Share Fund
Find out about Crispin’s sustainable Pendal Horizon Fund

Markets continue to see sharp falls.

A series of hawkish actions from central banks provided the catalyst last week, signalling their desire to raise rates more quickly. Some are interpreting the latest moves as signs of panic.

The Fed hiked 75bp. Their “dot plot” of expected hikes signals another 75bp in July, 50bp in Sep and then two 25bp moves to end year at 3.4%. Three months ago, this figure was 1.9%.

Elsewhere the Swiss National Bank delivered a surprise 50bp hike — their first in 15 years. The Bank of England increased rates 25bp and signalled they may add another 50bp in August.

There have been some decisive shifts in the way the market is behaving. Looking across asset classes:

• Equities were weak across the board last week: S&P 500 -5.8% (-22.3% CYTD), NASDAQ -4.8% (-30.7% CYTD), Euro STOXX 50 -4.5% (-18.9% CYTD) and the ASX 300 -6.6% (-11.7% CYTD)
• US 10-year bond yields rose to 3.5% — their highest level in 11 years — before falling late in the week to 3.23%
• Credit spreads — particularly sub-investment grade — widened
• Commodities sold off: iron ore -14.3%, copper -4.4%
• Crypto crashed. BTC was -28.1% for the week

The market is now fearing a recession. This is leading to two trends:

1. We are seeing positions liquidated, ie selling becomes more indiscriminate as correlations rise towards 1
2. Value is underperforming (led by energy and materials) for the first real time this year on the basis of cyclical risk. This is why we are now seeing the ASX underperform other markets

The core issue is whether the US ends up in recession. Investor surveys suggest an 80% probability. CEOs are suggesting 70%.

The market is concerned that the Fed has been cornered — it can see the risk of recession is rising, but needs to restore inflation credibility and raise rates quickly to at least get to neutral. We are all paying the price of central banks getting policy so wrong in 2021.

The Fed’s emphasis on spot inflation is concerning. This approach is flawed because it is driven largely by fuel and food factors where Fed action has little influence.

Chair Powell referenced the University of Michigan survey on inflation expectations, which is known to be correlated to fuel pump prices.

The combination of this backward-looking focus and the size and pace of rate increases means there is a high probability of over-tightening and a recession.

Under this scenario the S&P 500 is likely to fall through the 3500 support level at least to 3200, consistent with pre-pandemic levels.

The ASX is better protected in this scenario given lower valuations in a historical context, support from a weaker Australian dollar and index composition.

Central bank policy

It was a busy week for central bank watchers:

• Monday – The Wall Street Journal ran a story that the Fed planned to hike 75bps
• Tuesday – The European Central Bank announced an emergency meeting to address the issue of fragmentation amid concern about Italian bond spreads widening too far
• Wednesday – The Fed hiked 75bp and signalled rate would peak at 3.8% (the market is pricing in 4%).
• Thursday – The Swiss National Bank unexpectedly hiked 50bp and removed its currency intervention. The BOE hiked 25bp and signalled they may need to go 50bp in August regardless of the economic state.

There was only one dissenter against the Fed move. Ester George of the Kansas Fed argued for a 50bp hike given the uncertainty a 75bps hike could cause.

The remaining members of the Federal Open Market Committee justified the 75bp hike on the basis of a higher CPI print and the University of Michigan inflation expectations gauge.

They now expect rates to be a “moderately restrictive” 3.4% by the end of 2022, up from 1.9% in March. The ultimate peak rates are seen as 3.8%, previously 2.8%.

In their economic projections the end CY23 PCE inflation forecast rose 10bp to 2.7%. It is expected to be 2.3% (below the 2.5% target) by the end of 2024 and 2.3% at the end of 2024. Unemployment is expected to rise to 4.1% by the end of 2024.

It is worth bearing in mind the Sahm rule — that a 0.5% rise in unemployment signals a recession.

In an effort to soften the message Powell said in his press conference that the Fed would be flexible in implementing policy. But containing inflation is the priority.

As much as the Fed says it does not have to lead to recession, all logic suggests it will if the rate hiking path continues as signalled.

The central banks of the US and Australia continue to emphasise that the economy remains in good position to withstand rate hikes.

While this sounds reassuring, it’s also a problem since policy makers need to create slack in the economy to ensure the second-order effects of inflation don’t flow through. This implies even tighter monetary policy.

Australia

There were two important developments last week.

First, the RBA indicated their modelling (using current commodity prices) has inflation at more than 7% by the year’s end.

Second, we saw an increase of about 4.7% in the minimum wage and low-end award rates.

These show Australia faces similar challenges to the US with high inflation triggering second-order inflationary pressures in areas such as wages.

The RBA hopes that easing commodity prices — combined with companies being prepared to absorb cost pressures through lower margins — will stop an inflationary loop. For that to occur the economy needs to be weaker. By definition that would lead to earnings weakness.

The hope for Australia is that lower inflationary pressure, a looser job market and more exposure to variable rates means sufficient cooling can occur without rates needing to rise to the 4% level the market is predicting. But this would require a material slowdown in growth.

Our sense is the RBA is three months behind the Fed in gauging what they need to do.

Europe

The ECB held an emergency meeting to signal they were working on a mechanism to backstop the peripheral bond spreads.

Italian spreads did fall. But the important point was that through controlling the spread they would enable policy rates to be pushed higher without creating another periphery crisis. So this is a negative signal for tightening.

Switzerland

The rate increase here is more technical in nature since it does not apply to local borrowers. It is believed to be a signal that they want to stop further weakness in the Swiss franc to help contain inflation.

This may lead the Swiss central bank to liquidate offshore investments, where they have holdings in German Bunds and US equities. 

Japan

The Bank of Japan continues to dig in and remain committed to yield curve control. This is putting a lot of pressure on the Yen, which is heading back to its lows and approaching levels last seen in 1998.

We could see a major crack in terms of FX markets given the divergence between Japan and other regions. This adds to overall uncertainty.

US economy

It is increasingly hard to see how the US avoids a recession from here.

First the lagged effect of inflationary pressures means we are unlikely to see much relief on this front given fuel, food and shelter components are still rising. This gives the Fed little room to back off hikes.

Second, the lead indicators of activity are deteriorating:

• The “rule of ten” (which looks at the historical correlation of mortgages rates plus petrol prices on consumer spending) has a good track record of predicting slowdowns and recessions. It is now above the crucial “ten” mark.
• Housing looks like it is about to roll over as affordability deteriorates at an unprecedented rate. The only thing propping it up for now is low inventories. Falling house prices flows through into other areas of consumption.
• Consumption has benefitted from a material tailwind of credit growth and home equity withdrawal, which is likely to slow down. Even if this stabilises at current levels it removes an impulse to consumer spending.

Putting these factors together, you can see why the Atlanta Fed GDP tracker is deteriorating and is well below market consensus on growth.

This is also coming through at a global level with GDP growth forecasts for 2022 and 2023 rolling over.

This is an important issue for commodities.

Copper is a key indicator to watch. It has weakened recently and while it hasn’t broken through technical support measures, it is sitting on them.

 

This economic risk has implications for the market.

The market is discounting a material drop in earnings while they continue to hold up. Since 1987 we have only seen this disconnection twice (in 2002 and 2011) where markets overstated risk.

However in 2000, 2008 and 2020 earnings caught up with the market. Therein lies the risk if the US and global economy go into a recession.

Valuations in markets other than the US — including Australia — are lower and provide some protection. But we remain wary of how the market performs as downgrades come through.

While the risk is material, this bearish scenario is not a certainty. Factors which could see a better outcome include:

• Inflation momentum slows more quickly than expected. There are signs of hope with higher inventory at US retailers and evidence of discounting appearing. The fall in the oil price is a very important lead if sustained.
• Labour markets loosen up sooner. We have seen announcements from the tech sector on layoffs, but collectively this is not sufficient. On the supply side perhaps inflation and the crypto bust help drive participation higher.
• Supply chains begin to ease up as China re-opens and demand softens.

Should these factors start to play out we may see the Fed swerve again and be less aggressive on rates.

It’s unclear if this would be enough to avoid a recession. But in the market’s eyes it would at least signal the depth of the downturn could be lower.

Markets

The medium-term outlook is still bearish but there are signs the US market is tactically oversold — as you would expect after such a big move.

• We saw the first sign of an extreme in sentiment in this bear market with the 10-day average of advancing volumes falling to its first percentile (ie the number of stocks falling on short-term basis is at extreme levels)
• Another flag was Monday’s 46:1 decline / advance ratio in the market. On Thursday it was 17:1. Both are among the worst ratios for years
• We saw a spike in flows into short-dated treasuries
• Investor sentiment is pretty bleak

However we are not seeing signals to suggest the market is forming a bottom.

Put/call ratios are not at extremes. The number of stocks putting in a 52-week low is still expanding.

One signal to watch is the divergence between stocks and the market. Note the top was formed well after the average stock had rolled over. A similar outcome is likely at the bottom.

The other flag which is likely to mark the low in this cycle is the passing of time.

This market looks closer in nature to 2000 and 2008 where the market had to consolidate near its lows for a number of months before sentiment improved – unlike the sharp policy-driven bounce of 2020.

It is also worth noting that energy stocks could see a decent correction following a period of strong relative performance.

We’d likely see this as an opportunity, given supply issues remain severe with no sign of resolution.

Australian equities

There were few places to hide last week. The 20 largest stocks were as weak as the smaller caps.

Mining and energy underperformed. The gold miners held up well, as did some interest-rate sensitives among the financials and the defensive telco space.

Miners, industrials and tech were all hit hard. Most of the selling was largely indiscriminate. We are in a relatively quiet period for corporate news so expect the macro factors to dominate for now.

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About Crispin Murray and Pendal Focus Australian Share Fund

Crispin Murray is Pendal’s Head of Equities. He has more than 27 years of investment experience and leads one of the largest equities teams in Australia. Crispin’s Pendal Focus Australian Share Fund has beaten the benchmark in 12 years of its 16-year history (after fees), across a range of market conditions.

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

Find out more about Pendal Focus Australian Share Fund  

Contact a Pendal key account manager

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

Find out about Crispin’s Pendal Focus Australian Share Fund
Find out about Crispin’s sustainable Pendal Horizon Fund

HIGHER-than-expected US inflation data, combined with a hawkish tone from European and Australian central banks, have helped push equity markets down through the May lows.

US bonds have sold off, with a “bear flattening” of the curve as 2-year yields rose 41bps and 10-year yields rose 22bps (at Friday’s close). Risk aversion saw the US dollar and gold hold up, while equities fell.

The S&P 500 was off 5% last week, the NASDAQ lost 5.6% and the Euro STOXX 50 was down 4.9%. For the year-to-date the S&P 500 is -17.6%, the NASDAQ -27.3% and the Euro STOXX 50 -18.5%.

A record low in the University of Michigan Consumer Sentiment index (which goes back to 1978) and evidence that consumer longer-term inflation expectations are on the rise add to the sense of foreboding.

The market increasingly fears high interest rates and a recession.

The RBA’s 50bp rate hike triggered recession fears domestically. This prompted some shorting of domestic banks by international investors and saw the Australian market sell off even before Friday’s move.

The banks sector fell 10.6% last week. The S&P/ASX fell 4.3% and is down 5.5% in so far in 2022. 

The US Fed meets this week and the market is pricing an 80% chance of a 75bp hike.

The rationale is they need to “get in front of the curve” and restore confidence that inflation will be subdued.

There is a growing view the Fed has to choose between allowing inflation to stay high or triggering a recession. This translates to either rating or earnings risk for equities.

The combination of rates up, oil up and US dollar up is not good for equity markets.

Our view is the risk/reward trade-off remains skewed to the downside for now.

Economics and policy

The May CPI print was only 0.1% worse than expected. However the underlying components were considered more negative.

Some key points to note:

• Headline inflation rose to 8.6% year-on-year — a new high for this cycle and up from 8.3% last month. Energy accounted for was 0.3% of the 1% month-on-month increase. Gas prices are up a further 10% this month. 
• The Median CPI across all categories was +0.58% m-o-m. This was the highest-ever print, as was the y-o-y median. This reflects the breadth of pricing pressure. 
• Core CPI rose 0.63% m-o-m versus 0.5% expected. It’s running at 6% y-o-y, down from 6.2% last month.
• Core goods inflation picked up m-o-m, goods CPI +0.7% m-o-m versus +0.2% last month. New and used auto prices picked up as car manufacturing remained constrained.
• Core services inflation rose 0.6% m-o-m. Airfares remained strong, up 12.6% m-o-m.
• Shelter (50% of services inflation) did not decelerate as expected, rising 0.6% m-o-m.

One key issue is that goods inflation is not coming off quickly enough to offset the rise of services inflation.

The rent component was expected to decelerate, but did not. Some private measures of rent indicate this will continue to rise. This needs to be watched since it comprises 40% of core CPI.

The problem for policy makers is that inflation expectations are beginning to step up.

This puts more pressure on the Fed to break the wage-price feedback loop by slowing the economy and creating slack in the labour market. The Atlanta wage tracker is staying flat at 6.5% and hasn’t yet shown signs of falling back.

The University of Michigan Consumer Sentiment index weighed on markets, falling to levels not seen since the early 1980s. The disconnect here is that people are still spending despite a low confidence level.

There appears to be an emerging divergence between lower and higher income consumers. The former are hit harder by inflation and the removal of stimulus payments.

This is evident in feedback from consumer stocks, where luxury and premium products are continuing to see good demand.

Europe

The European Central Bank met and sent a clear hawkish shift in their outlook. They noted CPI was now expected to be above the target range through 2024, despite lowering the outlook for economic growth. They also signalled the risk to CPI expectations was to the upside.

The signal is for rates to increase 25bps in July. The market is now expecting 50bp in September and possibly another 50bp in October, with rates peaking at 1.75%.

This means the market is now seeing 125bps tightening this year, versus 50bps only four weeks ago.

It is worth bearing in mind that inflation isn’t expected to peak before September, at around 9.3%.

Using the old rule of thumb that rates need to reach the inflation level, there still seems risk to the upside.

The market’s other issue was the lack of any specific mechanism to avoid the “fragmentation risk” of widening spreads from Eurozone “periphery” economies.

This is already occurring with Italian 10-year yields now at 3.98% versus Germany at 1.58% — a spread of 240bp. This is a 100bp widening from the start of the year when German bonds were -0.18% and Italian 1.19%.

The ECB believes it has the tools to prevent this becoming a problem. But lack of detail opens the door to the market testing the level at which the ECB will act.

Markets

The rally over the last fortnight lacked conviction, with low breadth compared to previous market returns.

We are now breaking through the May lows in US equities. The near-term outlook is not constructive given:

• US bond yields have risen to cycle highs on the tail of a break-out in German bonds
• The most bombed-out tech names are rolling over again
• Mega-cap tech look to be rolling over; these have propped the overall index up
• The US dollar index is testing new highs
• Oil price – the source of a lot of problems – refuses to soften given supply issues

The risk-off signal is also apparent in speculative tech and also in cryptocurrencies, where Bitcoin is falling on liquidity concerns.

Tightening cycles often trigger some form of financial shock, which can create a capitulation in the market. This often marks the low.

In this context, there are specific areas we are watching for signs of further strain:

1. Peripheral bond spreads in Europe (indicates pressure on the Euro as ECB forced to raise rates into downturn)
2. Credit spreads (indicates evidence of recession risk)
3. US$/Yen and Japanese bond yields (indicates evidence market losing confidence in yield curve control)
4. CNY/USD (reflecting pressure on Chinese economy from higher energy and food prices)
5. Crypto, first real test of how liquid this is in a bear market
6. Performance of banks versus market

Technically, if the S&P breaks through the May low the next resistance is at 3500.

Beyond that, the pre-Covid level was 3250.

If we get into this territory it would represent a material tightening of total financial conditions which may see a moderation in the market’s view of how far the Fed needs to tighten.  

Australia

The RBA rose 50bps rather than the expected 25-40bp.  Like many other central banks the Reserve seems to realise the need to get back to neutral quickly. Rate expectations have now risen for the balance of the year. This has weighed on the ASX, with banks hit on economic concerns and REITs over the increase in funding costs.

 

After a multi-year cease fire, global long/short funds chose to put the short back on Australian banks, on the premise the economy is going to slow and that housing will follow.

We have been here before and it has historically been a losing trade.

The rationale, from an international perspective, is grounded in the fact that Australian house prices have more than doubled the growth rate of the US over the past 30 years.

There are explanations for this, including the impact of immigration and lack of supply.

But the simple narrative for now is that Australian mortgage rates are set to rise from around 2% to potentially over 5%. In the near term that means risk for housing and the banks.

This saw Westpac (WBC) -13.1% last week, Commonwealth Bank (CBA) -10.9%, National Australia Bank (NAB) -10.3% and ANZ (ANZ) -7.7%. Year-to-date the banking sector has now performed in line with the market.

Discretionary retail is the other sector particularly vulnerable to the rise in mortgage rates.

This is translating through to underperformance in JB Hi-Fi (JBH, -10%), Wesfarmers (WES, -7.4%) and certain small caps.

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About Crispin Murray and Pendal Focus Australian Share Fund

Crispin Murray is Pendal’s Head of Equities. He has more than 27 years of investment experience and leads one of the largest equities teams in Australia. Crispin’s Pendal Focus Australian Share Fund has beaten the benchmark in 12 years of its 16-year history (after fees), across a range of market conditions.

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

Find out more about Pendal Focus Australian Share Fund  

Contact a Pendal key account manager