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

JULY’S more positive tone was tested last week by a combination of:

1. US Fed officials rolling back a perceived “pivot” signal from Chair Powell the previous week
2. Strong US employment data (which is ironically poor news in the current environment)
3. China-Taiwan tensions

The first two points saw bond yields gain 34bp at the short end and 18bp for 10-year Treasuries. The yield curve is now more negative than it was in 2007 and the US dollar has started rallying again.

Despite this, equities ground out small gains, led again by growth stocks.

The S&P 500 rose 0.4% and S&P/ASX 300 gained 1.1%.

This resilience is surprising. We suspect it has as much to do with the market’s previous negative positioning and sentiment as any fundamentals.

The recovery has prompted some breaks in the previous bearish consensus.

We have seen a highly rated US technical analyst turn positive on the premise that the oil price and bond yields have peaked.

Energy is critical to the outlook.

A bounce-back in the oil price would kick-start stagflation concerns; a continued fall would help drive bond yields lower.

Locally, the focus will shift to stock specifics as reporting season kicks off this week.

US economics

US payroll data and household survey came in well ahead of expectations.

This suggests the job market remains strong despite weakening lead indicators, a technical “recession” signal and headlines about tech companies laying off workers:

• The US economy is averaging more than 400,000 new jobs a month over three and six months. The three-month average has fallen from 600,000 — though it needs to come down to 50,000-75,000 to be consistent with looser wage pressure. 
• Total US payrolls are back to pre-pandemic levels, though leisure and hospitality roles are 7% lower. The overall unemployment rate is at its lowest since 1969.
• Three-month average wage growth (measured by average hourly earnings) has ticked up and remains stuck with a 5-handle. This needs to fall back to the 3% range to help inflation back to 2%.
• The participation rate was down month on month and remains stubbornly low versus pre-pandemic. Older workers are still showing reluctance to return to work. 

There are early signs that the ratio of job openings to the number of unemployed is rolling over. But we have a long way to go to normalise and reduce pressure on wages.

These are all co-incident or lagging indicators.

It’s highly likely a weakening economy will start to flow into jobs in the next few months.

But the starting point is higher and the amount of slack needed is rising. This makes the Fed’s job harder.

Fed speak

Some outer members of the Fed worked this week to rectify the interpretation of Powell’s press conference, re-iterating the priority of fighting inflation.

Combined with the employment data this moved the short end of the yield curve in particular.

The market is back to pricing an implied 67bp rate hike for September.

The Fed’s initial plan is to slow growth below trend — which should loosen the job market, leading to lower wage growth and inflation.

It’s important to remember that equity markets form part of the overall total financial conditions index, which has an impact on the pace of economic growth.

The Fed had shifted this sufficiently to be consistent with 1% GDP growth — in line with the aim of a soft landing.

However the reaction to Powell’s press conference last week meant total financial conditions were beginning to ease.

The Fed needed to check that move to keep conditions conducive to below-trend growth.

US Inflation Reduction Act

This US$430 billion bill — intended to fight climate change, lower drug prices and raise some corporate taxes — has been further amended and is now highly likely to be passed in next few weeks.

The most relevant component is an emphasis on clean-energy investments, including increased subsidies for electric vehicles.

This is tied to requirements that companies source components from countries with free-trade agreements with the US, to prevent reliance on China. This should be a boon for the Korean battery industry.

It remains to be seen whether the capacity to deliver this exists. But for the moment sentiment towards electric vehicles and battery materials has improved.

Bank of England

The UK highlights the policy conundrum that emerges as stagflation takes hold.

The Bank of England now predicts five quarters of recession with inflation peaking above 13% this year and remaining above 9% next year.

The need to quash inflation takes precedence, so the BOE raised rates 50bps despite predicting recession.

The UK is facing a crisis in power prices, which is not the case in the US or Australia.

This is a reminder that energy prices are a critical factor in determining where all markets go.

Taiwan

Markets remained relatively sanguine around the tensions attached to Speaker Nancy Pelosi’s visit to Taiwan.

The view among most geopolitical experts is that Beijing is not confident in the success of any invasion and will not yet start to impose a blockade — the likely first step.

That said, there is a widespread view among western military experts that neither Taiwan nor the US is sufficiently prepared for any cross-Strait attack.

This is quite different to the preparation that had been happening in Ukraine for the past few years.

Pelosi’s visit and the Chinese reaction may be a catalyst for action to rectify this — which may also trigger Beijing to act before those preparations are in place.

This remains the single biggest long-term geopolitical risk for markets.

Markets

The big debate is whether the market’s rebound is a bear market rally or whether we have put in the lows for this cycle.

At this point the rebound is almost bang on the average bear market rally (in terms of rebound and length) in the S&P 500 since 1950.

The market breadth of the rally is not yet consistent with a change in trend.

The rule of thumb is you need to see 90% of stocks above the 50-day moving average to signal a change in market direction. We are at 73%. However this could continue to climb.

The yield curve is also sending a negative signal.

Its inversion is signalling recession, which would lead to a decline in earnings and pull the markets lower.

The challenge to this perspective is the unusual speed and scale of the increases and the market’s current confidence that inflation will be brought back down, which is reflected in long bond yields.

The bull case for equity markets is:

1. They have bounced off long-term technical support levels
2. Oil prices have peaked, with demand weakening
3. Bond yields have peaked, helped by lower commodity prices

The importance of oil

The positive case is underpinned by the view that oil prices won’t bounce back.

We see this as a potential negative surprise for markets. There are several reasons why oil could behave differently in this cycle:

1. Inventories are low, despite tapping the US Strategic Petroleum Reserve (SPR). The latter probably has capacity for three more months of contributions to supply, with the run rate falling in that time.
2. Spare capacity is very limited, as shown by OPEC increasing output by only 100,000 barrels per day for September. There is no buffer for demand recovery or for any geopolitical shock.
3. Europe plans to tighten sanctions on Russian oil in December, which could limit access to 0.01 to 1.5m bpd
4. China at some point will re-open its economy, increasing oil demand by 500K to 1m bpd
5. Oil demand may surprise on the upside due to fuel oil. This is the first downturn where alternate fuel prices (notably gas and coal) are far higher than oil. This is likely to see some substitution to oil — not away from it as is normally the case. The US gas market has remained surprisingly tight despite the closure of the Freeport LNG export facility.

This may not play out for a few more months, given US SPR is still being released, China is set to run with zero covid for another few months and the global economy is slowing.

For time being the weaker oil/lower bond signal could remain in place, but it is something to watch.

Australia

The S&P/ASX 300 is now down only 4.1% in 2022. This followed a US rotation to tech, away from energy last week.

Defensive sectors such as staples continue to perform as cash is put into market reluctantly.

We continue to see a bounce-back in small-cap performance which appears correlated to market direction.

---

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

Did this week’s RBA statement this week signal fewer rate hikes ahead? Probably not, says Pendal’s head of government bond strategies TIM HEXT

THE RBA statement this week played a reasonably straight bat.

Who can blame them given all the criticism and the upcoming review? They seem less keen to take on the market.

But it’s also reasonable in a highly uncertain and complex world that you maintain maximum flexibility.

Anyone with a strong opinion on the economy at the moment is likely displaying misplaced bravado.

What we do know is rates are going to hit neutral this year. Another 1% of hikes can be expected, moving the cash rate to 2.85%.

Whether it’s four lots of 25bp across four meetings or 50bp at fewer meetings is only of interest to short-end traders.

Hence the RBA’s line that “the Board expects to take further steps in the process of normalising monetary conditions over the months ahead, but it is not on a pre-set path”.

Sounds like an opportunity for everyone to interpret this with their own confirmation bias — which on Tuesday seemed to be fewer hikes, not more.

I think that’s reading too much into it.

Much like the US Fed, the RBA will be keeping a close eye on overall monetary conditions.

As asset owners we must remember the “central bank put” is now also a “central bank call”.

That is, if bonds, equities and credit spreads rally too much without a significant easing in inflation pressures, they will lean against the easing of conditions.

The rally of the past month suggests this is in danger of happening — so expect more hawkish speeches from officials, especially in the US.

RBA officials will have time over summer to sit back and see the impact of hikes on the economy.

I suspect the hikes will not have a big impact yet — but will do so next year.

This is when 30% of total mortgages come off 2% fixed rates onto 5%-plus floating rates.

However, while goods price inflation will be falling, services inflation will be becoming more embedded in the economy, courtesy of labour shortages.

This will limit any further rallies in bonds.

They are not expensive, but recent rallies mean they are no longer cheap.

---

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

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

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

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

Find out more about Pendal’s fixed interest strategies here

---

About Pendal

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

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

Contact a Pendal key account manager

A re-assessment of fixed income securities and yields — and their defensive qualities — have made bonds attractive again. Here’s a quick overview from Pendal’s head of client solutions DALE PEREIRA

AFTER a decade of strong returns, bond markets have been challenging for investors over the past year.

Returns have not been kind.

But in recent few months a re-assessment of fixed income securities and yields — and their defensive qualities — have made bonds attractive again.

Bond returns don’t predict future returns – they reflect what has happened. That’s where the opportunity lies: they may be showing negative returns now, but the future looks a lot brighter.

Why bond yields are up

Markets are forward-looking – prices reflect where the economy is heading.

Bonds typically lead equities in terms of market reaction.

From the end of 2021 and into the first half of 2022, bond yields moved in line with expectations of future rate rises – which in turn reflected inflation expectations.

But markets often over-react when extrapolating good and bad news. And that’s the case now.

The market has likely priced in too many rate rises. It’s priced in a good chance that central banks around the world won’t be able to control inflation. (Though recently that pricing has started to dissipate, making yields less volatile.)

This means the bond market is at a much better entry point for investors.

But aren’t central banks already lifting interest rates?

They are, but remember bonds are priced on expectations.

We’ve seen a big jump in yields because investors initially expected things could get out of control with supply-chain problems and higher prices.

There was plenty going on – Covid restrictions in China, the war in Ukraine, soaring oil prices and an energy crisis. It wasn’t long ago that people were talking about oil at $US200 a barrel.

Hence, central banks have acted aggressively.

In Australia we’ve seen consecutive 50-point rate hikes – the fastest rate-rise path in our history.

Other countries such as the US, UK, Canada and New Zealand have been even more aggressive.

Central banks understood their objective and acted to curtail inflation expectations. If they hadn’t, inflation expectations could quite easily have become reality.

What’s the prognosis for inflation?

In recent weeks there are early signs that inflationary pressures may be dissipating.

The flipside to reduced economic activity and price pressures is the prospect of a recession.

That’s an environment when bonds outperform.

Why bonds could be a good investment now

If inflation has peaked — and we’re now only expecting moderate inflation – that’s a good environment for bonds, since the starting point is a higher yield.

Coupon payments (and income) is higher. Plus there’s limited downside risk in terms of capital loss.

If we head into a recession, there’s a call option on bonds. That means the issuer can redeem the bond before its maturity date.

So the asset from which you are getting a coupon is at least in line with long-term inflation.

And it will appreciate in value if we do head into a recession.

What about corporate bonds?

Until recently, many corporate bond investment strategies were hit with a double whammy of interest rate risk and credit risk.

Corporate bonds are more susceptible to an economic growth slow-down and potential recession. Investors may worry that companies won’t be able to repay their debt.

The market has anticipated this and re-priced corporate bonds.

The riskiest companies don’t have a strong balance sheet. They may be operating in an environment where margins are under pressure because costs are going up while sales are flat or falling.

But that’s the worst-case scenario.

In Australia there are many investment-grade corporates with strong balance sheets.

How to invest in the bond market now?

Investors should consider a “barbell” approach.

At one end of the barbell, consider buy high-quality government bonds for duration.

Australia looks like a good place to re-enter the market. If investors already hold government bonds, now is not the time to sell because that would lock in losses.

Look for actively managed portfolios, because opportunities depend on choosing the right maturities of a government bond.

For example 5-and-10-year bonds — which take into consideration medium-term impacts of inflation and growth — now present interesting opportunities that active managers can exploit.

At the other end of the barbell, investors should consider investment-grade bonds which represent quality companies with good cash flows.

In Australia the level of default in investment grade bonds is much lower than the US, because of our higher-quality balance sheets.

Investors can also look for floating rate investments issued by corporates.

This means investors are less impacted by rate rises. They get an increase in income every quarter as the cash rate rises.

Floating rates haven’t been a good investment in recent years as interest rates tended down.

But in this environment they can outperform term deposits since investors pick up extra accrual as rates rise.

Other opportunities can be found in the fast-growing impact or “use-of-proceeds” bonds, often known as green, social or sustainable bonds.

Strong tailwinds in climate, regulation and human behaviour change mean there is increasing demand for these types of bonds — and not enough issuance.

This dynamic is likely to continue.

Dedicated strategies can find strong returns along while aligning with client principles.

ESG (environment, social and governance) has a different meaning in bonds compared to equities. Capital can be ring-fenced for specific projects or uses and the main elements of credit risk and duration risk can be managed.

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

MARKETS took a glass-half-full view last week, despite data showing inflation was still running hotter than central banks would like.

This was in stark contrast to recent market action.

There were two reasons for this more positive stance:

First, the market interpreted Fed Chair Powell’s remarks after last week’s 0.75 percentage point rate rise as leaving the door open to a more moderate pace of tightening.

The reaction suggests the Fed may have restored a degree of credibility in the market’s eyes.

Second, comments from several big US companies during reporting season suggest that while the economic slowdown is real, it isn’t derailing corporate earnings at this stage.

The S&P 500 gained 4.3% last week, while the S&P/ASX 300 was up 2.3%. Commodity prices rallied, while US 10-year bond yields fell 38bps.

Australia

Last week’s inflation data was seen as enough to support today’s 50bp rate increase, but not sufficient to warrant the 75bp “shock and awe” move that many feared.

CPI inflation rose 1.8% in the June quarter — slightly less than the 1.9% consensus expectation and down on the 2.1% gain in Q1.

Annual CPI growth was 6.1%, up on the 5.5% of Q1 and the strongest growth since 1990.

Trimmed mean CPI — the RBA’s preferred measure — rose 1.5% over the quarter, in line with consensus. It is at 4.9% for the year versus 4.7% expected. This remains well above the RBA’s 2-3% target.

Price growth was broad-based with sharp rises in food, transport and housing costs.

US Fed

The Fed raised its target band by 75bps to 2.25-2.5%.

The decision was unanimous and returns rates to a range the Fed considers neutral — though some observers disagree.

The market wanted to hear there was some chance hikes get throttled back. People saw enough in the accompanying statement to deliver this hope.

Chair Powell flagged some softening in spending and production. But he pointed out that labour markets remain strong and inflation elevated.

The Fed would need to see growth and inflation slowing to ease the pace of hikes, he said. Hence the market’s positive reaction to the data print of negative GDP growth in Q2, slipping the US into technical recession.

That said, Powell reiterated that failure was not an option in achieving price stability.

He could not rule out another out-sized rate hike for September, depending on the data. He wanted to see “compelling evidence” of slowing inflation in the core Personal Consumption Expenditures price index.

Powell also noted the natural rate of unemployment was likely a lot higher today than prior to the pandemic. At 3.6% the labour market looks extremely tight — and hence a generator of primary inflation.

US GDP

The US economy contracted 0.9% in the June quarter after falling 1.6% in Q1 — signalling a recession.

But it does not feel like a recession, given strength in the jobs market and an unemployment rate of only 3.6% in the past four months. This remains a key factor to watch.

Unemployment benefit applications last week were the highest this year, which may signal a shift.

Consumer spending rose 1% annualised, down from 1.8% in the previous quarter.

The slowing pace of inventory restocking was a big draw-down on economic growth. Changing consumption patterns have left many retailers with excess stock that needs to be discounted and cleared.

Most economists have growth in the September quarter and for calendar 2022 — so the current contraction is not expected to continue.

US inflation

A few other data points indicate that inflation remains high.

The Employment Cost index rose faster than expected, up 1.3% for Q2 and 5% year-on-year.

However the market is seeing signs of near-term softening in labour markets and at this stage seems happy to look through this print.

The Core Personal Consumption Expenditure index (which excludes food and energy) rose 4.8% in June, up from 4.7% in May. Prices rose 0.6% in June, following several months of 0.3% increases. Consensus expected a 0.5% gain.

One positive is that US petrol prices have now fallen for more than 40 days straight.

Markets

Last week was strong across the board.

Every major equity index except Japan made gains, while commodities and bonds were both stronger.

It topped a strong month. The S&P 500 gained 9.2%, the NASDAQ lifted 12.4% and the S&P/ASX 300 moved ahead 6%.

US mega-cap stocks caught a strong bid, reflected in growth outperforming value.

So far 56% of US companies have reported Q2 results.

About 75% have delivered better than expected EPS results, versus an 81% average over the past year and 77% over five years.

Overall, earnings are on track to rise 6% — the slowest rate since the end of 2020.

Amazon delivered an unexpected loss for the quarter — though sales for the quarter were up 7% to US$121bn versus $119bn expected.

Management guided to $125-130bn of sales next quarter, versus $126bn consensus. Crucially, management indicated it was getting costs under control and productivity at fulfilment centres was improving.

Revenue grew 33% for Amazon Web Services and advertising was up 18%, continuing the theme that the stronger franchises are taking revenue from the weaker franchises. Amazon shares were up 29% in July — their best month since October 2009.

Intel shares tanked after missing quarterly profit and revenue expectations. Revenue fell 22% — the biggest drop in a decade. The chip-maker flagged weaker PC sales and poor execution on a rollout of a new generation of chips for data centres.

Microsoft’s 12% revenue growth fell short of expectations. However an upbeat outlook saved the day, with management expecting double-digit growth in sales and operating income for FY23.

Apple revenue rose 2%, driven by stronger-than-expected demand for iPhones. Sales rose 2% while the market was expecting a 3% fall. CEO Tim Cook said he was seeing pockets of softness but expected even stronger year-on-year revenue growth next quarter.

Google’s parent Alphabet reported sales up 13% on the previous comparable period. It was the slowest growth in two years as advertising decelerated in many areas. Net income was down 14%. The company has slowed down hiring plans.

Meta (previously Facebook) reported a decline in revenue versus the previous comparable period for the first time and a third sequential fall in operating profits. Ad revenue declined 18% and pricing fell after recent strong gains. Meta also flagged slower hiring.

Shopify’s stock fell 14% after cutting 10% of its global staff in response to the reversal of sales back to physical retail.

Australia

In Australia materials (+5%) led the market higher as miners dominated the leader board, led by the lithium and EV-related names.

Real estate (+3.9%) was also strong.

Health care (-0.8%) lagged, as did consumer discretionary (-0.3%).

---

About Jim Taylor and Pendal Focus Australian Share Fund

Drawing on more than 25 years of experience investing in top-performing Australian companies and a background in accounting, Jim manages our Long/Short Fund and co-manages our Imputation Fund. He is a Chartered Accountant with membership of the Australian Institute of Chartered Accountants.

Pendal Focus Australian Share Fund is managed by Crispin Murray. The fund has beaten its benchmark in 14 years of its 18-year history (after fees), across a range of market conditions. Find out more about Pendal Focus Australian Share Fund here.

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

Contact a Pendal key account manager here

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

THE market is seeing signs of inflation easing, the economy slowing and policy having an effect.

As a result, concerns over the extreme tail risk of substantial central bank overtightening may be receding.

It remains a challenging environment. The key questions around where inflation settles, the path of rate hikes and the economic impact are still unanswered.

Energy remains a wildcard. But at this point there is a reduced probability of some of the most negative projected scenarios.

The market bounce continued last week.

The S&P 500 gained 2.6% and the S&P/ASX 300 3.6%. This was despite more bad news on economic growth and the European Central Bank (ECB) striking a more aggressive stance than expected with a 50bp rate hike.

At this point bad news is seen as good news. Weaker growth is seen as helping drive inflation lower, bringing forward an expected peak in rates and bond yields.

US 10-year government bond yields are now 66bps lower than the June high, which is helping support the equity market. The S&P 500 is up about 8% from its lows. We are also seeing a rotation back to longer-duration sectors.

Oil prices, bond yields and the US dollar all remain tightly correlated and a key driver of markets. Recent falls in yields and oil and a pause in US dollar gains are all helpful for equities.

Early US corporate earnings signals are supportive. It was interesting to see Netflix bounce about 25 per cent despite weaker subscription numbers.   

Where to next for markets?

It is too early to call whether we have seen a bottom or if this is another bear market rally.

Technical measures of market breadth and volumes are not indicating a sustainable turn in sentiment.

Seasonally, August and September are typically soft months for equities.

That said, a market moving higher on bad news suggests some stale positioning and the squeeze could continue.

Bear markets don’t tend to end until policy direction shifts. It would also be unusual to see markets bottom before the extent of any earnings recession is known.

The challenge is that bear market rallies and squeezes can be large.

The average NASDAQ bear market rally since 1985 has been 30% — and the NASDAQ is only up 11% from its recent low.

The S&P/ASX 300 is now down 7.2% for the year to date. Technology is off 27%, consumer discretionary is down 17.6% and REITs has lost 16.8%. This leaves plenty of scope for these sectors to squeeze higher during reporting season.

This week will bring a lot of new information including a Fed meeting, the US Q2 GDP print and a raft of US earnings results.

Macro and policy outlook

Europe

The ECB raised rates 50bps — the first hike in 11 years — in response to a worse-than-expected inflation print of 8.6% year-on-year. The market was not expecting such a big move, only ascribing a 25% chance.

The market’s reaction was positive.

This could be partly because the ECB stated there was no change to the ultimate expected terminal rate. There was also likely some relief that the bank was catching up to the reality of dealing with inflation.

Given the likely slump in the European economy, there is a view the ECB has only a small window politically to raise rates — and therefore they are better to front load.

The ECB also provided the latest “tool” to manage the “fragmentation” risk of bond spreads blowing out in the periphery and creating the next Euro crisis.

The Transmission Protection Instrument (TPI) represents a form of Quantitative Easing in an era of rate tightening and Quantitative Tightening. The purpose is to prevent the upcoming recession from putting pressure on the Euro.

It is said to have no budget limit on the purchases or periphery bonds (refers to being “proportionate”) or any need to negotiate some economic reform package.

There is no stated threshold for use, which will be determined by the European Council. It will also likely relate to circumstances beyond the country’s control, so the current Italian political crisis is unlikely to trigger its use.

As with most European tools, this is deliberately vague. We suspect the market will want to test this at some point.

United States

It is almost unanimously expected that the Federal Reserve will hike rates 75bps this week. Speculation about a 100bp hike has dwindled along with the latest inflation expectations data.

The Fed is maintaining a hawkish tone.

We suspect they would rather wait for more firm evidence of slowing inflation over next two months – remembering they do not meet in August – than ease up too early and risk another embarrassing U-turn.

The curve of expected future policy rates shifted down 15bps last week. It now has rates peaking at the end of 2022, rather than the previous end of Q1 2023.

This is a big shift from where we were a month ago. It is likely the economy will need to be a lot weaker for this to happen.

Elsewhere there were limited data releases last week.

Regional Fed manufacturing indices were soft. But the Flash US Manufacturing PMI was better than expected at 52.3 vs 52.7 in June.

Interestingly the Services PMI was weak at 47 vs 52.7 in June, with the pricing component notably lower.

Overall, it painted a constructive picture of inflation easing.

Energy markets

Gas resumed flowing through the Nordstream pipeline from Russia to Europe after maintenance, calming some fears.

It is running at 40% capacity. This enables Germany to build enough reserves for winter – but only just. It remains vulnerable to any change in the Russian approach.

We now have the perverse situation where the West has imposed sanctions to constrain Russia’s ability to sell oil, but is desperately hoping Moscow keeps supplying gas.

Germany suffered the ignominy of asking the rest of Europe to reduce gas consumption 15%. Greece and Spain refused. The latter drew on Germany’s own Euro crisis era rhetoric noting that “unlike other countries, we haven’t been living above our means in terms of energy”.

Oil and gas will be key to determining whether sentiment around inflation continues to improve.

The growing consensus is that weak global growth will see oil prices fall below US$90, relieving pressure on headline inflation and consumer inflationary expectations.

This would allow softer Fed rhetoric perhaps as early as September.

 

The alternate view is that supply constraints, an end to strategic petroleum reserve (SPR) releases and Chinese re-opening could drive energy prices higher even as the global economy slows.

This would leave central banks facing an impossible choice.

China

Chinese equities have rallied since May on the easing of Covid restrictions.

However sentiment has turned more negative.

This is partly driven by the mortgage strike in relation to unfinished homes and also by the lack of any meaningful stimulus. Measures enacted recently really only serve to offset the negative impact from housing weakness.

At this point, it appears growth with be sluggish for the next few months. It is hard to see China as a big driver of any improvement in sentiment towards global growth in the near term.

The US dollar continues to drag the Chinese Yuan (CNY) higher, affecting its ability to compete with Korea and Japan. There is a risk we may see another step down in the CNY, which would likely be negative for commodities.

Australian market

Last week’s broad ASX rally was led by tech (+7.3%), financials (+4.5%) and small caps (+5.8%).

Small cap resources had a good bounce (+6.9%) after a sharp fall in recent weeks (about -33% since April).

This is symptomatic of being oversold and the market chasing beta into the bounce, rather than a shift in fundamentals.

We are seeing small signs of rotation from consumer defensives to discretionary. This was helped by an upgrade from JB Hi-Fi (JBH, +10.1%).

This will be something to watch in reporting season. We note Nine Entertainment (NEC) as a good example of stock that has been heavily de-rated without any sign of earnings softening.

---

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

Bonds are back. Here Pendal’s head of income strategies AMY XIE PATRICK explains why

• Ten-year bond rates close to 4 per cent
• Benchmark returns for other asset classes higher
• Negative correlation between bonds and risk assets has re-emerged

INVESTORS have struggled to earn good returns from fixed income assets in recent years.

But yields on government bonds have risen over the past year — and the negative correlation between bonds and risk assets has re-emerged.

That reflects the narrative around a recession in the United States, Europe and possibly even Australia, says Pendal’s head of income strategies Amy Xie Patrick.

“The bond story of recent years has been flipped on its head,” says Xie Patrick.

“Buying 10-year government bonds in Australia can get you nearly 4 per cent. At the height of the pandemic, it was 50 basis points.

“Now the credit risk-free rate is 4 per cent, which raises the bar for other asset classes.”

Those other assets might be riskier fixed income instruments including junk bonds and private sector debt, or other asset classes such as equities and alternatives.

When government bonds yields have risen so much, so quickly, the economics of all other investments change.

“You can get credit-risk free, 10-year yields in Australia for 10 per cent. That sounds pretty good,” Xie Patrick says.

Investors should consider buying high-quality sovereigns, such as United States or Australian bonds, which are free from credit risk, says Xie Patrick.

Changing attitude to bonds

Investors have been hesitant to include bonds in portfolios in recent years — but that’s changing, says Xie Patrick.

“For the last three years equity yields were much higher than bond yields. Investors were better off sitting in equities and collecting the dividend.”

But fears of a recession have changed all that. Xie Patrick points out that it isn’t central banks around the world that will trigger a recession. Rather, it’s tumbling consumer sentiment that reflects inflation.

“You’re filling up your petrol tank and the cost at the bowser just keeps going up. Grocery bills are so much higher and feeding a family is becoming expensive. None of that is good for consumer sentiment,” she says.

Private sector sentiment is critical to economic growth because confidence leads to higher spending. The most recent Westpac-Melbourne Institute of consumer confidence in Australia (PDF) – the long-time benchmark – this month fell to its lowest level since the beginning of the pandemic.

In the US, the benchmark measure from the University of Michigan has hit a record low.

No quick turn-around

Consumer sentiment isn’t going to improve quickly, Xie Patrick says.

“High levels of inflation tends to lead consumer sentiment by six to 12 months, so even if inflation has peaked, we’ve still got six to 12 months of poor consumer sentiment. That’s not great.”

This adds to the argument why bonds are back.

One lingering question for investors is whether four per cent is a good return, given inflation is currently higher than that.

“To put that value into perspective, inflation markets infer that over ten years inflation will be, on average, around two-and-a-half per cent, which is the Reserve Bank’s inflation target,” Xie Patrick says. “Ten-year bonds are yielding a nominal rate of four per cent.”

“By owning a 10-year Australian bond, you are taking effectively no credit risk, keeping up with the two-and-a-half per cent long-term rate of inflation and then getting another one-and-a-half per cent.

“You’re getting paid to own something without credit risk and keep up with inflation.

“The value proposition for bonds is really back.”

The Reserve Bank considers a neutral rate around 2.5% and a bit. But how much is the bit? TIM HEXT has some answers

IT’S BEEN clear for a number of months that the Reserve Bank wants rates back to neutral sooner than later.

Quite simply nothing about high inflation and low unemployment cries out for expansionary rates.

Governor Phil Lowe has implied he would like to see neutral rates by year-end — and he considers neutral around 2.5% or slightly higher.

I was therefore quite excited to see the RBA has been working on “what is neutral” and whether it’s changed since the pandemic.

They referenced this work in this week’s RBA minutes, but the contents will have to wait for public release at a later date (we hope).

The concept of a neutral cash rate is very fluid to begin with.

The best notion is a rate that reflects long-term inflation expectations plus any adjustment for productivity.

That is, you should expect your cash returns through the long-term cycle to keep pace with inflation and (assuming positive productivity) deliver some small extra return.

This leads to the notion of 2.5% (the RBA target) plus a bit.

The size of that “bit” becomes crucial — and for that we need a view on productivity.

There are many reasons and views on why the last decade has seen poor productivity growth (less than 1%) and cash rates have been at or lower than inflation.

The neutral rate was roughly the inflation rate as evidenced by cash rates stuck at 1.5% from 2016 to 2019 — just below inflation at the time.

Have we experienced, as with many things, a Covid reset that changes this outlook for productivity?

That question will be answered in time, but there are some positive signs.

Firstly, business lending is strong. Private sector credit is nearing double-digit growth (currently 9%) for the first time since the mining investment boom more than 15 years ago.

And it’s not just housing driving it. Labour shortages are playing into the idea of replenishing capital stock and using existing labour more efficiently.

Secondly, Covid-driven supply shortages have seen businesses and households rethink efficiencies, whether reducing commuting or streamlining processes.

Against this, of course, are the challenges of reduced globalisation and sustainable energy. Both of these, though necessary to meet other challenges, introduce potentially less productivity at least in the medium term.

As investors, a return to positive real yields should be seen as an encouraging sign that demand for money is picking up again.

Businesses see productive uses for borrowing. While higher cash rates in response may reduce longer-term valuations for assets, it is not a sign of imminent recession as some risk markets are now pricing.

Investors should welcome news that a risk-free asset can not only keep pace medium term with their cost of living, but also earn a return above that — something not seen for a decade.

---

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

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

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

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

Find out more about Pendal’s fixed interest strategies here

---

About Pendal

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

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

Contact a Pendal key account manager

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.

---

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 ANTHONY MORAN

Find out about Pendal Focus Australian Share Fund
Find out about Pendal Horizon Sustainable Australian Share Fund

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.

---

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

Find out about Pendal Focus Australian Share Fund
Find out about Pendal Horizon Sustainable Australian Share Fund

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.

---

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