If the US falls into recession, investors should be ready to buy falling equities and take advantage of higher bond yields, says Pendal’s head of multi-asset MICHAEL BLAYNEY
- US economy likely to fall into recession
- Investors should be ready for opportunities
- Find out about Pendal’s multi-asset funds
IT’S probable the US Fed’s rate hikes will push the world’s biggest economy into recession this year.
“Some of the forward-looking indicators in the US like the ISM’s Purchasing Managers Index are showing signs of weakness,” says Blayney.
“There have also been some broker earnings downgrades, though history tells us that the more significant downgrades tend to happen after the event.
“Overall, this has been one of the most forecast US recessions ever.”
How should investors respond?
How to invest in a recession
Sticking to a long-term strategy is critical, Blayney says, though at the edges there is room to move.
That means holding a little more cash than usual, he says.
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“At this point it pays to be a little cautious, so we are a little underweight US equities.
“Last year the most important thing was to be underweight both bonds and equities in aggregate.
“At present we prefer taking relative value positions since markets are much less expensive than they were, effectively pricing in some of the bad news.
“While we are underweight the US, we maintain overweights to some of the cheaper, more ‘value’ equity markets like Australia and the UK.”
Investors should have some “dry powder” ready to use if valuations fall as a result of a recession, Blayney says.
“If the US goes through a recession and earnings are hit and markets fall, there will be an opportunity to buy equities. Markets do tend to over-react – both when times are good and when times are bad.”
Bonds look reasonable
Bond yields are now at “reasonable” levels, Blayney says.
The critical point is when the US Fed stops lifting interest rates, and potentially changes course and starts cutting.
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“If there is a recession, having some bonds in a portfolio will be a good thing because the Fed will have to step back from lifting rates.
“But it’s likely the Fed will want to make sure inflation is beaten before moving to cut rates.”
“In terms of momentum, the trend has been against bonds even if their valuations are now okay.
“But the cycle is turning a little bit towards government bonds in the sense that the economy is weakening.
“We are still slightly underweight, but I think government bonds are now reasonable value.
“If you look at corporate bonds, they got a bit cheaper last year.
“But credit spreads have come in as equity markets have risen. So compared to government bonds, corporate bonds are not offering great regward for risk if there’s a recession on the way.”
It’s not about forecasting recession
Good portfolio construction is not necessarily about trying to forecast recessions, Blayney says.
“It’s about maintaining balance, having a long-term strategy, at times dialling down the risk, and at other times dialling up the risk.”
Why bonds, why now
Ausbiz’s Nadine Blayney interviews CBA chief economist Stephen Halmarick and Pendal head of bonds Tim Hext
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About Pendal’s multi-asset capabilities
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
These include Australian and international shares, property securities, fixed interest, cash investments and alternatives.
In March 2024, Perpetual Group brought together the Pendal and Perpetual multi-asset teams under the leadership of Michael O’Dea.
The newly expanded nine-strong team will manage more than $6 billion in AUM and create a platform with the scale and resources to deliver leading multi-asset solutions for clients.
Michael is a highly experienced investor with more than 23 years industry experience, including almost a decade leading the team at Perpetual.
Inflation data due in January will set the scene for another rate hike in February. But from there the pace should slow, says Pendal’s head of cash strategies STEVE CAMPBELL
THIS week’s 25-point rate rise probably won’t be the last — but the Reserve Bank’s pace of tightening is likely to move from monthly to quarterly increments next year.
The cash rate will now sit at 3.1% for the summer. The RBA’s next monetary policy statement is due on February 10.
Between now and then we will see fourth quarter inflation data released on January 25.
It will be high. The annual headline inflation rate will be around 8% for 2022.
This will set the case for another hike in February.
Tuesday’s RBA statement contained nothing new. The central bank remains data dependent while the global outlook has deteriorated.
Domestically the labour market remains tight. Economic growth has been strong and household spending will start to slow due to policy tightening delivered so far.
For some this is yet to occur, given the higher-than-usual number of fixed-rate mortgages that are yet to reset.
This is the reason why the RBA doesn’t need to be as aggressive. Fixed-rate mortgages at rates around 2% will be resetting closer to 5.5% mid next year.
The RBA acknowledges they are walking a tight rope.
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“The path to achieving the needed decline in inflation and achieving a soft landing for the economy remains a narrow one.”
The further they push policy, the harder the landing becomes.
The RBA doesn’t want to cause a recession. But given a choice of embedded higher-inflation expectations or better growth, the former wins out for any central banker.
The longer-term task is no simpler.
Policy action to date “has been necessary to ensure that the current period of high inflation is only temporary”, the RBA statement said. “High inflation damages our economy and makes life more difficult for people.”
In a speech late last month RBA governor Phil Lowe pointed out that variability in inflation outcomes was more likely to increase than what we’ve become accustomed to.
He cited four key areas where supply issues in the longer term will occur:
- Reversal of globalisation
- Demographics
- Climate change
- The energy transition in the global economy.
The RBA has under-shot or over-shot its 2-3% target band more often than not over the past 15 years.
More variability in inflation outcomes? Who would want to be a central banker.
Central banks have tightened policy significantly over 2022 — and that will weigh on demand over 2023.
The current Christmas spendathon — where we are let loose for the first Christmas in three years — will hold activity up for now. But it’s unlikely continue into the new year hangover.
The supply side of the global economy is also likely to see capacity increase and downward inflationary pressure next year.
The supply issues that have resulted from the pandemic and Russia’s invasion of Ukraine will resolve over time.
But with it comes another set of challenges. And those are more likely to be skewed towards higher inflationary pressure in the longer term.
About Steve Campbell and Pendal’s Income and Fixed Interest team
Steve Campbell is Pendal’s head of cash strategies. With a background in cash and dealing, Steve brings more than 20 years of financial markets experience to our institutional managed cash portfolio.
Find out more about Pendal’s cash funds:
Short Term Income Securities Fund
Pendal Stable Cash Plus Fund
Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.
An annual strategic asset allocation review has led Pendal’s multi-asset team to make some recent adjustments to portfolios. Pendal’s ALAN POLLEY explains
- Strategic asset allocation process takes a long-term view
- Key factors are renewable energy, higher inflation and geo-political risk
- Find out about Pendal’s multi asset funds
THE build-out of renewable energy infrastructure, persistent higher inflation and geo-political risk will characterise investment markets in coming years.
But the threat of low returns related to zero interest rates is in the past as central banks revert monetary policy to more normal levels.
These are some of the findings from an annual strategic asset allocation review by Pendal’s multi-asset team.
“The strategic asset allocation process is where you forget about the day-to-day noise and think about the long term,” says Alan Polley (pictured below), a portfolio manager with the team.
“Investing, by definition, is long term. But we all get caught up in short-term, random happenings that tend to get averaged out over the long term.
“The strategic asset allocation process is that annual time to think about the long-term investment views, how you’re thinking about markets and asset classes and how to get the best outcome for your investors over their investment time horizon.”
Six major, long-term themes
Polley says six secular themes will likely characterise investment markets in coming years:
- The ongoing importance of ESG themes (from a risk and opportunities perspective)
- Better productivity
- Ageing demographics
- High debt and deleveraging
- Enhanced geo-political risk
- Higher inflation and spike risk
“One of the secular themes we have dropped this year is the risk of a low-return world.
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“For the past decade everyone’s been talking about expected investment returns being low.
“The main reason was because central banks had pushed down real rates to negative and market valuations to stretched levels.
“But that’s normalised. Cash and real rates are at reasonable levels.
“And now that markets have sold off as well, forward-looking returns are looking pretty good — probably the best they have for a decade.”
The other risk that is no longer hanging over markets is the prospect of a shock from the withdrawal of easy monetary policy.
“It’s been difficult this calendar year, but rates normalisation has effectively occurred.”
Inflation risk remains
Remaining as a risk is inflation, which will be a theme investors have to deal with for some time, says Polley.
“Investors consume real assets and so they’re interested in real returns. Over the last decade you’ve had this tug of war between deflation and inflation.
“Inflation will be higher than it was in the last decade and central banks are more likely to achieve their inflation objectives (as opposed to undershooting them).
“But we also think there’s more chance of inflation spikes.”
Portfolio adjustments
Weighing up the themes has led the multi-asset team to make some adjustments to portfolios.
“We’re increasing our exposure to bonds. They are offering attractive yields and have material diversification benefits again.
“This will also help defend against a potentially more volatile long-term outlook with more geo-political risk and less-supportive central banks.
“Another change we’ve made is moving some capital into listed, sustainable listed investment companies. With the secular theme of higher inflation, you want more real assets.
“The way we’re looking to get that real asset exposure is via renewable and sustainable companies with underlying real assets.”
Emerging Markets risk
“The other major change is we’re reducing exposure to emerging markets. The emerging markets index has a very high exposure to China that’s increased materially over the years to circa 30 per cent.
“Taiwan is another 15 per cent in emerging markets — so if there’s conflict, that’s almost half of the emerging markets index at risk.”
“China also appears to be transitioning to more authoritarian and nationalistic policies at the expense of market-based reforms.
Compounded by increased global national security concerns and politically driven onshoring preferences, deglobalisation could reduce China’s global manufacturing dominance. “
About Alan Polley and Pendal’s Multi-Asset capabilities
Alan is a portfolio manager with Pendal’s multi-asset team.
He has extensive investment management and consulting experience. Prior to joining Pendal in 2017, Alan was a senior manager at TCorp with responsibility for developing TCorp’s strategic and dynamic asset allocation processes covering $80 billion in assets.
Alan holds a Masters of Quantitative Finance, Bachelor of Business (Finance) and Bachelor of Science (Applied Physics) from the University of Technology, Sydney and is a CFA Charterholder.
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
There are three steps in checking the health of an investment portfolio. Pendal multi-asset portfolio manager ALAN POLLEY explains
- Annual asset allocation review critical to successful investing
- Three steps: strategic asset allocation, active asset allocation and diversification
- Find out about Pendal’s multi asset funds
A REGULAR portfolio health check is a critical part of successful investing — doubly so after a volatile 2023.
But what’s the right way to conduct a check up on your portfolio?
There are three parts to a successful annual portfolio review says Alan Polley, a portfolio manager in Pendal’s multi-asset team.
Here’s a quick snapshot.
1. Review strategic asset allocation
The first and most important step is reviewing your strategic asset allocation — in other words checking he long-term investment strategy is still consistent with your return objectives and risk tolerance, says Polley.
“It’s been a tough year. Equities and bonds are both down around 15 per cent this year.
“Some people may feel like their portfolio construction process is broken. But that’s where you come back to your long-term strategic plan.
It’s important to keep in mind the long-term returns from staying invested.
“Markets go up and down and you get paid through the cycle for those ups and downs.
“Since 1900, the average equity real return is around 5.4 per cent a year for developed markets, and a good per cent higher for Australia and the US.
“There were all sorts of global events and wars in there. But you got that return by keeping your long-term strategy consistent with your risk tolerance and your annual return objectives.”
Sound economic rationale
There is a sound economic rationale why this is true. Financial markets should pay a risk premium to people who choose to put their money at risk by investing, instead of keeping their savings safe in cash.
The strategic asset allocation part of a portfolio review is about adjusting your portfolio to ensure it still matches your long terms goals, risk tolerance and investment return objectives.
“Your risk tolerance changes naturally over time as you age, and potentially other exogenous life events,” says Polley.
“As you get older, you simply have less time left to recover from drawdowns, so you need a more capital stable portfolio. At some point, you will also need more income.”
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But your risk tolerance and long-term goals are not changed by a negative year on the markets, says Polley.
“When markets are volatile, your portfolio can stray away from your risk tolerance, either to a more defensive or aggressive position and potentially at the wrong time.
“The point of the strategic asset allocation process is to provide a sound central portfolio that enables you to rebalance, buying cheaper assets and selling more expensive ones.
“Buying cheaper asset classes at lower prices — the ones that have sold off and are giving you the pain — should add to your returns over time. As should selling the more expensive assets.”
2. Consider active asset allocation
Overlaid on the strategic asset allocation process is a review of your active asset allocation.
“This is where you can make short-and-medium-term asset allocations around your strategic asset allocation to enhance returns.
“This is what we refer to as going overweight or underweight relative to the strategic asset allocation.”
Active asset allocation changes the risk profile of a portfolio slightly — but the incremental additional gains can compound over a lifetime into a significant difference at retirement.
Polley says there are two keys to successful active asset allocation.
The first is having the discipline to ensure the active positions in a portfolio average out over the course of a cycle to match the overall risk objectives.
“If you go overweight, you should at some point also go underweight such that sum of those overweight and underweight positions is zero — which means the average allocation along the cycle is equal to your strategic asset allocation.”
The second is ensuring that your active position sizes are modest compared to your strategic asset allocation.
“The sizing of an active allocation should be roughly up to 10 per cent the sizing of the strategic asset allocation because it’s the strategic asset allocation that is calibrated to meet the investor’s return and risk objectives over time.
“Active allocations need to be incremental because we don’t want them to put us off the path of the optimal long-term portfolio and the portfolio’s targeted risk tolerance.”
The complexity and discipline required to successfully manage active tilts in a portfolio is why many investors choose to use professional fund managers for this portion of their investments, says Polley.
3. Ensure sufficient diversification
The final step in a portfolio health check is ensuring you have sufficient diversification.
“It’s often said — but tends to be forgotten — that diversification is the only free source of return in investing. So when you think about your strategic asset allocation, really try to maximise the level of diversification in your portfolio.
“That means having non-traditional assets alongside your traditional assets.
“Non-traditional assets should at least hold their value like they have this year when traditional assets fall and that gives you the dry powder to sell and rebalance.
“The benefits of rebalancing doesn’t work if all your asset classes fall at the same time.
“You need something that holds value or better yet performs at different times to traditional assets — cash holds its value and non-traditional assets almost by definition perform at different times.”
About Alan Polley and Pendal’s Multi-Asset capabilities
Alan is a portfolio manager with Pendal’s multi-asset team.
He has extensive investment management and consulting experience. Prior to joining Pendal in 2017, Alan was a senior manager at TCorp with responsibility for developing TCorp’s strategic and dynamic asset allocation processes covering $80 billion in assets.
Alan holds a Masters of Quantitative Finance, Bachelor of Business (Finance) and Bachelor of Science (Applied Physics) from the University of Technology, Sydney and is a CFA Charterholder.
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
The long-term outlook for investment markets is more positive than it has been since 2014, argues Pendal’s Alan Polley
- Bonds attractive once again
- ‘Long-term opportunity set looks better than it has been for a while’
- Find out about Pendal’s multi asset funds
THE long-term outlook for investors is more positive than it has been for almost a decade, giving reason for optimism despite the volatility of 2022, says Pendal’s Alan Polley.
The forecast comes from Pendal’s multi-asset team, which has just completed its annual strategic asset-allocation process, looking at long-term trends and expected returns across asset classes.
Key to the forecast is improved returns for bonds. US 10-year treasury yields have risen almost 3 percentage points in 12 months, offering attractive yields for the first time since the global financial crisis.
Bonds can once again play a defensive role in a traditional balanced portfolio — often termed a 70:30 portfolio for its split between equities and fixed income — as well provide a reasonable level income.
This is even more important for conservative portfolios, which tend to have a higher allocation to bonds.
“The investment outlook now is more normal than it has been for a decade,” says Polley, a portfolio manager in the multi-asset team.
The 70:30 portfolio is not dead
“Over the past five or so years there’s been commentary declaring the death of the 70:30 portfolio.
“Not only was it never dead, but now it’s definitely back and in a much stronger position than it has been for quite some time.”
That’s a good thing for investors, says Polley.
A significant implication of low returns over the past decade has been a move by investors up the risk curve into private markets and illiquid assets. Many saw no alternative.
“Looking forward, you’d think the marginal dollar that’s been chasing illiquid assets will start to dissipate, and this issue will be compounded with lagged higher discount rates.”
Investors looking for clues from history as to how markets will perform should look back to the 90s and early 2000s — because the ultra-easy monetary policy distortions of the post-GFC world are over.
“We’re going back decades prior to the GFC for a reference point when central banks weren’t artificially manipulating markets with low cash rates and quantitative easing.”
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Lift in long-term returns
Across all asset classes, Pendal’s review shows forward-looking, long-term returns have lifted about 1.5 per cent on average from last year.
“That additional 1.5 per cent really increases the chances of a portfolio achieving its return objectives.”
The multi-asset team’s strategic asset allocation process is run annually to analyse long term investment market behaviours.
“It’s important because all investors have a return objective and risk tolerance. The strategic asset allocation process is about building an optimal portfolio that meets those risk tolerances and long-term return objectives.
“Over the long term, what really determines your outcome is your risk tolerance, which leads to whether you invest in a 70:30 fund or a 30:70 fund or 90:10 fund.
“This is where having a long-term perspective matters,” says Polley.
“The whole point of investing is that over the long term, through the cycle, you expect to get paid for incurring the short-term ups and downs.
“You need to stay the course with a long-term investment strategy that’s consistent with your risk tolerance.
“Right now, because central banks have been materially unwinding their exceptionally loose monetary policy and markets have sold off and become better value, the long-term opportunity set is looking better than it has been for a while.”
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About Alan Polley and Pendal’s Multi-Asset capabilities
Alan is a portfolio manager with Pendal’s multi-asset team.
He has extensive investment management and consulting experience. Prior to joining Pendal in 2017, Alan was a senior manager at TCorp with responsibility for developing TCorp’s strategic and dynamic asset allocation processes covering $80 billion in assets.
Alan holds a Masters of Quantitative Finance, Bachelor of Business (Finance) and Bachelor of Science (Applied Physics) from the University of Technology, Sydney and is a CFA Charterholder.
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
Trend, valuations and the economy are the key measures when deciding if it’s time to re-enter the market, says MICHAEL BLAYNEY
- Bond, equities closer to fair value
- Opportunity to rebalance portfolios
- Find out about Pendal’s multi-asset strategies
MANY investors are trying to pick the right time to re-enter the market.
Pendal’s multi-asset chief Michael Blayney is closely watching three key market drivers – the trend, valuations and the economic and earnings backdrop.
“The history of markets tells us that often when it gets to fair value, markets fall through that level and that’s when there are great buying opportunities,” says Blayney.
“It’s when the newspaper headlines say it looks diabolical. We’re not quite there yet but…”
Three key things drive markets, says Blayney.
1. The trend
“There’s the trend. That’s the tendency of markets that have been going up to keep going up, and those that have been going down to keep going down. That tends to work over shorter time horizons.
2. Valuation
“Then there’s valuation. Through time, markets do tend to revert to some sort of measure of fair value.
“Ultimately markets are real companies generating earnings that have value, and people are willing to pay for that over time and through the cycle.
“Over the long term, there’s a sensible range, and when [assets] get outside of that range, they have a habit of coming back in.
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3. Economy
“The final thing important to the market is the economic and earnings backdrop. That essentially provides the subjective overlay.”
Time to invest?
On these three critical measures, it’s time to start inching back into some markets, Blayney says.
“The trend is still negative, though there’s been some short-term bounces. The trend measures we look at say we’re still very much in a bear market in equities and bonds.
“On the value side, we’re now at the point where we think in aggregate, equities and bonds are fair value,” Blayney says.
Though a regime-shift from a falling and low interest rate environment to a rising rate environment complicates the analysis, he says.
“It kind of reminds me of the kids in the back seat of the car always asking, ‘are we there yet’? Well, we might be there in terms of fair value.”
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That doesn’t mean that market won’t fall further because investors tend to overshoot on the downside, Blayney adds. But they do ultimately revert.
Consider fixed income
Fixed income valuations across geographies, with some notable exceptions, seem reasonable, Blayney says.
“Australians bond and US treasuries are both around our estimates for fair value.”
Fixed income is a critical part of the valuation puzzle because other assets classes are valued in relation to bond yields.
“We’ve just updated our long-term capital market assumptions and for the first time in a long time, things look sensible.
“You’ve got cash at a sensible level. You’ve got bonds at a decent premium to that and then equities on top.
“It’s been a painful adjustment, but we’ve gotten to the point where, at least for the long-term investor, it’s a pretty reasonable point to be back in the bond market.”
What about the economy?
The third factor driving markets is the economic cycle and company earnings.
So far in this US September quarter profit season, positive surprises have been slightly lower than other quarters.
“But when you buy a stock, you are buying earnings into the distant future. From a valuation measures, the earnings cycle is normalising,” Blayney says, adding that investors should be focusing on relative value positions.
“We like the Aussie market, the UK, Japan and markets with weaker currencies that could support earnings,” he explains.
“We are still underweight the US and Europe.
“Europe has quite a diabolical backdrop with energy, high inflation, high debt levels — and the single currency makes them a little bit less flexible.
Three-legged stool
“The market is like a three-legged stool,” says Blayney.
“Right now, value has improved. It’s telling you be neutral.
“The trend is still negative and that’s telling you to be underweight.
“And the cycle is still negative, but we are getting more clarity on that.
“Investors need to be vigilant.”
About Pendal’s multi-asset capabilities
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
These include Australian and international shares, property securities, fixed interest, cash investments and alternatives.
In March 2024, Perpetual Group brought together the Pendal and Perpetual multi-asset teams under the leadership of Michael O’Dea.
The newly expanded nine-strong team will manage more than $6 billion in AUM and create a platform with the scale and resources to deliver leading multi-asset solutions for clients.
Michael is a highly experienced investor with more than 23 years industry experience, including almost a decade leading the team at Perpetual.
Australians should prepare for another 25-point rate hike next month before policy tightening slows in the new year, says Pendal’s head of cash strategies STEVE CAMPBELL
THE US Fed hiked rates overnight by 75 basis points to 4 per cent, but indicated that future hikes may occur in smaller increments.
The key line here was: “the committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments”.
The market has priced in a terminal rate (essentially the peak of the Fed’s interest-rate cycle) of just over 5 per cent by the middle of next year.
As expected, the Fed remains open to more aggressive moves to tame inflation if needed.
What it means for Aussies
The Reserve Bank of Australia is a couple of months ahead of the Fed when it comes to the cumulative tightening effect.
In early September Governor Phil Lowe dropped a hint that the pace of tightening would slow when he said “the case for a slower pace of increase in interest rates becomes stronger as the level of the cash rate rises”.
The RBA followed through with its decision to tighten less than expected in October when raising the cash rate by 25 basis points.
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The decision to increase the cash rate by a further 25 points to 2.85 per cent on Melbourne Cup Day was in line with expectations.
What of the RBA’s decision?
Most had been expecting a 25-point move this month, in line with the RBA’s move last month.
A higher-than-expected third-quarter inflation number prompted headlines that 50 basis points was a possibility.
The market had assigning about a 20% chance of that.
Consequently, short-dated bank bill futures rallied after the announcement, though volumes were very light.
The RBA revealed some of the economic forecasts that will be included in Friday’s monetary policy statement.
These include:
- Inflation is now forecast to peak at around 8 per cent later this year, from up 7.75% previously
- CPI inflation is expected at around 4.75 per cent over 2023 and just above 3 per cent over 2024
- Economic growth around 3% for 2022, 1.5% for 2023 and 2024
- Unemployment rate to remain around the current 3.5% before rising to over 4% in 2024 as the economy slows
What’s next?
Further rate increases are expected, according to the RBA.
Key uncertainties remain on the response of household spending to monetary policy tightening and a gloomier global economic outlook.
We believe another 25-point hike is more likely than not in December.
Next year should see things change however, with policy tightening likely limited to one or two hikes.
For many race-goers Tuesday was a tough day. That’s also the case for households with a variable mortgage.
For households with fixed-rate mortgages mid-2023 and beyond is when the pain is really set to kick in with mortgages repayments about to increase sharply.
The RBA is more than aware of this. It’s a reason not to overtighten in the first half of 2023.
About Steve Campbell and Pendal’s Income and Fixed Interest team
Steve Campbell is Pendal’s head of cash strategies. With a background in cash and dealing, Steve brings more than 20 years of financial markets experience to our institutional managed cash portfolio.
Find out more about Pendal’s cash funds:
Short Term Income Securities Fund
Pendal Stable Cash Plus Fund
Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.
What does this week’s big inflation number mean for rates? Here’s a snapshot from Pendal’s head of cash strategies STEVE CAMPBELL
WEDNESDAY’S 7.3 per cent headline inflation number was the highest annual increase since 1990.
The key numbers were:
- Q3 headline: +1.8% (v 1.6% market forecast), taking the annual rate to 7.3% (v 7% market forecast)
- Q3 trimmed mean: +1.8% (v 1.5% market forecast), taking the annual rate to 6.1% (v 5.5% market forecast)
- Q3 weighted median: +1.4% (v 1.5% market forecast), taking the annual rate to 5% (v 4.8% market forecast)
The most significant contributors to the rise in the quarter were new dwellings (+3.7%), gas (+10.9%) and furniture (+6.6%).
New dwelling costs rose due to higher labour costs (due to labour shortages) and material shortages.
The rate of price growth did ease relative to prior quarters though (+5.6% and 5.7%), reflecting softening new demand and easing supply constraints
Electricity prices rose 3.2% for the quarter. This was offset by subsidies from the WA, Qld and ACT governments. Excluding these, electricity would have risen 15.6% in the quarter.
New dwellings (+20.7%) was also the biggest contributor to the 7.3% annual headline inflation number, followed by and automotive fuel (+18%).
However automotive fuel was down 4.3%, reflecting a fall in the crude oil price.
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What does it mean for investors?
The Reserve Bank was always going another 25 basis points at its meeting on Melbourne Cup day next week.
This inflation data — while higher than expected — does not warrant a bigger move.
One thing the RBA has in its favour over other central banks is its higher meeting frequency.
With the exception of January the RBA meets monthly, as opposed to the six-week cycle of most other central banks.
However today’s data does is make it more likely the RBA will follow up with another 25-point hike in December.
Merry Christmas from the RBA!
What would delay a December hike?
External forces increasing the likelihood of faster deterioration in global economic growth would make them reluctant to tap the brakes further.
The RBA is more than aware of the balance of risks from aggressive central bank policy tightening this year.
About Steve Campbell and Pendal’s Income and Fixed Interest team
Steve Campbell is Pendal’s head of cash strategies. With a background in cash and dealing, Steve brings more than 20 years of financial markets experience to our institutional managed cash portfolio.
Find out more about Pendal’s cash funds:
Short Term Income Securities Fund
Pendal Stable Cash Plus Fund
Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.
As the Aussie hits multi-year lows against a rising US dollar, is it time to currency-hedge international portfolios? Pendal’s ALAN POLLEY argues the ‘yes’ case
- Strong diversification benefits in foreign currency exposure
- Low Aussie dollar offer hedging opportunity
- Find out about Pendal’s multi asset funds
INVESTORS should consider hedging foreign currency exposure in international share portfolios as the Aussie dollar hits 2½ year lows against a rising US dollar, arguesPendal’s Alan Polley.
The US dollar’s strength has been the big story of 2022 as the Fed battles inflation by lifting interest rates at the fastest pace since the ’80s.
Higher rates are drawing in money from overseas investors, sending the value of the US dollar higher.
The Australian dollar traditionally offers investors natural diversification benefits because it tends to fall when global markets fall, softening any global declines for local investors.
But at current levels it could pay to think about reducing foreign exchange exposure, says Polley, a portfolio manager with Pendal’s multi-asset team.
“At this point in time, with the Aussie dollar very low versus the US dollar, it’s just natural to ask how much FX exposure should we have and if now is a good time to hedge a little bit more.
“The US dollar on our metrics is becoming expensive — and historically the AUD tends to find support around these levels.
Australian dollar to United States dollar
“It has positive momentum – the US is increasing cash rates at a greater rate than we are – but in long-term investing, you should focus a bit more on the valuation metric. Buy things when they are cheap.
“Arguably the Australian dollar versus the US Dollar appears on the cheap side.”
Foreign exchange exposure is an important consideration for Australian investors who are increasingly holding offshore assets in their portfolios.
“There are strong diversification benefits just by having foreign currency exposure,” says Polley.
“The Australian dollar is seen as a ‘risk-on’ currency – that means in a risk-off environment, the Australian dollar tends to fall.
“If your international equities are falling, typically the Australian dollar might fall as well and that provides an offset for international equities. That diversification benefit from FX exposure is quite valuable.
“There’s not that many defensive exposures in the world. Owning developed-world foreign currency provides significant diversification benefits at the whole portfolio level.”
The right exposure
So what’s the right way to think about the optimal level of exposure?
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Polley says investors can best understand the effects of hedging in a portfolio by considering what happens if you take a theoretical fully hedged portfolio and then start introducing currency exposure.
“What tends to happen is the volatility of the whole portfolio comes down because of the diversification benefits from adding foreign currency exposure.
“But as you keep increasing the amount of foreign currency exposure, the diversification benefits become marginally less and the incremental volatility of currency starts to dominate.
“That means the more currency exposure you have, at some point the volatility of the overall portfolio starts to go up.
“So theoretically there’s an optimal – or a volatility minimisation – point.”
Important considerations
There are other considerations to keep in mind, says Polley.
“As the amount of currency exposure gets large, you’re exposed to the risk of a sustained rise in the AUD.
“Also, future correlations may be different to the past and expected diversification benefits may not arise.
“Lastly, we tend to invest overseas for the offshore assets, so the currency exposure is more a by-product than an explicit aim.”
For most Australian investors, a 20 per cent FX hedge ratio on an international equities portfolio will balance these considerations — and should also mitigate overt sensitivity to FX movements, says Polley.
“You’re getting diversification benefits by having some FX exposure, but you’re not having too much of a good thing.”
How can you do that?
“Consider buying a hedged international equity product and have that at about 20% of your international equity portfolio.”
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About Alan Polley and Pendal’s Multi-Asset capabilities
Alan is a portfolio manager with Pendal’s multi-asset team.
He has extensive investment management and consulting experience. Prior to joining Pendal in 2017, Alan was a senior manager at TCorp with responsibility for developing TCorp’s strategic and dynamic asset allocation processes covering $80 billion in assets.
Alan holds a Masters of Quantitative Finance, Bachelor of Business (Finance) and Bachelor of Science (Applied Physics) from the University of Technology, Sydney and is a CFA Charterholder.
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
How are different asset classes faring in these rough economic conditions? Here’s a quick snapshot from our multi-asset chief Michael Blayney
- Opportunities in REITs and infrastructure
- Be ready to shift to bonds if recession looms
- Find out about Pendal’s multi-asset strategies
THE key risk to equities in coming months is how hard profit margins and earnings are hit by slowing economic growth from rising interest rates, and higher inflation, says Michael Blayney, head of Pendal’s multi-asset portfolios.
For bond investors, high inflation continues to be a headwind. But with a slowing economy, investors need to be ready to shift to the security of bonds if a recession looms.
The de-rating of real assets means there’s some opportunities in real-estate investment trusts and infrastructure, Blayney says, while the prospect of recession makes investing in high yield credit markets more difficult.
The silver lining for (new) investors from falling markets during the past six months is the de-rating of assets.
But the rise in fixed income yields makes other assets, which are priced off bonds, less attractive, Blayney adds.
Equities
The valuation backdrop in equity markets has improved, Blayney says.
“We are getting to the position where there’s some opportunities to buy. But we are not at the point of seeing broad based bargains yet.”
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“US large cap stocks remain expensive, while Australian equities are closer to fair value,” he says.
“The Australian economy and market are not really in bad shape. Our equity market is a value market … and the resources sector is less negatively impacted by inflation.”
“Globally, small and mid-cap equities are fair value, or even cheap, relative to large caps.”
Blayney says lower valuations of small caps partly reflects market sentiment that they’re more likely to underperform in a recession.
But he adds: “For a longer-term investors cheap valuations represent an attractive entry point, to the extent in which a significant amount of ‘bad news’ has already been priced in.”
Similarly for investors with a longer-term horizon, value stocks continue to provide an opportunity in major markets, particularly Europe, Japan, and the small cap end of the US market.
“In addition, a rising interest rate environment should remain supportive of value as a style.
“Value outside of US large caps is the most attractive area to play a value tilt, given the spread in earnings growth for value versus the broader market has been considerably smaller in most other markets than it has been in the large cap end of the US market.”
Bonds
Bonds remain attractive because of their defensive characteristics, but they still have significant headwinds from inflation.
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“We generally retain some duration exposure for defensiveness within portfolios, but this is at a lower level than usual,” Blayney says.
“Where possible, we have a preference for inflation protection and Australian exposure within portfolios.”
Credit
Investment grade credit offers reasonable returns on a medium-term basis, he says.
“High-yield spreads are now better than they were. However, we believe that the risk of investing in high yield during an economic slowdown outweighs the benefit of higher yields at this point.”
Listed Real Assets
In listed real assets, the increase in interest rates have triggered a de-rating of both global REITs and many listed infrastructure assets.
“Higher bond yields have caused REITs to de-rate significantly, moving A-REITs and global REITs back towards fair value,” Blayney says.
“There are also some attractive opportunities available in listed infrastructure.”
About Pendal’s multi-asset capabilities
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
These include Australian and international shares, property securities, fixed interest, cash investments and alternatives.
In March 2024, Perpetual Group brought together the Pendal and Perpetual multi-asset teams under the leadership of Michael O’Dea.
The newly expanded nine-strong team will manage more than $6 billion in AUM and create a platform with the scale and resources to deliver leading multi-asset solutions for clients.
Michael is a highly experienced investor with more than 23 years industry experience, including almost a decade leading the team at Perpetual.