China’s new hard-line ideological approach introduces risks that most investors have no experience with, warns Pendal’s SAMIR MEHTA

• Xi Jinping’s new terms elevates risk for investors
• ‘An environment that has completely changed’
• Find out about Samir Mehta’s Pendal Asian Shares Fund

THE consolidation of Xi Jinping’s power in China heightened sovereign risk for investors in Chinese companies, says Pendal’s Samir Mehta.

China’s 20th Communist Party Congress cemented Xi’s grip on power, delivering him a third term in office and installing a leadership team of loyalists that reduces the potential for political rivalry.

Markets reacted negatively to the elevation on concerns that Xi’s hard-line policies may affect China’s economic growth.

“We are in an environment that has completely changed,” says Mehta, who manages Pendal’s Asian Shares fund.

“In the upper echelon of the party there were always factions that jostled for power and compromise.

“Now Xi has done away with the once-dominant factions and he reigns supreme.

“President Xi today exercises complete control over society in a modern state with technology and surveillance unparalleled in history.”

This has important implications for government policy, the economic outlook — and therefore investors, says Mehta.

“The appointment of Xi’s right-hand man Li Qiang to the premiership — where he will be in charge of economic policy — is another signal to the world that there is little chance economics will take precedence over national security.

“This signals that what Xi considers to be right cannot be disputed.”

What it means for investors

For investors, this indicates that policies like the zero-tolerance approach to Covid are not going away.

“Economic outcomes like employment and growth will become secondary to satisfy Xi’s idealism of zero Covid.”

To be sure, sometimes the greatest investing returns are found at the point of maximum pessimism, and investors will be tempted to take a risk on China, says Mehta.

“There are short-term positives that might surprise.

“What if, in the next three-to-six months, Chinese authorities reduce quarantine, or introduce new vaccines?

“These things at the margin will create hope and that’s what markets are about.

“There’s so much pessimism that any small change will see the markets bounce.”

But the hard-line ideological approach introduces investment risks that most investors have no experience with, he says.

“If you extrapolate the policy approach to economics and business, you can see a society where an entrepreneur with a great idea is unable to raise capital or do business if, for some reason, they do not adhere to ideology that Xi has laid down.

“That has severe repercussions.

“In the long run, when trying to understand what might happen to a sector or a company, we need to look at fundamental growth opportunities — and that aspect of investment in China has narrowed a lot.

“In the long run, when it comes to investing in China, I’m going to be a lot more cautious.”

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About Samir Mehta and Pendal Asian Share Fund

Samir manages Pendal Asian Share Fund, an actively managed portfolio of Asian shares excluding Japan and Australia. Samir is a senior fund manager at UK-based J O Hambro, which is part of Pendal Group.

Pendal Asian Share Fund aims to provide a return (before fees, costs and taxes) that exceeds the MSCI AC Asia ex Japan (Standard) Index (Net Dividends) in AUD over the medium-to-long term.

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 MidCap Fund here

Contact a Pendal key account manager here

Here’s a quick take from Pendal Aussie equities portfolio manager BRENTON SAUNDERS

CONFIRMATION of Xi Jinping’s third term as China’s leader last weekend wasn’t surprising, but the degree of his apparent control is greater than most expected.    

Most commentators say this is close to a worst-case outcome in terms of concentration of power, says Pendal portfolio manager Brenton Saunders.

“All members of the powerful seven-person central standing committee are considered Xi loyalists,” says Brenton, who manages Pendal’s Australian midcap and resources portfolios.

“This is likely to embolden Xi to continue pursuing his regional and global geopolitical ambitions. 

“Details of a five-year plan will be forthcoming. But it appears the main aim will be to turn the ‘successfully achieved moderately prosperous society‘ into a ‘modern socialist society’.

“This is seen as part of China’s ambitions to be an independent technology powerhouse and to project power and influence.

“This may suggest the economy remains on a relatively austere pathway by historical standards.

“Stimulus could be used in a more surgical manner to achieve economic goals where needed.

“The potential outcome for the property market remains muted. Material stimulus is unlikely beyond the short term.

“This is a headwind to economic growth and demand for steel-making materials.”

Iron ore and coking coal stocks are most exposed to the trend long term, says Brenton.

But China’s strategic pivot to technology, grid investment and electric vehicles should benefit base metal and lithium-producing companies in the long term, he says. 

Waiting for a market inflection point? Pendal’s BRENTON SAUNDERS outlines a few issues to watch

GLOBAL markets are down in 2022 as the US Fed tightens monetary policy to tackle rising inflation, leaving investors searching for signs of an end to the bear market.

Events in the UK are important reminder of how interwoven financial markets are – and that crisis events can come from the most unlikely of places.

The full fallout from tightening monetary policy has not yet been seen in the global economy, says Brenton Saunders, a portfolio manager in Pendal’s Australian equities team.

“The one thing that’s outstanding from this cycle is that we haven’t had a major crisis,” says Saunders, who manages Pendal MidCap Fund.

“In history, every big down-cycle like this has been caused by, or caused, a financial market crisis of some sort.

“The GFC was full of these kinds of second- and third-derivative market failures.

“The issues in the UK pension market unearthed in late September was ironically in the very conservative asset class of long-dated gilts [UK government bonds], but it could have caused a very significant issue if there wasn’t an intervention.”

Last month’s panic in the UK was triggered by market reaction to a tax cut plan that sent yields on UK government gilts higher.

This had the unexpected effect of forcing pension funds — which are big holders of gilts — to sell other assets to cover their liabilities, ultimately forcing the Bank of England to step in.

Where’s the turning point

Saunders says investors looking for the inflection point in this year’s down trend should look out for a few signs to know if the cycle is finally turning positive.

“One is the Chinese macro-economic outlook. It’s unclear, despite some attempts at stimulus, that they are addressing the right areas that need to reverse that market in any kind of meaningful way.

“Covodi policies continue to be a big drag on that.

“Energy policy has also changed gears. We’ve had the rumoured sabotage of the Russian gas pipelines to Europe. That almost assures Europe will have a much tougher winter.

“The other is the OPEC agreement to cut supply — that’s last thing the US Fed and politicians wanted and will come as a headwind to getting inflation under control.”

Saunders says the RBA decision to slow the pace of rate increases was a surprise to markets but did not materially change the outlook for interest rates.

“We still think the Fed remains heavily committed to staying the course on its rate cycle and will continue to do what it needs to get inflation under control, which just means further rate rises and possibly more than the market’s expecting and then likely keeping interest rates high for longer than the market would like.”

“We continue to have this incredibly strong labour market and high savings rates which has so far limited the rate rises from manifesting in anything other than the housing market.

“We still expect that to put a bottom into this market we need to have an earnings downgrade cycle, especially in the discretionary retail and then possibly commodity cyclicals as well.

“From a portfolio perspective, we continue to think that there’s still some outstanding correction that needs to happen and we continue to retain a fairly defensive, conservative exposure.”

Inflation, interest rates and labour were all big talking points in this year’s ASX earning season, says Pendal mid-caps portfolio manager BRENTON SAUNDERS

• Earnings season better than expected
• But averages hide wide variation
• Find out about Pendal MidCap Fund

ASX-listed companies posted better-than-expected earnings in the full year reporting season, although the averages hid a wide variation in individual results, says Pendal’s Brenton Saunders.

Inflation, interest rates, labour availability and the impacts of and trade working capital increases were the biggest talking points in a reporting season that was complicated by a shifting global macroeconomic environment.

But uncertainty about the outlook for interest rates and consumer confidence has led many companies to be conservative about providing forward guidance, leaving the outlook unclear, says Saunders, who manages Pendal MidCap Fund.

Saunders’s highlights, sector by sector:

Consumer discretionary

A somewhat surprising mix of results for the sector that is traditionally most likely to suffer the effects of higher interest rates.

“Interest rate-sensitive, consumer discretionary stocks have performed much better they might have expected them to in this environment. The impact of higher mortgage rates is yet to be reflected in large parts of discretionary retail.

“We have tell-tale signs of low consumer sales in some areas, but on average, consumer purchases, consumer foot traffic and the ability to retain margin has been good.

Technology

Better than expected results from some of the high-flyers caught the market by surprise.

“There was an element of tech that did really well – some of the racier tech stocks had good results, good cash flow and good prospects – that caught the market by surprise. Unprofitable tech battled more.”

Decarbonisation

Companies in the electrification and decarbonisation sectors performed very well, led by the lithium producers.

“Lithium just powered ahead. From companies that are still in development or exploration to companies that are already producing, we’ve seen some spectacular outcomes. These companies are getting bigger quickly.

Housing and construction

Home builders and related businesses are clearly starting to feel the effects of higher interest rates, which has shown up in their reluctance to provide earnings guidance for 2023.

“They are being very conservative about guidance and their ratings are starting to face some headwinds.”

Banks

The banks were disappointing and mostly failed to translate higher interest rates to earnings.

“Competition and costs remain a big impost for the banks. That was that was quite disappointing pretty much across the board.”

Mining and energy

Energy was understandably strong given the higher global prices for oil, coal and gas because of the Russia Ukraine conflict.

“Both the refiners and the energy producers are cycling very high historical prices and had bumper profits and record of dividends.

“The energy sector has transformed itself very quickly from, in some cases, pretty highly leveraged to unleveraged and paying strong dividends in a very short space of time.”

Saunders expects this sector to remain a beneficiary of the ongoing Russia-Ukraine conflict and associate supply chain disruptions.

Infrastructure and contracting

This sector is benefiting from a lot of new work being tendered by government as well as the from the mining, energy and renewables sectors. The negatives are high labour cost and raw material inflation.

“Most are seeing high amounts of work available for tender and larger contract books. There is a mix in terms of margin performance with high labour cost inflation proving a headwind to some. Available contract work in the space is likely to remain elevated especially in mining, energy and renewables.”

Where to next?

The outlook is complicated by global macro-economic events, Saunders says.

“The market came into reporting season in a frame of mind that we had seen the worst of bond yields, inflation was slowing, and the Federal Reserve interest rate policy would moderate, he says.

“The market was quite heavily positioned for that.

“Following the Jackson Hole meeting, with Federal Reserve commentary was much more hawkish the whole narrative changed in a very short space of time.”

Saunders says from a portfolio construction perspective, investors continue investors should continue to exercise caution with hawkish US monetary policy being reinforced at the Jackson Hole Meeting. The interest rate cycle has more to run.

“You’ve had very wide divergence in performance. Look for stocks that are either beneficiaries of the move higher in interest rates or those whose business are not overly geared to higher rates and have been heavily sold off year to date.”

The sharp rally in mid-June shows how quickly the market can bid up oversold companies, but the macro outlook remains mostly depressed, he says.

“It’s very much an alpha kind of environment, where staying across stock specifics is not only useful, but also an absolute necessity.”

There’s no obvious default for equity investors in this kind of market says Pendal midcap portfolio manager BRENTON SAUNDERS. Research and stock-picking will make the difference

• Markets caught between inflation, higher interest rates and slowing growth
• Commodities starting to come under pressure
• Find out about Pendal MidCap Fund

FEELING like there’s nowhere to hide in global markets? You’re not alone, says Pendal’s Brenton Saunders.

Higher energy prices from the Russian-Ukraine war are fuelling inflation. But just as policy-makers look to raise interest rates, growth is slowing in Europe and China, raising questions about the right policy response.

“There really is no obvious default for investors in this kind of market,” says Saunders, who manages Pendal MidCap Fund.

“With macro factors lurching around so quickly, it pays to have a very balanced portfolio.

“Things that once took a year to play out are happening inside of a quarter. If you have big macro tilts in your portfolio, you run a big risk of getting it wrong at some stage if you’re not nimble enough.”

Market drivers

Markets are caught between the impact of Russia’s Ukraine invasion and the ongoing effects of the pandemic, says Saunders.

The US is faced with an over-heating economy and very high inflation. But European growth is dragging as higher energy prices and the Russia-Ukraine conflict crimp growth. And China is slowing amid a resurgent pandemic.

This is causing market gyrations as investors try to take a read on the outlook.

“You’ve seen markets generally look overdone and come off the peaks,” says Saunders.

“We’ve seen an extension of the de-rating of high-multiple, high-growth sectors. Then the most recent manifestation we’re now seeing is cyclical stocks like commodities getting impacted as well.”

Until recently commodities producers have been quite big beneficiaries of the “strange collusion of forces that is Covid and the Ukraine war”, says Saunders.

“It has all manifested quite positively for commodity players. But it’s starting to become less clear that it’s entirely positive for them.

“If you do have slowing growth, you’ll have low demand and that will manifest itself in commodity prices at some stage.”

Inflexion point for markets

Saunders says this inflexion is what the market is grappling with at the moment.

“The result is you’re seeing some fairly odd sector rotations — the market is too concerned about the growth stocks and high PE stocks to go back there just yet, especially the pre-profit growth stocks.

“But at the same time, there’s a realisation that the dream run we’ve had in commodities is at best having a consolidation period and at worst is showing signs of topping out.”

What’s the right path for investors?

Saunders says a sensible positioning is to stay conservative, pragmatic and style agnostic.

“We’re close to as conservatively positioned as we get.”

“It’s very much a stock picker’s market. It is really now about understanding a company’s specifics, spending time with a company. Even subtle differences in terms of exposures in cost and revenue bases can create quite different outcomes in quite similar looking companies.

“It is an environment where research and stock picking are making a difference.

“There’s no prizes for heroes in this market.”

Russia’s unprovoked invasion of Ukraine is causing structural changes to commodity markets that will be with us for a generation, says Pendal resources and midcap manager BRENTON SAUNDERS

• Commodity markets undergoing structural changes
• Not widely understood by investors
• Find out about Pendal MidCap Fund

RUSSIA’S unprovoked invasion of Ukraine is causing structural change to commodity markets which will not be easily reversed as the world weans itself off Russian energy and mineral exports, says Pendal’s Brenton Saunders.

Saunders, who manages Pendal Midcap Fund and has extensive experience in resources, says the market is underestimating the depth and longevity of the changes that will result from Russia’s aggression.

The war will lead to long-term rises in commodity prices, he says. And buyers are likely to turn to Australia for commodities they once bought from Russia.

“Russia is such a big player — natural gas and coal but also steel, aluminium, fertiliser, nickel and palladium,” says Saunders.

“The eventuality, extent and longevity of the Ukraine invasion has led to an evolution of thought about what it means — not only for Russia, but how the free world reorganises itself to lower its dependence on Russia and protect itself against further military issues with Russia.”

Long-term support for commodity prices is enhanced because rising energy prices drive production costs higher, Saunders says.

“When energy prices go up, the cost curves for all the commodities go up. As long as energy prices stay high, commodity prices stay high for longer.”

The market dislocation should also take some of the pressure to decarbonise off the fossil fuel industry as the world reorganises itself to go without Russian energy.

Saunders sees a growing role for uranium and nuclear power as the once-maligned fuel gets new consideration as a climate friendly energy source.

“Uranium has been sidelined in the wake of the Fukushima disaster, but it should play a much bigger part in the decarbonisation process,” says Saunders.

“Now it’s being recognised as a necessary part of the landscape again by a whole host of OECD countries.”

Implication for portfolios

The implication for portfolio construction is to seek exposure to the commodities that with be beneficiaries of the transition away from Russia, Saunders says.

“By and large we are in a defensive frame of mind, but it’s a stock-picker’s market and there are some real gems out there that we’re finding.”

Pendal analysts recently met with BHP’s marketing team who relayed stories of sustained disruption in commodity supply.

“When you speak to the BHP marketing and logistics team that are dealing with these cargos for their customers all over the world, you can see that the impact and implications from this are wide-ranging and immediate.

“You have got ships that won’t go to certain parts of the world anymore to transport commodities. Ships that can’t get insurance to go to certain parts of the world. Traders that can’t get collateral to deal with parts of the world they have been dealing with for decades.

“This is the biggest dislocation I’ve ever seen in commodity markets.

“The war will — and we pray it does quickly — but the implications will be with us for a generation.

“I’m not sure the markets completely understand that.”

Sustainable investors may receive APRA letters informing them that their super fund has failed a performance test — even though it’s doing precisely what was intended. Pendal’s ANTHONY SERHAN explains

• APRA testing compares super funds to unscreened, cap-weighted indices
• Sustainable funds that screen out sectors like fossil fuels are left at a disadvantage
• Find out about our sustainable Aussie equities Pendal Horizon Fund

THE federal government’s Your Future, Your Super annual testing regime for super funds is disadvantaging investors seeking to do good with their savings by investing in sustainable or impact funds, says Pendal’s Anthony Serhan.

Sustainable investing is a fast-growing part of the superannuation industry. Responsible investing now influences strategic asset allocation for most super funds in Australia (55% up from 39% in 2019).

But the YFYS test administered by the Australian Prudential Regulation Authority benchmarks super funds against pre-set, cap-weighted, broad-based indices — without regard to factors like the environmental impact of the underlying companies.

“If you’re investing in a sustainable way, you can be investing a long way from unadjusted market capitalisation weighted indexes,” says Serhan, Pendal’s distribution director.

“In Australia, an investor who wants to support net zero carbon emissions will not want to invest in anything related to fossil fuels — but that takes out a huge chunk of the market.

“Yet you’re being compared to something that does include those fossil fuels stocks, as well as other sectors of concern including tobacco, gambling and armaments.

“That’s clearly going to create noise. While it’s reduced over longer periods, the YFYS test is dealing in basis points — so if there’s a significant move at the start or end of a reporting period it will still impact the results.

“And while the eight years used in the test is a long period, some of the themes addressed in sustainable strategies are multi-decade.”

Serhan says the result is that some investors will receive letters informing them that their super fund has failed the performance test — even though it’s doing precisely what they intended it to do.

“It is highly probable sustainable super funds will fail the test at some point because they are not owning certain parst of the market.

“Is that a good policy outcome? Probably not.”

Impact on global equities

And it’s not just investors in Australian equities that are disadvantaged by APRA’s tests.

Global sustainable investors tend to be underweight developing countries that naturally have fewer large companies fitting ESG criteria.

Yet they are now compared to indexes that fully weight emerging markets and pay no regard in the allocation process to issues such as human rights and the rule of law, corporate governance standards, or environmental impact.

“What do you do about that? If you’re a sustainable manager you’re likely underweight emerging markets which creates a mismatch between the index and your portfolio — that either creates noise or you’re going to have find a way to close that gap,” says Serhan.

Potential solutions

Serhan says the solution for APRA would be to adopt more flexible frameworks to assess super funds, judging them more on performance against their stated aims rather than against a passive index approach.

The APRA tests are likely to see a convergence of portfolios around the stated benchmarks which will push some investors to self-managed super funds where there is currently greater flexibility to do good with their super savings while investing for retirement, he says.

“The market cap weighted indices are simply a reflection of what has worked in the past — they are not a reflection of where markets are going in the future and they certainly don’t reflect which companies will be the winners from the move to net zero.”

So, what should you do when you get that letter saying your fund has failed APRA’s tests?

“Take a look at the fund and make your own assessment — is this fund delivering what I wanted it to deliver?” says Serhan.

“The letter will point you to government websites or super comparators — but these are very poor forms of financial advice.

“Instead, just ask yourself and your financial planner: am I happy with the returns and what the fund is achieving in the way it invests my money?”

Investors willing to pick through the market stock-by-stock have an opportunity to uncover good companies that have been oversold in the market’s volatility, says Pendal’s BRENTON SAUNDERS

• Rate rise cycle to be steeper and longer than usual
• Growth stocks derated
• Opportunity for stock-picking approach

THE volatile start to markets in 2022 has been well-documented — the expected tapering of covid stimulus, higher inflation and rising interest rates have prompted investors to recalibrate portfolios.

Market decline has been substantial in some sectors as investors absorb US Fed policy refinements.

But the wholesale sell-off is creating opportunities for investors willing to take a stock-picking approach, says Pendal portfolio manager Brenton Saunders.

“The market is changing gear substantially in quite a short period of time,” says Saunders, who co-manages Pendal’s Midcap Fund.

“Even though the catalyst for the change has been consensus view for a while now, investor positioning is only now changing to reflect the macro environment.”

In recent weeks the US Federal Reserve has spent time educating markets that the rate hike cycle this time around is likely to be longer and steeper than previous cycles, says Saunders.

“The current macro economic backdrop is very different from cycles in recent times.

“Previous rate hike cycles have been short and sharp — this one will be different.”

This has important implications for asset allocation and for sector allocation within equities, Saunders says.

“A lot of the stocks and sectors that were beneficiaries of the huge stimulus we’ve seen through Covid are now starting to battle the impact of higher bond yields and the prospect of higher interest rates down the line.”

The result has been an asymmetric sell-off: highly rated stocks, especially those that are not yet profitable, have sold off hardest.

And while the headlines have been about well-known technology stocks, this phenomenon has also affected early-stage Australian resources stocks like explorers and developers.

“Many long-duration stocks have been hit hard.”

Stock-by-stock approach

The result is that investors willing to pick through the market stock-by-stock have an opportunity to uncover good companies that have been oversold in the market’s volatility.

“We think asset performances will be quite moderate this year and stock selection will be more important than it has been in recent years.”

Saunders says a rising rate environment typically hurts the share prices of highly rated, high-growth companies, while more defensive high-quality stocks with high dividend yields and strong earnings tend to be better favoured.

“With a notional increase in the cost of capital, long-duration companies — especially companies that have most of their profits in prospect and not in the present — tend to get hurt more,” he says.

But that does not mean all growth stocks will do badly, he says.

“One of the characteristics of this current cycle is that the fundamentals underlying many growth stocks remain incredibly robust.

“In many cases the demand for services in these areas remains strong along with a strong pricing environment. They continue to have cyclical tailwinds.”

Caution on earnings

Risks associated with earnings disappointments are currently high.

The risk of highly rated stocks failing to meet the market’s expectations is a sharp de-rating.

“For the first time in a while, it’s our sense that 2022 will be less about beta and more about alpha.

“That’s an environment that we typically thrive in — identifying stocks on their individual characteristics and investment theses, as opposed to making directional bets over where the market is headed.”

Further bolstering the argument for stock picking in Australia this year is the recent reunification of BHP’s dual-listed structure into a single, ASX-listed company.

This lifts BHP’s weighting in the ASX200 from around 6 per cent to above 11 per cent.

“For anybody investing in an index-aware fund that includes large caps, there’s stepwise increase of around 5 to 6 per cent in your exposure to materials and the iron ore price and everything that that goes with that.

“That’s a significant change in a short period of time.”

The outlook for major ASX-listed miners is looking positive again. But investing in resources is now more nuanced with issues such as ESG and China. Pendal’s BRENTON SAUNDERS explains

• Outlook for miners is mixed and heavily dependent on China
• But conditions should be right for a rebound next year
• ESG issues come to the fore in AGM season

WITH a combined market cap of $190 billion, BHP, Fortescue and Rio Tinto are all top 15 companies and key pillars of the ASX.

They’re hard to avoid if you’re investing broadly in the ASX.

Iron ore is the major export of all three. When the price of the ore was above $US230 a tonne, the big three miners were reaping the benefits, and all three paid shareholders a special dividend this year.

But iron ore prices have dropped back to around $US100 a tonne and the share prices of the big three have underperformed in recent months.

So what’s ahead?

“The landscape for resources is pretty dynamic at the moment,” says Saunders, an experienced geologist and manager of Pendal’s natural resources portfolio.

“Investing in resources is now much more nuanced and that has to do, in large part, with how the Chinese economy has evolved.

“The outlook is also dependent on how demand and supply evolves for some of the major commodity groups, particularly energy.

“To that extent, the outlook for the large cap miners is looking more positive again, in part because they have sold off as much as they have, as has their principal commodity, which is iron ore.”

Improved outlook for 2022

“I think it’s reasonable to think that in the first half of next year — and probably the second quarter — that the sector will improve again, albeit off a highly eroded base,” Saunders says.

The next few months could still be bumpy though.

Chinese demand for iron ore and steel is low and could get worse, Saunders says. But most of the negative sentiment is priced in.

“Also, this time of year is difficult for China from a pollution perspective as the country heads into winter and generates a large temperature inversion layer across the big metropoles, making pollution worse,” Saunders says.

“Typically at this time of year, there are restrictions on production. Then we move into Chinese New Year and after that there’s normally a rebound.”

But 2022 will be different with the Winter Olympic Games being held in Greater Beijing in February and the government determined to keep pollution levels down.

“The Beijing region does host a large percentage of the country’s steel production, so that will probably be depressed until the end of February,” Saunders says.

“Then as we move into spring, we could see an aggressive rebound that could be concurrent with stimulus and a lightening of some of the regulatory imposts on the property sector.

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“There should also be a partial restocking of the steel value chain that’s been quite heavily denuded.”

ESG issues come to the fore in AGM season

It was an interesting AGM season for the major miners — in large part thanks to the evolution of environmental, societal and governance (ESG) concerns, votes on remuneration and the emergence of vocal, activist investors.

Faced with volatile commodity prices, ESG challenges and plenty of activist investors, two of the big three — BHP and Fortescue Metals — have fronted shareholder in recent weeks. Rio’s AGM is later in the year.

One of the key benefits of Fortescue’s AGM is that it allows shareholders to learn more about what Fortescue Future Industries (FFI), the company’s green offshoot, is doing, says Saunders.

“It’s been a bit frustrating for shareholders because there isn’t a lot of transparency in FFI,” he says.

“The FFI business is evolving fast and it’s difficult to keep track of,” he says. “But at AGMs we learn more about it and this year was no exception.”

Two weeks ago, at the Fortescue meeting, chief executive Elizabeth Gaines revealed FFI had an unspent allocation of funds from last year, and the offshoot plans to spend $US600 million on clean energy projects this year.

BHP’s AGMs have demonstrated how the company has evolved and has been paying more attention to ESG issues.

“Over the last three years at its AGM, BHP has faced at least one quite controversial ESG proxy, or proposal,” Saunders says. “And over those three years they have become much more embracing of them because BHP’s ESG process in the background has evolved.

“BHP has actually approved some of these proposals, though when these issues first emerged several years ago the approach from them initially was to throw their hands up in the air and say that’s not feasible, or it’s unrealistic.

“There’s been quite a big evolution along the ESG lines specifically for BHP to become more aligned with some of the objectives of these action groups.”

Higher interest rates will eventually work, but they’re not working just now, argues Pendal’s OLIVER GE. That could mean bonds become even better value next year

• Inelastic demand and supply mean rates work differently
• In likely scenario, bonds a good place to invest
• Find out about Pendal fixed interest capabilities

WHAT if higher interest rates worked against cutting inflation?

Or at least had little effect on demand — making rate hikes ineffective in the fight against inflation?

“I want to talk about the idea that in an environment where demand is still reasonably strong, interest rate hikes effectively do nothing,” says Oliver Ge, an assistant portfolio manager with Pendal’s income and fixed interest team.

“Rather than cooling things down, they might be pushing them back up,” Oliver says.

The idea comes down to the notion of elasticity of demand – a measure of the change in the demand for a product in relation to the change in its price.

Elastic demand means there’s a big change in quantity demanded when there’s a change in price.

Inelastic demand is the opposite – little change in demand no matter what the change in price.

“When households are in decent shape, as they are today – when you have wages growth at decade highs and unemployment at near record lows, and savings are still plentiful – you end up with an environment where people are much less sensitive to price changes,” Ge says.

Covid lowered our price sensitivity

“During lockdowns, people were happy to pay for a whole range of goods like laptops, gardening tools, toilet paper,” notes Ge. “Consumer demand collectively channelled its momentum into household items.

“Suppliers jacked up prices but there was still plenty of demand.

“While we have moved on from Covid, we haven’t moved on from this sort of low-price sensitivity environment.

“The money has only moved on from chasing goods to instead chasing services.

“The bottom line is that the elasticity of demand is very, very low. It’s basically inelastic.”

Services are labour intensive – hospitals, hotels, cafes, restaurants, airlines employ hundreds of thousands of people, Ge says.

“Even though we’ve added a million people to the workforce since 2020, businesses are still experiencing labour shortages.

“It’s a Covid hangover. People want to go out. They don’t want to be the people serving everyone else.”

“As a central banker you see inflation rising and your natural instinct is to raise rates. But the usual transmission mechanism is broken,” he says.

Transmission breakdown

Previously lifting interest rates would trigger tighter lending and refinancing, and companies would cut back on costs, including staff, says Ge. That would lead to higher unemployment and that would dampen inflation.

“But today, businesses aren’t really cutting back on staff. They’ve struggled to find and retain the right people, and thus don’t’ now want to lose them,” Oliver explains.

“Instead what they’ve chosen to do is compromise in other areas – say reduce the quality of ingredients if they are a restaurant.

“Or they are just passing the cost through to the consumer. And people are happy, at present, to pay the higher prices. Until they’re not.”

This process demonstrates an inelasticity of supply, as well as demand.

“So you have this relationship where higher rates are hurting businesses and to cope, they’re lifting prices, which consumers are paying.

“There’s a breakdown in the transmission of monetary policy to the employment market. In a very counterintuitive way, hikes are making things worse, not better.”

What it means for fixed interest investors

Higher interest rates will eventually work, but they’re not working just now, argues Ge.

“It will be the straw that breaks the camel’s back. It’s hard to see the stresses today but when it comes, it will come suddenly.

“I think there will be a fairly aggressive breaking point around the middle of next year. The Reserve Bank could realise too late, and then desperately try to reverse the rate rises.

“At which point bonds could become very good value. They are already good value, but that’s when the have the potential to become even better value.”

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About Oliver Ge and Pendal’s Income and Fixed Interest boutique

Oliver Ge is an assistant portfolio manager with Pendal’s Income and Fixed Interest (IFI) team.

Oliver works on developing and running key quantitative investment models, and acting as trading support for the team. Oliver received his Bachelor of Commerce (Finance) from the University of Sydney and is also a CFA Charterholder.

Pendal’s IFI 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.

The invests across income, composite, pure alpha, global and Australian government strategies.

Find out more about Pendal’s fixed interest strategies here

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About Pendal Group

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

Contact a Pendal key account manager