China’s DeepSeek technology has changed how markets think about AI investing. Pendal’s ELISE MCKAY explains

• Free, open-source AI from China’s DeepSeek surprises markets
• Volatility reinforces case for active management
• Find out about Pendal Horizon Sustainable Australian Share Fund

MARKET volatility sparked by new AI innovations from China underscores the benefits of taking an active approach to portfolio management, argues Pendal’s Elise McKay.

Chinese start-up DeepSeek rocked the tech world last month by releasing an AI model with similar performance to market leaders like OpenAI’s ChatGPT but built at a fraction of the cost.

The free, open-source model was developed without access to the kind of high-end Nvidia graphical processing units that power similar systems.

McKay — an investment analyst and portfolio manager with Pendal’s Australian equities team — says the innovation demonstrates that AI can be trained and run on older, less-powerful chips that are free from US export controls.

It also challenges long-held assumptions that AI dominance requires billons of spending, access to cutting-edge semiconductors, and massive energy use.

The market reaction was swift. Nvidia, the leading supplier of AI chips, dropped 17 per cent in a single session before rebounding 9 per cent the next day as investors grappled with the implications.

“We are early in game for generative AI, so it’s too soon to tell how this will play out,” says McKay.

“But what we do know is that the day-one market reaction is not necessarily reflective of the medium-or longer-term outlook. It is important to look through the noise.”

Need for active management

Market uncertainty about how AI will play out has echoes of the evolution of the COVID pandemic and the impact of GLP1 weight-loss medications such as Ozempic.

“Volatility is a reflection of the unknown — and uncertain situations can create opportunities as we get clarity,” she says.

McKay says the violent market reaction triggered by DeepSeek’s innovation reinforces the need for investors to ensure they are taking an active approach in how their money is managed.

“It demonstrates how the increasing influence of passive money in equity markets is creating these opportunities for active managers,” she says.

“Nvidia was down 17 per cent one day and up 9 per cent. That throws up opportunity for an active manager prepared to take advantage of those kind of liquidity events.”

Transformative technology

Investors can look to the past for hints on how these changes are likely to play out.

McKay points to Jevons’ Paradox – named for English economist William Stanley Jevons who observed that coal consumption increased through the 1800s despite rapid improvements in steam engine efficiency, challenging the belief that improved technology would reduce resource use.

The argument? More efficient systems are more cost-effective for users, which increases their adoption.

“Same with AI – if it’s cheaper, we’re going to be using more of it,” says McKay.

Economic growth, productivity effects

Greater AI adoption has the potential to lift global growth as businesses and individuals find new ways to boost productivity, says McKay – and falling AI costs could reshape how that value is distributed across society.

“Cheaper AI shifts power away from the handful of hyper-scalers who could previously charge a premium for access. Open-source models mean a wider range of people can use it. It democratises access.”

That could mean a broadening of market leadership away from the Magnificent Seven tech leaders such as Nvidia and Meta.

“Expanding breadth from the Magnificent Seven to the broader tech space is generally good for a bull market continuing, because you need that breath to extend.”

For Australian equities, the impact remains unclear.

“Australia is a reasonably early adopter of technology – particularly cloud computing – so I’m excited to see how Australian companies embrace generative AI.

“It’s still early days, but we’re on the precipice of something exciting.”

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About Elise McKay and Pendal Australian share funds

Elise is an investment analyst and portfolio manager with Pendal’s Australian equities team. Elise previously worked as an investment analyst for US fund manager Cartica where she covered a variety of emerging market companies.

She has also worked in investment banking and corporate finance at JP Morgan and Ernst & Young.

Pendal Horizon Sustainable Australian Share Fund is a concentrated portfolio aligned with the transition to a more sustainable, future economy.

Pendal Focus Australian Share Fund is a high-conviction equity fund with a 16-year track record of strong performance in a range of market conditions. The Fund is rated at the highest level by Lonsec, Morningstar and Zenith.

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

The door is wide open for modest rate cuts as inflation settles back to around 3 per cent, argues Pendal’s head of government bonds, TIM HEXT 

• Register now: How to prepare for rate cuts in a shifting global economy
• Browse Pendal’s fixed interest funds

AUSTRALIA’S latest quarterly inflation figures offer good news to both the Reserve Bank and the Albanese government.

Headline CPI came in at 0.2% for the quarter, now 2.4% year-on-year (yoy). Trimmed mean inflation, our version of underlying inflation, came in at 0.5% and 3.2% yoy.

In November, the RBA had forecast inflation at 2.6% and trimmed mean at 3.4% for the end of 2024, so these numbers are a 0.2% improvement on recent expectations.

More important, though, is the significant improvement in several key areas that show it is not just a story of government subsidies artificially lowering inflation. Subsidies directly likely only kept trimmed mean inflation around 0.1% lower as the large falls are trimmed away.

New dwelling costs were one of the poster children for runaway inflation through the pandemic. Labour shortages and massive homebuilder subsidies saw 10% annual growth for several years.

Prices have now plateaued and even slightly fell in the quarter, as it has shifted from a sellers’ market to a buyers’ market. These constitute 8% of the CPI basket so they can make a big difference.

The other key area of housing is rents, which are 6% of the CPI basket. These went up only 0.6% on the quarter and were dampened by a 10% increase in rental assistance to the 1.5 million people who receive it.

Nevertheless, the underlying pulse for rents is now heading nearer 5% than the 8-10% of the past few years. These two key areas are partly behind services inflation, falling from 4.6% to 4.3%.

If services (two-thirds of CPI) can settle around 4% with goods prices (one-third of CPI) nearer 1%, then the RBA should be more confident of medium-term inflation being within its 2-3% target, albeit more at the top end of its range.

Finally, as you would expect with falling inflation, the number of components rising faster than 3% is now down to 37% from around 85% in late 2022.

This graph, courtesy of NAB, shows that only 42% of items are over 2.5%. This is not weighted, but speaks to the breadth (also called diffusion) of price disinflation.

 

All this leaves the door very wide open for an RBA cut in February. The market is now 90% priced and has another rate cut priced by May and a third by August.

We agree with the first two, but caution against pricing too many more beyond that.

Inflation will push back nearer 0.7% in Q1 CPI, due in late April. However, large government spending here, both Federal and State, will continue to keep a solid footing under growth and employment.

The RBA will need to do a twist around its estimate of full employment.

Its rates-on-hold narrative was based on excess demand versus supply in employment markets, given the 4% unemployment rate. Its estimate for full employment, where demand and supply are in balance, was nearer 4.5%.

However, with wage growth moderating to 3.5%, it points to full employment being nearer the current levels of 4%. Expect some commentary on this.

We continue to favour steeper curves and modest overweight duration positions, focusing on one to three-year part of the government yield curve as we expect both short-term bond yields to fall, while longer-end bond yields may rise or stay the same.

If not for the high level of uncertainty out of the US, our long duration views would be more confident.

Perhaps the biggest sigh of relief on the release of today’s numbers will have come out of Canberra.

A pre-election rate cut, possibly even two, would be welcomed by young people living in the mortgage belts, and often swing seats, of Australia.

In what is shaping up as a close election, any good news on the cost of living will be grabbed by Albanese and Chalmers.

 

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

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

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

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

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

Find out more about Pendal’s fixed interest strategies here

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About Pendal

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

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

Contact a Pendal key account manager

Pendal equities analyst RACHEL FOLDER recently joined Livewire Markets to discuss her picks and predictions for the year ahead

• Browse Pendal’s Australian share funds

SMALL-CAPS analyst Rachel Folder recently joined other Aussie fund managers for Livewire’s 2025 Outlook Series to discuss the outlook for Australian shares in the year ahead.

Despite a resurgence of risks and the impact of political changes in the US last year, Rachel says the market’s current state is strong and that things are looking “pretty good” for 2025. 

In the full interview below, Rachel reveals:

• Her top pick for growth in 2025
• An industry set to break out
• A stock she would avoid
• A contrarian stock idea
• A stock she would choose if she could hold just one in her portfolio this year.
  

See more on Livewire Markets

About Rachel Folder

Rachel is an investment analyst with Pendal’s Smaller Companies team, providing fundamental analysis on a range of companies within the ASX ex-100 universe.

Previously, Rachel was an Investment Analyst covering smaller companies for NAOS Asset Management and First Sentier Investors, where she began her career in their graduate program.

Rachel holds a Bachelor of Commerce (Actuarial Studies and Financial Economics) from the University of New South Wales and is a CFA Charterholder.

Pendal is an 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 portfolio manager JIM TAYLOR. Reported by investment specialist Jonathan Choong

• Find out about Pendal Focus Australian Share Fund

DESPITE much anticipation for the new US President’s policies, which marked the beginning of a new direction for the country, last week was notably quiet with minimal market impact.

Early White House statements aligned with pre-inauguration rhetoric on immigration, energy, trade and tariffs, causing little market movement except for China tariff news affecting resources.

Economic data was sparse and the Federal Reserve (the Fed) remains in blackout ahead of the FOMC meeting at the end of January. US bonds rallied 15-20 basis points (bps) from recent highs.

A broadening of market strength will be a key indicator of market health, but it might be too early to call yet. We saw a few days of broad strength punctuated by one day, led by mega tech.

The Fed is widely expected to leave rates unchanged at 4.25-4.50% on 29 January, with a 25bp rate cut in March having a probability just below 30%.

Rate cut expectations for 2025 remain stable.

Last week saw the replacement of Fedspeak with “Trumpspeak”, where President Trump – at Davos – demanded global interest rate cuts and urged Saudi Arabia and OPEC to lower oil prices. Here, he emphasised the vast oil and gas reserves for the US.

Trump also signed off a slew of executive orders, with the most relevant to markets including:

• Return to office: All executive branch employees must return to in-person work, with necessary exemptions.
• Tariffs: Trump emphasised an America First trade policy, proposing a 10% tariff on China due to fentanyl issues, and hinted at tariffs on the EU for “fairness”.
• TikTok: Trump suspended the Protecting Americans from Foreign Adversary Controlled Applications Act for 75 days to reassess its impact on national security and TikTok. He suggested the US should get half of TikTok’s value, threatening high tariffs if China disagrees.
• Infrastructure: Trump announced a $500 billion private sector investment in AI infrastructure, with OpenAI, Softbank and Oracle’s Stargate project planning to create more than 100,000 US jobs. The first of 20 data centres is under construction in Texas.
• Energy: Trump’s agenda focuses on lowering energy costs – urging US companies to increase oil drilling i.e. “drill baby drill”. The transition to supermajors has improved efficiency and cash discipline, but its future under the new regime is uncertain.

On another note, the breakout release of Chinese developed AI assistant DeepSeek garnered significant attention for its sophistication, rivalling US mega-tech generative AI at a fraction of the cost. This has raised concerns about the massive spending of mega-tech companies on AI and, in particular, chipmaker Nvidia – more to come next week.

US macro and policy

Initial jobless claims rose to 223k, above the 220k consensus. Continuing claims increased to 1,899k – well above the 1,866k consensus.

WARN layoff announcements in November and December were 22% higher than the first 10 months of 2024. WARN data are very closely related to layoffs in one-to-two months’ time.

Indeed’s job postings remained unchanged after hitting a four-month low in December, suggesting laid-off workers may struggle to find new positions quickly. Some see these factors as pointing to a continued rise in initial claims to 250k by March, which could help the Fed lean towards further rate cuts.

On the growth front, the Atlanta Fed’s GDPNow model estimates Q4 growth at 3.0%. The 2025 growth consensus is 2.1%, up from 1.8% prior to the election.

Cleveland Fed data shows that underlying rental growth aligns with private sector data (such as Zillow) when excluding new leases.

Existing home sales rose to 4.24 million in December (above the 4.20 million consensus), with a 2.2% increase in Q4. The average mortgage rate on existing homes is about 4%, compared to 7% for new mortgages, contributing to sluggish sales.

Local macro and policy 

It was a particularly quiet macro week in Australia, with the only notable datapoint being that consumer confidence is slowly grinding higher.

In New Zealand, headline CPI rose 0.5% quarter-on-quarter in Q4 2024, with annual growth steady at 2.2% (within the Reserve Bank of New Zealand’s (RBNZ) 1-3% target).

This was slightly above RBNZ’s forecasts but aligned with consensus expectations. The surprise came from tradables prices, while non-tradables were lower than expected.

Measures of core inflation also showed ongoing signs of disinflation, with the ex-food and energy measure easing to 3.0% annually. The weighted-median and 30% trimmed-mean measures also decelerated to 2.6% and 2.5%, respectively.

Eurozone macro and policy

Eurozone economic data continues painting a bleak picture – particularly for Germany, which is often considered a canary for Europe.

Since 2017, Germany’s industrial production has fallen 15% (2.3% annualised). Car manufacturing has dropped to 1985 levels, with exports at 1998 levels.

The decline has been attributed to demographics, the green transition, and years of underinvestment. A recent study suggests that EUR600 billion in public investment over the next decade (1.5% of GDP) is needed for education and transport.

To the UK, productivity growth fell from 2.22% annually (1998-2007) to 1.12% (2011-2019), a decline known as the “productivity puzzle.”

China

The yuan strengthened notably alongside equity markets after President Trump told Fox News he would rather not impose tariffs on China-made goods.

He added that the tariffs represented “one very big power over China” and that Beijing did not want tariffs to be implemented.

Markets

Fourth quarter earnings season for the S&P 500 is off to a strong start, with both the percentage of companies reporting positive surprises and the magnitude of those surprises above 10-year averages.

Overall, 16% of S&P 500 companies have reported Q4 results, with 80% exceeding EPS estimates – above the 10-year average of 75%. Earnings are 7.3% above estimates, slightly below the five-year average but above the 10-year average.

The Q4 year-over-year earnings growth rate rose to 12.7%, which is the highest in three years.

Financials led the positive surprises, boosting the overall earnings growth rate, while Energy saw downward revisions.

If the 12.7% growth rate holds, it will be the highest since Q4 2021 and will also mark the sixth consecutive quarter of growth.

Seven of the eleven sectors in the S&P 500 reported year-over-year growth, with six showing double-digit increases such as Information Technology, Financials and Health Care. Energy was the only sector with a double-digit decline.

Looking ahead, analysts expect earnings growth of 11.3% and 11.6% for Q1 and Q2, respectively, and 14.8% overall for 2025.

The forward 12-month P/E ratio is 22.2, above both the five and ten-year averages.

More than 100 companies, including some of the Mag 7, are reporting this week. Market implications include shorting of companies near the $4.5 billion market cap cut-off, anticipating MSCI World deletions.

 

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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

Trump is off to a flying start with a flurry of executive orders – and there’s more to come on tariffs and taxes. Yet markets seem complacent about the future, writes TIM HEXT 

• Register now: How to prepare for rate cuts in a shifting global economy
• Browse Pendal’s fixed interest funds

FEW would have predicted the thunder and awe of Trump’s first week would see a somewhat collective yawn from markets.

My main question after week one, though, is why Canada is the first cab off the tariff rank – with 25 per cent announced to start on February 1.

I mean, I know Trump hated Trudeau – but he’s gone now.

Canada has only a small trade surplus with the US and, from what I can see, the US has no new geopolitical beefs with Canada.

If that’s how they treat a relatively friendly neighbour without a large trade imbalance, then markets seem rather complacent about what  might happen to less-friendly peers with large trade surpluses, like China and Europe.

What is clear after week one is that Trump is paving the way for executive authority to be used to its full capacity around tariffs and taxes.

It has been described as the most expansive US presidential power in modern times.

A never-used, 90-year-old US tax code provision has even been mentioned as a way for Trump to tax foreign citizens and companies doing business in the US – potentially including Australia.

The question is when and where these powers might be used.

Markets are trying to adjust for likely outcomes, but pricing signals such as forward inflation have not changed this week.

We believe markets are still too complacent over tariffs, both on inflation and growth.

US 10-year inflation expectations are now at 2.4%, only slightly above the 2.3% average of the past 12 months.

While tariffs may give an initial impression of boosting the US economy, trade wars are always bad for growth.

Markets seem to be saying that, yes, tariffs will come and push up inflation over the short term – but not enough to cause concern.

It is not pricing in trade wars and de-globalisation on a scale bad for global growth. Trump appears keen to break things, and I would caution against dismissing it all as just about the negotiation and the deal

In the meantime, central banks are left to face the incoming data and do what they always do – talk about uncertainty but not get too caught up in the political game.

For Australia, business as usual is likely to see a lower inflation-led rate cut in February, with another likely to follow in May.

And by May, at least, the full range of Trump’s measures will be on display, and then everyone can react accordingly.

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

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

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

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

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

Find out more about Pendal’s fixed interest strategies here

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About Pendal

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

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

Contact a Pendal key account manager

Pendal’s head of income strategies explains how her team found the sweet spot for through-the-cycle success across our fixed income funds

• Find out more about the Pendal Monthly Income Plus Fund

CREDIT is the main income engine for most income funds.

Pendal’s income engines look to high-quality, Australian investment-grade credit to generate a core level of stable and repeatable income.

With so much uncertainty given the current macroeconomic backdrop, some credit-based income engines need a little help.

By visiting the basics of asset class behaviour, this article highlights the importance of conviction and flexibility to ensure through-the-cycle success for any income fund.

Credit likes moderation

As far as asset types go, not much beats Australian investment-grade credit for its superior risk-adjusted performance. Even private credit, with its double-digit returns over the past few years, remains untested through a real cycle.

For credit more broadly, moderation in the macro backdrop is key.

If recession becomes a real and tangible threat, government bonds start to offer greater potential for returns.

As well as a potential boost in returns from likely interest rate cuts, high-quality government bonds are the safe haven asset of choice in times of market turmoil.

On the other hand, if growth is a little too hot, equities are more likely to keep running while credit loses steam.

There are three main reasons for this:

1. Asymmetry of upside between bonds and equities

Equity prices reflect the market’s expectation of the strength and sustainability of corporate earnings, which means – in theory – unlimited upside is possible.

For corporate bonds, this upside is capped.

A hold-to-maturity bond investor’s best case is receiving all the coupons over the life of the bond and the safe return of their principal when that bond matures.

2. How companies behave as growth accelerates

Management teams tend to see more opportunities to invest or acquire other businesses, and it usually makes sense to fund these activities through issuing more debt.

If corporate bond supply is heavy, credit markets can go through periods of underperformance while the investor community tries to digest the issuance.

Even if indigestion is not an issue, the market must judge whether these companies will successfully grow into more leveraged balance sheets.

3. Higher debt-servicing costs that come with a higher interest rate environment

An accelerating economy is likely to lead central banks to adopt a tightening bias and/or raise interest rates.

Companies with floating rate debt will feel the pinch immediately. Those with fixed rate debt will incur higher refinancing costs. If earnings growth fails to keep pace, credit spreads become vulnerable to widening.

Should the economy start to overheat, and inflation hurts the performance of both bonds and equities, cash becomes king.

Competing themes

While the Santa rally failed to deliver in December 2024, both bond and equity markets are pricing in a continuation of many of last year’s themes:

• American exceptionalism: Bond markets price fewer than two cuts for all of 2025, and equity analysts see more than 10% earnings growth from the S&P 500.
• Daunting deficit: With the US deficit running at more than 6% of GDP (as at the September 2024 quarter), the bond market continues to worry about debt sustainability. This has contributed to the recent steepening of the yield curve.
• Trickling bazooka: Despite much talk of stimulus efforts from Beijing, Chinese government bond yields have continued to drift lower, signalling a lack of market optimism for a turnaround from the world’s second largest economy.
• Trump 2.0 policy uncertainty: From tariffs to immigration, tax cuts and deregulation, there is nothing but uncertainty about how this Trump administration’s policies are likely to impact the global economy. Both bond and equity volatility indices have picked up from their lows since mid-December.

It’s interesting to note that the latter three themes all pose risk to the first theme of American exceptionalism – or at the very least, American equity market exceptionalism.

To the extent that Trump policies or a high US deficit can push bond yields meaningfully higher, equity market sentiment can be de-railed. In fact, it is interesting to us that the latest march higher in yields (and real yields in particular) have largely been brushed off by the S&P 500 (Figure 1).

Figure 1: Shake it off | US real yields and S&P 500

What could knock things out of the sweet spot?

These competing themes may have been keeping each other in check, leading to a backdrop of that kind of moderation that is so well-liked by all markets (Figure 2). That is a backdrop of stable growth, supported by monetary policy that is neutral to easing in its bias.

Figure 2: The sweet spot

That’s certainly how much of 2024 played out, but the above themes point to risks that could knock things out of the sweet spot in both directions.

Growth could start to decelerate, leaving the zone of stability. This could come about from tariffs that eat into consumers’ spending power and ignite trade wars on a larger scale.

Slower growth outside of the US, including China, could also bite back on the US via various channels such as capital flows and trade. Credit spreads will come under threat if recession comes into view.

Growth could also start to accelerate and bring inflation fears back into focus. Certainly, US inflation data in the latter months of 2024 started to show signs of stubbornness once again.

While the Fed may be prepared to look through the one-off effects of tariffs, it would need to take lasting effects more seriously. One such effect could come about through draconian immigration policy which causes significant tightening of US labour markets.

On balance, we see more downside risks to growth in 2025 than a re-acceleration, simply because that seems to be the underlying direction of travel for the economy.

But we haven’t hit the inflection point just yet. Pandemic savings are far from being rundown (Figure 3), but we do note that the liquidity position of the poorest half of Americans has come off its peak.

Figure 3: Cashed-up and spending

More than just coupons

With the “sweet spot” covering a narrow range of economic environments, income funds need more than just corporate bond coupons to successfully navigate the economic cycle.

It is tempting to reach for higher coupons (i.e. higher default risk), but that will mean a higher risk of large drawdowns, defaults, and loss of income at the economic extremes.

Similarly, if growth stays robust or picks up, income funds could benefit from having more ways to participate in the upside. Investment-grade corporate bonds won’t get you there.

That’s why Pendal designs its income solutions with the entire spectrum of economic and market scenarios in mind. Our funds can access levers outside of just credit, and our investment process actively exploits opportunities conjured up by market themes.

In portfolio terms, this translated into a strong 2024 return outcome.

By actively positioning into and away from interest rate exposures throughout the year, Pendal was able to benefit from bond-favourable market themes of “benign disinflation” and “Sahm rule breach” (where recession fears came back into view), while also avoiding any tantrums relating to Trump and inflation fears.

We also actively positioned into and away from return boosters such as equities and emerging markets, which allowed us to further benefit from the optimism around rate cuts and China stimulus and avoid the disappointment relating to both.

 

Despite a recent lull in the luxury segment, one iconic brand is making a comeback. Pendal’s SAMIR MEHTA outlines a fashionable investment opportunity

• A well-established brand that encountered tough times
• Prada’s youth brand Miu Miu leads a turnaround
• Find out more about Pendal Asian Share Fund

IN THE film The Devil Wears Prada, Miranda Priestly – the formidable editor-in-chief of Runway Magazine – sarcastically declares: “Florals, for spring? Groundbreaking.”

Miranda personifies an uppity, sceptical and dismissive know-it-all, putting down any style trend that she was not the first to spot.

Identifying turnaround stocks requires a similar type of scepticism.

These days I’ve mostly eschewed the practice, but one type of turnaround story still catches my interest – a well-established brand encountering tough times.

And Hong-Kong-listed, Italian luxury brand Prada is one such case.

Back in fashion

The century-old fashion house was recently flagged as an opportunity by one one of our in-house investment screens which looks for improvements in incremental operating and free cash flows.

Between 2016 and 2019, Prada’s financial performance was anaemic.

A reliance on wholesale distribution (as opposed to retail), undesirable store locations and rudimentary online marketing efforts didn’t help.

But all was not lost.

Prada is an established brand with a founder-led team (owning 80% of the business) and a long-term commitment to fashion, legacy and – importantly – a willingness to hire professionals.

Prada generated minimal operating cashflows but had low debt (other than committed leases).

Stagnant sales and low profit margins stood starkly against the might of France’s LVMH — the world’s biggest luxury goods company.

A lull in luxury

In recent years the pandemic, government stimulus, and inflation have somewhat reshaped the luxury industry.

Pre-pandemic, Chinese consumers were the driving force for luxury goods.

During and post-pandemic, demand was fuelled largely by Western consumers assisted by government stimulus and a shift in spends from services to goods.

In 2023 and 2024, inflation and rising interest rates dented disposable incomes.

Perhaps most underestimated was the moderation of demand in China.

A slower economy, poor job market, falling property values, and a clampdown on conspicuous consumption by the Chinese Communist Party became strong headwinds.

In a way, Prada is lucky for its marginal presence in the US, where luxury spends have come off the sharpest in 2024.

Industry-wide, sales growth polarisation between brands seems to have further accelerated.

Prada, Hermes and Brunello Cucinelli still delivered double-digit revenue growth in 2Q24, while some brands in turnaround remained under significant pressure (Gucci and Saint Laurent within Kering, as well as Burberry and Swatch Group), with sales down in double-digit territory.

Margin pressures were exacerbated by currency headwinds, particularly from JPY and RMB, and 1H24 EBIT for the sector declined 11% year over year.

Prada bucks the trend

In Prada’s case, a confluence of factors over the past five years seems to have made a marked difference.

A shifting away from wholesale distribution meant an initial disruption in sales. But once accomplished, this tactic brought better control over inventory and pricing.

The business revamped its online marketing and influencer engagement.

Millennials and Gen Z – once dismissed as fickle – became the new darlings of luxury retail.

Prada courted them not with “florals for spring”, but with sustainability initiatives and inclusive marketing.

It spoke the language of the young – not in patronising tones, but with the authenticity of a brand reinventing itself.

Product mix was another key factor.

Prada and its youth brand Miu Miu (founded in 1992), diversified their offerings, creating a balanced portfolio.

They refocused on craftsmanship and heritage. And in today’s world of fast fashion and disposable trends, Prada doubled down on quality – embracing its history not as a burden, but as a differentiator.

A changing season

Miu Miu – historically a small brand within the Prada Group which rarely surpasses €500m in annual revenues – has struck a chord among the younger generation of shoppers.

Yes, we do expect brands – sometimes out of nowhere – to gain traction in a social media influencer-dominated world.

But for a 33-year-old brand to achieve this sort of growth is staggering (see below).

Needless to say, with a high base, Miu Miu’s revenue growth in 2025 will see a moderation.

Besides, we need to monitor how sustainable this supercharged growth is, particularly when the luxury industry at large is struggling.

If it has the brand pull, which leads to growth of 20-25% in 2025, the margin expansion should be a positive upside too.

Out of the way, Miranda Priestly

Ultimately, similar to any business, the right people make all the difference.

Prada founders Patrizio Bertelli and Miuccia Prada (aged 78 and 75, respectively) made several changes to the management team.

Their elder son Lorenzo joined in 2017 and is now group CMO. A highly experienced management team (including Andrew Guerra as group CEO, Andrea Bonini as CFO and Gianfranco d’Atttis Prada as brand CEO) were appointed in 2022 to further bolster the team.

On the creative side, the 2020 appointment of Belgian designer Raf Simons as co-creative director of the Prada brand (alongside Miuccia Prada) seems to have boosted creativity and commerciality, while also ensuring a stable succession plan for Ms Prada over the longer term.

Simons previously worked with Jil Sander, Christian Dior and Calvin Klein while running his own label.

From all accounts, Ms. Prada and Raf Simons’ joint collection (starting in 2021) were well received by fashion critics.

In 2024, all geographies grew in the double digits – Europe at 18%, APAC at 16% (China was low double digits), Japan at 46% (with mainly Chinese tourists) and the Middle East at 15% – with the exception of the except US, which grew 9%.

Miu Miu remains the star with 90% growth.

The younger brand is now almost 22% of total revenue and at its current run rate could see €1b in annual sales. 

Fashion forward forecasting

To demonstrate such strength globally during a challenging period for the industry is an achievement.

There is no room for complacency in any business, let alone fashion.

It is fitting that there are rumours of a sequel to The Devil Wears Prada.

If it went ahead, I wonder whether Priestly might climb down from her high horse and acknowledge the new kid on the block.

The Devil Wears Miu Miu?

Either way, we wait to see if the markets recognise Prada for its resilience and renaissance and afford it much higher multiples than it has in the past.

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About Samir Mehta and Pendal Asian Share Fund

Samir manages Pendal’s 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 Perpetual 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.

Find out about Pendal Asian Share Fund

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. Reported by portfolio specialist Chris Adams

• Overall, the US economy looks “robust”
• Early earnings season shows expectations high but still being met
• Find out about Pendal Focus Australian Share fund

MARKETS have been positive, following a soft US Consumer Price Index (CPI) print and robust economic data in the US, China and Australia.

This would provide a positive setup for equity markets – except for the uncertainty surrounding the Trump administration, which takes office this week.

There is potential for unpredictability and market volatility on the back of announcements on tariffs, undocumented immigrants and government spending.

It is a broad range of outcomes, which supports having balanced portfolio positioning.

The S&P 500 rose 2.9% and the S&P/ASX 300 0.2% over the week.

From a portfolio perspective, the combination of (i) yields having peaked, (ii) global economic growth remaining robust and (iii) China turning a corner could see a reversal of some of the dominant investment themes from CY24.

US CPI

December’s CPI week print was dovish, with the Core measure up 0.2% month-on-month (MoM), the lowest rate since July, compared to consensus at 0.3%. The year-on-year (YoY) rate was 3.2%.

Global bond yields had been rising consistently into this report, so the outcome was contrary to market positioning and saw a fairly sharp reversal in yields.

Headline CPI rose 0.39%, as energy prices rose 2.6% and food prices rose 0.3%.

Digging into the details:

• Goods inflation eased back (up 0.1% MoM) and is trending at a low level. Used cars and trucks are a key driver, with core goods inflation ex autos down 0.1% MoM. With CPI auto price indices catching up to market-based indices, we may see a slowdown in growth. Some of the goods components that serve as source data for core Personal Consumption Expenditures (PCE) – the Fed’s preferred inflation measure – fell sharply this month (e.g. major appliances down 4.1%), possibly reflecting larger-than-usual holiday sales. We saw a similar pattern take place last year, which was reversed early in the new year.
• Services inflation ex-Owner’s Equivalent Rent (OER) was up 0.2%, the lowest level since June, with stronger airfares (up 3.9%) offset by a decline in hotel/motel pricing (down 1%). Medical care services inflation moderated, with prices rising 0.2% this month (versus 0.4% last month). Trend services inflation appears to be easing after an acceleration earlier in 2024. 
• OER/Rent bounced back to 0.3% MoM, which comes after a surprisingly weak November print. Zillow’s observed rent index is showing a rising MoM trend in recent months.

The CPI print followed a likewise benign US PPI print for December earlier in the week, up 0.2% MoM.

The Fed’s Governor Christopher Waller’s comments were dovish, noting that the CPI data was “good” and that “as long as the data comes in good on inflation or continues on that path, then I can certainly see rate cuts happening sooner than maybe markets are pricing in.” 

Waller went on to note that if the US makes “a lot of progress” then three or four more cuts could be delivered, but if the “data doesn’t cooperate, then you’re going back to two and going maybe even one.”

Overall, this print shows inflation that is generally stabilising at a level a little above the Fed’s target range. It is a bit of a goldilocks outcome for markets, as it averts the risk of too-hot inflation leading to higher-for-longer interest rates – but equally not seeing the deflation that might accompany a cooling economy.

President Trump’s tariffs may, however, muddy the waters on goods inflation.

Commodity prices

The global rally in commodity prices over the past month and a half is a fly in the ointment for the dovish inflationary view.

Oil price is a big driver, with brent crude up 8.9% year-to-date, while copper (up 10.6%) and agricultural prices have been rising strongly as well.

Resources was broadly a one-way trade to the downside in CY24; positioning almost certainly started the year quite short, accounting for some of the aggressiveness of the pricing move.

Risk/reward may be moving to the upside, with China positioned to stimulate in response to any tariff moves and a better-looking starting position.

Other US macro data suggesting a robust economy

US Retail sales were solid. Headline sales rose 0.4% MoM (below consensus) and control group sales (excludes gasoline, autos, food and building materials and feeds into GDP estimates) were up 0.7% MoM (above consensus).

Strength was broad-based across categories, though strong sales for Durables in the December quarter may reflect some buying by consumers ahead of potential tariffs.

The Philly Fed Survey was stronger than expected (+44 in January versus -12 in December), but the Empire Manufacturing Survey was weaker (dropping to -12.6 from +2.1 in November and +3 expected).

These surveys were attributed as being drivers of market behaviour on individual days during the week but are more likely to just be noise.

US Industrial Production rose 0.9% in December (well above consensus expectations of 0.3%), with manufacturing output up 0.6%. There was a degree of “catch-up” in these numbers with a Boeing strike ending.

Weekly employment claims were stable on a seasonally adjusted basis. Unadjusted numbers were quite weak – something to keep an eye on. The perma-bears believe lead indicators for the labour market are deteriorating.

 

US housing construction

There was some positive news on US housing construction – an important lead indicator for the economy – last week, starting with the pullback in bond yields and mortgage rates from recent highs following the CPI release.

Sentiment has been very negative over the past couple of months for homebuilders, but December new housing starts weren’t as bad than feared. Single family starts were down 1.4% YoY in December after being down 10.5% in November, while multi-family starts were down 5% after being down 30% in November.

KB Home was the first listed homebuilder to report its quarterly last week.

After a super strong November quarter with orders up 40%, new orders were down 12% YoY in the first six weeks of the company’s February quarter. However, it guided for its February quarter new orders to be flat YoY as new communities came online, which is much better than feared.

Finally, the key sentiment survey for the homebuilders sector, the NAHB Housing Market Index, was up one point in the December quarter (versus the September quarter) to 47 points, despite the increase in bond yields. But within that, the Future Sales Index declined to 60 from 66 last month.

The outlook for Repair and Remodelling (R&R) is looking better after a weak couple of years.

The Remodelling Market Index jumped to 68 in the December quarter versus 63 in the September quarter. The improved R&R outlook appears to be supported by a return to YoY growth in existing and pending home sales.

Pulling this together, there is a fair bit of evidence that the outlook for US residential construction, while softer, is not as bad as feared, which supports a view of a still-robust US economic outlook.

Early US reporting season read

Overall, the US economy looks robust, which is supportive for earnings. Broadly speaking, expectations are high but are being met.

It was banks reporting in the US last week. There were strong results from the investment banks and money centres, with JP Morgan, Citi, Wells Fargo and Goldman Sacks beating on EPS and providing better-than-expected 2025 guidance.

The key Trading, FICC and Equities divisions are all doing well and the credit environment remains benign, with provisions coming lighter than expected.

Regional banks underperformed during the week, including PNC and US Bancorp, with less-bullish guidance looking soft compared to the investment bank outlooks.

There was a small hiccup for the Chip/Data centre stocks, with Nvidia declining after press reports that some of its biggest data centre customers were cutting back on purchases of Nvidia’s Blackwell racks after initial shipments of the product had some glitches.

Insurance stocks were weaker given estimated economic costs from the LA wildfires coming in at $150 billion, one of the costliest natural disasters ever.

Australia

The unemployment rate rose by 0.1% to 4.0% in December due to a higher participation rate, but jobs growth was very strong (up 56k versus consensus expectations of 15k). This was largely driven by part-time jobs.

Unemployment of 4% is below the RBA’s year-end forecasts for 4.3% and measures of labour market spare capacity, such as underemployment and hours worked, are showing tightening not loosening.

MYEFO estimates suggest government opex increasing 10% for FY25, suggesting continued strong support for employment.

Consequently, the prospects of rate cut prospects in February look slim despite several investment banks calling for one. It will require a surprisingly soft Q4 CPI print to be released on 29 January.

China – signs of life

The view on China remains wait-in-see ahead of Chinese New Year, major economic meetings in March, and the expected announcement of the Trump Administration’s tariff plans.

Having said that, the data from last week was generally more positive.

GDP growth rebounded to 5.4% YoY in the December quarter, with activity driven by better-than-expected retail sales (up 3.8% YoY in December) and exports (up 10% YoY), though strength in the latter may be linked to inventory building ahead of prospective tariffs.

Property sales and investment continue to cool, but manufacturing and infrastructure investment were robust.

Chinese credit growth picked up in December, with Total Social Financing up 47% YoY – taking the three-month trend to 8%, driven by government bond issuance. Private sector borrowing remains subdued.

More recently, credit growth has turned a corner after a very weak first half of the year.

In residential property, floor space sales were down 0.3% YoY and starts were down 23% YoY in December.

FY24 property starts were the lowest in nearly two decades. The stabilisation in sales over the past few months is a positive sign, but the lags to activity are long.

House prices are also showing signs of stabilisation.

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About Anthony Moran

Anthony Moran is an analyst with over 15 years of experience covering a range of Australian and international sectors. His sector coverage has included Australian Industrials and Energy, Building Materials, Capital Goods, Engineering & Construction, Transport, Telcos, REITs, Utilities and Infrastructure.

He has previously worked as an equity analyst for AllianceBernstein and Macquarie Group, spending a further two years as a management consultant at Port Jackson Partners and two years as an institutional research sales executive with Deutsche Bank.

Anthony is a CFA Charterholder and holds bachelor’s degrees in Commerce and Law from the University of Sydney.

Find out more about Pendal Focus Australian Share Fund  

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To cut or not to cut? Pendal’s head of government bond strategies, TIM HEXT, explains what information the RBA needs to make a decision

• Join our webinar: How to prepare for rate cuts in a shifting global economy
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WE are just over a month away from the next RBA meeting, the first of the year.

The information the RBA will need in order to decide on a rate cut is now falling into place. Let’s look at what we know and what pieces of the puzzle are left.

Employment and wages

Today’s employment numbers were the last before the meeting, with January’s numbers not coming out till 20 February.

An unemployment rate of 4% for the end of 2024 is definitely lower than the RBA (and nearly everyone else) expected. The RBA had forecast 4.3% by now. This, of course, counts against a rate cut but is not the end of the story.

What matters more is where full employment is, and this is not something scientific.

The US Federal Reserve believes its full employment to be around 4%, so were happy to start a rate cut cycle despite overall strong job markets.

The RBA has previously suggested that full employment here was closer to 4.5% but – as always – it is an educated guess. What is the main observable indicator? That would be wages.

On this front, the news has been far better. Wages look to be settling down nearer 3.5% than 4%, suggesting that full employment may also be closer to 4% than 4.5%.

The only large pocket of elevated wage claims seems to be public sector unions playing catch up, as their wage agreements always lag inflation.

So, on the employment and wages front, the RBA will need to work out just how much excess demand is in the job market – one still largely fuelled by the public sector.

In summary, the job and wages market is not a reason to cut, but may also prove not strong enough to stop one.

Inflation

The Q4 2024 inflation data does not come out till 29 January, but we already have around 70% of the data and a good idea on most of the rest.

We anticipate market expectations to be at 0.3% headline and 0.6% underlying for the quarter.

Clearly, government subsidies are artificially depressing headline numbers, but that is not the only news.

In the housing sector (23% of CPI), two stars of the inflation surge in 2022 and 2023 – new dwelling costs (9% of CPI) and rents (6% of CPI) – are also moderating. We expect rental cost growth to be down from 9% in 2024 to nearer 6% and for new dwelling costs to settle nearer 4%, having peaked around 10%.

This should help keep services inflation nearer 4% than 5% which, in turn, allows inflation to settle around 3% – the RBA forecast for June 2025. The fact is that inflation is somewhat circular, so as goods prices have fallen and subsidies have lowered other costs, then overall pressure comes off.

Most importantly, as consumers feel less of a cost-of-living squeeze, they are less likely to push for higher wage outcomes.

In summary, high inflation is now past us, inflation is moderating near 3%, and the need for rates up at 4.35% has now passed.

Growth

We won’t have Q4 growth numbers till early March, but we all know the story of sluggish growth, only held up and partly squeezed out by high public spending.

The RBA is forecasting a decent rebound in GDP, expecting 2.3% in 2025 after around 1% in 2024.

Growth has not been the factor keeping rates high, but rather a lack of supply in the key government areas of healthcare and social services and construction.

Unfortunately for the RBA, both state and federal governments have shown little drive to restrain their spending further. This could mean 2025 is likely to be another year where the private sector needs to make way for the government sector.

Either way, growth numbers are unlikely to be a major deciding factor for the RBA in February.

Putting the pieces together

I have avoided discussing international factors, such as Trump’s early weeks. In what might be a close decision for the RBA, these factors may yet play a part but will not be the main game.

The main game is that inflation is now back towards the top end of the RBA’s inflation range, meaning there is now space for moderate cuts.

We expect 0.25% in February (70% priced in) and 0.25% in May.

Cost-of-living relief for mortgage holders will be very welcome (especially by Albanese) and is unlikely to unleash any inflationary spending surge. In fact, the big spenders last year were retirees, pumped up with their 5% term deposit rates and strong equity markets.

I am sure they will survive on 4.5% term deposits.

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

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

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

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

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

Find out more about Pendal’s fixed interest strategies here

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About Pendal

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

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

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Here are the main factors driving the ASX this week, according to Pendal’s head of equities CRISPIN MURRAY. Reported by portfolio specialist Chris Adams

• Find out about Pendal Focus Australian Share fund
• Tune in: register to watch Crispin’s Beyond the Numbers webinar

MARKETS have started off the year on a weaker note, with the “US exceptionalism” theme seeing an increase in bond yields.

US two-year yields are up 14 basis points (bps) and 10-year yields up 19bps year to date. The move in bonds has been driven by some combination of:

• Signs of inflation basing out and turning higher
• Perceptions that US economic growth is stronger than expected, exemplified in US payroll data
• Building concerns that Trump’s policies will reinforce growth and inflation issues
• Some circumspect comments from the Fed on the rate cycle
• Structural fiscal deficit concerns affecting term premiums

We have also seen an impact on currencies, with the US trade-weighted dollar index up 0.6% year to date.

Equity markets have struggled when US 10-year bond yields move over 4.7%. They are currently 4.8%, which explains the small recent sell-off.

The S&P 500 was down -1.9% last week and -0.9% for the year to date.

Australian equities have held up better, with the S&P/ASX 300 up 0.5% last week and 1.6% year to date.

There is a perception that the US Federal Reserve (the Fed) declared victory over inflation too early, with bond yields up 115bps since the 50bp interest rate cut in September.

There are, however, some self-correcting mechanisms as the rise in yields potentially slows the economy, with some data points indicating this may already be beginning to play out.

Equities have also been affected by strength in the US dollar, which is back to three-year highs on a trade-weighted basis.

This partly reflects the divergence in the economic and rate outlook for the US versus the rest of the world and is reinforced by US funding needs tightening the market for dollars.

The final macro factor to watch is oil, which has risen 3.1% year to date, breaking through technical resistance levels. 

Potential macro outlook scenarios

We see four broad potential scenarios developing from here, with an aggregate 70% bullish/30% chance bearish conclusion for equity markets:

1. Recession. There is still a cohort of economists that believe the economy is softer than current perceptions and the risk of recession cannot be dismissed (~10% chance).

2. The economy slows, disinflation reasserts, leading to falling bond yields and equity markets continuing to rally (~35% chance).

3. US economic growth continues to hold up better than expected, prompting the Fed to pause rate cuts, meaning bond yields stay higher but equity markets are supported by better earnings (~35% chance).

4. Inflation goes higher, prompting the Fed to shift monetary policy stance to slow the economy. This is negative for equities, as we get higher yields without the higher earnings (~20% chance).

US economic data holding up OK

Recent US employment has been better than expected – see data below:

1. December payrolls added 256k jobs versus 156k expected – the strongest gains since March 2023. The unemployment rate fell from 4.2% to 4.1%. The three-month average is 170k jobs, which is running slightly above the threshold needed to hold unemployment constant. Unlike previous months, private payrolls were stronger than expected at 223k versus 140k expected. Economic bears believe this is overstating labour market strength as it is a catch-up post the hurricane and strike-affected September/October period. Still, the underlying unemployment rate has reversed its recent upward trend and therefore gives the Fed cause to pause.
2. JOLTS (the Job Openings and Labor Turnover Survey) saw an upside surprise in job openings, which still sit above the pre-Covid levels. This was mitigated to an extent by the quits rate falling to new low levels for the cycle, which is a positive signal for wage inflation.
3. Weekly jobless claims have fallen back and most recently came in at 201k versus consensus at 215k.

A stronger ISM Services Index gave the market a jolt.

The December Services Purchasing Managers’ Index (PMI) rose to 54.1 from 52.1, driven by the current business activity component and the price diffusion index. The latter increased to 64.4 from 58.2 – the highest since February 2023 – highlighting that services inflation will potentially prove more resilient.

More positively, December average hourly earnings rose 0.28%, which was in line with consensus and indicates that the likely trend is 3.5% annual wage growth.

US economic outlook

The upshot is that the market is now pricing in 25bps of rate cuts in 2025, with no rate cut in January and a roughly 35% chance in March.

Not until July will we see an implied chance above 50%.

The interesting issue is that by deferring a March cut, it would mean that the Fed would be cutting in May or June at a time when prospective tariff increases would be potentially impacting inflation.

There are several reasons why the Fed retains scope to cut rates in 2025:

• While there is more risk on inflation than three months ago, underlying drivers such as wages are relatively benign as demonstrated by average hourly earnings and the quits rate.
• Trump’s policies may represent a one-off price shock rather than a money supply or demand-driven impulse and are, therefore, not necessarily as negative for inflation – or as large an impediment to Fed easing – as perceived.
• Real rates do remain high and the move in bonds and currencies are tightening financial conditions.

The monetary policy environment is not negative but has shifted to a more neutral factor than was the case last year. This emphasises the need for vigilance on markets given current valuations.

Australian inflation – slightly better data raising hopes for rate cuts

November’s monthly Consumer Price Index (CPI) data was seen as aiding the case for the RBA cutting rates in February, rather than waiting for April or later.

While headline CPI rose to 2.3% from 2.1%, this was as expected, and the composition proved a bit better.

Electricity prices rose more than expected for the month, however, these are being distorted by the government subsidies.

Travel prices fell both for international and domestic travel.

Construction costs (new dwelling purchases – the largest component of the CPI) are falling quicker than expected. This segment was down 0.6% in November, taking annual inflation to 2.8% versus 4.2% in October.

The underlying trimmed mean measure of monthly inflation has improved to 3.2% from 3.5%.

Does this mean rates will be cut sooner? We do not think so.

Given a lower likelihood of US rate cuts, a weaker Australian dollar, uncertainty on services inflation and a healthy labour market, it would be a bold move that could very quickly look a mistake.

This would represent a significant gamble for a newly formed monetary policy board.

Markets

We continue to believe markets are consolidating, rather than starting a more material sell-off – but that is conditional on the above view that growth and inflation remain as expected.

The market consolidation has taken us back from an extreme in sentiment, looking at a variety of criteria such as S&P futures positioning, various bull/bear ratios, and sentiment surveys.

Equity ETF flows remain the biggest support for this market.

These are at an extreme for US equities, with a four-week average of US$9.6bn/week versus a $5.7bn/week average for the year. However, flows into other equity markets are subdued.

S&P 500 market breadth has deteriorated to the lowest level in a year in terms of percentage of stocks above their 200-day moving average. That is a warning sign we need to watch.

Bonds remain a key issue.

There appears to be some disconnection in yields from fundamentals, in that 10-year yields have risen from early December even as the overall economic surprise index has fallen.

This probably highlights the anticipation – or fear – of what Trump will do post-inauguration.

But this may prove overstated. Fiscal policy measures are likely to run into issues in the House and may be diluted. At the same time, tariffs may be designed to avoid giving the Fed a reason not to cut rates, nor to drive the US dollar any higher.

Australian equities

The S&P/ASX 300 has performed better than other equity markets, which reflects optimism that rates may fall sooner than expected, in addition to being helped by thin volumes.

Sentiment on Resources is very low. While iron ore prices have been subdued, copper and oil prices are bouncing off their recent lows and, given positioning is skewed against the sector, there has been better price action. The Resource sector is up 1.6% year to date.

Real Estate Investment Trusts have so far defied the negative lead from offshore, up 2.8% year to date.

Banks were the sector that caught much of the market out last year and have continued to perform well, up 1.8% year to date. Valuation multiples remain at historical highs for the Big Four except ANZ, where the market has been cautious on changes in strategy and management.

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About Crispin Murray and the 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 a 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