The Point

The ‘old normal’ is back. Here’s what it means for asset allocation

After 15 years of the ‘new normal’, the ‘old normal’ appears to be back as central banks return to the kind of conventional monetary policy not seen since before the GFC.

It’s potentially good for investors with a more positive outlook over the next decade, argues Pendal multi-asset PM Alan Polley.

But it may mean a reassessment of asset allocation. Faced with lower returns from bonds and equities, many investors pushed into small caps, high-yield credit, emerging markets and less liquid investments in recent years.

“Now investors need to ask themselves: do they need to chase risk when bonds have again yields of around five per cent, and equities have reasonable dividend yields,” says Alan.

“Investors should be thinking about leaning back into traditional asset classes, de-risking their portfolios and running a more ‘old normal’ portfolio for this ‘old normal’ environment.”

Here’s why Aussie bonds are looking attractive right now

Aussie bonds are “somewhat unique in the world” right now, argues Pendal’s head of multi-asset Michael Blayney.

“Our 10-year bonds are yielding more than the cash rate – whereas most other major markets have a strongly inverted yield curve,” he says.

An inverted yield curve is when short-term rates are higher than long-term rates. It’s historically associated with expectations of an economic contraction.

The possibility of a slowdown in the global economy helps make the Aussie bond market look relatively attractive.

“In addition, markets are pricing in inflation in the US and Australia to come back under control, and Wednesday’s inflation print in the US was very encouraging, noting of course that it’s still likely we’ll see bumps along the way,” says Michael.

Inflation won’t go down without a fight, but markets expect extended rate-hike pause

After Tuesday’s rate hike the RBA retains a tightening bias – though there’s nothing in its statement to suggest a follow-up hike in December.

Q4 inflation is out in late January and will determine if a move to 4.6% is required at the first meeting of the year in February, says Pendal’s head of cash strategies Steve Campbell.

Pendal’s income and fixed interest team expects a better-behaved quarterly inflation number – below 1% – which should take pressure off the RBA.

“The RBA is a reluctant hiker,” says Steve. “They’re aware of the lagging impact of monetary policy and they don’t want to overtighten.”

They would also be the stand-out central bank if they continued to raise the cash rate.

Bond markets believe we will join other central banks on an extended pause, notes Steve.

Michael Blayney: Now would be a very good time to revisit your asset allocation

Investors should be taking the time now to review portfolios amid geopolitical tensions and economic uncertainty, says Pendal’s head of multi-asset, Michael Blayney.

Michael is neutral on bonds and slightly underweight equities, though he believes there are opportunities in both asset classes.

He also sees opportunities in real assets such as listed infrastructure and property.

A noticeable feature of the market response to the crisis in the Middle East is a lack of panic, he says.

“The human toll is tragic, but it hasn’t triggered great volatility in markets.

“So far, oil prices have risen but remain below last year’s peak.

“Bonds yields initially fell, but have since risen again. Equities – aside from a modest move down on Wednesday night – have been pretty relaxed.”

How to hold commodities in a sustainable portfolio (and why you would)

Commodities perform an important role in portfolio diversification.

They tend to be highly correlated with inflation and have a return distribution with a positive skew, meaning returns on the upside can be bigger than returns on the downside.

But commodities – typically metals, energy or agriculture materials – are often excluded by sustainable investors as ESG-unfriendly.

Pendal multi-asset PM Alan Polley argues it needn’t be that way.

A nuanced approach that weighs up the benefits and drawbacks of individual commodities can offer advantages over a simplistic commodity index approach or just negative screening, he says.

“Many buy the broad commodity index which has the fossil fuels and livestock and isn’t consistent with ESG.

“Others think ‘commodities are mining, and mining is bad’.

“But you have to think beyond that because the transition to net zero is materials and resources intensive.”

Steve Campbell: Expect rates to stay unchanged til 2024

Inflation is moving in the right direction and it’s likely we’ll see Christmas with rates still at 4.1% after the RBA again sat on its hands this week.

But any talk of rate cuts in the first half of next year should be discarded (barring a big, external shock), says Pendal’s head of cash strategies Steve Campbell.

“Inflation has peaked and the move lower will provide comfort for the RBA,” says Steve. “But services inflation remains uncomfortably high.

“It’s the level at which inflation gets sticky that’s key – and that’ll only become apparent in time.”

The RBA is not expecting inflation to return to its 2-3% target until mid-2025.

“That’s predicated on slowing economic growth, resulting in higher unemployment and easing wage inflation.”

Further policy tightening is likely only if those factors play out more slowly than the RBA expects, says Steve.

Got money in a global bond index fund? You should read this

Got money in a global bond index fund? Pendal’s head of multi-asset Michael Blayney has a note of caution for you.

Indexing bond investments appeals to many investors because it’s a low-cost way of incorporating diversified, defensive assets into a portfolio.

But global bond index funds have a hidden risk that may undermine their role in providing stability and defensiveness in portfolios.

That’s because global bond indicies tend to allocate higher weightings to the most indebted countries, which is a fundamental flaw, argues Michael.

“In bonds, it’s how indebted you are that determines your weight. Essentially, we are lending more to the people that owe the most money.”

Global bond benchmarks could be overweight to countries like China, Italy and emerging markets that might not pass a quality screen.