The Point

Markets are underestimating structural change in commodities

Russia’s invasion of Ukraine has caused structural change to commodity markets which will be with us for a generation, says Pendal’s Brenton Saunders.

The market is underestimating the depth and longevity of those changes says Brenton, who manages Pendal Midcap Fund.

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

“When you speak to the BHP marketing and logistics team who are managing these cargoes for customers all over the world, you can see the impact and implications are wide-ranging and immediate.

“You’ve 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 end — and we pray it does quickly — but the implications will be with us for a generation.”

Good times for stock-pickers as rate-hike cycle arrives

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

Wholesale sell-off is creating opportunities for equity investors willing to take a stock-picking approach, says Brenton, who co-manages Pendal MidCap Fund.

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

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

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

Could higher rates work against lower inflation? And what would that mean for bonds?

Ongoing demand is blunting the impact of higher rates, argues Oliver Ge, an assistant PM with Pendal’s income and fixed interest team.

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

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

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

He believes there could be a breaking point mid-next year, leading to a reversal from the RBA.

That could make bonds even better value than they are today, he says.

Oliver Ge: Fears of a ’70s inflation re-run are overblown

US inflation numbers were higher than expected in August, prompting more headlines about a second wave of inflation and further interest rate rises.

Can investors really expect a 1970s inflation re-run?

“There’s a lot of commentary on a possible ’70s-style, second wave of inflation,” says Oliver Ge, a portfolio manager with Pendal’s income and fixed interest team.

“But I don’t believe we’re going down that path. We’re not even close to a rerun of the 70s.”

Higher US inflation in August is just one uptick after 13 consecutive months of disinflation – and inflammatory news headlines are unwarranted, Oliver argues.

“The difference is that back then, the US was highly oil-dependent, and it also was experiencing a massive devaluation of its currency. Put the two together and it triggered a big wave of inflation.

“The US is no longer energy-dependent – in fact it is an exporter of oil. Unionisation is no longer widespread. There’s none of the original catalysts that prompted the blowout.”

Recession risk is still out there. Here’s why

The risk of recession appears to be side-lined for now, but investors may be overlooking one factor, argues Pendal’s Oliver Ge.

Much of discussion about higher interest rates has been focused on the impact of bigger mortgage repayments for homeowners.

But tighter credit conditions and stricter collateral requirements for business are likely to have a more significant impact, says Oliver, an assistant PM with our fixed interest team.

“Higher interest payments are a strain for businesses, but it’s when you lose access to credit that the stress comes through.”

There is evidence of tighter lending standards in the US which will likely flow through to defaults in six-to-nine months, he says.

“The prospect of recession has for the moment been sidelined, but the risk is still very much there.”

Inverted yield curve: what it means (and it’s not what you think)

Longer-dated bonds usually pay higher interest rates to compensate for the increased risk over time.

But right now short-term interest rates are moving closer to — and even higher than — long-term rates.

This “yield curve inversion” is a very important signal since it usually means a recession is imminent.

But that’s not the case this time, argues Oliver Ge, an assistant portfolio manager with our Income and Fixed Interest team.

With a strong global economy, low unemployment and benign equity market conditions, analysts have been looking for an alternative explanation for the inversion.

The inversion may be explained by expectations that current inflationary pressures are only short term, says Oliver.

“Short-dated bond yields are higher because they carry a premium to their longer-dated counterparts to compensate investors for bearing higher near-term inflation risk.

“That’s what’s driving the inversion.”

Why bonds are worth considering even as rates rise

Most investors understand that when rates go up, bonds go down.

But what if bonds had the potential to provide an investment return during central interest rate hiking cycles?

It’s possible says Oliver Ge, a portfolio manager with Pendal’s Income and Fixed Interest team.

“The key is that it depends on how much is priced into the bond market at the point central banks start lifting rates.

“Looking at history, an investor who buys bonds at the moment of the first rate hike in a cycle and sells at the last rate hike actually gets quite a substantial return.”

Since the 90s there have four rate hiking cycles in Australia, each averaging an increase of 2.25 per cent to the RBA’s policy rate Oliver says. The annualised bond return over the same period was more than 4 per cent.

“The compelling story is don’t ignore bonds when rates are rising — they can still give you mid-single digit returns. That’s quite significant in a market where equities are negative.”