Market Insights and Education & Resources

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It looks like investors believe the RBA is wrong on its inflation outlook -- and they could be right, says Pendal's Tim Hext

MARKETS and most central banks have spent most of October talking about higher inflation and potential or actual rate hikes.

The RBNZ hiked in early October (delayed from August). The Bank of England looks like moving soon. The US Fed have signalled likely hikes in H2 2022.

Only the RBA is holding their line from earlier in the year -- they see no need to hike until 2024. Inflation may creep higher but they don’t see it hitting their 2.5 per cent target until 2024.

Usually on the hawkish end of the spectrum, the new RBA is firmly down the dovish end.

So which market has seen the biggest move higher in five-year bond yields over the last month?

Australia.

Even this week the RBA did not change sentiment in their minutes. I suspect they are even more perplexed by recent moves than us.

Whenever things like this happen we try and find a rational explanation. Often it isn’t rational but here goes.

The first one is duration positioning, which was longer in Australia than others because of RBA rhetoric. Painful stops have been apparent.

The second one is the market thinks the RBA will revert to previous modus operandi and hike before inflation reaches its target.

This would be wrong. The RBA knows its credibility is on the line and Governor Lowe has been at pains to say there will be nothing pre-emptive this cycle.

For economic reasons the only explanation may be that the market thinks the RBA is wrong on its inflation outlook.

On this one I agree. I think inflation will hit their target in 2022 and hikes will follow in early 2023.

On our portfolios we remain overweight inflation bonds where we can.

We have covered duration shorts and current levels leave us considering whether there is value in short-end yields.

Long-end yields however will need to see 2% before we ask the same question.

Re-opening 2.0 is perfectly timed for retail property, but the office market is also surprisingly robust, says Pendal's Julia Forrest in this fast podcast

Listen to the podcast above or read the transcript below

Interviewer Sean Aylmer: We're talking about property and particularly retail and office real estate. New South Wales and the ACT are emerging from lockdowns. Victoria is about to. From an investor’s point of view, what does it mean for retail property?

Pendal Portfolio Manager Julia Forrest: Well, it's exciting times and what a time to open – leading into summer and Christmas. They couldn't have got their timing better. We have been in lockdown here in Sydney for 102 days. So we're re-emerging.

The first point of call will probably be services. We'll see all of the services at all of the shopping centres fully occupied, probably from 8am in the morning to 8pm at night. Everybody's raring to get out and get their hair done, maybe update their clothes and their jewelry because of course we are leading into party season.

So I am expecting a very buoyant time in terms of retail and shopping centres. Partly it's timing, partly it's that we've been locked down over two lots of school holidays.

People have money to spend. I don't know about you, but I didn't have a lot of confidence booking holidays for December. I have two teenage daughters and looking forward to spending some money on them.

So in terms of timing, it couldn't have been better for shopping centres to be opening.

I think what will differentiate this reopening versus the previous reopening last year is that we're coming out into a period of surging asset prices.

So when we emerged last year in May-June, people were still uncertain. We have seen house prices up 20% to 25% since then, and also stock prices up a long way.

People have cash in their banks and they're feeling wealthy. So I'm expecting a pretty buoyant time for retail.

Interviewer: If you go to some of those shopping centres today -- and particularly the ones in Sydney – there are still some boarded-up shops. Do you think many retailers won't come back?

Julia Forrest: Unfortunately, that is a likelihood. We're probably opening up into a period of less supply, whether it’s cafes or apparel. Retailers have used this time to close their bottom 5% to 10% of stores – particularly if they are in hold-over (ie there wasn't an active lease on the premises).

So we probably are opening up into a period where they will be less supply. One of the issues for retailers is whether they actually have had the confidence to order enough inventory ahead of reopening.

So that will be an issue, as well as whether they have sufficient staff. So that complicates things a little as well.

Interviewer: Let's move on to office. People presumably will return to work in coming months. Though perhaps not at the same levels as they have been pre-pandemic. What do you think about the outlook for the office market?

Julia Forrest: I'm actually sitting in the office at the moment. There are very few people here, but I suspect that most people will be back in December for Christmas parties and lunches.

Because everybody has been locked down for a long time and they're probably missing their colleagues.

So I guess the big returning time, in earnest, will probably be sometime in January where you'll see this continuity of people back in the office.

But I think the cycle of “work-from-home” is quite well established. I suspect we're only going to see people in the office probably three days a week from here on, which will obviously impact demand for office property. Probably more in the reconfiguration of space.

I think that employers really need to get people back in the office to work together, to collaborate. But I think they probably need to “earn the commute”, to quote Lend-Lease. They need to make the office vibrant and compelling for people to really want to come back into the office.

Interviewer: So for investors, the big question is: what’s the medium and long-term outlook for retail and office?

Julia Forrest: For retail, we have seen a number of transactions announced in the last two weeks. We do expect a couple more, which really put a floor under prices.

Prices have been marked down in the last year and a half. They're probably off somewhere between 7% and 20%, depending on the quality and the dominance of the centre.

I think we're book values are now we're seeing quite a lot of support. So for retail things will improve from here. You have seen rents marked down and I think they're probably more at sustainable levels now.

The surprising thing has really been office.

The demand for office assets has been robust. Book values have held and that's despite what we can see is probably going to be slower demand, but also continued supply.

The reason why supply is continuing, is that office values have held their values.

It makes sense for developers to continue developing, because they can continue selling assets at book value, even though the underlying demand may not be there.

So we're pretty optimistic on retail, in terms of net operating income and in terms of values.

The office book values are holding, but we can see rents continuing to be under pressure for the next two-to-three years.

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Investors are closely watching the upcoming COP26 climate change conference and hoping for certainty around net zero targets. Regnan’s Maxime Le Floch explains what to look for

COP26 can provide greater certainty for investors
Rich v poor countries a sticking point
Find out about Regnan Global Equity Impact Solutions Fund

WHAT'S will investors be looking for from the much-vaunted United Nations COP26 Climate Change Conference starting in a little over a week?

Greater certainty, says Maxime Le Floch, investment analyst with Regnan's impact investment team.

Le Floch wants to see "countries arrive in Glasgow and have targets and commit to net zero. Countries arrive with a plan to reduce emissions. The most important thing is the individual country’s plans.”

Forums such as COP26 allows nations to outline how they plan to get to net zero emissions, theoretically by the middle of this century.

Those pathways give investors greater certainty on the rules they face in the future. And that certainty is good for investing.

More countries have made commitments in recent months, including China, Japan and South Korea.

Others, including Australia, are still debating the politics.

In Australia, the federal coalition is yet to outline its ambitions, in part because of disagreements between the Liberal and National parties. However it’s likely that Prime Minister Scott Morrison will have some sort of offering by the time he leaves for Glasgow.

Game theory

Global conferences like COP26 involve plenty of game theory, Le Floch says.

“If countries turn up and commit, or have previously announced their intentions, that’s a positive for other countries to commit to reducing greenhouse gases.

“That’s why China already committing to net zero emissions by 2060 is such a big deal,” he says.

Nations that provide concrete evidence of a pathway to reducing emissions are enabling greater investment, Le FLoch says.

It might be subsidies for electric vehicles, or carbon offset schemes or changed taxation arrangements.

Those factors become part of the investment decision, albeit not the central reason for buying or selling.

“As impact investors, we don’t rely on regulation, and we’re not waiting for it to happen," says Le Floch, who is part of a four-person team managing Regnan Global Equity Impact Solutions Fund.

"There has to be an underlying economic dynamic to unlock value, without any change to regulations.

"But we do recognise that regulation drives adoption and creates an environment in which laggards are forced to improve and leaders and green innovators can thrive."

He points to European offshore wind subsidies which were initially generous as part of a push to achieve carbon neutrality. But they have been phased out in some jurisdictions as offshore wind generation becomes cost effective. Investors in wind farms had to look well beyond the short-term subsidies.

Stumbling blocks to watch out for

The optimism of a global event like COP26 is well founded, but it can easily become unstuck.

“Typically, in a negotiation like this, the stumbling block is the distributive impact of climate change, both in terms of mitigation and adaption. Who is responsible for what, and what should we expect from rich and poor countries,” Le Floch says.

And conferences such as these don’t operate in isolation.

The International Energy Agency earlier this month forecast a need to triple investment in renewable energy to ensure fossil fuels were replaced without triggering an energy crisis.

“There’s a big gap at the moment and the IEA is explaining what’s needed to get on track. To accelerate that you need incentives and conferences like COP26 can help do that.”

It’s been six years since the Paris Accord.

That treaty was the first legally binding agreement to limit global warming to well below two degrees — preferably to 1.5 degrees Celsius — compared to pre-industrial levels.

As part of that, 196 parties agreed to reach peak greenhouse gas emissions as soon as possible and achieve climate neutrality by 2050.

This time around the UN Climate Change conference is being hosted by the UK in partnership with Italy.

It will take place from October 31 to November 12.

About Maxime Le Floch

Maxime is an analyst with Regnan's impact investment team. He focuses on Regnan Global Equity Impact Solutions Fund. Maxime has more than 10 years of experience in sustainable investment. Before joining Regnan he was an investment analyst with Hermes where he helped launch and manage the Hermes Impact Opportunities Equity Fund.

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Here are the main factors driving the ASX this week according to our head of equities Crispin Murray. Reported by portfolio specialist Chris Adams

WE SEE constructive signs emerging in recent market action after a period of consolidation.

Concerns over inflation and China remain heightened and persistent. Inflation, in particular, is likely to remain a key issue for markets for some time. But there are indications of small improvements at the margin for sentiment on these issues.

Further indication that concerns on these issues have peaked — combined with continued economic recovery and a period of seasonal strength in markets — could set up equities well into the year’s end.

It is far too early to declare victory in this regard. But equities moving higher despite ostensibly bad news, as we saw last week, can be a strong positive signal. The S&P/ASX 300 was up 0.65% and the S&P 500 1.84%.

Whether or not this continues in coming weeks is likely to rely heavily on US earnings season and Chinese data and policy signals.

Economics, policy and markets

The market has 3 broad concerns at the moment;

Inflation and its implications for policy tightening: The risk is that we start to see stagflation, where price rises choke off demand and economic growth, or that we see the Fed forced to tighten earlier, also weighing on growth.
Chinese growth: People are concerned that a slowing property market and power constraints will drive a sharper-than-expected slowdown in growth.
US debt ceiling: The fear is that political discord disrupts the government’s ability to function.

At this point there are signs that each of these issues may have reached a near-term crescendo, which is helping markets rally.

In the US, Congress and the Biden administration have been able to delay the debt ceiling issue to December. It hasn’t disappeared, but they’ve bought time.

Outlook on China

There are signs that China is addressing power shortages. Beijing is looking to source coal and gas from all available sources – including Australia, despite previous embargoes.

This will not flow through immediately, but the signal is that China is looking to solve the problem and not stubbornly stick to old policies.

Property remains more complex in China. The Evergrande issue has seen credit spreads blow out in the property sector. So far this looks contained within that sector and has not spread to other parts of the market.

There are indications in the data that monetary policy is too tight in China. There are various committee meetings this week which may result in some indication of easing.

Outlook on inflation

Inflation is the greatest long-term threat to markets.

In the past few weeks there has been a shift in expectations including a realisation that inflation is likely to be higher and more durable than previously thought.

At his Jackson Hole speech on 27 August, Fed Chair Powell was able to calm inflation concerns with the idea that it was transitory. His key reasons were:

It is not broad based
The largest surges are already receding
No threat yet from wages
Inflation expectations are anchored
Globally, pressure on inflation is downward

Since then inflationary pressures have strengthened, due to:

Expanding supply chain bottlenecks: Lockdowns in some countries and Chinese power issues have constrained production.
Labour availability: This continues to disappoint in the US, where it’s increasingly apparent there has been a reduction in supply, driving real wage increases and rising friction between employees and employers.
Commodity prices: Key inputs such as gasoline and power prices have continued to rise.
House prices: Continue to rise and are flowing through into rents.
Strong demand: Bolstered by re-opening and reducing delta concerns.

What was “transitory” is now being described as “transitory for longer”.

This is because the “transitory” argument is now falling foul of its own rationale outlined in the Jackson Hole speech:

It is not broad based: Inflation is showing up in a broader range of sectors as new supply chain problems occur and fuel prices rise. Last week’s CPI data shows prices in longer-duration areas are rising. Rents, for example, are increasing at their highest monthly rate since the housing bubble in 2006.
The biggest surges are already receding: This is true in some categories. In others, such as timber and autos, there have been recent rebounds. New auto prices were up 1.3% in the month.
No threat yet from wages: Average hourly earnings have not surged, but are steadily picking up.
- We are also seeing greater friction in labour markets. For example workers at machinery maker Deere and Co knocked back a front-loaded 11-12% wage increase over six years and called a strike for the first time in 35 years. This kind of action reflects the recognition that supply chains need to be shortened and the threat of off-shoring has diminished.
- There are further indications that early retirements and career changes are having a negative impact on labour supply.
Inflation expectations are anchored: This is still the case, but they are rising. The risk is this starts bringing forward consumption and drives higher wage demands.
Globally, pressure on inflation is downward: It’s true that inflation is less of an issue outside the US. But rising fuel prices are having an impact. The move in global bond yields indicates some concern on inflation.

The market realises the Fed is in something of a bind. It wants to promote growth while being mindful of the need to keep inflation expectations anchored.

The balance in recent weeks has been a shift in expectations to the Fed having to move sooner on tapering and rate hikes.

As a result we saw a “bear flattening” in bond markets, with two-year yields rising while 10-year yields remain flat. Despite this, equities and commodities made gains.

One factor could be that supply chain fears have perhaps reached their nadir. Freight rates from China to the US east and west coasts have rolled over recently.

Surveys suggest the proportion of US firms reporting inventories as “too low” has also rolled over.

The Biden administration has recognised the importance of this issue. It’s been working with stakeholders to keep the Port of Los Angeles open 24/7.

This alone won’t solve the problem. But combined with factories re-opening in Asia and private companies adapting their sourcing, it can help calm fears on the issue.

We see inflation as a key issue for markets going forward. But signs of alleviation in supply chain pressure, coupled with marginally better news on China and the US debt ceiling -- plus expectations of good US corporate earnings -- may continue to support markets in the near term.

US economic outlook

While the big risk issues are marginally improving, the outlook for US growth is also encouraging.

US retail sales were better than expected at +0.7% m/m, with positive revisions for the previous month. This means it’s holding up despite a surge in the past year. There is strength in discretionary spending (clothing, sporting, e-commerce) which was up 13.9% year-on-year (and 15.6% ex-autos).

Fiscal stimulus has played an important role in this. It also goes some way to explaining some of the supply chain issues we are seeing.

Consumer spending is expected to shift from retail to the service sector as restrictions are rolled back. It remains supported by $US2 trillion in excess savings as a result of stimulus. Income growth also remains greater than expenditure.

Markets

We are seeing some important and positive signs, such as:

Commodity prices appear to be breaking higher, having consolidated for six months. This reinforces the notion that concerns over supply chain issues may be peaking.
The sectors most affected by supply chain issues are beginning to perform. This suggests the market is looking through near-term issues and expecting a strong catch-up in demand next year.
Chinese bond yields have begun to move higher. They had previously been falling since the start of the year and were a decent signal on the impending Chinese slowdown.
The Australian dollar is rallying against the Yen — another positive cyclical indicator.
There are signs the equity market is broadening, with the small cap index stabilising versus the overall market.

In conclusion the market signals are more positive than the media headlines. This is often the right signal to watch for.

About Crispin Murray and 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 an independent, 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 here.

Contact a Pendal key account manager here.

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Stagflation is a buzzword in global markets at the moment. Is it really back to the 1970s? And what would that mean for investors? Pendal portfolio manager Amy Xie Patrick explains in this fast podcast

Listen to the podcast above or read the transcript below

Interviewer Sean Aylmer: Stagflation. It's a word we hadn't heard for a long time, but in the last few weeks or months, suddenly it's getting an airing again. What's behind that?

Amy Xie Patrick, portfolio manager, Pendal Income and Fixed Interest team:

Absolutely. I think the last time we heard about the word stagflation, and when it really was a theme, was when we thought about the oil shock crisis that happened in the ‘70s.

I think what's happened again this time round is that commodity prices, and these energy shortage stories -- all the way from Europe, throughout China and hitting a lot of emerging markets as well -- is making people think we're going through the same set of circumstances again, which could trigger stagflation this time round.

But I do think that for stagflation you need really growth to stall – not just slow – and you need inflation to be skyrocketing.

I think stagflation as a word to characterise what we're going through right now is a bit of an exaggeration.

Interviewer: Okay, so they're overplaying the slowdown in growth and they're overplaying the rise in prices – and that's why we're hearing stagflation?

Amy Xie Patrick Exactly. I think what's behind the rising prices is several fold.

Obviously because of the Covid pandemic and the crisis that ensued, there was a massive drop-off in demand.

Whenever there's such a massive drop-off in demand, the capacity always adjusts. The same goes for commodity capacity. The same goes for energy and fuel capacity.

When that capacity falls, it takes a long time to come online again. Furnaces don't just get switched back on. Miners don't manage to suddenly turn on a lot of capacity very easily.

As a result, as you've seen demand recover from the depths of the pandemic, the supply hasn't been able to really catch up.

So this is the first point that goes against this thesis of stagflation.

Demand is recovering. Vaccination rates are starting to really climb globally, even for those parts of the world that were really lagging at the beginning of the vaccination drive.

And as we see economies continue to open up, that demand recovery will continue to underpin some of the overall growth recovery that we're seeing globally.

So by no means do I see a picture where growth is suddenly stalling or going backwards.

And then on the inflation side, it's not just supply bottlenecks that are causing the fuel price rises and the commodity price rises. The demand side of the picture also seems pretty robust.

On the supply side, we have been told by a lot of policymakers in the central banks, not to worry about inflation because it is transitory. But some of them are starting to scratch their heads and think about how transitory.

I do think it probably leaves you with an inflation outlook that is slightly less comfortable than what we've been used to for at least the past five years.

Inflation – both headline and core – is likely to sit at or slightly above what central banks have as their targets.

Australia perhaps is one of the exceptions, because the RBA does target the middle of their ranges – 2.5 per cent as opposed to the rest of the world which largely targets 2 per cent.

But overall, just because inflation will sit at a slightly higher level than what we've been used to for the past five years, it doesn’t mean an inflation surge that suddenly becomes out of control.

Interviewer: So bringing that back to portfolio construction, if I'm hearing you right, we still have the same problem that we had six months ago. We may still have the same problem in six months time.

Amy Xie Patrick: Absolutely. You may not see yields go back to their all-time lows.

But by no means, are you going to see yields come back to the comfortable 4 per cent, 5 per cent or 6 per cent ranges where we can happily accrue a loss of income from our traditional fixed income portfolios.

Therein lies the problem for a lot of fixed income investors globally – and in fact portfolios as a whole.

If you've got still a lot of risk in your portfolio that is much more equity-beta driven, how then do you offset some of that risk with something that can be negatively correlated when those equity markets get into trouble – and in the meantime is still able to generate you sufficient income to offset some of those transitory or structural inflation concerns that are coming up?

I think that is the real challenge right now for fixed income portfolios.

For us at Pendal it really means thinking about using all the tools available to you in your toolkit.

Breaking down those traditional thinkings about the boundaries between asset classes and the boundaries between bonds and equities.

Thinking about where you can derive income from and where you can best use your levers to generate that alpha and those returns for still a very low-yielding world.

Interviewer: So how should we think about portfolio construction?

Amy Xie Patrick: Naturally it means you get pushed further out along the risk curve within fixed income.

You rely less on high-quality government bonds in the portfolio to provide you with that income, but you still leave enough of an allocation to those government bonds for safety.

For times, when you do get that sudden knee-jerk drop in equity market prices.

In the interim you search for income further along the risk curve in areas such as high-quality corporate bonds, but also diversifying into assets such as emerging market sovereign credit.

And that is ultimately the philosophy of how we make our income products.

The idea is to be able to generate steady enough income, that won't be jeopardised by the quality and default risks within your income-generating engine of the portfolio. And still keep some of that protection going with an allocation to government bonds in the background in case you need it.

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What can we learn as UK stocks outperform their global peers? We asked Pendal Group’s CLIVE BEAGLES

Post-Covid -- and five years after Brexit vote -- UK market is outperforming
British economy is growing fast as economy re-opens
Australia's re-opening is three-to-six months behind

FEDERAL treasurer Josh Frydenberg told Sydney radio this week that the United Kingdom's approach to re-opening was "really instructive" for Australia.

Despite a high infection rate, the British economy is growing fast and its stockmarket is out-performing its global peers.

"They’re still getting 30,000-plus cases each day, but their rate of hospitalisation has fallen by 83 per cent since the peak at the start of the year," Frydenberg told 2GB.

"As you know, they're not turning back -- they're living with the virus and so should we here in Australia.”

UK data supports his view.

Last week the UK's Office for National Statistics upgraded economic growth for the June quarter from 4.8 per cent to 5.5 per cent. The International Monetary Fund and the OECD expect the UK economy to expand at a 7 per cent clip this year, and around 5 per cent next year.

The FTSE100 gained around 1 per cent over the past month while other major indices in the United States, Japan, Germany and Australia were lower.

Five years after Britain voted to leave the European Union, the threat of a post-Brexit slowdown now appears to have well and truly passed.

“Whatever the reason, the conditions are right for the UK market to outperform,” says Clive Beagles, a senior fund manager at Pendal Group's UK-based asset manager J O Hambro Capital Management.

What can Australian investors learn from the UK?

If Frydenberg is right, what can Australian investors glean from the UK's re-opening experience?

"The fact that the UK is fully opened up now shows where Australia will go in three to six months," says Sydney-based Pendal portfolio manager Tim Hext.

We'll face similar issues such as demand outstripping supply and tighter labour -- and we have similar stockmarket themes such as higher exposure to commodities and lower exposure to technology.

In the UK, "employment is the main driver of growth at the moment ... the labour market is incredibly tight", Beagles says.

Labour supply issues supply should be a shorter-term issue in Australia as borders re-open, says Hext. The UK faces a more structural challenge on that front, reckons Hext.

Beagles says “the UK is more openly talking about raising interest rates … and bond yields have gone from 75 basis points to 120.

“While there’s a short-term focus on the cost-of-living crisis because of energy prices, there’s also this huge pool of savings ready to be unleashed.”

Stockmarket themes

The UK's economic pick-up underpins the stronger outlook for the FTSE. But several other factors that have worked against the UK market in recent years are now supporting shares.

The FTSE 100 has a heavy weighting to oil and gas and energy companies, including BP, Glencore, Anglo American and Royal Dutch Shell.

These have been less loved as support for environmental, social and governance (ESG) issues has grown. But as energy prices soar, hitting multi-year records, UK investors are again shifting into the oil and gas and coal companies, Beagles says.

The FTSE 100 gets around two-thirds of its earnings from outside the UK market, so it also depends on the global economy. But when the local economy gains momentum, sentiment for the bourse improves.

“The UK market also has a bias towards value stocks (there are relatively few technology stocks) and financials,” Beagles says.

“These can benefit from higher rates. And there’s a weighting towards commodities. Mining and oil companies tend to do well when rates are rising as inflation hedge.”

Combined it means UK equities are an attractive place to invest, he says.

“The day in the sun for the UK market might finally be coming after five years in the doghouse since the Brexit referendum.”

Australian investors will be hoping for similar as we re-open and learn to live with the virus.

About Pendal Group

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

Find out about Pendal's investment strategies

Contact a Pendal key account manager

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