GLOBAL fixed income markets have been marching to a common theme lately.
Inflation data have been on an upward trend and there seems to be consensus that inflation will climb higher still.
Market pricing for rate rises from major central banks is outpacing what the policy makers themselves are saying.
Inflation will be going higher over the next couple of quarters. That theme is global since the driving forces behind the trend are global.
Supply chain disruptions coupled with higher goods demand have affected us all. As lockdowns lift and consumption normalises, there will be a handover from goods inflation to services inflation.
There is an assumption that rising wage pressures will be an equally global theme.
That is not the case. As RBA Assistant Governor Lucy Ellis pointed out this week, market fixation with labour market patterns offshore is leading to an overly optimistic outlook for wage developments in Australia.
Labour force participation rates in the US have been slow to recover since the depths of the pandemic. That same degree of sluggish return to work need not apply to Australia.
Initiatives such as JobKeeper have been instrumental in maintaining a link between employers and workers.
In the US, the fiscal response was aimed at generous unemployment benefits. So generous at first, in fact, that many workers chose to quit their jobs so they could access a better income stream.
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Another difference is the health policy response in handling the pandemic.
In the US, despite attempts at various lockdown measures, Covid has unfortunately run rampant in the community. In Australia, a zero-Covid strategy until very recently has produced a far better population health outcome.
While the US vaccination rate seems to have stalled around the 60% mark, Australia’s vaccination rates continue to climb. New South Wales passed 92% this week.
For the US, this translates to slower re-entry into the labour force by workers who are still legitimately fearful of contracting the virus.
The resulting picture differs for wage pressures in Australia and the US.
Sure, both central banks are willing to let things run hotter for longer. But the heat is far more intense in the US.
Nevertheless, the market prices a matched pace of rate hikes for Australia and the US in 2022. Either the Fed will need outpace the market, or the RBA will prove the market wrong.
Likely driven by the fear of rate hikes translating into higher refinancing rates next year, the pace of corporate issuance has been heavy so far this month, especially offshore.
European and US credit markets have seen higher-than-typical new issuance volumes in the past two weeks.
Despite continued inflows into both sectors, the supply deluge has been weighing on credit spreads — and hence the secondary market performance of many of these new deals.
In Australia the new issue pipeline has also been solid — about $3.5 billion of benchmark deals hit the market this week.
Issuers have ranged from utilities and banks to commercial and industrial real estate investment companies.
Contrary to the offshore credit climate, however, demand appetite remains very robust in Australia. Most deals have been able to price at the tighter end of price guidance and perform well in the secondary market.
The higher yield environment would usually be a particular headache for emerging markets, especially accompanied by a climbing greenback and slowing China.
On the whole, emerging market hard currency sovereign debt has been resilient in the face of yield climbs so far this month, with yield-related widening in spreads broadly in line with global high yield.
This is because most emerging market central banks have been proactive and keenly aware of inflation pressures.
They have no desires to invite an ugly currency-inflation spiral. Moreover, the global economy is still in good shape, in spite of China’s property-driven slow-down.
The key driver of volatility for emerging market sovereign risk has been the volatility in Turkey and in particular around the currency.
This volatility stems from the Turkish’s president’s unorthodox views on the relationship between inflation and interest rates — and hence the high turnover of the leadership of the Turkish central bank.
A noteworthy improvement now versus the last Lira crisis in 2018 is the composition of the country’s external debt rollover risk.
A lot of the maturing debt is held by the government or institutions that have historically exhibited high roll-over rates even in times of crisis.
Our portfolios currently have no exposure to the Turkish Lira — or any other high-beta local emerging market risk.
Our income strategies employ a tactical allocation to the USD emerging market sovereign index. Turkey is a component of that.
We expect political developments in Turkey to continue punctuating sovereign credit spreads with bouts of volatility, but current market pricing is also compensating investors for that volatility.
Our exposure remains highly liquid and our investment process tunes into left-tail risks.
These are aspects of our investment philosophy that will help us to de-risk promptly and efficiently out of emerging markets when warranted.
This information has been prepared by Pendal Fund Services Limited (PFSL) ABN 13 161 249 332, AFSL No 431426 and is current as at November 25, 2021.
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