AT THE END of September we were trying to understand market pricing versus what the Reserve Bank was saying.
Governor Lowe had been at pains to say the RBA would not hike rates until inflation was sustainably at its 2.5% target.
Yet markets were pricing for higher rates, while expecting inflation at only 2%.
Unless your view is Governor Lowe will change his mind, something must be wrong. Given his term is up in September 2023, an about-face is not likely.
The question is whether rate rise expectations are too high or inflation expectations too low?
How will the circle be squared?
As mentioned many times before, our view is inflation will rise to 2.5% in late 2022 and into 2023 — so we expect higher rates in 2023.
We also own inflation bonds against being underweight in nominal bonds (in portfolios where they are allowed).
Of course it pays to remind investors that a nominal yield is made up of a real yield and inflation.
A fixed rate bond “fixes” a level on both of these. An inflation bond fixes the real yield but the inflation component is floating — that is, actual inflation.
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So the higher inflation goes, the more inflation bonds outperform nominal bonds.
This past week has seen bonds continue their sell-off on global inflation fears.
Expectations are now for cash rates to hit 1% in 2023, consistent with our view. We have closed underweight duration positions but will be leaving our inflation bond position on for now.
Equity markets and credit markets continue to adjust to a world of lower monetary support. So far moves have been modest and largely well behaved, consistent with a relatively smooth transition.
If we are right and inflation moves modestly higher it won’t upset the overall positive outlook for risk markets.
Maybe what’s happening is markets are beginning to price a risk, albeit a low one, for a world where inflation pushes far higher than 3%.
Stagflation always gets wheeled out at these times.
There is a chance of short-term stagflation on supply issues, but it is certainly not our medium-term base case.
Just don’t expect double-digit returns on risk assets going forward.
Tim Hext is a portfolio manager with Pendal’s Income and Fixed Interest team (formerly Bond, Income and Defensive Strategies).
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. In 2020 the team won the Australian Fixed Interest category in the Zenith awards.
With the goal of building the most defensive line of funds in Australia, the team oversees $A22 billion invested across income, composite, pure alpha, global and Australian government strategies.
Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.
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