Economic and Market Commentary

April 2024 Update from the Australia Trade Floor

Portfolio manager Rob Mead discusses why last month’s important shifts in central bank policies globally make the Australian bond market particularly attractive for investors right now.

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Lucy Garth, Head of Marketing, Australia and New Zealand
Welcome to this month's trade floor update with portfolio manager Rob Mead.

Rob, this month we've seen a couple of major moves by central banks globally. How should investors be thinking about these?

Rob Mead, Head of Australia, Co-Head of Asia-Pacific Portfolio Management

Yes, it's a really interesting one. So you're right. Policy makers, economies, markets are all diverging, which is great news first of all, for active managers like ourselves. And we start to put that into perspective.

So first of all, the Swiss National Bank cut rates. The market wasn't really fully expecting that. But it's a very clear reflection that the central bank feels like the tightening that they did for the previous couple of years now is meaning that their inflation outlook is consistent with their objectives.

On the other hand, Bank of Japan hiked rates for the first time since 2007. So complete divergence in terms of central bank activity. One reflecting the fact that inflation is coming back towards target. The other reflecting that inflation expectations are de-anchoring or re-anchoring into positive territory in Japan.

One of the really interesting takeaways from that, though, is that this is the first time for many, many years where we've had both policy rates from central banks and the entire treasury bond universe in positive territory. If you look back at 2020, almost 40% of that index was negative yielding.

So we've moved incredibly far. Maybe we've moved all the way. That remains to be seen. But the bulk of change in terms of interest rate levels is well and truly behind us. For the rest of the developed markets central bankers are really trying to calibrate how quickly their economies are moderating.

The US is a bit of an outlier. It's proving to be very resilient versus some of the other developed markets. I think we can put it down to at least three reasons, but there are multiple reasons why the US economy is more resilient.

So the first one is that fiscal policy has been very generous. We're moving into an election cycle, so expect fiscal policy to still be stimulatory. We also know that the vast majority of households borrow fixed rate in the US, so it takes longer to be impacted by a rising interest rate environment. And the US has also been the epicentre of AI. So some of these reasons mean that the US economy is being more resilient.

But given that backdrop, given the commentary I made around the central banks, our preference for active positioning in interest rates is to be underweight Japan as we see that repricing and then be overweight the markets that are more exposed to floating interest rates like the UK and like Australia.

Garth
So you mentioned Australia. Can we just focus there now and hear your views on the local bond market.

Mead
So for quite a while now we’ve suggested that policy rates at this level would be sufficient to slow the economy and bring inflation back to expectations. That conviction is even greater now that the RBA's moved or removed their hawkish bias, so very neutral at the moment, very balanced, which is encouraging.

We do still see some headwinds and tailwinds for the Australian economy, though. So clearly the headwinds in terms of population growth, the mismatch in demand/ supply in the housing market, keeping the economy reasonably buoyant, offset by sluggish household spending and also the growth trajectory from China being sub-par, which will start to impact iron ore prices. And we're already seeing that.

So some positives and negatives in terms of the Australian outlook. In terms of when the RBA will actually cut, I think that's a less relevant thing for investors because there's no point waiting for that moment.

And I can think of at least four reasons why investors should be doing something right now. So when you think about the first thing: that the most important driver of bond market returns is the starting yield. So investors should stop worrying about the scar tissue that they all feel from 2022 and focus on the returns we saw in 2023. So core bonds generating 5 to 7% returns.

Second thing is that the investment grade credit market in Australia has been incredibly vibrant and new issuers, a broadening issuer base, lots of liquidity and yields that are regularly north of 6%. So a great opportunity for investors to again do something now. Given this starting point in yields, we're also very confident that the negative or the lowly correlated asset class of bonds versus other risky assets will play a really key role in a portfolio context.

And the final thing is that when you think about the cost of de-risking, it's actually much lower than it's been for a long time. So a few years ago it was a decision between “do I de-risk from an asset class that may generate low double digit returns into an asset class that may return zero?” We're no longer making that decision.

Investors are now making the decision to de-risk from an asset class that may be high single digits into an asset class that may be mid to high single digits. So it's a much easier decision for investors to make and they should be making that decision.

Garth
Thanks, Rob.
As you've heard, investors who may be waiting for the RBA to cut rates before investing in bonds again risk missing some attractive opportunities on offer today. If you've got any questions or you'd like more information, please visit our website or contact your PIMCO account manager.

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