Text on screen: David Orazio, Account Manager
Orazio: Welcome to this month's trade update. Today, I'm joined by portfolio manager Aaditya Thakur.
July's inflation data confirms that inflation is falling and trending in the right direction. However, it is still above the RBA's target band. What does this mean for markets?
Thakur: Yes, we've had some really good news on inflation recently. When we look at near-term trends in inflation, as you can see in the slide, depicted by three month annualised rates of core inflation both in the US and Australia, it has been coming down quite quickly and we kind of expect a couple of more benign inflation prints in coming months to reinforce this trend of disinflation.
Now what that means is that it's helping to bring consumer inflation expectations down and that's providing central banks with a lot of breathing space to go on pause, much like we saw with the RBA. Potentially an extended pause to assess how economies handle the ongoing tightening that's still feeding through the system through the second half of this year.
So as central banks go on pause. Markets are placing more weight on the chance that the hiking cycles are done and the range of possibilities around the hiking cycle is also narrowing. So markets are saying really that they're either done or they've got one more at most to go. And as that range of possibilities narrows, it's helping to bring bond volatility down, and that is helping to result in a relief rally across all asset classes.
Now, whilst the near-term trend is good, when we look a bit further beyond the next couple of months, we think that the risk to inflation is a little bit more balanced and wages are still growing at too high a level given the tightness in labour markets all around the world. Wage growth is still inconsistent with longer-term central bank inflation targets given the level of productivity that we're seeing. So at some point, central banks may have a very difficult question, do they keep policy at a very restrictive level for longer to squeeze out that last bit of inflation and get inflation down from three down to two? Or do they kind of accept that high to low 3% inflation is good enough? And we think that different asset classes are making vastly different assumptions to that underlying question.
Orazio: Now, I do want to pick up on your comment in terms of the relief rally, we have seen equity markets and real estate markets recently price in a soft landing. Is that a realistic scenario? And what's the outlook for recession?
Thakur: Yes, certainly risk assets, growth related assets are pricing in a very high probability of a soft landing. Implicit in those valuations is also the assumption that central banks will soon declare victory on inflation and then cut policy rates from very restrictive down to more neutral levels. But we think that there's a significant risk that central banks keep policy at a tight level for longer than expected to really squeeze out that last bit of inflation.
And certainly valuations for risk assets aren't providing much buffer for that type of scenario. However, we think that the bond market is pricing in a decent probability of that scenario. And that's why when we look at slide two, we can see that both under the scenarios of interest rates staying around current levels for longer, or recession scenarios, and bonds do reasonably well with strong positive returns.
And even if we're wrong and interest rates go up even more from here, given the high starting level of carry of 4% to 6% for bond funds, that the downside is fairly limited under those type of scenarios. So we think overall that the bond market is better placed on a risk adjusted basis and covers more bases and more scenarios than other risk correlated assets.
Orazio: Thanks Aaditya, I really appreciate your insights today.
Now, it's no doubt that the recent slowdown in inflation has provided central banks some much needed comfort. However, with equity markets and labour markets partying like it's 1999, we believe it's a little premature to declare an emphatic victory just yet. Now, given the uncertain outlook and the lags in monetary policy only now starting to affect the real economy, we believe it's prudent for investors to revisit their defensive allocation to build resiliency in their portfolios.
If you have any further questions or would like further information, please reach out to your PIMCO account manager.