Economic and Market Commentary

February 2022 Update from the Australia Trade Floor

Aaditya Thakur discusses the latest market and policy developments impacting the investment environment.

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Text on screen: David Erdonmez, Head of Research, Consultants and Product

Erdonmez: Hi everyone, thank you for joining us for our first trade floor update of 2022. My name's David Erdonmez. Today I'm joined by Aaditya Thakur, the lead portfolio manager for our Australian short-term bond fund. Aaditya, thanks so much for joining us today.

Thakur: Thanks, David and thanks everyone for joining.

Erdonmez: We've been seeing quite a sizeable shift in interest rate expectations occurring over the last quarter. Can you talk us through what we're seeing in terms of the outlook for monetary policy in 2022, particularly maybe with the Fed and the RBA now being in play for hikes this year?

Text on screen: Aaditya Thakur, Portfolio Manager, Australia and Global

Thakur: Yeah, sure. So with the ongoing pandemic, with the Omicron variant, still causing a lot of disruptions and adding to the noise in economic data, one thing that has become abundantly clear, however, is that the level of inflation has become uncomfortably high for several central banks around the world.

So they are now quickly pivoting towards removing monetary policy support away from emergency level settings to something of a more neutral stance.

So if we think about the Fed, they look set to start raising interest rates as early as March this year. They've left open the prospect of raising rates at each consecutive meeting, as opposed to a more modest pace of say once a quarter. And they've also pulled forward expectations of reducing the size of their balance sheet via quantitative tightening, which may begin in the second half of this year as opposed to next year.

Now, closer to home, the RBA, announced an end to their QE programme and they also drastically increased their inflation forecasts. So they now see underlying inflation being above the mid-point of their 2 to 3% target for the next eight consecutive quarters. So that clearly opens the door for rate increases in the second half of this year, should they get the final piece of the puzzle, which is slightly stronger wage growth.

Now, despite all of this, it might surprise some of you to know that the 10-year interest rate in the US, the 10-year government bond yield, is about 1.8% and that's only about 5 or 10 basis points higher than what it was at its peak last year. And that's just because the bond market has been gently rising since the fourth quarter of 2020. The bond market has been re-adjusting and repricing to the prospect of earlier rate increases and faster removal of monetary policy support.

I mention all of this because the long end interest rate is really embedding, really already pricing in a return to more neutral levels of interest rates. And as we've outlined in our latest cyclical outlook, we expect a peak in growth, a peak in inflation and a peak in monetary policy support in the first half of this year. And that's generally a recipe for high volatility.

And that volatility is precisely because other asset classes have to now play catch-up to the bond market and re-adjust and re-price to the prospect of higher interest rates and lower levels of central bank liquidity.

Erdonmez: So these are really interesting points that you're raising here, Aaditya. If I think about the aspects around rising rates, I guess a more volatile environment going forward, I think the key question to ask is what are we doing in our portfolios at the moment? But also what clients should be thinking from a risk and return perspective going forward?

If I think about some of your comments around interest rates moving higher, I think about things like carry in our portfolios at the moment being significantly higher than what it's been in the past. So maybe if you would add some colour on that, that's be great for our viewers.

Thakur: Yeah, sure, I think there are three main things I'd like to convey. The first one is, as I mentioned, the bond market has for some time now been re-pricing and re-adjusting to the prospect of monetary policy support being removed.

I think investors have to look across their entire asset allocation and make sure that other asset classes that they're invested in are also adequately re-adjusting and re-pricing to this new reality.

When we look across other asset classes, things like growth assets, equities, for example, they've only just started that process at the start of this year. Whereas other asset classes like commercial property, real estate, and residential real estate I should say, haven't begun that process at all.

So I think investors, first and foremost, have to look across their asset allocation and make sure they're not overly exposed to sectors and assets that haven't re-priced to this new reality.

Now, secondly, a somewhat related note, I would say that over the past 5 to 10 years, we've had this low inflation environment and that's allowed central banks to remain very dovish. And that's provided somewhat of a safety net for investors and rewarded a buy-the-dip-type mentality.

But given the level of inflation now, central banks are effectively removing that safety net. So I think investors need to recalibrate what they see as value. They need to make sure that they're getting adequately compensated for higher interest rates and lower levels of liquidity.

And so on a third point I would say investors really need to think about expecting a re-rating of liquidity risk within the next few months.

So putting that all together, we're simply following the same advice in our own portfolios. So we're expecting still a modest further increase in interest rates by being short duration. We've lowered our beta to risk assets. And we've been looking to increase our liquidity buffers in our portfolios.

And finally, I'd say that we've been looking for more relative value opportunities. Looking for markets, places like New Zealand, where we've priced in not just a return to neutral interest rates but actually well above neutral interest rates. So we're happy to be invested there whilst being underweight in other countries, which haven't quite fully priced in a return to neutral interest rates.

So they're the main things that we're doing in our portfolios now.

Erdonmez: Thanks so much, Aaditya for those comments. Thank you for joining us. If you'd like more information, please go to pimco.com.au or please feel free to contact your PIMCO account manager.

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