Economic and Market Commentary

February 2024 Update from the Australia Trade Floor

Portfolio Manager Adam Bowe discusses why it’s important to construct portfolios that can deliver resilient income amid falling interest and term deposit rates

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Text on screen: John Valtwies, Account Manager

Valtwies: Welcome to the first trade floor video of 2024.

Well Adam, in 2023, I think it's fair to say investors were afraid of the bond market, afraid of the possibility of another sharp increase in interest rates.

Just to recap, can you distill what took place over 2023?

Text on screen: Adam Bowe, Portfolio Manager, Fixed Income, Australia

Bowe: Yes, you're right. Investors were fretting about the bond market. I think, there's always a level of interest rates that stops people borrowing and spending. I think in 2023, central banks in most parts of the developed world reached those levels and so when you, despite volatility, when you look point to point, ten year government bond yields in Australia and in the US started close to where they finished around 4% and despite the cash rate.

So the RBA and the Fed lifting policy rates by another 100, 125 basis points, the impact on bond returns is pretty muted. That was largely expected and priced into markets.

So when interest rates are more stable, you tend to earn your yield or carry in a bond fund.

So for high quality core bond funds, it doesn’t matter if it was Australian ag composite style or global aggregate hedge to Aussie or investment grade credit hedged to Aussie dollars, returns of around 6%. It’s pretty reasonable for a year when the cash rate averaged in the high 3% area.

So we've been saying it for a couple of quarters. The opportunity in core bonds hasn't

looked this attractive in over ten years.

Valtwies: So I guess with that backdrop and thinking about the year ahead now, we've already seen the Fed announced they're on hold for now.

The RBA as well for now, but we know they're likely to be patient. With that in mind and the prospects for a soft landing, or that's what the markets are certainly pricing in, what should investors focus on this year?

Bowe: We do think that most central banks around the developed world have reached or really close to reaching their peak in policy rates this hiking cycle. And in fact, as we navigate 2024, interest rates in most parts of developed world will start to come down.

So why do we think that? Starting point of policy is really tight. Inflation is moving back towards

target and unemployment rates are drifting higher.

For context, if we just focus on Australia, for a minute. If we look at the percentage of income

households are having to dedicate to paying interest on their mortgage and paying tax to the government, it's never been this high.

So both monetary and fiscal policy are really tight here, which explains why household spending has been so sluggish.

So certainly expecting as we move through 2024 central banks will start to bring interest rates down. So for investors, they need to start turning their mind to portfolio construction, in an environment of declining interest rates.

So for context, in the US, the markets pricing the Fed to lower interest rates by about 2% over a couple of years. About half that in Australia.

So the challenge for investors that have built up large piles of cash in term deposits is, how do I maintain resilient levels of income in my portfolio as these start to reset and roll off at much lower levels of interest rates?

So that's the challenge.

The opportunity is, the flip side to the opportunity we had in 2020, which was we got the chance to lock in low rates on our mortgages. 2024 the opportunity is we get to lock in high interest rates on our income producing assets before they start to come down and, for core bond funds,

we think it presents the most compelling opportunity for investors to do that.

The starting yield’s around 5%, and they have daily liquidity.

Valtwies: Well, thanks, Adam.

And some important takeaways there for the year ahead as we move into an environment of lower interest rates, now is certainly the time to be allocating to bonds with starting yields at 5 to 6%.

To learn more, please get in touch with your PIMCO Account Manager.

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