Economic and Market Commentary

July 2022 Update from the Australia Trade Floor

Adam Bowe discusses how investors should prepare for rising recession risks.

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Text on screen: John Valtwies, Account Manager

Valtwies: Welcome to this month's Trade Floor Update.

Well, Adam, it's the start of a new financial year, and often at this time of year, investors take the opportunity to reassess their own portfolios.

Now, when we look globally, we see that central banks are moving towards higher interest rates and our own RBA is on their determined path for higher interest rates to rein in some inflation.

So as investors look out to the new financial year, what can they expect?

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

Bowe: Well, I think next year, next financial year is going to be another challenging one JV, for both investors and Australian households.

We've got higher mortgage rates expected, as you said, really elevated cost of living already and rising recession risk as we look out. So I think it's going to be increasingly a year when investors pivot from worrying about inflation to worrying about recessions.

And there's a few reasons why recession risks are rising. You know, the important one is there's always a level of interest rates that stops investing and spending. And central banks have said they'll do whatever they need to do to get inflation back down.

You can just take the RBA, for an example. The RBA has already got interest rates back to 1.35. That's higher than it was before the pandemic. You have to remember that when we hit the end of 2019, the cash rate was just 0.75%, so 1.35 gets it back close to where it was all the way back in 2016, which is one and a half. And as we look at the next 12 months, financial markets are expecting them to get it up to around three and a half per cent by second quarter of next year. We haven't seen three and a half per cent since 2012.

So it's taken the RBA ten years to get from three and a half per cent down near zero and the financial markets expect them to get it back to three and a half in just a 12 month window.

So, recession risks are real. I think it's going to be a challenging one and monetary policy does need to be tight.

We're starting at very elevated inflation and very low unemployment. But every 50 basis point hike in interest rates from central banks, I think reduces the risk of inflation going forward and increases the risk of recession.

Valtwies: Adam, given that backdrop, I cast my mind back to our previous Trade Floor Updates where we've emphasised the importance of reducing underweights to duration and building portfolio defences.

Today when we look forward and think about that environment for the next 12 months, what are some of the ways that investors should be thinking about their own portfolios? How do they construct a portfolio when you've got stubbornly high inflation combined with rising recessionary risks?

Bowe: It is a really challenging backdrop, as you mentioned. So I think as investors sit down to start the new financial year and look at their portfolios, they should be thinking about how they can build some or rebuild some more resilience into their portfolios.

So thinking about going up in quality, up in liquidity and it's really important not just so that their portfolio fares reasonably well through an environment of rising recession risks, but so they have liquidity and dry powder to deploy capital because I think the next financial year probably provides some really attractive opportunities to redeploy capital.

So as you mentioned, we've been adding back some duration into our portfolios. So for clients that are underweight bonds, we still think that's a reasonably attractive opportunity.

Core bond funds have yields of between 4.5% and 5%. That compares really well against a lot of other asset classes, whether it's residential property yields, whether it's high dividend stocks. It's very liquid, high quality.

And from these starting level of yields, it's not just the yield that you're earning, it's the starting level of yields, bonds have the potential to provide that buffer, that cushion or that defensive characteristic to your broader portfolio

If we pivot into a state of the world next year, that is recessionary. So that's important as well.

And to keep in mind as well, the bond market is already pricing in central banks to get cash rates above 3%. You know, in places like Australia, New Zealand, Canada and the US, around 3, a little bit more than 3%.

So all else equal, if central banks keep increasing cash rates to above those levels, the impact on bond returns should be fairly minimal. We've already factored that in. That's why the last financial year was so challenging for bond funds.

I don't think you can say that for every other asset class around the world. So that's really important.

So as we look out over the next financial year, rebuilding resilience, going up in quality, up in liquidity, investing in areas of the financial markets that should do reasonably well as recession risks rise. And I think that's the landscape we're going to be in.

So rebuilding resilience is important.

Valtwies: Well, thanks, Adam. To learn more about our outlook for interest rates, we've just published our Secular Outlook “Reaching for Resilience”, which you can access on our website pimco.com.au

Have a great day.

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