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Economic and Market Commentary

March 2022 Update from the Australia Trade Floor

Rob Mead discusses the latest market and policy developments impacting the investment environment.

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Text on screen: John Valtwies, Account Manager

Valtwies: Welcome to this month's trade floor update. Rob, we caught up a few weeks ago, it's fair to say that we were probably set for a number of interest rate increases this year, with markets already pricing in the RBA to hike, the Fed to hike.

Fast forward to where we are now. A lot's changed. There's obviously significant events taking place in Europe. Can you distill for us what's going on in the global economy and in markets?

Text on screen: Rob Mead, Head of Australia, Co-Head of Asia-Pacific Portfolio Management

Mead: Yes, it's a turbulent time to say the least. But I think the most important takeaway for investors and the bond market is that some of this normalisation of policy is still somewhat inevitable.

But we've always thought that the extreme uncertainty that we were in, and that the phase that we're in, meant that the speed with which policy was normalised and the destination were uncertain. And I think that's already showing up in terms of the adjustments to market pricing.

I think the other really important thing is that there's some other issues that we need to grapple with too, in terms of inflation, what the inflationary impulse looks like going forward. We're hoping that we're seeing the beginning of the end in terms of the Omicron variant, but again, we still don't know. We also know that central banks are moving from a QE style backdrop to potentially QT. That has liquidity implications for markets.

So all of these things generate even more uncertainty. So from an investment point of view, you want to be pretty close to your structural targets rather than taking any very significant risks.

Valtwies: So you talked about central banks. What does this mean for expectations for this year?

Mead: Well, I think there's still going to be some normalisation. And again, the geopolitical backdrop makes that less certain. But there will be a path to normalisation. And I think the really important takeaway, and we talked about this many times over the past decade, in fact, is that this new neutral concept still holds.

So we still think that rates getting back to that 2% range, maybe into the low twos, in most developed economies that will feel like policy is genuinely tight. So when I look across markets at the moment, some of those markets are already priced for that – and priced for more than that.

So even with some uncertainty in the backdrop, places like New Zealand, rates had already been pricing more than 3% as a policy rate. That represents value to us. Other jurisdictions still have further to go in terms of some of that normalisation.

Valtwies: So let's look at the portfolio. How should investors be thinking about bonds today? What are some of the key messages our audience should be thinking about?

Mead: Yes, as we've talked about before, bonds do multiple things in a portfolio context. So core bonds, especially the very high-quality US Treasuries, European bonds, Australian Commonwealth Government bonds, all being the natural safe haven asset. That's never going to change.

And we'll say that in terms of bouts of volatility, we'll see that flight to quality. That will stay with us, obviously providing a tremendous benefit in terms of portfolio diversification.

And the other extreme of the bond market, we have the income generation. And again, as credit spreads widen, they were widening already. So again, partly reflecting that move from a very liquid QE environment where low interest rates have meant that all asset prices were elevated.

Some of that credit spread repricing is already taking place. In fact, in our own market, we saw Australian bank bonds five-year bonds senior debt – we're not talking about subordinated debt – already with a 3% yield only a few days ago. So those sorts of things representing a tremendous opportunity for income generation.

And finally, there's always going to be the illiquid sector, the private sector, especially in the structured credit space, where we see tremendous value and tremendous opportunity to generate income, even under really stressed environments. That's part of our role to understand how they perform and under extreme stress.

Valtwies: Well thanks Rob, and thank you for joining us today. For more ongoing updates, please visit pimco.com.au.

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