Economic and Market Commentary

March 2024 Update from the Australia Trade Floor

Portfolio Manager Aaditya Thakur discusses why now is the best opportunity in over a decade to de-risk from equities into fixed income without giving up much return.

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Text on screen: David Orazio, Account Manager

Orazio: Hi, and welcome to this month's Trade Floor Update. Today, I'm joined by Portfolio Manager Aaditya Thakur.

AT, thanks for joining us today.

Now, we're hearing from advisers that many of their clients are in fact waiting for the RBA to start cutting rates for them to reallocate back into fixed income in a meaningful way. What's your take on this approach?

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

Thakur: Yes, it's understandable to see this kind of hesitancy. I think clearly people are still anchored in fixed income markets through 2022 and the first half of 2023. And this kind of recency bias though, is a bit of a mental trap.

As investors, we need to be forward looking. And when you look at the current economic environment, three things are really clear. Inflation is coming down back towards central bank targets. Growth is now slowing to below potential and that means unemployment rates are creeping higher around the world. So that's keeping central banks firmly on hold and they're now explicitly telling us that they will be thinking about easing in the second half of this year.

Now, there might be a little bit of volatility as markets continually re-price exactly when rate cuts will happen, and the degree of the cutting cycle. But ultimately, the range of possibilities or the distribution of outcomes is narrower now than it was over the last two years. So that's helping to bring volatility down and keep bonds in a fairly range bound environment. And that means investors can earn a positive carry given attractive starting yields of 4 to 6% for core bond portfolios.

Now, we tried to put some numbers around this in terms of what does the history tell us. And as you can see in the first chart here, we’ve gone back and had a look at the last 40 years of Fed hiking cycles and looked at 12 month forward returns for bonds relative to when they reached their peak in the cash rate cycle.

As you can see, bond returns start to turn positive on average about four months prior to reaching the peak in the cash rate. And they really turn very positive around eight months after the peak is reached. That's typically when economies have tipped over into recession.

Now, as it stands, the Fed has been on hold for six months, the ECB for five months and the RBA since November. So really, history is telling us this is the optimal time to allocate to fixed income. I'd put it a little bit more simply, the time to buy insurance is when it's cheapest. When you're getting paid 4 to 6%. If you wait for when you really need it, it's going to be too late.

Orazio: That's a great way of putting it. Now, thinking about the high yields on offer in fixed income today, you did mention obviously high quality core bonds yielding 5, 6%. Great attractive entry point for investors. Now, in January and February we've seen some record levels of corporate issuance, particularly in the Australian marketplace. Can you talk us through what opportunities this presents investors?

Thakur: Yes, it's definitely been one of the biggest and most busy starts to the year in terms of primary markets. They've had some CapEx plans that they've deferred over the COVID era, which they're now starting to put in place. So they've got some funding needs.

A good example are the airports. They need to build new runways, new terminals, particularly given the population growth that's forecast over the next ten years. So we've had transactions from Perth airports, Brisbane airports doing 7 to 10 year deals coming at yields of 5.6 to 5.9.

We've had Telstra, again a very  defensive and monopolistic company, issuing ten year bonds at around 5.6%. And more recently we've had Aurizon Networks come, they are a rail transport operator in Queensland in the commodity sector, again a monopolistic and regulated asset base, high quality, and they've been issuing seven and a half year bonds at around 6.1%. So really attractive defensive high-grade bonds at yields which are not too far from forward earning yields for equities.

So when we look at it in an aggregate sense, as the second chart shows, looking at the yield to maturity on the Australian Composite Bond Index compared to the forward earnings yield for the ASX 200, that spread is the tightest it's been in over a decade. Whereas our discussion earlier was really about macro top down reasons to invest in fixed income, even from a bottom up perspective, you're seeing really attractive opportunities where investors can deallocate from equities into core fixed income and really not give up that much return. Again, this is one of the best opportunities to do so over the last decade.

Orazio: Thanks AT, I really appreciate your insights today.

Now, as you've heard today, the fixed income market offers a wide variety of opportunities for investors to build robust, high quality portfolios that generate really attractive levels of income.

We'll soon be embarking on a national roadshow around the country with our portfolio managers who will delve deeper into many of these opportunities. If you'd like to attend, please look out for your invitation, visit our website, or contact your PIMCO account manager.

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