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May 2022 Update from the Australia Trade Floor

Aaditya Thakur discusses the latest rate rise and what it means for investors.

MORE ABOUT INFLATION AND INTEREST RATES

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Text on screen: Hugh Holden, Senior Vice President, Australia

Holden: Hello, I'm Hugh Holden. I'm joined today by portfolio manager Aaditya Thakur.

And we have lift off! At their May meeting, the Reserve Bank of Australia raised the official cash rate for the first time in over a decade by a quarter of a per cent. That takes it to 35 basis points, and that was off the back of a higher than expected inflation print for the first quarter, which also took Australia's year-on-year inflation rate above the Reserve Bank's target range of 2 to 3%.

So Aaditya, first cash rate rise in over a decade, inflation running above target. Is the Reserve Bank now behind the curve and are they going to have to move really quickly to try to get on top of things?

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

Thakur: So when central banks raise interest rates, they're willing to give up a little bit of growth to curb inflation. So in terms of the pace of hikes that are required, it really depends on the degree of inflation overshoot.

So when we look at the data, underlying inflation is now at 3.7% and it's expected to rise to around 4.5%. Wages are running at 2.6%, expected to rise to the low-3s, and that’s relative to the top end of their target band of 3%. And, in the context of fairly stable inflation expectations.

Now contrast this to the Fed, where headline inflation is 8%, core inflation 5.2%, and wages running at a hot 4.5 to 5%.

Holden: That's in the US.

Thakur: That's in the US. And that's relative to a lower inflation target of 2%. So I think the urgency is much less for the RBA. They're in a position of strength on a relative basis and that can afford them the ability to raise rates at a standard pace, say 25 basis point increments, over the next few meetings.

Holden: OK. And so that's I guess the pace to expect over the next few meetings. But what about the end point? How high do we see rates moving?

Thakur: I think this is the more interesting question. When we look at the first slide, when we compare Australia and the US, given that they've got quite different inflation overshoots, both markets have forecasted or priced in for cash rates to reach almost 3.5% by the middle of next year.

Text on screen: Global central banks sharpened their focus on tackling elevated inflation

So in Australia, in particular, we think that that's too much. To get cash rates to 3.5% would imply mortgage rates would move to 5.5 to 6.5%, and that we think would be too much of a negative impact on consumption and house prices, and a trade-off that the RBA won't be willing to make under this kind of inflation outlook.

So we expect them to raise rates to around 2 to 2.5%. We think that gap between our expectation and market pricing is more a reflection of risk premia rather than a genuine, expected move in the cash rate. And when we think about that risk premia, it's really extra compensation investors want due to elevated volatility due to inflation, central bank uncertainty and COVID.

Now if I can cast everyone's mind forward three to six months, we would have had a few hikes out of the way, so uncertainty around central banks will be reduced. The inflation outlook, it's likely that inflation would have peaked and we'd have better clarity on the inflation trajectory, and COVID is that much further behind in the rear view mirror.

So I think that risk premium will start to come down, and in the second half of the year, price action will be determined by valuations as opposed to volatility like in the first half of this year.

Holden: Ok. And then valuations, maybe that's a good final point. We have seen a big rise in yields. We've also seen credit spreads widening. So what sort of opportunities does that create?

Thakur: Yes, I think in the extreme volatility that we've seen, it's often easy to lose sight of valuations. We think US Treasuries at around 3% and Aussie bonds at around 3.5% are now constituting good value over the medium term.

So we're having a lot of encouraging conversations with clients, particularly those that have been underweight bonds, to start reducing those positions. And that's something that we're looking to do in our own portfolios.

Secondly, when we look at the second slide and we look at valuations across other asset classes and we look at what's changed, what's moved to incorporate this higher inflation, higher interest rate outlook, the one thing that stands out to us is investment grade credit. Investment grade credit spreads have widened a lot and they're offering some good value.

Text on screen: Dispersed valuations reinforce the importance of active management and selection

And bringing it back to Australia, we see value in subordinated debt in the major banks, in high quality REITS, names such as Charter Hall, GPT, Dexus, Lendlease, and also some key infrastructure-related assets, things like WestConnex, Transurban Queensland, all these bonds are now offering yields of 5% or above. And we think that that constitutes really good value over the medium term.

Holden: Ok. And I guess as a bond manager, the advantage of that shift higher in yields being so rapid is that of course we're reinvesting coupon payments and proceeds from maturing bonds every day at those higher yields. So it does have a benefit for investors in terms of the yield on portfolios and forward looking returns.

Hopefully you found that useful. If you do have any other questions or want any more information, please visit our website at pimco.com.au. Thank you.

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