Economic and Market Commentary

May 2023 Update from the Australia Trade Floor

Portfolio Manager Adam Bowe discusses the rationale behind the RBA's rate hike and its implications for our economic outlook and investors.

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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 Adam Bowe.

Adam, after pausing last month, the RBA threw a bit of a curveball and surprised markets by hiking the cash rate by 25 basis points to 3.85%. What's the rationale behind that decision and has it changed our outlook in terms of rates and the economy?

Text on screen: Adam Bowe, Portfolio Manager

Bowe: Well, I think the key driver, David, was another inflation report that passed that shows that inflation’s still elevated. Sticky components like services inflation are still very high and they're not expecting the RBA's forecast inflation to come back within the band for a long time.

Still in the middle of 2025, they’ve still got it at the top of the band at 3%. So they did raise rates again by a quarter of a per cent. But importantly it hasn't changed our view on the destination and impact over the next 12 months of where policy is. We've been saying since the middle of last year that we thought policy had to be very restrictive.

Inflation was extremely high, multi-decade highs, unemployment rate was multi-decade lows, policy had to be very restrictive. And we thought that between three and a half and 4% was where it would start to really bite. And we're in that zone now. The fact that the RBA is going through a stop start process every month and the fact that we're seeing still very elevated volatility in global financials, equity markets around the world week to week makes us more convinced we're closer to the end of the cycle.

So we haven't changed our view at all and we think that policy around 4% in Australia is going to be about as tight as and restrictive as households have experienced in Australia. So it's going to be a really challenging next 12 months and we think growth will slow materially from here in Australia.

Orazio: So Adam, what you're saying, notwithstanding stickier levels of inflation, we haven't changed our thinking in terms of the destination of rates.

Bowe: That's right.

Orazio: And history shows that central banks at the end of a tightening cycle it's usually the best time to buy bonds.  Why is it the case?

Bowe: Yeah, that's right David. I’d encourage investors and our clients to think of it in terms of the flip side of the cycle we've just been through. So a big part of the mortgage market fixed rates at very low levels at the bottom of the easing cycle and those that didn't are kicking themselves. We’re at the other side of the cycle now, the other side of the coin, where we're coming up to the end of the hiking cycle and it gives investors a wonderful opportunity to lock in rates in their investment portfolio.

So it really is the flip side of the cycle. When rates are low and steady, you should borrow money and lock those rates in. And when rates are high and coming to the end of a hiking cycle, it's a great opportunity to lock those rates in for your investment portfolio.

Orazio: Adam, talking to our clients, there seems to be a bit of inertia out there allocating away from cash into fixed income at the present time. What would you say to these clients?

Bowe: Well, first of all, it's not unreasonable. Core bonds have come through a challenging period in 2022. So clients with a bit of inertia is completely reasonable. But I think we have to think about, cash, TD’s, core bonds, all provide different functions and have different roles in your portfolio.

Cash gives optionality and liquidity, which is something you do want in this environment. TD’s let you lock in a higher level of yield, but you lose liquidity. Core bonds, give you the liquidity, a higher yield and the diversification benefit for the riskier parts of your portfolio.

So core bonds are yielding anywhere between four and 5% for Aussie investors at the moment. To get comparable interest rates on your cash, you’re probably having to look at 12 month TD’s depending on the financial institution. So you lose liquidity for 12 months in that situation and you don't have the diversification benefit, and TD’s don't go up in value when your risky assets go down and core bonds from these level of yields can provide that function now.

And so with inertia, I'd encourage clients to also think about what if we're wrong on timing, we're slightly wrong? We said we're coming to the end of the tightening cycle, what if we’re a little off in terms of timing.

With the starting yield levels of 4 to 5%, we would have to be wrong by a long way in terms of where we think policy ends up. So instead of being close to 4%, the RBA would have to get close to 5% just to break even on core bonds, with that starting level of yield of 4 to 5%. And by the way, in that environment at 5%, the riskier asset parts of your portfolio are probably doing very poorly. So you've got a lot of other issues on your on your plate.

But from starting level of elevated yields, the ability to provide diversification in your portfolio and the return buffer that we have now, given the level of yields, the opportunity set for core bonds hasn't been this attractive in many years.

Orazio: Great.

Really appreciate your insights today, Adam. Thanks for joining us. And thanks, everyone, for joining today. I think the big key take out of today's discussion is that for those people that were really excited over the last couple of years of locking in low mortgage rates, they should equally be excited about the elevated levels of yield on offer for high quality bond portfolios to add not only resilient income, but diversification in portfolios. Thanks for joining us.

And if you’d like any further information, please reach out to your PIMCO account manager or visit our website. Thank you.

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