Economic and Market Commentary

September 2023 Update from the Australia Trade Floor

Portfolio Manager Adam Bowe discusses why there really hasn't been a more attractive time to invest in bonds over the last decade, especially when comparing bond yields to equity dividend yields.

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Text on screen: John Valtwies, Account Manager

Valtwies: Welcome to this month's Trade Floor update. Adam we are about to bid farewell to Philip Lowe and welcome the first new governor in seven years. How much of a deal is this for markets?

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

Bowe: Well, I think it's a big deal in the near term for financial markets. You know, Phil Lowe has taken policy from very easy to very restrictive and he's transitioning to a new governor at a period where we think policy’s in a fine tuning mode. So I don't think there's going to be a sort of a near-term big financial market impact.

However, there's medium-term challenges for the need for the new governor. She has to deal with implementation of the review. There's going to be a lot of new communication tools where press conferences and new committee, new voices on the board. So it's going to be very challenging for her to implement that, find consensus amongst a bunch of new voices and then communicate that clearly to the public.

So medium term challenges for the new governor but I don’t think any near-term financial market impact.

Valtwies: So speaking of impact, we've had 400 basis points of tightening of the cash rate, yet we haven't seen significant cracks. What's going on in that respect?

Bowe: It's a good question. I think the first point I'd make is, you know, there are visible signs of tighter policy already. Household spending slowed materially last three real retail sales prints of quarterly prints have been negative. House prices came off sharply, although they've stabilised. Residential investment is contracting. So there's signs already that policy is very tight.

But also we've got some lags that will be rolling off into Christmas. We have excess savings that households that's nearly fully normalised now through the pandemic. We have this big wall of fixed rate mortgages rolling from 2% back to five and half, 6%. We had a strong burst of immigration as the borders reopened, which weren't going forever.

So there's several lags that are rolling through now we expect to wain into Christmas. So policy is tight, already visible, and we expect, these lags for this cycle just roll off into Christmas. So I think when we when we look out 12 months, we'll be sitting here discussing rate cuts and how much the RBA will be needing to lower rates rather than sitting here talking about rate hikes.

Valtwies: Well, to that end, on the lagging side of things, we saw some resilient earnings over reporting season. But we remind ourselves that a lot of these borrowers in the corporate and consumer space are floating rate. Therefore debt repayments are likely to come up. How much of a watch point is that for us?

Bowe: Yeah, we have seen resilient earnings. Earnings are subject to the same lags I talked about with tighter policy, but you still are seeing weakness in pockets of the corporate market, whether it's big write downs in REITs, listed REITs for their asset base. Pockets of weakness in retail.

On the floating rate side, the biggest sector I worry about is households. They're the most fragile balance sheet in Australia, the most debt relative to their income and most of it's variable. And the ones that will be rolling back to variable over the next few months. So I will more worry about fragile balance sheets like households, some highly levered, lower quality borrowers in the private space, particularly real estate, will struggle with this with this dramatic lift in in interest rates.

But by and large, high quality investment grade borrowers in the public markets are still looking pretty resilient. You know, the punch line coming out of earnings season for me is that for the first time in over a decade, if you look at the local investment grade credit index, it comfortably out earns ASX dividends in terms of dividend yields now.

So the spacing in core bonds in Australia hasn't been this compelling on a standalone basis and relative to all asset classes in 10 to 15 years, I think.

Valtwies: Well, thanks, Adam. Central bank policy settings are tight and the impact of those settings are likely to accelerate over the next few months. For bond investors, there really hasn't been a more attractive time to be investing over the last decade, especially when we compare yields against equity dividend yields by example. For asset allocators, we think now is the time to be investing in bonds.

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