Dousing the inflationary flames, while trying to keep alive the embers of recovery

ABEWeekly 01-04-22

“Tough times never last. Tough people do.”

  • Robert H. Schuller

Key Points

  • Higher than expected growth, stronger commodity prices, and a vigorous jobs market have given the Federal Government greater room for maneouvre as it juggles boosting electoral support, dealing with the debt hangover from the COVID-19 pandemic, and attempting not to drive inflation up further.
  • If central bankers and public policymakers were huddled around a campfire, they would be in the difficult position of having to douse the flames of inflation, while at the same time keep alive the embers of economic recovery.
  • The ongoing uncertainties and volatility in investment markets reinforce the need to ensure that investment portfolios are spread across multiple asset classes to protect and build wealth.
  • Investment in carefully selected corporate bonds provides both higher, regular and reliable income than many alternatives, as well as potential opportunities for portfolio diversification. This is valuable given some of the arguably extreme valuations in other asset classes.
  • Our latest offering is a bond linked to Fortune 500 company Goodyear Tire & Rubber. Full documentation for this bond is available here, and you can watch a recording of a recent webinar here. You can also invest in bonds linked to FHIM Trade Logistics and Xerox.

Australia

Higher than expected growth, stronger commodity prices, and a vigorous jobs market have given the Federal Government greater room for maneouvre as it juggles boosting electoral support, dealing with the debt hangover from the COVID-19 pandemic, and attempting not to drive inflation up further.

As extensively trailed beforehand, Tuesday’s pre-election Federal Budget contained measures to alleviate household and business cost pressures. These included a six-month halving in the 44 cents per litre fuel excise, one-off tax rebates for low and middle income earners, and one-off ‘cost of living’ payments to pensioners and welfare recipients.

While the Budget revised down the deficit for this financial year from A$98.9 to A$78.0 billion, the national books are forecast to remain in the red for another decade.

Given the existing inflationary pressures, a key question is the potential effects of the Budget on the prospects for inflation and interest rates.

As the Australian Financial Review observed, “the extra household stimulus simply threatens to generate more inflation and force the Reserve Bank to eventually increase interest rates by more”.

Laminar Capital’s Stephen Roberts also commented this week that “strong past growth and prospects plus a pre-election budget add to the likelihood that Australian inflation will catch up with high inflation readings overseas before long”.

The labour market also remains tight, and will stay that way for some time. Unemployment at 4% is the lowest in nearly 50 years, with 77,000 new jobs in February.

Continuing restrictions on international movement and migration will extend skills shortages and wage pressures in sectors including hospitality, manufacturing, agriculture, and technology. The Federal Budget does not forecast net overseas migration (including Australians coming and going) returning to pre-pandemic levels for another three years.

As always, the timing of the Reserve Bank’s next policy cash rate increase continues to depend on the central bank’s analysis of whether inflation is sustainably in the 2-3% per annum target band (not just expected to be), and actual evidence of a broadly-based, sustained pick-up in wages growth.

The Reserve Bank is likely to wait for the temperature checks of the March consumer price index (27 April), and perhaps also March wage price index data (18 May), before making any move.

Market commentators, however, continue to expect the next increase in the policy cash rate either in June (after the federal election), or August. UBS economists have brought forward their forecast for the first increase from August to June, while AMP Capital is predicting three rate rises this year, starting in June, taking the cash rate to 0.75%.

Global

If central bankers and public policymakers were huddled around a campfire, they would be in the difficult position of having to douse the flames of inflation, while at the same time keep alive the embers of economic recovery.

Oil price fluctuations and the additional stresses on global supply chains and economic activity have stymied hopes that the inflation induced by the pandemic stimulus would only be temporary.

Although the price of Brent crude oil fell from over US$120/barrel last week to around US$109/barrel this week, this is still about 40% higher than at the beginning of this year, and continues to fluctuate significantly in response to geopolitical developments.

(Although parallels have been drawn with the 1970s, the last time the ‘stagflation’ combination of persistently high inflation and low economic growth was evident, there are significant differences. The U.S. is now one of the world’s largest oil producers, and so should be able to better withstand any drawn out strains in global energy supply chains.)

Hitting the Brakes

The U.S. Federal Reserve has now signalled unequivocally that it is prepared to move aggressively to put severe downwards pressure on inflation, even given the brake this will exert on economic activity.

The release this week of U.S. personal consumption data and jobs numbers for February, the last ahead of the Federal Reserve’s next meeting in May, will give markets more to digest. Economists are picking 475,000 new jobs and for the U.S. unemployment rate to move down even lower to 3.7%.

This would add to the case for pressing on the brakes firmer and faster in May, with an 0.5% increase in the federal funds rate rather than an 0.25% one. Fed Chair Jerome Powell indicated this could be the case to the National Association of Business Economists in Washington last week.

On the basis of this tougher talk, Westpac’s economics team is predicting 50 basis point moves at both the Fed’s May and June meetings, followed by 25 basis points hikes in July, September, November, and December, taking the federal funds rate to 2.375% by the end of this year.

The U.S. two-year bond yield was briefly higher than the 10-year yield earlier this week for the first time in three years, suggesting greater investor pessimism about the economic outlook. Some commentators have taken this as a warning that the Federal Reserve’s policy rate increases could lead to a recession.

Bond fund manager PIMCO, however, argued this week that “yield curve inversion may not be as good of an indicator [of an impending downturn] as it has been in the past, particularly given the enormous amount of quantitative easing undertaken by global central banks”.

Also out this week will be data on inflation in the Eurozone. This is expected to have reached 6.5% from factors including soaring energy costs. A strong inflationary out-turn would bolster the case for multiple hikes in Eurozone interest rates. Bond markets are pricing in up to five increases of 10 basis points each by the end of this year.

The China Syndrome

Uncertainties also remain about the extent to which China will be able to contribute to the ongoing post-pandemic global economic recovery.

Industrial production, retail sales, and investment spending numbers for February were higher, and additional government spending will support demand.

However, Chinese authorities are fighting a resurgence of the omicron strain of the COVID-19 virus with the imposition of further restrictions on virus hotspot cities. The announcement this week that Shanghai is to be locked down led to an immediate fall in the crude oil price, on the assumption of reduced demand for transport fuel.

The war in eastern Europe has also triggered an exodus from the Chinese share and bond markets. Institutional investors are pondering the risks of international sanctions on China, should the Chinese feel compelled to provide Russia with military assistance.

As always, we live in a complex world with a great deal of background noise. Continuing volatility and uncertainties in investment markets reinforce the need to ensure that investment portfolios are not over-dependent on any asset class or sector to protect and build wealth.

Investment in carefully selected corporate bonds can offer both regular and reliable higher income than many alternatives, as well as the potential for increased portfolio diversification. This is valuable given some of the arguably extreme valuations in other asset classes.

Corporate bonds are not term deposits, and come with additional risks.

Current Investment Opportunities

Goodyear Tire & Rubber

Our new Goodyear bond is a fixed coupon credit-linked note yielding 4.5% per annum and maturing in March 2027.

The bond is issued in Australian dollars, eliminating foreign currency risk.

We held a webinar last week launching the offering. You can watch it here, and full documentation for the offer is available here.

NASDAQ-listed Goodyear develops, manufactures, and sells tires for cars, trucks, buses, aircraft, and earthmoving and mining and industrial equipment in 48 facilities in 21 countries.

The company earned $US17.5 billion in revenue in 2021, more than leading Australian companies such as Commonwealth Bank of Australia and National Australia Bank.

Goodyear is a leading global consumer discretionary company. This bond can help you introduce sector diversification to your investment portfolio.

FHIM Trade Logistics

This Australian dollar-denominated note is linked to a shipping and trade finance fund from TradeFlow Capital Management.

TradeFlow is a fintech-powered commodity investment strategy and business which enables physical commodity trading, using a proprietary digital trade services platform to manage and monitor cargoes globally.

This senior unsecured unsubordinated note will pay a 5.50% fixed rate quarterly, maturing in October 2025. All coupons and any final value will be in Australian dollars. The note is suitable for sophisticated/wholesale investors. You can read full documentation here.

Xerox

You can still invest in an Australian dollar fixed coupon credit-linked note over Xerox Holdings Corporation, a 6.5-year note offering a 4.50% per annum fixed rate with coupons paid half-yearly. You can read full documentation here.

Contact us if you have any questions or would like any assistance.

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