David Orazio: Hi and welcome to this month's trade floor update. Today I'm joined by portfolio manager Adam Bowe.
Adam, let's start locally. The RBA has raised rates again to 4.6%, the highest level that we've seen since 2011. Now, whilst we weren't expecting this at the start of the year, how have Australian bonds fared this year?
Adam Bowe: Yes. It's a good point. I think there's been a lot that's happened over the course of the year so far that we weren't anticipating. And the local bond markets had a lot thrown at it.
When you reflect on the year we've had conflict in the Middle East. It's driven oil prices back over 100, surge in petrol prices, elevated headline inflation and importantly, underlying inflation that's been sticky in the three point something range instead of the two point something range. And subsequently 100 basis points of hikes from the RBA.
So a lot has happened, yet, year to date returns on the Australian bond market have actually been modestly positive, which is a pretty remarkable result when you think just about everything that could go wrong in the local bond market has gone wrong. And relative to other domestic asset classes, Aussie bonds haven’t been a terrible place to be.
Returns here today have been fairly comparable with the local equity markets, modestly positive, better than the declining residential real estate market that we have at the moment. And we're just at the early stages, I think, of an impairment liquidity challenge in local private direct lending market.
So not a terrible place to be. And the market has one and a half more hikes from the RBA into the end of the year. There's a lot of price, starting yields on local active core Australian bond funds are up over 6.5%. So from here my bet’s on bonds.
David Orazio: Now stepping back globally. Now Australia certainly isn't alone, we've seen other central banks this year tighten policy. What's driven this pivot to tighten policy? And the important question is where to from here?
Adam Bowe: Yes, you're exactly right. It's not just the RBA. We've had hikes from many other central banks around the world, including the Fed, across the ditch in New Zealand from the RBNZ, the ECB, Bank of Japan even. So plenty of other central banks tightening policy.
Globally, the key driver has been oil prices. The conflict in the Middle East, driving up oil prices and creating inflation challenge from central banks. Now historically when it's just a supply problem like this central banks might look through that. But remembering we were on a starting point of inflation that was already sitting above target, had been for a while.
So the tolerance from the global central banks was pretty minimal to not respond to an even longer period of inflation above target. Apart from that, we've had some resilient growth data, particularly around AI infrastructure rollout and data centres.
Even in Australia, we've seen that. And so there are a couple of key drivers. Importantly, it hasn't been, as much as the headlines would suggest, it hasn't been global deficits and bond supply that's driving up long end yields. Front end yields have underperformed. It's really been central banks adjusting policy to the new inflation dynamics.
So where to from here? There's considerable uncertainty over the next couple of months particularly around the Middle East and ultimately where oil ends up. But the market has a very aggressive tightening cycle, even from here priced into markets. So another 100 basis points of hikes from the Fed, another 100 from the RBNZ, another 100 from the Bank of England, another 100 from the ECB, another 100 from Canada, another 100 from the Bank of Japan.
So even if, when you have a look at starting yields on core bond funds for Australian investors, so that could be the Aussie Bond Fund, Global Bond Fund hedged to Aussie, Global Investment Grade Credit Fund hedged to Aussie, the Income Fund hedged to Aussie, starting yields between 6 and 8%. So even if all those central banks deliver all those tightenings and nothing else happens, you'll still earn your 6 to 8%.
Now, ultimately, we think central banks would deliver less tightening that's priced into markets. So potential tailwinds in addition for returns, in addition to the starting yields of 6 to 8%.
David Orazio: Thanks, Adam. Really appreciate your insights today.
Now, markets may continue to wrestle with uncertainty in the short term. But from our perspective, the medium-term outlook for bonds remains as compelling as we've seen over the last decade.
As always, if you have any questions, please reach out to your PIMCO account manager.