The Prices Are Not Right
“Let perseverance be your engine and hope your fuel.”
- H. Jackson Brown, Jr.
Key Points
- Market commentators continue to expect the next increase in the Reserve Bank of Australia’s cash rate in either June or August.
- Energy security remains a key concern in the global economy. Energy costs have become a key driver of inflationary expectations and business and consumer behaviour.
- Bond market investors are currently more pessimistic than sharemarket investors about the possibility of a recession in the United States. However, inversions of the yield curve may not be as reliable an indicator of recession as previously. The U.S. Federal Reserve’s massive purchases of government bonds have artificially suppressed the yields of longer-dated bonds.
- Continuing investment market uncertainties and volatility reinforce the need to ensure that investment portfolios are not over-dependent on any asset class 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 beneficial given arguably extreme valuations in a number of asset classes.
- Our latest offering is a bond linked to Fortune 500 company Goodyear Tire & Rubber. Full documentation 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, Xerox, and Jaguar Land Rover.
Australia
The Australian economy overall is robust. February retail sales numbers were healthy. Prices for commodities including coal, iron ore, and wheat remain elevated and are boosting national income, on the back of global supply constraints stemming from the conflict between Russia and Ukraine.
The labour market remains tight, with unemployment at its lowest level in nearly 50 years and headed down further. Ongoing restrictions on international movement and migration will sustain skills shortages and wage pressures. Last week’s Federal Budget also introduces further demand into the economy.
The Reserve Bank of Australia left its policy cash rate unchanged at 0.10% on Tuesday 5 April.
The Bank focuses on both wages growth and inflation in its decision-making.
In its accompanying statement, the Bank noted that wages growth is only around relatively low pre-pandemic rates, and that “growth in labour costs has been below rates that are likely to be consistent with inflation being sustainably at target”. The Bank also stated it wanted to see “actual evidence” that inflation was sustainably in the 2 – 3% target range before increasing interest rates.
The Bank concluded by stating that “over coming months, important additional evidence will be available to the Board on both inflation and the evolution of labour costs. The Board will assess this and other incoming information as it sets policy to support full employment in Australia and inflation outcomes consistent with the target”.
March quarter wage price index data will be published on 18 May, and March quarter consumer price index data on 27 April. The results are likely to be highly influential in the central bank’s deliberations.
A number of market commentators continue to pick June or August for the next increase in the cash rate. Westpac’s economists, for example, are sticking with August, and noted earlier this week that the June quarter could show a fall in annual inflation as a result of lower petrol prices.
Some market players may be getting ahead of themselves in their interest rate expectations further out. Following interpretation of the Reserve Bank’s statement on Tuesday as being more hawkish, the market began pricing in a cash rate of up to 3.3% by the end of 2023.
This seems unlikely. As Morningstar’s Graham Hand commented recently: “If the Reserve Bank announces a new rate rise almost every time it meets for the next year, followed by a rise in mortgage repayments, borrowers will become increasingly worried and stop spending. If variable rate housing rates head to 6%, thousands will default and property prices will fall.”
Global
Between a Shock and a Hard Place
Energy security remains a major concern in the global economy. Energy costs have become a key driver of inflationary expectations and business and consumer behaviour. (Interested readers can learn more about the mind-boggling complexities of current global energy politics here.)
Sean McCloskey from Energy & Capital Newsletter summarised the situation neatly: “If energy costs stay too high for too long, companies will stop producing goods because margins will be too tight and producing things will no longer be profitable. This will further reduce supplies across the board from food goods to services.
“This loss of supply will further amplify the effects of inflation, which further erodes consumers’ wealth. This compounds the demand destruction problem. In short, if energy costs are too high for too long, a recession will take hold in short order.”
Oil prices remain volatile. They fell this week, following U.S. President Joe Biden’s announcement of the release of over a million barrels of oil a day from the U.S. Strategic Petroleum Reserve for six months from May.
The implications of this for the U.S. consumer’s all-important ‘price of gas at the pump’ will play out in the coming weeks and months. Inflation and fuel prices will be ‘hot button’ issues in the midterm elections in November.
As the conflict in eastern Europe drags on, Germany has warned its citizens to prepare for liquefied natural gas (LNG) rationing, which the governments of The Netherlands and France are also apparently considering.
(Russia and European nations are squabbling over delivery terms for natural gas. Given the importance of the trade for both sides, this will be patched up pretty quickly.)
This issue will assume less significance as the northern hemisphere begins to move into its warmer months. If the conflict in eastern Europe drags on throughout the year, however, the pressure will resume with the return of the colder weather.
Inflation in the Eurozone hit a fresh record recent high of 7.5% in March. This adds pressure on the European Central Bank to move to curtail price rises at its next meeting on 14 April, even as economic growth shows signs of slowing. Bond markets are currently anticipating five increases of 10 basis points each by the end of this year.
The Prices Are Not Right
The U.S. added 431,000 new jobs in March. Unemployment fell from 3.8% to 3.6%, and is now lower than it was at the onset of the COVID-19 pandemic in early 2020.
The U.S. Federal Reserve is watching employment trends closely as an input into decisions about the rate and pace of increases in the federal funds rate.
Although U.S. average hourly earnings increased by 5.6% over the 12 months to March, this was below the rate of inflation, which reached an annual rate of 7.9% in February, the highest level in 40 years.
Another closely watched indicator, the Personal Consumption Expenditure Index, rose by 6.4% over the year to February, like inflation the fastest rate of increase in 40 years.
Prices of food and other staples have surged following significantly increased input costs for farming, manufacturing, and distribution. Robust economic conditions are also providing many U.S. corporations with growing sales volumes and greater ability to increase their prices.
The Federal Reserve’s recent public pronouncements have been steelier in response. Chair Jerome Powell has indicated that the U.S. central bank is prepared to raise its cash rate aggressively to prevent this surge in inflation from becoming entrenched.
One potential pathway is consistent 0.25% hikes from every Fed policy meeting from May through to the end of the year, potentially stepping up to 0.5% hikes if inflation does not show sufficient signs of being restrained.
The Fed has to balance stamping down hard on inflation while avoiding unnecessary damage to economic activity and employment.
Bond market investors are currently more pessimistic than sharemarket investors about the possibility that the Fed will tip the U.S. into recession.
The yield curves of the two- and 10-year U.S. government bonds inverted over the past week.
(An inversion of the yield curve – when shorter-term bond yields are higher than longer-dated ones – has in the past predicted recessions. There’s considerable debate – verging on the theological – about which relationships between which bond maturities have the greatest accuracy as predictors of recession.)
However, inversions of the yield curve may not be as reliable an indicator of recession as previously. The U.S. Federal Reserve’s massive purchases of government bonds have artificially suppressed the yields of longer-dated bonds.
As always, continuing investment market uncertainties and volatility 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 recently 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.
Jaguar Land Rover
You can still invest in an Australian dollar fixed coupon credit-linked note over Jaguar Land Rover, a senior unsecured 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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