NAB Morning Call

Weekend Edition: The Art and Science of Fixed Income. Without the straight lines.

Friday 28th June 2024

Please note this communication is not a research report and has not been prepared by NAB Research analysts. Read the full disclaimer here.

Could central banks push their timing back even further? Emma Lawson says we can’t ignore how economies are slowing, so there’s every chance that market pricing for cuts could move forward. It’s never a straight line, the fixed income strategist at Janus Henderson says.

Does that mean we have to put aside the hope of a soft landing, anywhere in the world? Emma suggests we haven’t seen the cumulative impact of the tightening of policy yet because it takes time to filter through. But what about government spending, in Australia, the US and Europe? Does it help or hinder the fight against inflation, and does it provide opportunities for investors.

Emma give her take on the macro picture and the philosophy behind Janus Henderson’s approach to investing, and talks about Australia’s opportunity for investors – a mix of stability and instability and knowing what to do with it. Also, if the slow decline in central bank rates is one of the surprises of 2024, what does Emma think will be the next surprise that most people aren’t seeing?

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Duration:: 22m
Broadcast on:: 28 Jun 2024
Audio Format:: mp3

Well, nobody knows for sure when central banks will cut rates and how aggressive they'll be with those cuts. What we do know is it's taking longer than most people have expected, so how can we gauge really what happens next and what opportunities are there for investors to capitalize on in this period of uncertainty. One thing is for sure, there are no straight lines, so don't go looking for them. But what else can we take out from our guest today as we look at the art and science of fixed income without the straight lines. Well, it's always good to take someone else's take on the lay of the land outside the hallowed halls of NAB. So this week, another macro economist, Emma Lawson, is a fixed income strategist at Janice Henderson. You'll find out more about them today. Before that, she worked at the Treasury in Victoria. And if you go back far enough, well, six years or so, she was a currency strategist at NAB. So yes, it all gets back to NAB eventually. So she's with us today. So Emma, we've talked a lot on the morning call about the timing for central banks. And we have seen that timing by and large being pushed back to the point where the Fed, there's even a question mark over whether they will cut it all this year. So do you think we might still be a bit too optimistic on timing? Could we get to the end of the year with perhaps only a few central banks having cut and then maybe once or twice? And how does that change your thinking? There's this risk of pushback all the time. Yeah, thanks, Phil, and lovely to be here. But yeah, you have seen that there's been a lot of slowing priced in that it's being pushed back and back in further and further out. And a cold and economies are holding perhaps better than many had expected through this year. We've also seen really sticky inflation. So rate cuts get pushed out further and perhaps shallower the cycle than in previous ones. But determining what the central bank will actually do over the coming years and keep in mind now the majority of that market pricing for central bank action is actually a year away and even into two years. So predicting what's going to happen is both an art and a science and it's never ever a straight line. So at the moment, we are intensely focused on sticky inflation, which is pushing out that path of cuts and locally even some risk of a hike. But we also see real economic data softening right across the economies. And this focuses the market back on those rate cuts when we get more evidence. So we see the surprise indices, for example, and they just show you the difference between the economic data outcomes and forecasts against the forecasts in aggregate. And they've fallen sharply in Europe and remain negative in Australian US. That actually tells you that the economy is weakening more than people expect. So things like the recent market purchasing manager indices, which fell locally in Germany and Australia. So whilst at the moment, the market is likely to air and flow between the forces of sticky inflation and the slow puncture of a weakening real economic growth. So the key for us as investors is to be positioned ahead of those turns in the market. As the market doesn't always show the way and it often gets it wrong or changes its mind. So the market may start to put in more easing back as the real data slows in this late cycle environment, but it certainly won't be a straight line and we can expect a bumpy path. So for the moment, markets are pushing them out through into 2025 and even into 2026 as the economy changes and the data may be weakening, that gets pulled forward. So it's never a straight line. But you're not giving a lot of weight there, Emma. Is the market being too pessimistic or too optimistic? What do you think? I think at the moment, you know, the starting point is probably around the right framework that we start by the end of the year, maybe into next year is the starting point. And the Fed might go once, maybe even twice this year. But the real crux of the matter is what happens over the cycle rather than focusing intensely on the starting point. So that pushes you what really happens in 2025 and even into 2026. At the moment, you know, we really do feel like particularly for Australia, you know, the market has only the cash rate coming down to around 3.7%. Now, you heard the RBA this week talk about their neutral cash rate at three and a half. So if that is even close to being the case, then we would have the case where you never got a cash rate that was easy in that easing cycle. It gets less tight. Do we really think that after a period of tight policy rates that that is enough priced in? And the answer to that is probably no. We would expect that you actually get more tightening than the market expects. But whether they're going to price that in right now or down the track is the question. And those high interest rates for a long time, what's that going to do for the economy generally? And we've talked in the past about, you know, well, are we going to have a soft landing? Even some people saying, well, it's not even a soft landing. We're going to have no landing at all. But it seems like we're going to feel the hurt to get inflation down, aren't we? That idea of a soft landing, when you talked just a moment ago about seeing the slowdown in the economy, we've got to go through. Yeah, that's right. You get a cumulative impact of the tightening of policy. Keep in mind that tightening of interest rates can take 12 to 18 months to flow through fully into an economy. In Australia, we had the last hike almost a year ago, but it's still coming through. And so each economy does have a different reaction function to monetary policy. It flows through in different speeds. In Australia, it comes through the household sector much, much faster than that does in the United States. But it still takes time. So we are starting to see that full impact now. So you can't say, well, we have no landing at all, because you haven't actually seen the full impact of the hikes we've already seen. So it does require a lot of patience and a lot of uncertainty. But policy really does work at the end of the day. And we're starting to see that come through now. Has it been slow? Yeah, it has been slow. But does it, and you expect it to, obviously, but does it happen to the same extent everywhere? Or does the U.S. for whatever reason, I mean, it's a reserve currency, it's a big population, and it seems to be able to somehow be able to spend more and more government money without bond markets getting too upset about it. So does the U.S. get off scot-free compared to the rest of the world? I don't think so. They are being subjected to different forces, and that's where you can get a little bit of desynchronization in economies and policies. So if you look to the United States, they have, but that's one reason why they have a policy rate at a peak of 550, and we have 435, for example. They had different forces, a lot of influence of fiscal policy, things like the inflation reduction act, pushing through that stimulus, through the economy, they've had similar to us, that migration. So these different forces are allowing economies to move at different speeds, but you are seeing the start of, and again, it's incredibly slow. I like to talk about it like a very small puncture in the tire. It's going down incredibly softly. You might not even notice it to start with until you hit a particular speed, and then it becomes much more of a problem. So those policy impacts are starting to come off now, unless you get a re-acceleration in that stimulus, then they come off. So you are starting to see that hit in the United States now, but it does take time. But the one key thing in allowing you to reduce your monetary policy is that inflation is coming down, and it is starting to come down. We're in a post-pandemic, post-distortion phase. So those things are coming out slowly, and eventually the impact of the monetary policy on that services side of the economy will come down, and inflation starts to normalize, as it is in the US right now, and that allows them to ease policy. So those influences are still coming through. There is a reason why we have differences in policies across countries, but those impacts do come through. But the influence of fiscal policy on monetary policy, so the US putting all our money into the economy. I mean, there was even talk in the last budget in Australia that if there was too much spending by the government, it could be an inflation risk. I mean, is that because more consumption, higher pressures on prices, that sort of thing, which could delay the RBA? Is that the case, or is that scenario a little overblown? I mean, we're talking about a massive difference between fiscal spending in Australia pay ahead versus what's been going on in the United States. Yeah, there are definite differences in the fiscal policy in the two countries, and in the US they've had this huge profligacy, which has stimulated the economy. In Australia, we have a much better fiscal debt situation. Our overall debt levels are on a relative basis, very, very good, and so it does give us a little bit more leeway in terms of fiscal stabilizers if necessary. But you had seen, and you do have a lift in the fiscal polls through the last budget, but it hasn't been enormous. You actually get more from the state government fiscal polls here, and that's because there is a recognition that you spend more on a fiscal side, and absolutely, if you boost demand, then the central bank will have to do something about it at this point in the cycle because that could possibly influence inflation. Do you have a symbiotic relationship? There is an awareness of that at the policy level, and there has been some care about that in Australia. In the US, they get away with it, a greater extent, because they have that exorbitant privilege of being the global reserve asset, so those chickens haven't come home to Bruce at this point. The obvious question for Australia, why is it taking so long? Why will we be one of the last central banks? It seems, and be interested in your take, we've been talking on the morning culture and the week about the order of things, but who goes first, who goes next to, and almost always, RBA is the straggler. Why are we at the end? Why are we the last to go for to come down? We started later. Influence does take a bit longer. Look at history, that's very often the case. It is the case that we don't have to be synchronized with the rest of the world, but you look at the fact that we started hiking later than the others, and also we didn't go up as much, but you could counter that as the RBA does in the fact that our reaction function is a lot faster and more sensitive to the interest rates because are much higher levels of household debt, so it flows through quicker. In different countries, it just comes through different channels at asset prices and saving and spending decisions, so it does influence, it just influences at different times. We started later, we might come out later. We did have some things that did adjust the path along the way. Nobody was expecting the very strong levels of population growth, which do boost GDP and boost demand along the way. We have had a level of labour market strength that hasn't been expected, but again, we're not unique in that, and that does appear to be another one of those post-bank endemic distortions of hoarding, perhaps, labour after labour shortage in the past. Those things have kept us going for quite a bit further than had been anticipated, perhaps, or make it different from previous cycles, but it's not to say that policy doesn't work at all. And this desynchronisation that you mentioned, that we are all going at different rates all around the world. Same problem, but at different times and different ways of dealing with it and different government policy as well, and then thrown to the fact that US equities just seem to be going a bit crazy as well. So, what does all that do for currency risk? Could we see that the US dollar, for example, stays higher for longer? Seems like there's every chance of that, doesn't there? And how does that change investment decisions? And what does it mean for Australia as well? Because presumably, that also means the Australian dollar stays lower for longer. The US, if we go back just a little step, if we look at that desynchronisation, and it's being driven by a lot of different things, that means that it can actually continue for quite a long time. Some of that is structural. We call them the 5Ds, de-globalisation, decarbonisation, digitisation or AI, demographics and debt that we just touched on before. And they are kicking in now, and they are impacting economies differently and at different times. And that will mean greater divergence in policy, both monetary and fiscal, different growth rates, different inflation rates. And that you expect to continue, and that will, one of the key drivers of that will be volatility and uncertainty. And I expect that you'll get that situation continuing for much longer, or anything different than you've seen in the last couple of decades. So, that makes a difference to where asset prices go. The currency is an interesting one. The US dollar has held very, very strong for quite a long period of time. Because of some of those influences of those 5Ds, you think about the migration. You think about the US inflation reduction act helping the US with its climate transition, for example. And you think about the future of tariffs and trade restrictions in that de-globalisation. So, the US dollar has been benefiting from many of these structural things. That's allowed it to have greater fiscal policy, spending growth. It's allowed it to have a stronger monetary policy. You tie that in with the certainty of its exorbitant privilege of the global reserve asset, and it holds that US dollar strong. That possibly will continue for a little bit longer down the track. Now, the Australian dollar is actually, we're not as weak as others. We've held in relatively well of all of that. And it does look like that's the one asset that remains relatively stable at this kind of lower. It's not even terribly weak level going ahead. So, that gives you a little bit of certainty in that situation. We may want it a little bit stronger, just to pull inflation down a little bit. But I think in the face of that strong big dollar, you're not going to get too much movement there. And so, domestically, where are the opportunities, though? How do you make money out of Australia rather than investing overseas? I mean, there's that temptation to look to the US because it's doing so well. Yeah, it is really interesting at the moment. And we touched on that debt situation. And you think things like that can actually be both a risk and an opportunity. So, we're looking at the fiscal side of many countries. And we go back to the idea of volatility. So, for now, the risk pricing is relatively low for debt expansion. But we know that it remains a risk. So, places like France at the moment are under the spotlight. So, even when the market really reacts to these things, we know that want to react. But they really, when they do react, they overdo it. And that presents itself as an opportunity. So, that's particularly true in local markets. Australia's federal debt position is actually relatively good. So, any sell-off on the back of an EU or even US fiscal problem would present itself as an opportunity. So, you have to wait for that opportunity. You want to be positioned as that hits. So, you need to be really quite tactical in these positions. One example of that is the UK debt blow-off in September 2022. So, when you see other markets frat, if it's not a local problem, that's your opportunity. So, we're at it. So, yes. So, when you have a list trust moment, which is what you're talking about there, you play to Australia's stability, really. That's right. So, as long as you really know your fundamentals, you really know where something you believe should be valued. And that your fundamentals are solid. If there becomes an opportunity, that a risk can then turn into an opportunity. So, elsewhere in Australia, I talked about earlier, if you see at the moment that we may look at being longer bond duration, if this market sell-off post the high monthly inflation print begins to price an even tighter monetary policy across time, and that presents itself as an opportunity. As we said before, if the market is only pricing in rates coming down to 3.7 over the next decade, then that presents itself as an opportunity. I've got one more question for you. But before that, just tell me very briefly about Janus Henderson, because he's actually, I mean, he's a UK headquartered company, isn't it? So, tell me about the sort of clients who got how big is the Australian operation and how you do your work globally, in terms of research and strategy and an Australia's part in all of that. If you can do that in two minutes, that's a lot of questions. So, is everything about the company in two minutes for me, Emma? I'll focus on the Australia fixed income team. We very strongly believe in strategic and active management across the broad spectrum of fixed income investing. We believe active management gives you better returns than passive, and we have a 30-year track record to prove it. We always start with the fundamentals of the asset, what is its value? And we can and do talk across the global spectrum of our peers to get support in what's happening in the global environment, but we do all of our research on Australia, in Australia, and have a very collaborative approach. So, we do look for those strategic opportunities, so we know market slice to price short-term factors into long-term assets. So, when those gaps open up and present opportunities, things like airports and universities in the pandemic, we actually go for them. So, that is our generalized approach. We have a whole spectrum of retail and institutional clients in Australia, and we are around $21 billion in assets on the management for the Australian. So, looking for stability in an uncertain world seems to be the sort of approach that you've talked about a couple of times. But instability provides you with those opportunities, so we will take advantage of that. And knowing your underlying fundamentals, and the value of things, and when those gaps open up is really defines our investment approach. Makes sense. So, look, final question then. Tell me about something that surprised you, either domestically or internationally, the biggest surprise this year, perhaps, and also, something that you think isn't being seen at the moment, which might be the next big surprise. What's in your head that perhaps not everyone's seen? Yeah, I think that persistence of underlying inflation has been a surprise, maybe to us, and also the markets. It may be a continued by-product from pandemic distortions, but also the lagging nature of labour markets and wages to policy tightening, and which lifts services inflation. So, we see that locally. Maybe the same as the US and Europe faced earlier in the year, but it definitely has been keeping things interesting, the markets and policymakers. If we look ahead, what feels like some of the big structural themes are coming at us, I think faster than anyone expects, and maybe the next big surprise. Those things like warming temperatures, lowering productivity, geopolitical risks, de-globalisation, and of course, on the plus side, artificial intelligence driving growth, for example. So, all of those, they're bringing a flurry of macroeconomic and asset price contradictions. They, I think, can take the market by surprise and keep volatility high, and that pays investors to be strategic and active, which are both approaches that we like. Yeah, makes sense. I mean, how the focus seems to be off climate change a bit, doesn't it? You can't help feeling that at some point soon, we'll be back onto it and how the markets react to that. Lots to think about there, Emma. Great to have you on, and yeah, what a shame we didn't get you on the morning. You are actually working at NAB when the morning call started, and we never got you on. I don't know how we missed that opportunity, but it's good to have you on today. I missed my opportunity. You missed your calling, although that might be egging it a bit, mind it. Good to talk. Anyway, good to have you on, Emma. Lovely. Thanks very much. And that is the weekend edition. Next week, I think we'll return to housing again next week. We haven't done that for a few months, and we will have got a lot of data by then. And of course, there's always a lot of interest in housing in Australia, isn't that? People could talk about it forever. So, we'll talk about it next week, and I'm back on Monday morning for another edition of the morning call. I'm Phil Dobby for NAB. Thanks for listening. The weekend edition.