February 2025 Update from the Australia Trade Floor
Text on screen: Haydn Scott, Account Manager
Hi and welcome to this month's trade floor update. I'm joined by portfolio manager Adam Bowe.
Adam, after a lot of speculation, after a lot of market movements, the RBA has finally joined the party and we've seen our first rate cut for the best part of four years.
Firstly, what did the bond market make of it? And what do we think of it all?
Text on screen: Adam Bowe, Portfolio Manager
Well, you're right, the RBA finally got there and there wasn't a lot of bond market volatility on the day leading into the meeting. The market had largely priced a 25 basis point cut. I think the important question for investors is, where to now? Where to from here?
They've finally started. Where do they go? And I know that Governor Bullock cautioned investors from expecting too many more rate cuts but we’d disagree. I think with the last couple of inflation prints firmly in the band and inflation expected to remain there, the RBA have to start making their way back towards neutral.
So the question is really importantly where is that roughly? I would start with the observation that 4.35 cash rate was very tight. It caused a per capita recession in Australia, household spending and business investment has been flat for 12 months, and it brought inflation from 8%-ish back to 2-3% band. So it's materially tight.
On the flip side, I'd cast my mind back to 2019 before Covid and the RBA were easing rates below 1% and there were no signs that that was accelerating growth or anything. And so it didn't look super easy.
So, I think at the moment the market's expecting a couple more cuts. I know Governor Bullock cautioned against it but we think a cut a quarter, another three this year seems entirely reasonable. We think that would only get rates back towards neutral, certainly not stimulatory. And that's our baseline.
Scott: So with cash rates and TD rates both coming down and really importantly with APRA removing hybrids, what would your advice be to investors looking to deploy capital in a world without hybrids?
Bowe: I think I'd start by making sure that investors are thinking about the risk of the income they're replacing, not just the yield level. And I say that because there’s two things you mentioned, hybrids and cash and term deposits.
A big part of the attractiveness of hybrids was franking credits. That's tax credits from the government. That's as close to risk free in the investment world as you’ll get.
Bowe: And on the other hand, cash and term deposits are very low risk. So I'd caution about trying to match that yield level they were getting by stretching into illiquid, high risk credit investments, particularly in sectors that are experiencing meaningful stress at the moment. Whether it's property development, construction would be two key examples. You see headlines of it every day.
So that would be the first warning. And I would caution about buying shares in the same banks that you had exposure to through hybrids and cash and term deposits. Just chasing high dividend yields because starting valuations are expensive and associated capital volatility and risk. So that's what I'd start with. Think about the risk you're trying to replace, which is very low.
The good news for investors is they don't have to reach down the credit and illiquidity spectrum. They don't have to step down the capital structure to equity to find attractive alternatives. Core bonds are a great example. You have high quality daily liquid core bond funds yielding between 5 and 6% at the moment. And for those investors that like the exchange traded alternative for hybrids, ETF formats are also available.
So you've got a world where cash rates are declining. Inflation is declining. Stress and defaults restructuring in certain sectors are increasing. Equity markets are fully valued, hybrids are disappearing. I don't think the case for core bonds has been this attractive in a long time.
Scott: Great. Thanks for those insights, Adam.
So as we've heard, there's definitely reason to be optimistic into 2025, particularly for those investors seeking income. However, we would caution there are risks on the horizon, particularly with the uncertainty coming out of the US.
We have also broadened our suite of investable options to cater for growing demand and have recently launched some active ETFs in the market.
So for more information, please visit our website or reach out to your PIMCO Account Manager. We would love to help. Thank you and bye for now.