June 2023 Update from the Australia Trade Floor

Text on screen: Hugh Holden, Account Manager

Holden: Hello and welcome to our monthly trade floor update. I'm joined today by portfolio manager Aaditya Thakur. Aaditya, the Reserve Bank of Australia at their May meeting increased interest rates by another 25 basis points, taking the cash rate to 4.1%. The reaction of bond markets was fairly muted after we'd seen bond yields rise throughout the month of May, but that only took them back to levels a little bit below where they began the year after we saw quite a strong rally from bonds through the first quarter. So what can we make of it all?

Text on screen: Aaditya Thakur, Portfolio Manager

Thakur: So I think the key takeaway for investors from the RBA statement following their hike was that they have a much greater sense of urgency and far less flexibility with respect to meeting their inflation objectives, and that's going to be at the expense of growth and employment. So with the cash rate now at 4.1%, which is firmly restrictive, if they continue to keep hiking from here, we think that that will induce a recession by the end of this year or early next year. So investors really need to start acting now to increase their defensive allocations in their portfolios. Now, with respect to the move in yields that you mentioned, I'd make two quick points. Firstly, despite the rise in yields last month, if you look at core bond funds, they've still returned a little above 3% year to date. So that really speaks to the power of carry in a kind of range bound environment. And also, as you can see from the chart, the peaks in yields have been great opportunities to buy bonds and the subsequent peaks have been at slightly lower levels each time. Now, in the context of what I said earlier with the RBA, this well could be the last major peak and major window to allocate to bonds before we see a bigger repricing lower in yield as recession risks really hit the table in the second half of this year.

Holden: Okay. And you mentioned recession becoming increasingly likely. So investors now need to begin thinking about how they can recession proof their portfolios. So what sort of things do they need to be thinking about?

Thakur: Yes, I think now is the time to really more proactively reduce allocations to risk assets and increase allocations to the defensive anchors in their portfolios like bonds. Secondly, investors really need to think carefully about allocating new money to illiquid or private assets and really do their due diligence that valuations for those assets have been remarked, mark to market, in the context of what's happened in public markets over the last 12 to 18 months. And thirdly, they really need to increase levels of liquidity in their portfolio, like true liquidity, and be in a position that they are able to act if we do get that correction in risk assets.

Holden: Yes. So that point on liquidity is an interesting one. We’re receiving a lot of questions from our clients at the moment about the role of cash,  term deposits and bonds in portfolios. So how would you see that asset allocation between, say, term deposits and bonds in this current environment?

Thakur: Yes, there's definitely a role for cash and TDs, but I think a lot of investors, they perceive TDs as risk free. But you have to remember you are taking illiquidity risk. You're locking up your money for that period. You don't have the ability to reallocate that money if there was a correction in risk assets until that money matures. You're taking on reinvestment risk. So at maturity, if yields are much lower, you're not going to be able to reinvest at the current attractive yields. And thirdly, you're not getting the diversification benefits and the potential for capital price appreciation should recession hit and yields fall. You're not going to get that benefit from TDs. So I think investors need to think very carefully about that, think very carefully about actual liquidity and not be anchored to the past. 

Holden: Yes, perfect. Well, thanks Aaditya. And I guess it's time for investors now to begin preparing their portfolios for recession. As Aaditya said, there's a role for cash, there's a role for term deposits and for core bonds. But right now, core bonds are an asset class that we know can provide potential capital upside in a recessionary environment. They can provide that important liquidity, particularly if we want to rebalance towards riskier assets, if they correct over time. As Aaditya said at the current yield levels, the window to allocate is wide open and we don't know if we'll see a better entry point in future. So I hope you found that interesting. If you want more information, please visit our website at pimco.com.au. Thank you.