October 2023 Update from the Australia Trade Floor

Text on screen: David Orazio, Account Manager

Orazio: Hi, and welcome to this month's Trade Floor update. Today I am joined by portfolio manager Rob Mead.

Rob, yields have risen recently as markets are priced in further rate hikes and also pushed out the timing of rate cuts. Yet, the RBA this month felt confident enough to pause once again. What's driving these different views?

Text on screen: Rob Mead, Head of Australia, Co-head of Asia-Pacific Portfolio Management

Mead: Yes, David, what we're seeing is a few different things.

So first of all, the difference in transmission of monetary policy in floating rate versus fixed rate markets. And as we know, the RBA are still in pause mode. It's partly to do with the most levered part of the Australian economy being the household. And while we're in the epicentre of switching between fixed rate and floating rate mortgages by early ‘24, well north of 75% of mortgages in Australia will be floating rate, so the traction of policy should start to materialise. In contrast, in the US, well north of 90% of household mortgages are fixed rate and often for 15 to 30 years.

Second thing is that economies have been much more resilient than anyone would have thought given the amount of monetary policy tightening we've seen. Part of that is due to some of these lags we've talked about on previous calls and previous videos just in relation to labour hoarding, some of these switching from fixed to floating, some issues around immigration and clearly partly driven by excess savings built up during the pandemic.

So all of these lags are working differently than they would in a normal cycle. So what this means for investing is that we want to be invested in markets where the transmission of policy is more observable and also where these floating rates are likely to get more traction more quickly. So a bias towards portfolio investing in terms of our bond positioning in countries like Australia and New Zealand.

Orazio: Now, Rob, we've talked about it in the past that we might now be entering a period of a higher for longer rate environment. Now what is the implications of this new environment for both defensive and risky asset classes?

Mead: It's a really interesting period of time we're in right now. So one of the things we talked about many times is that we could not envisage an economic environment where you had a combination of soft landing or no landing and interest rate cuts. That scenario was never going to happen. And now there's a realisation that given the resilience of economies, that interest rates are going to be higher for longer.

And so the most important takeaway is that any investors, and we know there were many out there that were thinking that we just had to ride out a short term interest rate storm with higher rates, and then all of a sudden miraculously they'd come back down.

Any business model or even a household budget that is assuming that outcome we think will be problematic. We need to be prepared to pay higher rates for much longer.

So when it comes to asset allocation and you start to look at forward expected returns from different asset classes and you compare things like equities versus bonds, it just shows very, very clearly that structurally you should be allocating more and more  to the defensive asset classes.

And any investors that are still underweight, we think now's an optimal time to at least get back to neutral targets, if not start to move overweight the bond asset class.

Orazio: Great. Thanks for your thoughts today. Really appreciate that as always Rob.

And whilst it's incredibly difficult to time the peak in bond yields, we believe we're now entering a new period of monetary policy fine tuning. Fixed income investors today can earn attractive and resilient levels of income not seen for decades with the added benefit of diversification should we see the effects of tighter policy start to effect the real economy.

Now, if you'd like any further information or have any further questions, as always, please reach out to your PIMCO account manager or visit our website.