The Point

Oliver Ge: Fears of a ’70s inflation re-run are overblown

US inflation numbers were higher than expected in August, prompting more headlines about a second wave of inflation and further interest rate rises.

Can investors really expect a 1970s inflation re-run?

“There’s a lot of commentary on a possible ’70s-style, second wave of inflation,” says Oliver Ge, a portfolio manager with Pendal’s income and fixed interest team.

“But I don’t believe we’re going down that path. We’re not even close to a rerun of the 70s.”

Higher US inflation in August is just one uptick after 13 consecutive months of disinflation – and inflammatory news headlines are unwarranted, Oliver argues.

“The difference is that back then, the US was highly oil-dependent, and it also was experiencing a massive devaluation of its currency. Put the two together and it triggered a big wave of inflation.

“The US is no longer energy-dependent – in fact it is an exporter of oil. Unionisation is no longer widespread. There’s none of the original catalysts that prompted the blowout.”

Recession risk is still out there. Here’s why

The risk of recession appears to be side-lined for now, but investors may be overlooking one factor, argues Pendal’s Oliver Ge.

Much of discussion about higher interest rates has been focused on the impact of bigger mortgage repayments for homeowners.

But tighter credit conditions and stricter collateral requirements for business are likely to have a more significant impact, says Oliver, an assistant PM with our fixed interest team.

“Higher interest payments are a strain for businesses, but it’s when you lose access to credit that the stress comes through.”

There is evidence of tighter lending standards in the US which will likely flow through to defaults in six-to-nine months, he says.

“The prospect of recession has for the moment been sidelined, but the risk is still very much there.”

Inverted yield curve: what it means (and it’s not what you think)

Longer-dated bonds usually pay higher interest rates to compensate for the increased risk over time.

But right now short-term interest rates are moving closer to — and even higher than — long-term rates.

This “yield curve inversion” is a very important signal since it usually means a recession is imminent.

But that’s not the case this time, argues Oliver Ge, an assistant portfolio manager with our Income and Fixed Interest team.

With a strong global economy, low unemployment and benign equity market conditions, analysts have been looking for an alternative explanation for the inversion.

The inversion may be explained by expectations that current inflationary pressures are only short term, says Oliver.

“Short-dated bond yields are higher because they carry a premium to their longer-dated counterparts to compensate investors for bearing higher near-term inflation risk.

“That’s what’s driving the inversion.”

Why bonds are worth considering even as rates rise

Most investors understand that when rates go up, bonds go down.

But what if bonds had the potential to provide an investment return during central interest rate hiking cycles?

It’s possible says Oliver Ge, a portfolio manager with Pendal’s Income and Fixed Interest team.

“The key is that it depends on how much is priced into the bond market at the point central banks start lifting rates.

“Looking at history, an investor who buys bonds at the moment of the first rate hike in a cycle and sells at the last rate hike actually gets quite a substantial return.”

Since the 90s there have four rate hiking cycles in Australia, each averaging an increase of 2.25 per cent to the RBA’s policy rate Oliver says. The annualised bond return over the same period was more than 4 per cent.

“The compelling story is don’t ignore bonds when rates are rising — they can still give you mid-single digit returns. That’s quite significant in a market where equities are negative.”

Look to government bonds instead of term deposits

Ultra-loose monetary policy is creating exceptions to risk and reward – and bringing opportunities for better returns, says Pendal’s Oliver Ge.

Investors who choose the safety of a government bond held to maturity are now offered better returns than a nominally higher-risk bank term deposit.

“The big banks are offering about 0.25 per cent on a one-year term deposit — $25 on a $10,000 investment.

“A one-year Australian government bond is paying 1 per cent — four times as much money.” State government bonds offer more — as high as 1.6 per cent for West Australian semi-government bonds.

The anomaly exists because the RBA is providing very cheap funding to the banks, meaning they can keep deposit rates artificially low without affecting the financing of their lending businesses.

By contrast, government bonds are issued into a competitive global market and rates are set by investor demand.

It’s likely to stay this way as long as banks have access to cheap funding.

“This is a genuine opportunity to get a lot more juice with the same or better safety – assuming you hold to maturity.”

China isn’t likely to invade Taiwan any time soon. Here’s why

It’s understandable that investors pondering their exposure to Russia’s invasion of Ukraine might also think harder about the China-Taiwan stand-off.

But a Chinese invasion of Taiwan is a very low probability event in the short or medium term, says Pendal’s Oliver Ge.

“Near term the Chinese Communist Party has other priorities at stake. President Xi has promised to rectify growing domestic discontent over diminished living standards. Housing affordability and employment opportunities are key focal points for the CCP leadership.

“In the medium term, Taiwan’s support from the US remains crucial. Remember that Taiwan (but unfortunately not Ukraine) is of great strategic importance to Washington. China has no appetite for a direct confrontation with the US.

“These points don’t negate the possibility of a conflict in the longer term. A unified China is arguably the biggest political objective of the CCP.

“But for now the carrot of economic cooperation remains the preferred policy over brute force.”