Jenna Hayes

Strong and growing demand from domestic and international investors alongside a broadening base of issuers, including debut participants from Europe and Asia, are strengthening the case for Australian fixed income, Jenna Hayes, executive director capital markets at Income Asset Management says.

Hayes says Australia has now surpassed both the Sterling and Canadian debt markets to become the world’s third-largest fixed income market by issuance, trailing only the US dollar and Euro markets

“When you weigh up the benefits of the Australian market, such as being one of only 10 countries in the world with a sovereign rating of AAA, deep and liquid markets, and solid fiscal policy, it’s not a surprise why we finally seeing Australian markets on the radar of international investors.

“Rising investor interest is, in turn, giving issuers the confidence to come to market, which is boosting the supply side. It’s a virtuous cycle where with this increased issuance comes more liquidity, which gives investors and issuers more confidence.”

Australian bond markets have undergone rapid shifts following recent softness in labour market data. The spike in Australia’s unemployment rate to 4.5 per cent in September saw markets increase the probability of an RBA rate cut at the November meeting from 44 per cent to above 80 per cent.

Hayes says that Australian investors, who have historically been overweight in property and equities and underweight in fixed income, are increasingly looking for corporate bond exposure. In the past for true corporate diversification, they needed to turn to more developed fixed income o markets like the US whereas now they can look closer to home for a broad range of issuers including more recently names such as Transgrid, Ausnet, Aurizon and Melbourne Airport

“Australians have always been underweight in bonds, so it’s encouraging to see fixed income become a staple within investors’ portfolios, and I think the demand side will remain,” Ms Hayes says.

“On the supply side, it’s Wriston’s Law of Capital that capital will go where it is welcome and stay where it is well treated.”

“We have seen a lot of offshore issuers tap this market in the past twelve months and have signified their intention that they are going to be repeat, regular participants in our market.”

Hayes says there has been an active period of bond issuance, pointing to a standout hybrid issue from Lendlease (ASX:LLC) that drew strong investor demand.

“The new Lendlease corporate hybrid is particularly attractive due to its 100 per cent franked distributions, significant yield of around 7.4 per cent, and investor-friendly structure such as an unusually large coupon step-up after three years.”

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Jenna Hayes

As private credit grows into a global asset class exceeding $1 trillion, investors in a maturing credit cycle must adopt smarter strategies to balance yield with resilience, Jenna Hayes, executive director, capital markets at Income Asset Management says.

With cash offering minimal returns, Hayes says rushing into deals risks overpaying for weaker assets. Instead, she highlights senior secured syndicated loans as a compelling, defensive option for wholesale high-net-worth investors.

“Senior secured syndicated loans give investors the ability to access high-yield opportunities, often above nine per cent per annum, while maintaining defensive characteristics in their portfolios,” Ms Hayes says.

Despite regulatory scrutiny, including ASIC establishing a dedicated taskforce and releasing a discussion paper on the systemic risks of private markets, Hayes says the outlook for private credit remains constructive when managed with discipline.

“Private credit, done well, benefits both the economy and investors,” Ms Hayes says.

“The key is ensuring there are frameworks in place and that investors are selective in how they deploy capital.”

Direct investment in syndicated loans offers significant advantages, including timing flexibility, transparency, and direct control over credit quality, collateral, and covenant protections. Unlike pooled funds pressured to meet deployment targets, direct ownership allows investors to underwrite each loan on its merits.

“Syndicated loans are structured with ongoing maintenance covenants, scheduled amortisation and cash-sweep provisions that help protect investors in a downturn,” Ms Hayes says.

“They are secured by large asset bases and strong cash flows across diverse sectors, from infrastructure to financial services.”

Looking ahead, regulatory changes such as APRA’s phase-out of hybrid bonds by 2032 and proposed Division 296 tax changes are expected to further drive demand for income-focused investments.

“As likely RBA rate cuts eat into term deposit returns, investors are seeking yield stability and tax efficiency,” Ms Hayes says.

“Syndicated loans offer a powerful trifecta of yield enhancement, credit quality and diversification, which can be particularly valuable in a late-cycle environment.”

Ms Hayes said that as regulatory scrutiny intensifies and markets face greater uncertainty, the appeal of syndicated loans for wholesale investors will continue to rise.

“In an era defined by late-cycle uncertainty, the ability to generate premium income without sacrificing resilience is invaluable,” Ms Hayes says.

“That’s what makes syndicated loans such a compelling opportunity for investors today.”

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Jenna Hayes

The market outlook for bonds and equities is strong, and investors can look forward to good returns on their super funds in coming years, according to Jenna Hayes, executive director of capital markets at Income Asset Management.

“Income assets, like bonds, will help manage a higher tax bill arising from Div 296 tax liability. In terms of corporate bonds delivering attractive returns, the recent Macquarie Bank and Melbourne Airport bonds offer good investment opportunities,” Ms Hayes said.

“The recently issued Macquarie Bank 10yr bond paying a fixed coupon above 6 per cent unsurprisingly saw strong demand. As interest rates fall and inflation continues to moderate, it’s a perfect time to lock in bonds paying strong fixed returns.

“The corporate hybrid market has exploded this year. We are seeing unprecedented demand from clients for this product, given the pick-up in yield over senior paper for strong investment grade issuers. Melbourne Airport is one example, which was well received by our client base”.

Hayes noted there has been a strong appetite for corporate bond issuance in recent months.

“We have seen bumper issuance in May and first half of June. There are too many to name, but our picks of the month are the bonds issued by One Rail Australia, Barclays, Next Era Energy and Melbourne Airport to name a few” Ms Hayes said.

“Issuers are milking opportunities in the corporate bond market. In terms of the big banks, we are likely to see less T2 issuance this year. But there is a lot of other corporate issuance and secondary opportunity for investors.”

According to Hayes, the Reserve Bank of Australia (RBA) is likely to cut interest rates several times this year.

“We are now within the RBA’s target inflation band of 2 per cent to 3 per cent and currently markets are pricing in a high likelihood of a July rate cut, with a cut 84 per cent priced in.  By this time next year, markets are pricing in four more cuts from the prevailing 3.85 per cent cash rate, but I think that is a little bit optimistic,” Ms Hayes said

“If these additional cuts eventuate, this means investors will be seeing even less income from their cash investments. That is likely to boost the appeal of corporate bonds for the reliable income they provide.”

Approximately 80,000 Australians who will face higher superannuation taxes on higher balances as significant changes to Australia’s superannuation system come into effect.

Superannuation account earnings for individuals with balances above $3 million are expected to be taxed at a higher concessional rate of 30 per cent, with that rate rising from 15 per cent on the portion of earnings attributable to the balance above $3 million. The changes are expected to be introduced in the coming financial year if the legislation passes through the Senate.

“While 80,000 people are likely to be immediately affected by this change, that number is forecast to grow significantly in coming years and it could rise to 500,000 in coming decades, so the implications of this change could be very broad,” Ms Hayes said.

“While these legislative changes were due to start on July 1, 2025, that will likely be pushed back because the legislation needs to be redrafted and go back to the new parliament. Still, we do have a lot of investors, especially high net-worth individuals, who are assessing what this change means for them. Some are considering taking money out of superannuation and putting it instead into defensive assets like corporate bonds, to avoid being charged that incremental 15 per cent on their super contributions where they have high balances.”

While the superannuation legislation had faced delays under the previous Labor Government, particularly over the taxing of unrealised gains and the non-indexation of the $3 million threshold, the passage of the legislation is now more likely with Labor’s increased Senate presence.

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Bob Sahota

Income Asset Management (IAM) has successfully arranged commitments for a $130 million debt transaction across multiple tranches for MONEYME (ASX: MME), acting as the sole lead manager.

This structured debt package marks IAM’s largest unrated over-the-counter bond transaction in Australia’s asset-backed securities (ABS) sector as sole lead manager. The transaction will support the refinancing and expansion of MONEYME’s Horizon Warehouse Trust, increasing its lending capacity for personal loans and credit cards.

The cornerstone investor for the transaction is Revolution Asset Management, a private debt investment house run by Bob Sahota, Simon Petris and David Saija, and secured strong investor support across all tranches from credit funds, family offices, and high-net-worth investors.

IAM’s chief executive officer Jon Lechte said IAM led the transaction drawing on its structuring and distribution expertise, and highlighted the high investor demand.

“The deal was oversubscribed at all tranche levels, underscoring the appeal of unique opportunities like this. It also marks a significant milestone for IAM Group, as our largest sole-led primary bond transaction, delivering above-average credit margins for investors.”

“We thoroughly enjoyed working with the MONEYME team, whose innovative approach to credit, strong execution, and commitment to responsible lending were key to this successful transaction.”

The transaction refinances an existing $85 million warehouse facility for MONEYME. Due to the company’s strong growth and positive outlook for loan expansion, the facility was increased to $130 million.

Clayton Howes, Managing Director and CEO of MONEYME said: “MONEYME has a long-standing relationship with IAM, and we are pleased to be working with them again to refinance our Horizon Warehouse Trust. Their expertise helped secure an upsized $130 million facility on more favourable terms, expanding our lending capacity while lowering our cost of funds. The strong investor appetite and improved margins reflect confidence in the asset class, the quality of our portfolio, and our market position.”

Settlement is expected to take place on 18 March 2025.

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Matthew Macreadie

The banking regulator’s announcement that it plans to phase out bank hybrid securities over the next seven years could see the price of hybrids rise as they become scarcer and see an increase in the value of bank shares as investors price in a possible rise in dividends as banks seek to utilise available franking credits according to IAM’s Matthew Macreadie, the executive director of credit strategy and portfolio management at Income Asset Management.

APRA is proposing that banks phase out the use of AT1 capital instruments, often called hybrid bonds or simply hybrids, and replace them with cheaper and more reliable forms of capital that would absorb losses more effectively in times of financial stress.  Any moves could impact retail investors, who hold more than 50 per cent of hybrids on issue.

Hybrids sit at the bottom of a bank’s debt capital stack and just above common equity. They have characteristics of debt and equity, in that they pay investors a set level of income, though they rank below bondholders and depositors in the event of a bank’s collapse.

APRA recently said^[1] it has three options: maintaining the status quo, redesigning bank hybrids to make them operate more effectively, or replacing hybrids with other existing, more reliable forms of capital.

According to IAM’s Matthew Macreadie, if hybrid bonds are replaced, this could potentially boost the value of hybrids bonds held by investors as they become scarcer.  “This is a result of APRA effectively removing hybrids as an asset class for investors from 1 January 2027,” he said.

“Bank share prices may factor in higher franking credits being attached to future dividends as a result of the removal of hybrids as an asset class. This could see the gross dividend yield on a major bank share increase from the current 6 per cent to 7 per cent level.

“Existing hybrid bonds held by investors such as SMSFs should provide good, regular income up until their call dates when they are redeemed. The door hasn’t closed on capital instruments being in the hands of retail investors in the future. Thus, a bank could issue ASX-listed Tier 2 with franking credits attached to meet the needs of SMSF investors,” he said.

“With banks paying 30 per cent corporate tax, hybrids were a nice way of monetising the franking balance that doesn’t get paid out as dividends.  Thus, investors such as SMSFs may look to replace hybrids with ASX listed Tier 2 going forward,” Mr Macreadie said.

The removal of hybrid bonds from the capital structure of banks reduces the income generating assets available to retail investors.  IAM is currently developing products that will allow individual investors seeking income certainty access to the broader fixed income market. Hybrid instruments issued by other sectors such as insurance are not part of the reform.  These assets will also likely see a lift in demand from investors seeking income.

The proposed changes follow last year’s global banking turmoil where several US and European banks either failed or needed to be resolved in short succession, with several governments having to intervene to minimise the risk of contagion and financial system instability.

“The purpose of hybrids is to absorb losses in the instance of a crisis. Unfortunately, events last year highlighted that hybrids did not fulfil this function in a crisis situation due to their complexity and the risk of causing contagion. These risks are greater in Australia due to the high proportion of hybrid securities held by retail investors,” he said.

APRA’s announcement follows an extensive consultation process that began with the release of a discussion paper^[2] last year asking for feedback from the financial services industry on a range of ideas to improve the effectiveness of hybrid instruments for use in a potential bank stress scenario. APRA received feedback from 26 submissions and more than 40 engagements.

APRA has proposed starting the transition to a simpler bank capital framework from 1 January 2027, with all current hybrid bonds on issue expected to be replaced by 2032. For existing investors, APRA said it does not envision an immediate impact with AT1 capital instruments continuing to be eligible as regulatory capital until their first call dates.

———–

Notes:
[1] https://www.apra.gov.au/news-and-publications/apra-proposes-update-to-bank-capital-framework-to-strengthen-crisis
[2] https://apra.us19.list-manage.com/

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Matthew Macreadie

Key points

The post Implications of higher interest rates on the Australian credit market appeared first on AdviserVoice.

US interest rate cuts on the horizon.

With the prospect of interest rate cuts on the horizon in the US, corporate bonds have started to perform well with the market already pricing in the cut expected in September, offering investors income and the opportunity for capital gain when the US Federal Reserve (the Fed) starts to lower interest rates, according to Darryl Bruce, executive director of capital markets at Income Asset Management. 

“It looks like the US might be on the cusp of interest rate cuts in September, with an 85-to-90-per-cent chance of a rate cut priced in from the Fed that month,” Mr Bruce said. “Being at the top of the interest-rate cycle, it is likely that money going into the fixed income markets now will reward investors over the coming years as rates move lower.”

With yields on investment grade bonds hovering above 6 per cent, Mr Bruce added that investors are being lured into this asset class by relatively high returns.

“We are seeing strong demand for new bond issues. We’ve come from an environment a few years ago where yields were much lower and now, in the investment grade part of the market, we’re seeing yields of 6 per cent-plus. That is driving a lot of investor interest. We recently saw that with a tier-two bond issue from Spanish bank giant Santander. We are also seeing plenty of issuance from the big four banks in Australia,” he said.

“Santander’s order book was over $4 billion. They only ended up issuing $600 million of bonds in Australia and we would have liked to have seen them issue a little bit more. The coupon came out very close to 6.5 per cent, which is probably 50 basis points higher than we’re seeing on coupons for big Australian issuers, such as the banks. 

“The Santander issue was only rated one notch weaker at Triple B-plus. This is good compensation for investors for the risk. It is also good to see a big global bank like Santander come into the Australian market to issue bonds,” he said. 

According to Mr Bruce, with yields sitting relatively high on investment grade debt, it is a good time to be investing money into the corporate bond market.

“We’re talking to clients and one consistent message we give is to look at where yields are now. Using the Santander issue as an example; if you can lock in a coupon of 6.5 per cent for the next five years from a from an institution of Santander’s quality, that’s 6.5 per cent return per annum for the next five years from a defensive asset in your portfolio. That’s a good outcome, and it is clear that money going into the bond market right now will reward investors over the coming years. 

“That’s the story that we’re talking about to investors.”

Mr Bruce also sees healthy outcomes for carefully selected private credit assets, which historically have offered an illiquidity premium over corporate bonds, which are publicly traded.

“In the higher yield loan environment, we see some great opportunities in the private credit market, and we’ll continue to access that market,” he said. “Investors are picking up an extra 3 per cent or so return for going into some private credit assets compared to bonds, over a three-year period. Liquidity is a bit less of an issue for a three-year period so the payoff is attractive,” Mr Bruce said.

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That change, again like sustainable investing, has moved from niche to mainstream in terms of its impact on investment markets. That means that it cannot be ignored. It doesn’t mean however that one has to believe artificial intelligence will fundamentally change investment markets or be positive for certain assets. But it does mean that the time has come to understand how this technology will change markets’ pricing, particularly given the attention that both of these themes are receiving from investment media and researchers.

The Digital Economic Revolution can transform the global economy in a material way, but only if it brings changes that have economy-wide impacts, not the relatively niche changes to date. The digital economy has mostly changed consumer logistics, with capital markets’ impacts largely focussed on economy-wide providers such as Apple, Nvidia and Facebook.

But this is the not the fundamental change that the steam engine or electricity had in the Industrial Revolution. Artificial Intelligence (“AI”) is the first of these more fundamental changes of this economic revolution. The trick, as always, is to pick such fundamental changes before the herd, but not too much before. Economies, companies and families that supported these changes in the Industrial Revolution are still benefiting from the wealth gained more than 100 years later.

Believe or don’t believe: Just understand the trend and its impact

AI is being included as one of the major changes to the global economy because we believe that it will be such a fundamental force. However, the power of IAM’s direct model, of course, is that you can read the argument for AI, but conclude that we’ve got it wrong and take the other side of that trade (ie buy those assets underpriced by everyone else believing in AI).

That said, the position here is that AI will impact global markets, particularly their volatility as markets try to predict the impact of AI on the real economy. Regardless of the magnitude of its impact, AI will cause three fundamental changes to capital markets:

• A direct impact on capital markets as the demand for capital shifts from operating capital (for labour) to investment capital (for technology investments)
• Productivity improvements, depending upon the economy’s encouragement of innovation, and
• Finally, AI will shift capital to those parts of the economy most likely to profit from the changes that AI brings eg infrastructure providers such as data centres, software providers and other technology infrastructure providers; and those sectors much disrupted.

The scale of this impact is huge, hence the opportunities and risks for investors. Some researchers have been specific about forecasting this impact, while others (like JPMorgan and the IMF below) have been less specific but no less dramatic in their predictions.

• Goldman Sachs have estimated an average impact of 1.5% per annum productivity growth over the next 10 years.
• Capital Economics^[1], a more independent researcher, concludes a similar global uplift, but also concludes that that positive impact is most acutely felt in countries that encourage innovation.
• Capital Economics have predicted the US, Canada and the UK will see productivity gains leading the world in the 2030s, with the US seeing even higher productivity gains than the 1990s, during the second phase of the internet’s economic impact. They have gone as far as to state that the US is now likely to remain as the world’s largest economy by 2040, keeping ahead of China due to the US’s stronger encouragement of innovation.
• JPMorgan has sensationally opined that AI will have a larger impact on the global economy than electricity and that it “has the potential to augment virtually every job”.
• On a similar line, the IMF has predicted AI disrupting around 40% of global employment.

AI also creates investment risks

But AI also creates investment risks that will create valuation bubbles and disrupt monetary policy over the next decade. Like any major disruptive force, AI will disrupt market valuations; it will displace some workers but create more opportunities for others; and it will force investment market forecasts to throw away old assumptions about earnings and economic growth.

What’s more, the impacts are not limited to the technology sector, or the old school sectors that are disrupted. Assets such as office property are impacted by any change to employment trends, as we saw with the global pandemic. The impact for property investments is particularly uncertain, hence particularly risky, given the impact on employment.

Robots won’t be taking over the world

Let’s be clear on this topic though: We are not talking about AI helping robots take over the world in 2024.

AI is like a really talented intern with a bad memory. Give them a repetitive task with clear rules, and AI-powered software can do that task in a fraction of the time that humans can. Ask AI or interns to use their experience and think laterally, and the results are terrible.

However, AI’s first and likely most significant impact will be to remove the administrative, repetitive tasks involved with almost all industries, and for many industries, it will dramatically reduce costs.

Conclusion

From an investments’ viewpoint, what revolutions tend to do is create permanent change (opportunities) and bubbles (risks). There is no great mystery to why this happens: Rapid and significant change moves wealth, creating greed, and meaning that the next wave of change has more people backing it.  So it would seem the question is now more about where this revolution will take us, and which empires and individuals will “win” from the revolution by the time it ends.

———

Notes:
[1] https://www.capitaleconomics.com/ai-economies-and-markets-how-artificial-intelligence-will-transform-global-economy

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Ms Labib, says the new appointments bring additional fixed income experience and expertise to the IAM team, and mark IAM’s strategic expansion into Perth, extending its reach beyond its existing offices in Sydney, Brisbane, and Melbourne.

Darryl Bruce joins as Executive Director and Head of Western Australia for IAM. Mr Bruce was most recently at FIIG Securities’ where he was state manager for WA, and will spearhead IAM’s entry into the West Australian market.

Ms Labib says: “Darryl brings over 20 years’ experience working in the financial services sector across Australia, UK and New Zealand to the team.

“He has an established track record in fixed income investing and, importantly, in managing a small team as a business. He is a great addition to IAM as we mark our entry into the WA market,” she said.

Accompanying Mr Bruce in WA will be Ellen Allardice who joins as Associate Director-Capital Markets. Ms Allardice was previously an associate director at FIIG Securities.

IAM has also made new appointments to the fixed income sales team in Sydney including Victor Gugger, Sandra Ang, Frederick Stewart, and Nick Lowings.

Mr Gugger brings over 30 years’ experience in financial markets across Sydney, Hong Kong and London to the role.

Ms Ang joins IAM from NAB where she was a Senior Investment Relationship Manager.

Mr Stewart, Mr Gugger and Mr Lowings join from FIIG where they worked for over 6 years in the private clients team assisting investors manage their fixed income investments.

In Brisbane, Harry Roberts joins the sales team as Associate Director.

Ms Labib says that IAM is seeing very significant growth in enquiry from advisers nationally, looking for a transparent way to buy income assets.

“Rates have been rising and competing growth assets face head-winds, it is a great market for Fixed Income.

“Against this backdrop, IAM has forged partnerships with platforms like HUB24 and Netwealth and is proactively building a powerhouse team to capitalise on these favourable market conditions.

“IAM has a vision for the sector’s growth and is committed to bringing client-focused fixed income solutions to Australian investors and establishing a firm foothold as the pre-eminent fixed income broker in Australia.

“With the addition of these new appointments, IAM is well on the way to achieving that goal.”

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Craig Swanger

The below is our view of the largest risks facing Aussie investors in 2024. Some of these, such as the rising risk of a property correction in China, were raised during the past year but are now being expanded upon and some are new.

The 5 biggest risks facing Australian investors:

• Top Risk:  China slows faster than expected and exports deflation
• Risk number 2:  Populist politics and its impact on global trade
• Risk number 3:  Market risk and models: Specifically equity market volatility
• Risk number 4:  The economic disruption of technology and AI
• Risk number 5:  The impact on market volatility of Sustainable Investments.

Top risk: China exports deflation

China has been the growth engine of the world’s economy for nearly thirty years, but now is the source of its largest economic uncertainty.

The growth in China has been significantly fuelled by urbanisation, ie the 320 million people moving to China’s cities, and the related ability of China’s central government to invest in infrastructure and property development to stimulate economic growth in tougher global conditions such as the post-GFC period last decade.

Now the benefits of that investment-fuelled growth have reached their limit. This limit is due to both the urbanisation trend itself, but more specifically that China’s total debt burden has become too high. We touch on this more below.

At the same time, China’s consumer prices are falling too quickly, the property development crisis is worsening and exports are slumping, so stimulus of some sort is required. China’s central government has little option but to try to boost exports.

If global conditions were very strong, this would be difficult but possible. The problem for China is they are attempting to improve exports at the same time that global consumers are spending less.

The implications for investors will be lower inflation and therefore lower interest rates globally. It also puts earnings pressure on the global companies that dominate equity markets’ growth.

Let’s look at the issues forcing China to boost exports as these are typically less understood and therefore less priced into global markets.

China is reaching its debt limits, reducing its options for stimulating growth

Borrowing by the central Chinese government is not the right measure to watch to understand China’s ability to borrow more to stimulate growth. The debt-to-GDP ratio for the total Chinese government is actually around the same as Japan’s (as shown below).

As a result, we tend to look at total government obligations as shown in Figure 1 below. That is, what debt will the central government be under significant pressure to support in the event of default? For the US, for example, this includes mortgage entities Fannie Mae and Freddie Mac and the US Post, but debt is still relatively centred on US federal debt (as shown in Figure 1).

For China, the total debt obligation needs to include local governments, local government finance vehicles (“LGFV”s) and state-owned enterprises (“SOE”s). It is worth noting that China’s SOEs comprise a massive 40% of China’s GDP, making China’s SOEs around six times larger in output than the whole of Australia’s economy.

As shown below, China’s total debt is approaching 300% of GDP and is largely driven by state-owned enterprises. That leaves Beijing policy makers with little room to move if they, like us, think that stimulus is needed, forcing them to lower centralised borrowing rates, but then they only have the option of combating the US and EU for trade competition.

China’s total debt is around the same as Japan’s

Total debt for China’s economy needs to be carefully compared to other economies. As shown in the left-hand chart, China’s total obligations are actually around the same as Japan’s and around twice that of the US and EU.

The right-hand chart shows that corporate debt in China, around 68% of which is from state-owned enterprises, surged past global averages since the last global economic crisis. As shown in the left-hand chart, SOEs are the primary source of China’s debt-to-GDP ratio today, so this surge has narrowed its options to stimulate its economy.

Together these charts show the bind that China is now in and the risk that this poses. In our opinion, this is a risk that investors are not being adequately compensated for at present.

Total Debt-to-GDP ratios
Key global economies and Australia, 2022/23

Corporate debt vs GDP
China vs the US and global benchmarks, 2022

The impact on global deflation

China’s property development fixes require control of domestic consumer confidence as they are major investors in Chinese property. Even for the centrally controlled government in China, consumer confidence of 1.4 billion people is very difficult to control.

So it is likely that Beijing’s policy leaders are smart enough not to rely upon turning around confidence in property and will turn to export growth policies, as export markets are the only other sector of the economy that has the scale to fill the gap left by property development.

Therein lies the problem for the world and for China: China’s factories selling to the world means that they will be exporting deflation.

This could take a while to hit the global headlines as deflation, not to mention weaker export earnings, tends to be bad for equities markets, but avid IAM readers will know we don’t tend to be shy about calling out underreporting investment market risks and opportunities.

This is particularly risky for Australia’s growth assets and their investors, but a strong opportunity for investments that will benefit from lower interest rates and increased global competition.

The so-what: Investment strategies to suit

Strategies include switching from high growth assets, particularly regional property and small-cap stocks, to higher quality assets.

The above also implies two likely themes will emerge:

1. In the first response, markets will have their typical “flight to quality” reaction, reducing their exposure to high growth markets and increasing hedges and assets perceived to have lower risks. Australia is considered a high-growth (high-beta) country as a whole, so this would mean Australian assets increase in value relative to US assets. This includes the AUD itself. The investment strategies that come from this phase include finding better value in Australian assets, and just avoiding sectors overly exposed to the true source of the uncertainty: China’s growth (avoid iron ore, copper, and assets overly reliant on WA and Qld, the mining states).
2. As the dust settles and markets start to focus on the real issues, non-China dependent growth markets will recover. For example, commodity markets such as coal, food and base metals (other than copper) will recover.

Despite the focus on China above, this is not an issue limited to the challenges that China faces. This is a global issue. Lower consumer spending in the US and EU will combine with the under-reported economic issues in China to create lower inflation, lower interest rates, and lower growth expectations globally.

With that said, in 2024 the largest risk for investors is how China will respond when it starts to fall short of its own economic growth targets. Because of past borrowings by parts of the centralised Chinese economy, they have little option but to depend upon export sectors to drive economic growth.

Doing this at the same time that the US and EU consumers will reduce spending is difficult. But this challenge will be made even harder by the impact of 2024’s extraordinary election cycle globally (#2 of the largest risks of 2024). Global trade is a common enemy raised during election cycles, and with nearly half the world’s population represented in elections in 2024, increasing global trade will be even harder.

Unrelated to these issues, two of the longer-term issues also require adjustments over 2024. These are the impact of the digital economic revolution, eg artificial intelligence; and the impact of sustainable investments, ironically positive for commodity prices too.

And final of the five largest themes for investors, market overpricing, is far more short-term. This risk requires immediate repositioning. Equity markets are still priced for perfection, which 2024 is highly unlikely to hold. Due largely to the issues above, “growth” volatility will rise, which will cause more volatility for equity markets in particular.

The overall theme for Australian investors in 2024 is to derisk. Derisking does not mean reducing total risk, but rather it means being smarter about where risks are taken. Risk must always be considered relative to return, so derisking does not mean loading up on cash, government bonds or bank stocks. It means making sure you are getting paid for the risks you take.

The global themes highlighted suggest that there will be higher market volatility, which might lead to some sectors being oversold. For instance, China’s risks are not bad for all commodities, and certainly not as bad for Australia as world markets will initially imply. However, the overselling of Australian assets, including the AUD itself, has occurred with every global market shakeup. Assuming this will happen again, which is a fair assumption, means opportunities to swap growth risk for smarter risk and maintain investment returns.

In short, 2024 is not the year to blindly follow the pack. Rather, it is the year to observe global themes unfold and be ready to take advantage of market mispricing.

By Craig Swanger, Chief investment officer

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