Andrew Canobi

Andrew Canobi, director of Australia Fixed Income for Franklin Templeton Fixed Income says “A look at the instrument panel in the US reveals little showing up in the gauges that says landing imminent.  Employment firm and now core CPI ex-housing motoring along – 3 month annualising well north of 7%!

“The data is simply not providing cover for the Fed to cut in June or July as yet.  It may start to do so but core inflation has accelerated since Q4 2024, so things need to reverse course pretty quickly for this to be a chance.  Take out a June or July cut and cuts become difficult for the Fed this side of the Presidential election.”

Jeff Schulze, Director and Head of Economic and Market Strategy at ClearBridge Investments, a global investment manager notes “The March CPI release came in hotter than anticipated with core and headline inflation coming in at 0.4% and 0.4%, respectively.

“The recent barrage of hawkish Fed speak proved warranted in light of March’s inflation release suggesting achieving the “last mile” of inflation on the journey to the 2% target is going to prove more challenging than initially perceived considering the 3, and 6-month annualized rate of Core CPI is running at 4.8% and 4%, respectively.

• After experiencing the first positive move higher in core goods inflation since May 2023, the trend of lower goods prices reasserted itself in March with used car pricing reversing last month’s strength coming in at -1.1% which was accurately foreshadowed by the recent decline in used car auction prices.  A return of goods deflation is a welcome development as its been one of the main drivers lower of inflation over the past 18 months
• The problem child continues to be sticky shelter inflation with its biggest component OER coming in at 0.4% on the month.  OER hasn’t had a print lower than 0.4% since August 2021. Shelter inflation has remained sticky even though many private measures of rent growth have been showing declines for a year.  While this gap may eventually close, the bifurcation remains after today’s release.
• Airfares decreased -0.4% in March, partially reversing the largest monthly rise in that subcomponent going back almost 2 years (May 2022).  However, airfares are one of the categories that do not carry from CPI over to the Fed’s preferred core PCE measure as PCE measures airfares from tomorrow’s PPI release.
• Motor vehicle insurance continues to be a source of sustained inflation seeing its largest monthly reading since July 2020 while increasing by +20% over the last 12 months.

The bottom line

Shculze says “The battle between the sticky vs continued disinflationary narratives is moving decidedly toward an inflation backdrop that is plateauing and potentially accelerating.   March’s hot CPI release coupled with last month’s hot jobs data reaffirm that the Fed will remain data dependent requiring more data to feel confident for the commence of the rate cutting cycle.

“This inflation release effectively takes June off the table for the first rate cut and should push the odds out further with a coin toss in July or September.  This release should put upward pressure on 10-year treasury yields along with the broader equity complex as valuations come down,” says Schulze.

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Andrew Canobi

Economic indicators are weakening in Australia but that doesn’t mean that yields will fall the way many expect says Andrew Canobi, Portfolio Manager for Franklin Templeton Fixed Income.

Canobi says “We wish we could bring better news but the prognosis for the Australian economy is not good with recession risks rising as the consumer enters a new era of pain, whilst the RBA is likely to only consider limited relief by way of cuts. The consumer has been under pressure for some time, but business confidence and activity has held up. That’s changing now, which sees both consumers and business start the year more aligned in a sombre outlook.

“Central banks will ease rates around the world, but this is already starting to be priced in. Policy rates are in restrictive territory, which is helping to slay the inflation dragon as the post-COVID spending frenzy fades. Central banks have been fighting against government policies which have and continue to be expansionary. Employment markets are cooling but from a still firm position providing central banks permission to keep rates higher for longer whilst they await evidence that the inflation job is done. In the US, the rapid deceleration in CPI means the Fed is in play earlier than the RBA, from Q2. To keep rates at their current levels as inflation falls, in a sense, would see the Fed de facto tighten policy as real rates would move higher as inflation falls and policy remained unchanged.

“Markets will oscillate around the timing and magnitude of cuts in 2024 but the more important driver for returns over the next 12-24 months is the endgame. We expect the easing cycle to end with a relatively higher policy rate in Australia and the US than prior cycles. To state the obvious, absent an accident, we won’t see a return to ultra-low settings – zero or quantitative easing. And in Australia, it’s clear the 0.75% pre-COVID cash rate won’t be revisited unless we see an economic shock. It’s more likely central banks now regard nominal neutral rates as in the 2.5-3% area. This is only slightly less than what is currently priced into markets over a two-year period. So, to excite bond markets, we need cuts to be brought forward and/or to be larger.”

“The consumer in Australia enters 2024 on the ropes, which is remarkable given the still low level of unemployment,” he adds.

Canobi says “Australians are saving at the lowest level since the GFC. This is not a bullish signal reflecting confidence to spend but a desperate response to a cost-of-living crisis that has seen real incomes decimated. We know from national accounts that a significant driver of the destruction of real incomes has been by higher levels of tax through bracket creep along with higher interest payments. The implosion in the rate of savings clearly follows a period of accumulation through the COVID period but we now know that the core consumption group of ~24-55-year-olds have burnt through the buffers. As can be seen below, despite the lower savings rate, consumption hit stall speed in 2H 2023 and we see no change in the year ahead.

“The labour market is softening. Sure, from a strong position but with the consumer already stretched unemployment doesn’t need to rise that much to accentuate the pressure. The timely SEEK (a popular job search website) monthly job ads data tells us that unemployment is going to 4.5% and possibly in the coming months. Still low by historical standards but coming from a low of 3.4% and in a context where the consumer is tapped out, we will see pressure build.

“We have observed from the Westpac Melbourne Institute monthly sentiment survey that consumers have expressed extreme levels of pessimism for many months. More recently, however, business confidence has also rolled over after holding up (surprisingly so in our view) for much of 2023. It shouldn’t surprise that business is finally receiving the feedback from their customers and reacting accordingly. The latest reading on confidence from the benchmark NAB Business survey is in negative territory.

“The bottom line is that consumers were weak in 2023 whilst business, until recently, remained more optimistic. As we head into 2024, both pillars of the economy are weak. This means recession risks are now higher, particularly as the explosive migration led population story settles down and with it the risks that high population growth papers over underlying weak consumption fall.”

So, what now for yields?

Canobi says “We have maintained that the market is unlikely to see a lot of demand for 10-year bonds that fail to price an adequate risk premium. If central banks perceive neutral rates in this easing cycle to the 2.5-3% area, and the term premium remains around the ~1% area, then the fair value for 10-year government bond yields both in the US and Australia (the latter being dictated to largely by the US) will be in the 4% area. US 10-year treasuries are currently trading at around a 4.14% yield, and Australian 10-year yields are priced at 4.29%. Rather than the persistent 2-3% range for 10-year yields as seen in the 6 years before COVID, it’s more likely we see a 3.5-4.5% range.

“There are any number of risks that could push yields lower in 2024 but it’s likely these would be adverse shocks from left field.

“Whilst 10-year yields noodle around their current levels, we expect yield curves to continue to steepen as shorter-term yields decline. In particular, we expect that the US 2-year vs 10-year yield curve differential will return to a positive position after nearly 2 years of inversion. Front end yields historically rally more into easing cycles, and we expect no different behaviour this time. For cash and bank funding, the banks being the savvy participants they are, will likely notch down their term deposit rates as funding rates fall.

“Credit markets enjoyed a very strong run in 2023 and will confront macro headwinds building in 2024. Credit can continue to perform as investors favour higher yielding but still defensive sectors leading into an easing cycle. We expect non-cyclical investment grade to perform in 1H 2024 as all-in yields in the 5-6%+ area remain attractive. Beyond the 1H 2024, we are more cautious on credit and will monitor if the risks to the downside grow. Within the broader defensives, AAA-rated Residential Mortgage Backed Securities (RMBS) and select Asset Backed Securities (ABS) remain solid and attractive sectors delivering excess returns of approximately 100-150 basis points over cash.

“What does it all mean for returns? We believe 2024 might be similar to 2023, a year where yields trade sideways to slightly down with spreads largely stable but facing more pressures as the year progresses.

“This means returns will be a function of starting yields plus some upside as yields likely moderate lower leaving total returns higher than starting yields. If this proves the case, the outcomes will be quite attractive, with the result being attractive returns above cash and term deposit alternatives to bonds. Should the macro environment see cuts brought forward or delivered in greater quantum, then bonds will rally more.

“With respect to our positioning within the Australian Absolute Return Bond Fund, we believe somewhere between a mid to high single digits total return for 2024 expresses a plausible outlook given both our current portfolio positioning and our expectations for the global economy in the year ahead. This would be a similar outcome to 2023 but, arguably, with less volatility likely as inflation risks are now more skewed to the downside,” says Canobi.

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Angela Guan has been appointed as a Portfolio Analyst. She has previously worked as a researcher, an econometric modeller and data analyst at the Department of Finance at the University of Melbourne.

Guan holds a Bachelor of Commerce with first class Honours from the University of Melbourne. She is currently studying for a PhD in Finance at the University of Melbourne.

George Lim has joined the Franklin Australia Fixed Income team as a Credit Analyst. He will be responsible for researching corporate credit issuers across Australia and Asia Pacific. He is also part of the Franklin Templeton Fixed Income global credit research group.

Lim joins Franklin Templeton from MUFG Bank, where he managed the end-to-end process for new transactions, from credit analysis to deal closure. He holds a Bachelor or Commerce and Bachelor of Finance from Monash University, with majors in Finance, Economics and Actuarial Science.

Felicity Walsh, Managing Director and Head of Australia and New Zealand, Franklin Templeton said: “We are delighted to have Angela and George join our growing team. They will add depth to our analysis of fixed income markets. They join our experienced local fixed income investment team and will contribute valuable insights to the Franklin Templeton’s well-established global fixed income research platform.”

Chris Siniakov, Managing Director, Franklin Templeton Fixed Income added: “The investment environment has rarely been more challenging and the opportunity in fixed income is very compelling. The addition of these two talented professionals to our team positions us to expand our reach and serve our clients.”

Andrew Canobi, Portfolio Manager, Franklin Templeton Fixed Income said: “The volatility in fixed income markets over the past six months now presents outstanding opportunities and we are looking forward to working with Angela and George to realise those opportunities for Franklin Templeton’s clients.”

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Closing in on a three-year performance track record and managed by local co-portfolio managers, Chris Siniakov and Andrew Canobi, the fund is an absolute return focused strategy that primarily invests in fixed income opportunities in the domestic market, with select exposures to the broader global universe of securities, and has a strong focus on protecting against capital volatility.

“In an environment where we are seeing potentially rising global yields and yet declining yields in Australia, taking an absolute return approach can help restore the defensive characteristics of the fixed income asset class”, says Siniakov.

According to Lonsec, “The two co-portfolio managers are seasoned investment professionals with a long history of working together. The investment team leverages the significant resources of the manager’s global fixed income platform and has demonstrated an ability to adhere consistently to their investment process.”

The fund’s investment team draws on the expertise of Franklin Templeton’s fixed income group, a global platform with over 170 investment professionals and more than 30 years of experience managing bond strategies.

Lonsec also noted: “The two investors have created a strategy that leverages their specialisation in macro and credit opportunities. The portfolio managers’ successful history of collaboration has helped Lonsec to gain confidence in their ability to effectively manage an investment team.”

Maria Wilton, Managing Director said: “We believe this upgrade recognises the deep experience and expertise of the team, the significant global resources of Franklin Templeton as well as the successful track record of the strategy since its inception in 2014.”

“Importantly, the fund provides a potential solution for the challenges facing many advisers and their clients today as they seek regular income and capital preservation in the fixed income sector,” Ms. Wilton added.

The fund also has an ‘Approved’ rating from Zenith and 4 Stars from SQM Research.

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