Australian Fixed Interest: The three big themes you can’t ignore
Jay Sivapalan, Head of Australian Fixed Interest, identifies three macro themes investors should bear in mind as they navigate the evolving investment landscape.
6 minute read
- Following the extraordinary monetary and fiscal distortions of the pandemic recovery, the investment landscape has shifted.
- We see three major themes shaping the outlook for inflation and fixed income in the years ahead.
- The path ahead is unlikely to have the same degree of stability and certainty that investors have enjoyed for the past few decades.
Looking to 2023 and beyond, we see a number of structural forces akin to tectonic plates moving within the global economic landscape. These are worthy of investor attention and will likely determine asset allocation and returns over the coming decade. Getting the ‘big picture’ right will be vital for investors, creating risks, along with abundant opportunities.
Following the pandemic recovery, markets are burdened with the task of ‘normalising’ from extraordinary levels of monetary and fiscal support. Finding natural market pricing after the COVID-driven distortions is unlikely to be an orderly process, particularly given the very different world we find ourselves in today.
Rather than assuming a return to pre-pandemic norms and the stability enjoyed over the past few decades, we believe investors must factor in some key macro themes going forward. In this article, I discuss the disruptive nature of these themes and why they should matter to investors.
Macro themes in a changing world
The world’s alignment into trading blocs:
In recent years, while events such as Brexit and the US/China trade wars led to the growing view that markets are de-globalising, our view is that rather than the start of de-globalisation, we are in fact witnessing the re-arrangement of global trade into like-minded trading, security and defence blocs.
We see two main groups emerging – democratic, capitalist developed nations along with their aligned developing partner nations, and socialist, communist nations with their developing nation peers. Recent geo-political events, such as the West’s response to Russia’s invasion of Ukraine provide a glimpse into these alliances in action.
That said, while freer trade within blocs will be more efficient, in situations where raw materials or efficient production are too hard or too costly to substitute, we still expect trade to continue across bloc lines. This should limit the economic impact for resources-rich countries like Australia, but trade could be disrupted in times of heightened tension, as experienced by the Australian agriculture sector in recent years due to a strained relationship with China.
Nationalisation or national security?
Today, assertive actions from Russia and China aimed at challenging the United States’ status as ultimate super-power are becoming more commonplace.
When cut-off from the rest of the world during the pandemic, nations’ vulnerabilities to supply dislocations and weaknesses in their manufacturing sectors were laid bare.
While there has been suggestion by market participants that a trend of nationalisation has emerged, this implies countries are pursuing a closed economic model. We believe, however, that rather than nationalism, economies are more likely to pursue an agenda of national resilience and security, while remaining open to trade. ‘Resilience’ for a country like Australia means becoming self-sufficient in a period of growing geo-political instability. We expect investment in defence, cyber-security, health systems and advanced manufacturing, as well as other sectors identified as vulnerabilities.
Over the past 70 years, governments, market participants and businesses have been able to take the relative geo-political stability for granted. However, the rise of major powers, each with competing agendas of influence and expansion could see confrontation and conflict erupt. This could result in rapid escalation where military pacts commit nations to support their fellow members. In this uncertain environment, companies and markets will demand higher risk premia to compensate them for the additional risk on their capital.
The renewable energy revolution
The transition to renewable energy and targeting net zero emissions is likely to give rise to opportunities and risks for investors. The risks range from physical asset risk, stranded asset risk and revenue loss, while the potential opportunities resulting from this multi-trillion dollar, long-term investment thematic are broad and include initiatives related to green hydrogen, solar, wind, hydro-electric power generation and battery storage, along with the infrastructure required to enable the electrification of the economy.
Beyond emissions targets, the Labor government has committed to a target of 80% renewable energy in the electricity mix by 2030. The government aims to achieve this through community batteries, low-cost solar banks, new electricity transmission infrastructure and improvements in existing industry’s energy-efficiency.
With large scale capital investment, Australia has the potential to become a leader in renewable energy generation. Being endowed with abundant space, along with sun, wind and river systems, Australia’s renewable energy needs could be catered for domestically, while surpluses could be exported to neighbouring countries, enabling an economic growth engine if the opportunity can be seized.
The energy transition will require the re-allocation of capital away from fossil fuel energy generation, along with levels of new investment not seen in decades. This transition will be costly and is likely to manifest in higher consumer energy prices.
The above structural themes, along with cyclical elements must be considered in order to gain an understanding of the future path of monetary policy, term risk premia and risk-free yields – crucial factors in the valuation of all asset classes.
Cyclical inflation, primarily driven by pandemic-induced supply side shocks, pent up demand and high levels of consumer savings, should peak very shortly and subside in 2023. In our assessment, near-term inflation is likely to be sticky and last longer than markets anticipated, but will normalise nonetheless. Many of the initial supply issues have been resolved with their prices heading back down. However, second round inflation such as rents, energy and wages will take longer to resolve, especially at ‘above full employment’ labour market conditions. We expect to see meaningful progress towards the Reserve Bank of Australia’s (RBA) inflation targets next year, even though they may not be fully met until 2024 given the significant monetary policy tightening and fiscal restraint observed this year.
The path ahead
With such an array of themes at play, one thing is clear, the path ahead for the economy won’t have the same degree of stability and certainty that investors have enjoyed for the past few decades. Therefore, having an understanding of how markets and the geo-political landscape can shift in response to these macro themes will help investors to navigate the path ahead.
This journey will be neither smooth nor easily predictable and active management and careful analysis will be vital in identifying the risks and opportunities that will emerge.