Anna Hong: Debt, disruption and demographics
determine where bonds go next
25 March 2022
AUSTRALIAN 10-year bonds yields are at a four-year high.
Where will they go from here?
To answer that we need to ask another question: what level of interest rates can the Australian economy withstand?
We think a neutral cash rate of 1.5% to 2% is bearable. But 3% will be an overshoot that strains the Australian economy.
Under those conditions, the Australian Government 10-year bond yield becomes interesting at current levels around 2.75%.
Why? Because the global trajectory of three key factors — debt, disruption and demographics — hasn't changed despite recent events, especially in developed economies.
Even though headline population growth is positive, it's largely driven by net migration which has been impacted by Covid.
Australia's fertility rate is below the replacement rate and life expectancy is on the rise. This means we have an ageing population. Adding higher interest rates to that mix will significantly impact GDP growth.
Technology has transformed every facet of our lives and it's not about to stop.
With continued technological progress we can expect goods prices to move downwards as we reap the rewards of manufacturing and logistical efficiencies. (Once the current supply-shock eases of course.)
This means that while inflation is a now-problem, it will not be a long-run issue which central banks need to tackle with never-ending rate hikes.
Finally, consider the debt overhang.
As a nation we continue to indulge in our favourite activity - buying property.
The Australian household debt picture is nuanced, however.
We're one of the most indebted nations in the world, but we're also rather good at things like pre-payment, so we can get ahead of the debt mountain.
This pragmatism will lead to many households tweaking spending decisions as interest rates rise. At a time when disposable income has already been hit by oil prices, the RBA will be cautious about adding further strain.
The dynamics of Debt, Disruption, Demographics means that the most probable outcome is a neutral cash rate of around 2%.
Rates higher than that will lead to curtailing of GDP growth, straining the Australian economy.
This may be welcomed in restraining inflation in the near-term but not in the medium-term.
With current Australian Government (ACGB) 10-year bond yields at 2.75%, aggressive rate hikes are almost fully priced in.
Cash sitting on the sidelines will find value here as the Reserve Bank continues to delay rate hikes.
Economists' consensus has the first hike occurring in August — therefore investors may need to wait until late 2023 for cash returns to exceed 1.5%.
The risk versus reward makes this an attractive option for balanced portfolios.
Bonds are still a defensive instrument, given forward uncertainties, especially in the geopolitical space.
Investors will need them in their portfolios.
Any investor currently underweight bonds should be looking to get back to neutral. We think the next three-to-six months may bring levels which are attractive for investors looking to go overweight bonds.
Written By Anna Hong, Assistant Portfolio Manager
Funds operated by this manager:Pendal Total Return Fund
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