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David Miller: Hello, I'm David Miller and this is Capital Ideas, your connection with the minds and insights helping shape the world of investments. Today we will be discussing, are rate cuts coming this year and does it really matter? I'm joined today by our fixed income investment director, Haran Karunakaran. Welcome Haran.

Haran Karunakaran: Thanks Dave, glad to be here.

David Miller: So, starting this podcast today, as we are recording this in Australia, could you share capital groups perspective on the inflation and subsequent interest rate forecast for Australia?

Haran Karunakaran: Yea, happy to and I think it's been very topical at the moment. The RBA over the last few weeks has been back in the headlines and expectations about potential rate hikes in Australia are a front-page news for most of our listeners. If you look at futures markets today, the expectation is one to two rate hikes by the RBA by the end of the year. And that is quite a change, I think, from a few months earlier, where the expectation was more for a pause that would be extended or even rate cuts. And what's really driven this has been a few upside surprises in inflation. So, the most recent CPI data in Australia came in above expectations and was at 4% and I think that shift from a three handle to a four handle is quite a quite a big psychological one and as a result of that people are increasingly thinking about the risk of RBA rate hikes. More recently the RBA minutes that were released confirmed this. It was pretty clear for the minutes that the discussion in the meeting was a pause versus a hike. So, no discussions about cuts anymore. It's all a question of whether to hike now or extend the pause.

David Miller: Interesting. And shifting our focus internationally, we're observing some disparities among different countries in their central banks with some reducing rates or anticipating rate cuts. Which key countries should investors be focusing on and what are the inflation and interest rate expectations of those nations?

Haran Karunakaran: So, I think that it's important to highlight that the dynamic internationally is very different to Australia. I talked about Australia in the situation of weighing a pause versus a hike. I think in much of the developed world, it's actually a pause or a cut. And this is really because Australia is, I think, on a similar trajectory to the rest of the world in terms of inflation moderating. But Australia is lagging quite a bit in that cycle. And what we are seeing in other markets is that some central banks in the developed world have already started cutting rates. The Bank of Canada led the way. European Central Bank has also cut, Swiss Central Bank has cut as well. If we look at what's priced in by futures markets, you know, I mentioned earlier one to two hikes in Australia for the rest of this year. If we look at two more cuts by year end, and then potentially more rate cuts in 2025. Europe and the UK kind of similar one to two rate cuts priced by the end of the year. So, I think what we're seeing globally is a well-entrenched disinflation trend that's happening. There is definitely volatility around that trend and Q1, we saw some of that volatility. But the trend is downward, and we are starting to see initial signs of softening in economies, which I think will allow central banks to take their foot off the brake in most other countries around the world. Although, as we said earlier, Australia is slightly different scenario where we will probably see more rate hikes before any cuts start to come through.

David Miller: Interesting. And you mentioned the Federal Reserve in inflation and interest rates in the US as significant points of interest for global investors. Could you elaborate on the expected inflation in interest rates in the US and share Capital Group’s viewpoints on this matter?

Haran Karunakaran: Yeah, I think in the US, what has been very topical is the spike in inflation that we saw in the early part of the year. So just for the benefit of listeners, in Q1 and in April, we saw inflation in the US, CPI data coming in well above expectations. And that got many market participants worried about, worried that the Fed had got ahead of itself in starting to think about rate cuts. When you looked at more detail, looked at the data into more detail rather, what was interesting to us, though, was that spike in inflation seemed like it was a bit more of an aberration. What we saw was that there were only a handful of elements of the CPI basket that were driving inflation up. Whereas most of the basket was actually continuing to disinflate. In Q1, 35% of the CPI basket was actually in deflation, so negative inflation. Another 20% was under 2%. So, if you add those two together, over half the CPI basket was already below the fed target of 2%.

What we also saw in that period was labour markets showing early signs of moderating. Now to be clear, the US labour market remains very strong. Unemployment is near historical lows. But on the margin, what we are seeing is some signs of that turning. What a really good indicator of wage growth is what we call the quit rate. So, the rate of people quitting their jobs. Intuitively, this makes sense when labour markets are really strong, there is a lot of job out there. People are more likely to quit their jobs. When there aren't as many jobs out there, people will hold on to their jobs and quit rates start to fall. And what we've seen this year is a really clear decline in quit rates. And that's suggesting that wage growth should also come down over the next few quarters. And that was sort of the Q1 story and what we've seen in the last couple of months is data starting to support our view that actually Q1 was a bit of an aberration. The last two months of CPI data in the US, show a return to the disinflationary trend that we saw earlier. And PCE, which is the official measure that the Fed focuses on, is also moderating. The main number came in at 2.6%, which is getting reasonably close to the 2% that the Fed's targeting.

So that is, I guess, the inflation backdrop. What does this all mean for rates? Well, I think in the US, what we have is a Federal Reserve that really wants to cut rates. They want to get back to a more normal monetary policy footing after what was one of the most aggressive rate hiking cycles in history. Chair Powell has come out in the public and in his statements, very clear that current levels of monetary policy he sees as restrictive. What he and the Federal Reserve need to see is just more data to confirm that to get really the confidence to say that disinflation is here to stay and then start cutting rates. We think that confidence will come through in the data in the next few months. So, our overall view is that the US and probably similar to many other central banks like Europe and the UK is entering a multi-year rate cutting cycle, albeit a very measured and potentially slow one. So, what could that look like in the US? I think potentially one to two cuts in the remainder of 2024. Maybe a pause at that stage for the central bank to gauge the impact of those cuts and then a continuation or resumption of cuts at the back end of 2025.

David Miller: Fascinating. Thanks, Haran. And for our professional investor audience, could you provide some insights and practical suggestions for those constructing diversified investment portfolios, particularly in relation to allocations to global fixed income markets?

Haran Karunakaran: Yea, think, you know, many listeners would have heard the catch phrase by many fixed income asset managers over the last year or so that bonds are back. I'd say bonds are still back. Bonds are still very attractive today, particularly a high-quality credit. And they are attractive for a few reasons. I think yields are at historical highs and yields are very important because today's yield is highly correlated with the return, you're likely to get from investing in bonds over the next five years. So, if you look at investment grade credit, for example, you are talking about 5% to 6% yields, which points to an attractive return going forward. On top of that, you have the potential for upside from rates being cut if you're investing in fixed rate bonds or duration. So, that gives you a second source of return, which I think could reasonably be in the 1% to 2% per annum range over the next few years.

So, bonds provide a great return opportunity today, one that we haven't seen in well over a decade. But on top of that, we need to remember one of the key reasons we invest in bonds and that is to add defensiveness to a portfolio, to offset some of the equity risk or equity volatility that dominates most portfolios. Why bonds are so attractive today from that regard is that to generate a decent income from your bond holdings a few years ago, you would have had to take a lot of credit risk and you weren't getting that defensiveness. But today you can invest in high quality bonds and still get a decent return potential. So, at a high level, think bonds still very attractive. If we go a level deeper and think about which sectors of the bond market we'd be talking about. I think lower quality credit, less liquid credit, direct lending, private credit, etc., can be attractive. But I think the thing to highlight is that it doesn't necessarily provide the same defensiveness as high-quality fixed rate bonds. And because many of those sectors are floating rate, and they don't have as much duration exposure, they may not get the upside if we do start seeing rate cuts from central banks around the world. So, I'd be a bit less positive on that lower quality credit segment. If you look at the other end of the spectrum, the really high-quality sovereign bond area, those bonds look attractive, they're defensive, but they do give you a lower yield. So, I think that's the sort of sector that could make sense if you expect a severe recession, but maybe not otherwise. I think what is probably the sweet spot today, are high quality corporate bonds. They give you the defensive characteristics that you're looking for from a bond allocation. They have a very low probability of default, less than 1% historically. So, your capital is protected, and they give you an additional income over what you'd get investing in sovereign bonds today, paying about a 1% additional income. And if you look globally at investment grade credit, you have the benefit that most of these bonds are fixed rate bonds with an amount of duration, so that they will benefit when rate cuts do eventually come through.

David Miller: Interesting. So, not all bonds are created equal. And on that point, a lot of investors in Australia that I've spoken to allocated to low duration, no duration, free floating fixed income instruments over the last few years. What is your personal view on these types of investment strategies? And I guess more importantly, the role that they can play or do play within a diversified investment portfolio.

Haran Karunakaran: Yea, that's a great question. I mean, definitely a trend that I see as well when I'm speaking to financial advisers.  Over the last few years, low duration or no duration strategies, floating rate strategies made a lot of sense. When central bank rates were near zero, there was really no upside from investing in duration. Duration only has positive returns if rates start to come down. So, over that period, I think that was definitely the right position. In markets like 2022, when rates sold off, was also the right decision. My view is that we are moving into a new era of monetary policy. An era where, a more normalized era where rates will be higher, longer, coming down from where they are today, but still stay elevated. And in that sort of environment, I think duration has a much more important role to play. And particularly over the next few years, if you are like us and you expect rates to come down, I say 1% to 2%. That is going to be a big benefit for fixed rate bonds for duration and it will actually be a negative for floating rate bonds. Any floating rate strategies as central banks cut rates, we will just see their income levels ratchet down and down and down. Fixed rate bonds actually see exactly the opposite as central banks cut rates, they will see capital gains coming through and a boost in returns. And historically, we have seen that that return is quite substantial. So, as an example, investment grade credit, on average returns 10% per annum in the three years after the central banks start cutting rates.

David Miller: Excellent. And as we wrap up this conversation, do you have any final thoughts or pearls of wisdom you'd like to share with our listeners today?

Haran Karunakaran: Yea, I would say, my main piece of advice would be think long-term and don't miss the forest for the trees. In many of the discussions I have with clients around the day to day or month to month volatility and noise around the new inflation data, what is being predicted in terms of rate cuts, will it happen this month, next month? Will there be one or two, those sorts of questions. And I think for a medium to long-term investor, that is in a way that doesn't really matter. What I see is an environment where over a three-year time horizon, fixed income provides a great opportunity. Timing exactly when to enter that is I think a bit of a futile task. 2023 was a perfect example of that. A global investment grade credit returned 7% in Aussie dollar hedge terms over the year, but all of that return came in the last two months. So, if you tried to time that and got that wrong, you could have easily walked away with zero returns for the year. It is really impossible to predict, and I think this year could be quite similar where you have markets puttering along around zero for a little while, and then a sudden spike as markets starts embracing the potential of rate cuts. So, my advice would be don't get caught up in all that noise. If you agree with us that the high-quality fixed income sectors provide a medium-term opportunity, just get invested today and hold through the volatility and stay invested for the long-term.

David Miller: Excellent. Thank you for your time today, Haran, and insights as always.

We're always trying to get better. So, if you have any feedback, including topics you'd like to see addressed in future episodes, send us an email at CapitalIdeasPodcastAustralia@capgroup.com. And if you like what you heard today, please follow us on your favourite podcast platforms being Capital Ideas. This is David Miller reminding you that the most valuable asset is a long-term perspective.

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