Globally, equity markets were broadly positive in September. In the US, the S&P 500 rose +2.0%, the Nasdaq increased +2.7%, whilst in the UK, the FTSE declined -1.7%. In Australia, the All Ordinaries Accumulation Index outperformed, rising +3.5%. The top performing sectors on the ASX were resources and technology, whilst healthcare was the worst performer. Resources was boosted by news of stimulus from the Chinese government, following a period of weak economic growth, whilst technology benefited from lower bond rates as the US Federal Reserve commenced its easing cycle. Notably, small caps outperformed large caps on the ASX (ASX small ords increased +5.1%) as investor risk appetite improved.

As discussed, a key event for equity markets in September was the US Federal Reserve cutting interest rates by 0.5% due to inflation reaching acceptable levels and a slowing economy. Whilst the event was expected by the markets, it is still an important milestone for equities, particularly small/mid cap stocks. Currently, Australia is not as close to rate cuts as the US, however we believe some easing in monetary policy is likely in the next 9-12 months. In bond markets, the US 10 year government bond yield fell -8 basis points to 3.78%, whilst in Australia the 10 year bond rate was flat at 3.97%.

Disclaimer

This video presentation (the "Content") has been prepared by Australian Fund Monitors Pty Ltd, "AFM" (AFSL 324476) and has been prepared without taking into account the investment objectives of the viewer or recipient. The Content is intended for information purposes only, and recipients should conduct full research and take appropriate advice prior to making any investment decisions. The Content is believed to be accurate at the time of publication, but past performance is not guaranteed.

Copyright, Australian Fund Monitors Pty Ltd. October 2024.

In a rapidly evolving macroeconomic landscape, Australian investors are increasingly turning to global high grade government bonds as a highly defensive component of their investment portfolios. This move is predominately driven by global government bond markets offering greater portfolio diversity, enhanced return potential and broad sources of yield.

In this article, we unpack the key themes influencing investors' long-term views on the value of including global high-grade bonds into a fixed income portfolio.

Where are we now in the cycle?

The key question facing investors today is: Where are we in the current business cycle, and when will the next shift occur? A glance at the economic growth of the world's major economies and stock markets over the past decade reveals that we've been in an extended expansionary phase. However, determining exactly when the cycle will peak is notoriously difficult. While certain indicators have pointed to an approaching recession, accurately predicting this shift remains a challenge.

At a time where geopolitical tensions are intensifying and policy makers are grappling with softening global growth and persistent inflation, investors face a landscape of heightened uncertainty on many fronts.

Global central banks are embarking on a synchronized interest rate cutting cycle as the narrative has switched this year from inflation concerns to growth concerns. Global inflation has moderated from its peak levels, with current annual rates of inflation at 2.50% in the US (the lowest since February 2021), 2.00% in Canada, 2.20% in the UK, 2.20% in EU and 3.8% in Australia, although forecasted to fall to 2.70%. Meanwhile economic growth has started to show some cracks, which until now has been supported by government spending.

Employment remains a key determinant in the direction of growth and recent signs from the US indicate that this is turning. US employment data was recently sharply revised lower - which has triggered anxiety amongst central bankers. In response, they are eager to get on the front foot and curb labour market weakness before it deteriorates sharply. Savings are already getting depleted, and signs of rising delinquency are cautionary tales that will be exacerbated from job losses.

Asset allocations can be dynamically adjusted to optimise performance during different phases of the cycle. With the recent loss of US employment momentum, are we moving from Slowdown to Recession? If so, improving asset quality and liquidity will be important to navigate the coming market environment.

Chart 1: Phases in the business cycle.

The economic cycle consists of four key phases: Boom, Slowdown, Recession and Recovery, which then leads back to another Boom - continuing the cycle.

Expanding horizons: Unlocking enhanced alpha opportunities that may await

Not all bonds are created equal. High quality sovereign global bonds offer a lower risk profile due to their stability and creditworthiness. These bonds are typically issued by governments with strong financial standing, making them less susceptible to default and economic fluctuations compared to lower-rated or corporate bonds. As a result, they can serve as a safer option for investors seeking to mitigate risk within their portfolios.

Global high grade bonds currently present unique alpha opportunities for investors.

• Capitalising on the global interest rate cycle: With many G7 nations beginning to cut rates, increasing exposure to high grade government bonds can be advantageous. By extending the duration of high quality bonds during a period of falling interest rates, fixed income investors can achieve greater stability and lower credit risk. This strategy becomes far more attractive compared to newly issued bonds that offer lower yields in a low-interest rate environment.
• Highly liquid in all market conditions: The global bond market can play a pivotal role in an investor's portfolio due to its liquidity offering, with its ability to enter and exit positions to manage risk and changing market conditions. This flexibility allows fixed income investors to access their funds when needed, with a highly liquid bond market serving as a hedge against riskier assets during market volatility. Additionally, liquidity can present potential alpha opportunities, as investors can capitalise on market inefficiencies to enhance their returns.
• Lowering risk and volatility: Investing in a global bond portfolio reduces country-specific risk by spreading investments across multiple regions, mitigating the impact of economic or political challenges in any single area. It also provides access to different interest rate environments. Additionally, bonds from various regions often have lower correlation with domestic bonds or equities, helping to reduce overall portfolio volatility and improve stability.
• Optimising exposure through active management: By actively adjusting the duration of a bond portfolio, fund managers can respond to anticipated interest rate changes to maximise returns or minimise risk. They can also identify mispriced or undervalued bonds for enhanced yield opportunities and tactically allocate across different regions to capitalise on favourable economic conditions. Active managers employ risk management techniques to reduce downside risk and ensure liquidity by adjusting holdings based on market conditions, ultimately enhancing the overall performance of the portfolio.

Chart 2: Global Government Bonds Have Outperformed International Equities During Major Sell-Offs

Global government bonds are among the safest investments in an investor's portfolio, offering capital preservation and helping to reduce equity volatility due to their long-term negative correlation with stocks. They also provide stability to portfolios, especially during market downturns.

We can observe how global sovereign bonds perform during periods of financial market crises and significant events in the chart below. During the dot-com crash, the global financial crisis and European debt crisis, global government bonds outperformed equities providing capital preservation and a hedge against the equity market collapse. During the COVID-19 pandemic, global sovereign bonds and equities once again exhibited contrasting performances, although the dynamics were more complex than during previous crises. The pandemic caused a sharp, short-term market shock in early 2020, followed by an unprecedented recovery, largely driven by aggressive fiscal and monetary stimulus.

^{Source: JCB team analysis based on data from Bloomberg.
*CC JCB Global Bond Fund hedged to A$ (class A). Intl Shares are MSCI world ex Aus hedged to A$TR index.}

How should investors position fixed income portfolios as global rate cuts begin?

When considering the long-term value of fixed income, high grade bonds stand out as one of the safest investments in an investor's portfolio. Not only do they preserve capital but also help reduce equity volatility due to their long-term negative correlation with stocks, ultimately stabilising portfolios during tough market conditions.

We believe that now could be an ideal time to lock in elevated income levels and broaden fixed income portfolios to include a variety of global bonds.

The onset of the cutting cycle is likely to lead to a decrease in bank deposit rates, making government bonds a more attractive option for investors seeking capital appreciation. As a significant amount of dollars currently parked in money market funds is expected to flow into the government bond sector, this shift is further supported by the frothy nature of the private credit market, which has more than doubled in size since 2019. Interest rate cuts mean private credit's floating rate is less attractive, redirecting capital away from it into higher interest bearing assets. The transparency and liquidity of government bond funds provide a compelling argument for this reallocation.  

Adapting to market changes: why global sovereign bonds matter now

Falling interest rates signal a shifting investment landscape, presenting new opportunities for asset allocators. Rate cutting cycles underscore the importance of diversification, especially as economic conditions can change rapidly.

I recently spent a few days in Hong Kong meeting with Asian companies and experts to explore China's economic shift from relying predominantly on infrastructure and real estate to its emergence as a global leader in renewable energy.

Historically, China's economy relied heavily on real estate and industrial growth, benefiting nations like Australia through iron ore exports. However, global dynamics and the need to reduce carbon emissions are driving a significant transformation. With government policies encouraging the development of the 'New Three Industries'--electric vehicles (EVs), solar energy, and lithium-ion batteries--China is positioning itself at the forefront of the renewable energy sector, laying the foundation for future economic growth

Government policies support emerging industries

China's rapid economic growth over the last few decades has been driven by investment, infrastructure development, and real estate. In 2021, real estate investment accounted for 27% of China's total fixed asset investment, but by 2023, this figure had fallen to 22% and is arguably even lower today. The sector has faced shrinking investments, declining sales, and a notable drop in housing prices. Between January and July 2024, real estate development investment decreased by 10.2% year-on-year (YoY) to RMB 6.09 trillion. The gross floor area (GFA) of new construction starts also saw a significant decline, with a 23.2% YoY decrease, while the GFA of completed projects dropped by 21.8% YoY.

Although real estate remains a significant contributor to the economy, the Chinese government has been actively working to diversify the country's economic drivers.

The government has introduced policies aimed at reducing payments and interest rates on property loans to prevent a collapse in the real estate market, which remains a vital part of China's economy. At the same time, the government has implemented significant reforms and provided incentives to encourage the growth of key industries such as EVs, solar energy, and lithium-ion batteries. These new sectors are crucial not only for domestic growth but also for China's goal to become a global leader in renewable energy and green technologies. I will discuss two of these industries in further detail in this paper.

Global leader in EV manufacturing

The electric vehicle (EV) sector is a cornerstone of China's new industrial policy. As the world shifts toward cleaner energy, China has positioned itself at the forefront of the EV revolution. By 2024, domestic EV penetration had surpassed 50%, reflecting the growing consumer demand for environmentally friendly alternatives to internal combustion engine (ICE) vehicles. The Chinese government's push for sustainable transport has been instrumental in shaping this industry. However, subsidies are no longer the primary source of EV growth, as these vehicles have become competitive with ICE cars.

The rapid growth of China's EV market is one of the most significant trends in the country's industrial landscape. In 2023 alone, EV sales in China reached 7.8 million units, representing a significant share of the global EV market. This growth has been driven by several factors, including government subsidies, the development of battery technology and an extensive charging infrastructure network. Additionally, Chinese consumers are increasingly favouring EVs over ICE vehicles.

China's EV market is not only expanding domestically but is also influencing global markets. Chinese automakers such as BYD, Li Auto, and NIO are rapidly gaining market share within China and overseas. Chinese EV manufacturers have overtaken many traditional automakers in sales and technological innovation, with BYD now ranked fifth in global EV sales.

However, Chinese automakers face challenges in expanding globally, due to the impact of trade barriers and tariffs. In 2024, the European Union imposed tariffs up to 38% on EVs imported from China, while the United States and Canada have also increased tariffs on Chinese EVs.  The US and Canada appear to be particularly concerned about the software within the vehicles with a built-in internet connection.  The issue relates to concerns on Chinese companies collecting data on American drivers and infrastructure together with the potential for foreign adversaries to remotely manipulate connected cars on the US roads.

Overcapacity increases price competition

The Chinese government's massive investments in EV manufacturing have resulted in an oversupply of vehicles. Many companies, particularly smaller startups, are struggling to maintain profitability due to the high cost of production and competition from established players. While companies like BYD and NIO have scaled production efficiently, others are facing challenges with underutilised capacity and financial losses.

This overcapacity has led to price competition, with many manufacturers slashing prices to maintain market share. This has resulted in thin profit margins across the industry, particularly for companies still in the early stages of scaling production.

China dominates solar energy production

Solar energy is another key sector in China's energy transition. China is the world's largest producer of solar panels, accounting for over 90% of global production. Between 2021 and 2023, China's solar capacity more than doubled, driven by strong demand and technological innovation. The country added over 200 gigawatts (GW) of solar capacity during this period, making it the largest solar energy producer in the world.

The Levelised Cost of Energy (LCOE) for solar power has dropped significantly, making it cost-competitive with traditional energy sources such as coal and natural gas. By 2023, the LCOE for solar power in China fell to just $0.04 per kilowatt-hour, on par with the cost of coal-fired electricity.

Chinese companies have improved solar efficiency while reducing production costs, making solar energy more affordable and accessible. This has enabled China to export its solar products globally, particularly in Europe, Asia, and the Americas.

One of the most significant innovations in the solar industry has been the development of "N-type" solar cells, which offer higher conversion efficiency than traditional "P-type" cells. These advanced solar cells have helped reduce the overall cost of solar energy, making it more competitive with other forms of electricity generation.

Despite this impressive growth, China's solar industry faces similar challenges to the EV industry. The rapid expansion of production capacity has led to an oversupply of solar panels, causing prices to plummet. Between 2021 and 2023, the average cost of solar panels fell by more than 60%, squeezing manufacturers' profit margins.

To address overcapacity, the Chinese government has implemented policies encouraging consolidation within the industry. Smaller, less efficient producers are encouraged to exit the market, while larger companies expand their market share. This process of consolidation is expected to help stabilise prices and improve profitability in the long term.

Expansion into global markets 

China's solar industry is also expanding its presence in international markets, particularly in Southeast Asia and the Middle East.

Chinese companies such as Longi, Jinko Solar, and Trina Solar have established production facilities in countries like Malaysia, Vietnam, and Thailand, where they can benefit from lower production costs and favourable trade policies.

In the Middle East, these companies are scaling up operations to meet the region's growing demand for renewable energy. The United Arab Emirates and Saudi Arabia have become key markets for Chinese solar products.

China's dominance of the Global Battery market

The rise of electric vehicles (EVs) has significantly increased the global demand for lithium-ion batteries. As countries strive to transition to cleaner energy sources, the battery industry has become a critical component of this shift. China has emerged as a dominant force in battery production, contributing to a substantial oversupply in the market.

China's battery production capacity in 2023 alone matched global demand, highlighting its overwhelming presence in the industry. The country has invested heavily in research and development, with companies like BYD and CATL leading the charge. This dominance is not just in sheer volume but also in technological advancements, making China a formidable player in the global battery market.

Global lithium-ion battery manufacturing capacity has outpaced demand, with an estimated 2,600 GWh produced in 2023 against a demand of 950 GWh. This oversupply is expected to increase, leading to falling prices and squeezing profit margins for manufacturers. For consumers, this could mean more affordable EVs and stationary storage solutions.

The low prices are making it difficult for new entrants outside of China to compete, even with generous support provided by the US Inflation Reduction Act and other such support structures. 

The sustainability of the low battery prices is an intriguing question and will likely result in an industry shakeout as is normal during overcapacity cycles.  Lithium, a key raw material cost is in over supply and thus helping keep battery prices low.  However, regulatory and environmental approvals are making it more difficult to bring on new mining or refining capacity than build a battery plant.  This may help bring the supply and demand fundamentals back into balance.

Conclusion

China's industrial transition represents a fundamental shift in its economic model, as the country moves away from traditional investment-driven sectors like real estate and toward new, innovative industries such as EVs, solar energy and lithium-ion batteries. These sectors are crucial to China's long-term economic sustainability and its efforts to reduce carbon emissions and become a global leader in green technology.  Exports of the traditional labour-intensive products are declining due to falling competitiveness.  However, the capital and technology intensive industries are rapidly filling the gap.

This transition is not without its challenges. EV, lithium-ion battery and solar industries all currently face significant issues related to overcapacity, profitability, and growing international competition. The Chinese government's role in managing these challenges through policies and supply-side reforms will be critical in ensuring the success of these industries.

As China continues to expand its global presence in the EV and solar sectors, it is poised to remain a dominant player in the global market for green technologies. However, the country must navigate complex trade dynamics and competition from other global players to maintain its competitive edge.  Western World governments do not want to be totally reliant on China for these technologies.

Australia plays a significant role in China's ongoing industrial transition and its legacy industries given its endowment of both critical minerals and iron ore.  Tyndall currently holds a modest overweight in the resources sector, exposing it to the short-term stabilisation of the property market and the China economy, as well as to the longer thematic that relates to global decarbonisation and China's industrial transition.

Author: Brad Potter, Head of Australian Equities

The big question remains: will Australia follow the Fed's lead or stick to its current path?

In Episode 51 of The Rate Debate, Co-Head of Fixed Income Darren Langer and Investment Manager Jessica Ren unpack the Fed's recent decision, explore the chances of rate cuts before Australia's next federal election, and debate the importance and reliability of employment data for the RBA. They also take a closer look at inflation pressures, from petrol prices and energy rebates to rising service costs.

Author: Jay Sivapalan, CFA