Strategy commentary cont'd: October saw strong equity market performance globally, accompanied by a rally in global risk-free rates. The S&P 500 gained 2.3%, while the Nasdaq rose 4.8%. In Europe, major indices also finished higher, with the Eurostoxx 50 up 2.5% and the FTSE 100 advancing 4.1%. Gold ended the month up 3.7% at $4,000, though this remained about 10% below intra-month highs of $4,400. Equity gains were led by technology stocks, with the tech component of the S&P 500 up 6.2% for the month.

Fixed income markets ended the month on a softer tone after a strong rally in the first three weeks. Concerns over a weakening US labour market, coupled with the ongoing shutdown of the US Federal Government, were to the fore early in the month. On 22 October, the US 10-year yield reached a low of 3.94%, subsequently closing the month at 4.08%, still 7bps richer than 30 September levels. Credit markets were mixed, with European IG credit spreads 2bps tighter at 75bps, whereas US IG credit spreads finished the month 5bps wider at 78bps.

The US saw $161bn of USD investment-grade issuance in October — the busiest October in over a decade — bringing YTD supply to $1.51trn, according to Bank of America. Financials represented 36% of total supply, below the YTD average of 47%. Following mid-month earnings, Goldman Sachs, JPMorgan, and Morgan Stanley each issued new USD benchmark deals.

The standout transaction came from Meta, which launched a $30bn multi-tranche deal. According to Bloomberg, "Meta's ~$125bn peak order book was the largest on record, surpassing CVS's $120bn for its $40bn Aetna acquisition in 2018." This was also the largest corporate bond issue since Pfizer's $31bn Seagen acquisition financing in May 2023. Demand was strong, with each tranche around 4x oversubscribed.

We participated in the 5-year, 10-year, 30-year, and 40-year tranches. The bonds were volatile on the break, moving up to 4bps intraday, and ended slightly tighter: the 5Y, 30Y, and 40Y closed around RO-0.5bps, and the 10Y around RO-2bps.

In contrast, European primary issuance was subdued, totalling just €53.9bn, including €24.3bn from financials. The slowdown reflected front-loaded issuance in September and blackout periods ahead of earnings for many banks.

After results, reverse Yankee issuance resumed as Citi, Bank of America, and JPMorgan took advantage of the favourable cross-currency basis. Among European banks, Barclays issued €1.25bn of 11NC10 HoldCo debt late in the month, attracting 4.2x covered books.

European corporate supply was minimal, with Procter & Gamble's dual-tranche 8-year and 20-year issue being the only notable deal.

In the sovereign, supranational, and agency (SSA) sector, the European Union tapped an existing 7-year bond and issued a new 15-year line, together raising €11bn.

In Australia, spreads were volatile across the capital stack. While the major banks' 5-year senior spreads were very marginally wider, their Tier 2 bond spreads at the 5-year maturity point moved materially tighter by some 10bps. One notch down, the majors' 5-year AT1 hybrid spreads drifted 3bps higher.

We saw A$9.2bn of public IG primary credit issuance in AUD from domestic and global issuers. Deals of note included: CBA issued A$350m of an unusual 10-year SNR in a club deal, which we participated in. The deal priced at ASW+100bps. This was an unusual deal, as 10-year SNR is historically not a common format for domestic financial issuers outside of the occasional private deal.

NAB followed up with their own SNR deal after the success of CBA's experiment, and issued their own 10-year along with a more traditional 3-year FXD and FRN. They printed A$1bn of the 10-year SNR at ASW+103bps, A$350m of the 3-year FXD at ASW+60bps, and A$1.65bn of the 3-year FRN at BBSW+60bps. We participated in all tranches.

We also saw other smaller deals from Victorian Power Networks (A$850m dual FXD/FRN), Patrick Terminals (A$600m dual FXD/FRN), Credit Union Australia (A$500m), Ampol (A$500m), Lendlease (A$450m), Dominion (A$425m), Weir Group (A$400m), and Stockland (A$400m), which we did not participate in.

Strategy commentary cont'd: Amongst the mortgage-backed securities, there were primary deals totalling A$11.752bn, with notable issuances from: HARVEY printing A$736m of 2.7-year WAL at BBSW+85bps; MEDALLION printing A$1.38bn of 3.4-year WAL at BBSW+77bps; and PROGRESS printing A$920m of 3.0-year WAL at BBSW+85bps.

The challenge of high and rising public debt

High public debt is common to many economies, with the US, the UK and France in the worst position, running large budget deficits, and where Europe is beset by structural economic problems (Australian and NZ debt is rising, but remains relatively low). Debt is likely to rise further as countries spend significantly more on defence and with history suggesting a recession is always around the corner. There is no short-term solution because there is no political appetite for meaningful budget repair and higher debt has already added to bond yields over recent years.

Public debt is necessary because it is unfair for taxpayers to pay the upfront cost of services/facilities that will be used by future generations. Moreover, too little debt can signify underinvestment by government, which limits the public's access to education, health and housing.

Across the advanced economies, public debt - spanning national, state and local governments - is high as a share of GDP in most countries, bar Australia and New Zealand, and is rising once domestic central bank holdings are excluded. Japan is a notable exception, with debt falling as a share of GDP, while there are marked differences across the member countries of the euro area.

High public debt matters because:

• High public debt is likely a drag on economic growth. The effect could be non-linear, with very high debt an even larger constraint on activity, although there is lingering controversy over the Rogoff-Reinhart debt threshold of 90% of GDP.
• High interest payments reduce the scope for spending on social services and infrastructure. High debt could also limit a government's ability to respond to the next economic downturn.
• High public debt raises interest rates, boosting the short-term neutral policy rate and adding to the term premium on government bond yields.
• Some policies aimed at dealing with high public debt - such as engineering high inflation and/or financial repression - can have undesirable side-effects on the economy and financial markets.

Moreover, public debt is likely to rise further given most budget deficits are historically large, stuck well above pre-COVID levels, with the US and the UK in the worst position.

The situation is more variable across the euro area. Most euro area countries - even those with high levels of debt - have either small or modest deficits as a share of GDP. France stands out with a large US/UK-style budget deficit, although Belgium is in a similar position.

Strategy commentary cont'd:

Strategy commentary cont'd:

Importantly, all countries face two significant challenges to the budget outlook, one being the commitment to a very large increase in defence spending, and the other that history shows a recession is always around the corner.

At the insistence of the US, NATO members have committed to raising military spending to an ambitious target of 5% of GDP by 2035, where Europe faces a belligerent Russia. Other countries - including Australia - also plan to spend more on defence, although not by as much as NATO.

As for downturns, recessions occur more often than people think and inevitably add to public debt.

Strategy commentary cont'd: In the post-WW2 period, advanced economies have generally been in recession once or twice a decade and the last common recession of 2020 differed from past downturns in that it was driven by a health crisis rather than private-sector excesses and/or central bank/government policy.

Not only do recessions increase public debt, debt is usually higher for a long time. For example, US public debt typically increased by 2-3% of GDP in the wake of post-WW2 recessions.

Given these two clear risks to high levels of public debt in many countries, it is unfortunate that the most obvious way of bringing debt under control - namely, raising taxes and cutting spending - is politically unpalatable.

This leaves fallback approaches involving economic and financial means.

Of these, the best option is stronger economic growth driven by productivity. This is because population-led growth has an ambiguous impact on public debt, in that a larger tax take is countered by an increased demand for government services and infrastructure.

Unfortunately, the news here is not good for the highly-indebted economies of the UK and France because productivity is languishing outside the US and Japan.

Strategy commentary cont'd:

Another strategy for dealing with high public debt is financial repression, which involves forcing the domestic central bank, banks, and/or pension funds to buy government debt. Japan has effectively taken this approach in recent years, with the Bank of Japan and Japanese banks owning more than 60% of Japan's public debt.

Finally, a riskier strategy typically seen in emerging markets is to hold interest rates too low to generate high inflation to reduce the real burden of public debt. The US could go down this path if the government successfully takes control of the Federal Reserve next year and forces it to adopt artificially low interest rates.

As for the impact of higher public debt on financial markets, markets attempt to be forward looking, but in practice it is hard to forecast budget deficits and public debt because governments change their mind, policy costings can be wide of the mark, and the economy regularly turns out differently.

This is clearly seen in the difficulty the Congressional Budget Office - which is the gold standard in budget forecasting - has in forecasting US government debt, where the forecasts are often wrong and often wrong by a lot.

Strategy commentary cont'd:

Notwithstanding the difficulty in forecasting debt, the rise in debt over recent years has already contributed to higher government bond yields. Averaging across the results from a range of academic and official studies and surveys of investors, a 10% increase in public debt as a share of GDP increases long-term government bond yields by about 30bp. The largest increases in debt since prior to the pandemic have occurred in the US, the UK, Canada and New Zealand, suggesting that higher debt has already added about 30-60bp to bond yields in those countries, with the risk of more to come for the reasons outlined above.

US tariffs, global trade & disinflation in the rest of the world

The biggest change in US trade policy in about a century has cooled world trade and upended trade flows, but there is no evidence yet that US tariffs have been mildly disinflationary for the rest of the world, where goods prices are rising again in most countries.

The US effective tariff rate - which is tariff revenue as a share of the value of imports - has spiked to about 10-11% over the past few months, up from 2.5% at the end of last year.

This is the highest rate since WW2, but falls well short of a range of estimated tariff rates in the high teens/low twenties based on government announcements and historic trade shares.

The Supreme Court will rule on the legality of new tariffs in November, where it is not clear that the government has better-legislated tariffs in reserve, but in the meantime the government continues to announce more tariffs.

Strategy commentary cont'd:

There are several possible reasons for why the effective tariff rate has fallen short of earlier estimates, including;

• A short lag between announced tariffs showing up in higher revenue, where the government is still announcing new tariffs;
• US government exemptions and deals with corporates limiting gains in revenue;
• US firms substituting away from higher-priced imports to less expensive alternatives; and
• China - which is subject to very high US tariffs - potentially rerouting sales of goods to the US through lower-tariff countries in Asia, even though the US warned it will impose punitive 40% tariffs on redirected trade.

The split of US imports by trading partner shows that Americans have substituted away from higher-priced Chinese goods and bought cheaper alternatives from other countries.

China also looks to have rerouted US trade through lower-tariff countries in Asia and there also appears to be some rerouting of trade via Mexico.

In terms of the impact of US tariffs on global trade, growth in world exports - which is a (volatile) proxy for world output - has slowed recently, but remains positive.

The saving grace for world growth has been that most other countries have chosen not to retaliate to US tariffs, with the understandable exception of China.

Strategy commentary cont'd: This is unlike the depression of the 1930s, when widespread retaliation to the disastrous Smoot-Hawley tariffs led to even weaker world output.

Instead, US tariffs have had a more pronounced near-term effect on world trade flows.

Chinese export volumes have started to flatten at an extremely high level, Japanese exports have slipped from a high level in real terms and other Asian exports are still booming.

Canada - America's longstanding ally - has seen its export volumes slump. European exports remain very weak in real terms, especially UK exports, which are structurally depressed.

Australian and New Zealand trends have been unaffected; Australian exports remain in the doldrums and NZ exports continue to slowly pick up.

Longer term, the profound shift in US trade policy should see an unwinding of globalisation.

Globalisation - as approximated by the ratio of world exports to world output - has already broadly peaked over the past twenty years or so.

The most insular US trade policy in decades should trigger deglobalisation, leading to less efficient production, higher costs and higher prices.

The UK experience with Brexit suggests this structural deterioration should take place over several years.

Strategy commentary cont'd:

The dramatic change in US trade policy has also seen many central banks, including the RBA, think that the net effect of US tariffs could be mildly disinflationary for the rest of the world,

This view rests on disinflationary forces - such as weaker world growth placing downward pressure on world prices and China selling goods meant for the US market to other countries at a discount - outweighing inflationary factors - such as disruptions to supply chains and multinational corporations raising prices globally to partly compensate for the cost of US tariffs.

Weighing these opposing forces, there does not seem to be evidence of a disinflationary impulse to the rest of the world, at least not at the aggregate level.

Although growth in world trade has slowed, world export prices have actually risen over recent months and Chinese export prices are little changed from pre-tariff levels in both US dollars and renminbi (the invoicing of Chinese exports is split roughly 50:50 between the USD and RMB).

That said, the US dollar has fallen in value against most currencies, making USD-denominated Chinese exports more competitive in many countries.

This means that while China's share of the US market has slumped, its market share could continue to trend higher in other advanced economies, where it was rising in the euro area, Japan, Australia and New Zealand prior to the US tariffs.

Strategy commentary cont'd:

More pointedly, there is no clear sign of a disinflationary impulse from US tariffs in retail prices, where goods prices are actually rising again in many countries.

Goods prices, excluding food and energy, have picked up in the US on tariffs, but have also risen in the UK and the euro area. Prices have tentatively risen in Australia and have been growing strongly in Japan for some time. The outlier is New Zealand, where prices are weak.

Some of the increase in goods prices reflects recent rises in import prices in several countries.

There are no broad-based supply disruptions to date, although China has successfully leveraged its near-monopoly in the control of critical rare earths in its trade negotiations with the US.

Finally and more speculatively, some multinational corporations could be evening out the cost of US tariffs by globally raising prices, even though such companies are usually thought to discriminate between different markets when setting prices.

Strategy commentary cont'd:

The big RBA forecast miss on Q3 inflation

After a few encouraging readings on quarterly inflation that allowed the RBA to cut rates, consumer prices spiked in Q3, rising by an annualised rate of 4% in underlying terms, as foreshadowed by the monthly CPI. Outside of COVID, this was one of the highest readings on inflation since the RBA began targeting inflation in 1993.

With quarterly inflation revised up from 0.6% to 0.7% in Q2, this meant that the RBA staff's forecast miss for annual underlying inflation in Q3 was 0.5pp. Excluding a couple of extremes in inflation during COVID, this was the largest upside surprise for a current-quarter forecast since late 1992. It was also one of the RBA's largest forecast misses in absolute terms on record.

It is also a relatively large forecast error compared with the track records of the Fed and the ECB, where inflation is similarly volatile across the three economies. The Fed and the ECB's forecast errors are a little smaller than the RBA's errors, although to be fair the comparison is not like-for-like and flatters the forecasting ability of the Fed and the ECB. The RBA publishes its estimates early in the middle month of the quarter, while the FOMC and ECB estimates are published in the final month of the quarter, such that the Fed and ECB have access to more actual monthly inflation and labour market data when preparing their forecasts.[1]

The RBA staff will publish the updated economic forecasts that the board has considered at its policy meeting in tomorrow's Statement on Monetary Policy. Given the much higher starting point for inflation in Q3, our analysis suggests that the end-2026 forecast could be revised up from 2.6% to around 3%, with the risk that the end-2027 forecast is revised up from 2.5% to either 2.6% or 2.7%.

Strategy commentary cont'd: The longer-term forecasts for inflation should be helped by a higher forecast profile for the cash rate, assuming that the RBA still thinks the neutral cash rate is about 3.25%. The forecast cash rate is based on market pricing from the week before the forecasts are finalised, which in this case is about 20-40bp higher over the next couple of years than assumed for the August Statement on Monetary Policy.

If much higher inflation in Q3 is only partly unwound in Q4, this would completely derail the RBA staff's outlook for inflation and force the RBA board to rethink whether it was overly optimistic in believing that the NAIRU had fallen to 4.25% - versus the staff model estimate of 4.75% - and that monetary policy was still tight given the neutral cash rate was judged to be 3.25%.

Note:

[1] That said, the Fed estimates are at a disadvantage in that they are simple interpolations of median FOMC end-year forecasts. The ECB forecasts are at a disadvantage because the short history of forecasts for underlying inflation was spliced with forecasts for more volatile headline inflation. Also note that the RBA forecast errors were calculated using inflation as first published, while the Fed and ECB errors rely on the latest available estimates of inflation.

Strategy commentary cont'd:

Strategy commentary cont'd: