Mark LaMonica: Welcome to another edition of Market Minute. We have Joel today and we’re going to talk about bonds. Inflation plays a big role, and I know there’s been some news lately. So why don’t you go through what we heard from the ABS?

Joel Grosvenor: Just last week they reported May’s inflation data, and at the headline level it looked like things are improving. The year-on-year inflation rate reduced from 4.2% to 4% in May. However, a lot of that was driven by the reduction of the government’s fuel tax excise, which is a temporary measure. The underlying core inflation, the trimmed mean, actually increased from 3.4% to 3.6% over May.

That’s the more concerning figure because it’s the one the RBA focuses on when making interest rate decisions. We also had the unemployment rate released last week, and that showed a slight improvement from 4.5% to 4.4% in May.

Mark: So what does this potentially mean from an interest rate perspective going forward? And how did the fixed interest market react?

Joel: It’s been kind of interesting because despite the rising inflation being concerning for bond investors, we’ve seen interest rate expectations for an August hike reduce, despite inflation and the unemployment rate moving lower. We also saw that both the three-year and 10-year Australian government bond yields have continued to trend downwards, and they’re now approaching their pre-conflict levels as well.

So that’s been quite good for bond investors over the last month. But the key thing will be whether inflation remains quite sticky from here.

Mark: Maybe it’s a good time to remind viewers of the relationship between inflation and bond yields, because a lot of people look at nominal yields. But as investors, we’re obviously interested in real returns. So how does that interplay work, and what should bond investors consider?

Joel: When bond investors buy a nominal government bond, they’re getting a bond yield that has an embedded inflation risk premium in it. On a longer-term basis, the 10-year break-even inflation rate, which compares the yield on an inflation-protected bond versus a nominal bond, is still around 2.2%.

Long-term inflation expectations haven’t increased that much and remain around their long-term average. So the key question for bond investors is whether inflation will stay above that level over the long term, which could happen if we continue to experience repeated inflationary events. On a nominal basis, bonds are looking quite attractive, but the key thing will be realised inflation and how that plays out.

Mark: The other big consideration is trade-offs. When you’re putting together a portfolio, you’re looking at the relative attractiveness of different asset classes. So what are you doing in the portfolios you’re managing for clients right now in terms of bonds, and more broadly, equities?

Joel: Bonds have moved from attractive to around fair value. When Australian government bond yields were above 5%, which happened only a few weeks ago, they looked quite attractive. Now they’re sitting around fair value, so we still think they look relatively good.

The bigger issue is equities and the valuations currently priced into equity markets. Broadly, they still look quite expensive, with certain sectors driving those valuations. Technology stocks continue to look elevated despite last week’s sell-off.

We think there are better opportunities within healthcare and consumer-related stocks. On a relative basis, Australian equities have also become more attractive compared to broader international equities because they haven’t participated to the same extent in the technology rally over the past few months.