Interest rates fell over the month of September and for the ﬁrst time in New Zealand some market rates went negative. Into the tail end of the month government bonds with maturities out to 5 years were providing negative yields. This implies that a purchaser of these bonds, if they held them to maturity, would receive a negative return on their investment. The negative yields are a direct result of monetary policy in New Zealand and signal the expected direction and level of interest rates under the current policy settings. The RBNZ has advised ﬁnancial institutions to prepare for the possibility of a negative Oﬃcial Cash Rate (OCR) in terms of their systems. This is important as the OCR has an inﬂuence over the short- term interest rates retail investors receive from banks. The RBNZ has also continued to aggressively buy bonds issued to the market reducing the level of interest rates generally. Messaging from the RBNZ and Minister of Finance has been that interest rates will remain low, and potentially negative in some instances, for as long as required to lift the New Zealand economy back to full employment and a ‘healthy’ inﬂation rate. This suggests that the time period over which interest rates are at near zero levels will persist potentially for a number of years.
deposit rates have followed bond rates down. Bank term deposit rates are now
below 2% on all terms out to 5 years. Despite the low current rates there is
still some potential for interest rates to decline further given central
government objectives and it is conceivable that term deposit and bond yields
decline in interest rates has been prolonged and this has impacted on the
income available from ﬁxed interest investments. As interest rates continue to
fall into 2021 clients who require a regular income from their investment
portfolio, and have an allocation to ﬁxed interest, will ﬁnd the return from
this asset class will be near zero. These low interest rates may continue over
the next few years, requiring those investors to re-evaluate their objectives
and expectations. Allocating more investments to shares can increase the income
as well as the return for investors over the long-term, but this will come with
additional risk of the capital value of their portfolio rising and falling.
Portfolio Impact of Low Interest Rates on Debt Securities
Interest rates approaching zero, and potentially below, will result in the potential for capital gain but this is not on an open-ended basis. If eventually the current trend reverses and rates begin to rise in the future, then there is potential for capital losses to be incurred and given the low level of rates the magnitude of losses is ampliﬁed. An investor is faced with an investment class that after tax may generate an income for investors of close to zero but if interest rates rise, which may be some years away, a potential capital loss. We expect that in 2021 the risk and reward equation of investing and receiving nothing with the potential for a capital loss will test many investors’ patience. As an example of what an investor could expect from ﬁxed interest is the recent new issue by Mercury Energy of a 7-year bond at 1.56% p.a.
Portfolio Impact of Low Interest Rates on Shares
The fundamental driver of share values is cash ﬂow generation into the future, discounted to obtain a present value. Lower interest rates decrease the discount rate and increase
theoretical value of the shares. Likewise, the relative attractiveness of
dividends to investors improves as interest rates fall and provides a further
driver to capital growth in share values. In this scenario both growth
companies and yield companies are beneﬁciaries of the underlying monetary
short-term the translation of these market drivers is not always evident as
other factors inﬂuence the direction and magnitude of price changes in speciﬁc
securities. In the last month the S&P/NZX Gross index fell 1.6%. In
contrast the S&P/NZX All Real Estate Gross index rose by 2.6%. The broader
market index weakened as the previous market leaders A2 Milk and Fisher &
Paykel Healthcare share prices fell over the month 17.5% and 9.7%
respectively. These two companies are
growth businesses with no and minimal distribution yield respectively. With the
knowledge that low interest rates may be something we will need to live with
for some time, property emerged from a period of underperformance as yields
from property companies once again became compelling with an income return to
investors of approximately 5% p.a.
share markets also lost traction in local and New Zealand dollar terms. The US
market as measured by the S&P 500 lost the most ground. High ﬂying stocks
such as Amazon slipped (-8.9%) and investment ﬂowed to value companies e.g.
building materials (Martin Marietta +9%) and traditional delivery company FedEX
(+15%). Initial public oﬀerings of technology companies continued to be well
received e.g. Snowﬂake and Unit Software listing at large premiums to issue
The current interest rate settings are confronting conservative investors with a stark choice. If investors place greater weight on capital preservation, then the status quo in terms of asset allocation continues but this will be at a cost of minimal income. In order to generate some income from portfolios investors will need to consider increasing the risk within ﬁxed income assets or move from ﬁxed interest to other ‘stable’ assets that generate reliable cash ﬂows, such as selected forms of property and infrastructure companies. Investing in these assets is not without hazard and is always subject to the characteristics of quality and price. There is a popular saying ‘TINA’. (There Is No Alternative). It looks like we might be in a low interest environment for some years and the hunt for income will put pressure on assets that oﬀer an investor an income.
Information and Disclaimer:
Source: JMI (previously JMIS), the investment consultant to the Select Wealth Management service.
This report is for information purposes only. It does not take
into account your investment needs or personal circumstances and so is not intended to be viewed as investment or financial advice. Should you require financial advice you should contact Miles Flower on 021 645 000.
Investors continue to face two contrasting scenarios:
A) Global economies remain subdued and markets decline from elevated levels;or
B)Central bank stimulus continues to prime the pump and markets continue to climb in value.
As a result, investors are fine-tuned to market signals as to whether to retreat to safety or continue to pursue returns from more risky positioning. Investor returns in October were driven by sentiment relating to the immediate impact of interest rate policy decisions and trade negotiations. Consensus outlook improved over the month as the new calendar year approaches. The International Monetary Fund (IMF) published its projections for 2020 and expects 2020 to be a better year than 2019 in terms of economic growth. However the IMF, as usual, makes its projections with significant caveats.
United States Key to Global Trends
The United States share market is being buffeted by the trade dispute with China but has remained remarkably resilient. The S&P500 rose over the month, recovering early losses. Third quarter earnings reporting occurred over the month with 74% of companies delivering earnings in excess of admittedly muted market expectations. This is despite most of the S&P 500 earning substantial revenues offshore and the US industrial sector showing definite signs of deceleration. Supporting the equity market is resilient US consumer demand which comprises 70% of US GDP and the effect of the Federal Reserve’s prior interest rate reductions. Where the central bank makes a change to the benchmark interest rate it typically takes several months for the effect to translate to the real economy. US GDP’s latest print was 1.9% per annum. This exceeded market expectations of 1.6%. The better result was driven by higher consumer and government expenditure. In contrast investment and trade segments of the US economy were weaker.
The US Federal Reserve has continued to cut short-term interest rates as ‘insurance’ against a slowing economy. The Federal Reserve reduced the Federal Funds rate to a range of 1.5% to 1.75% at the end of the month, down 0.25%. It appears that the Federal Reserve will not increase the Federal Funds rate while inflation remains dull.
Australasia not Isolated
The local economy and share market are affected by offshore developments in terms of externally facing companies’ revenues and capital flows into and out of the New Zealand fixed interest and equity markets. The New Zealand share market slipped in the month with some intra-month volatility. This volatility reflected the circumstances of particular companies and positioning in relation to changes to the MSCI index as it relates to New Zealand’s largest companies. The composition of the MSCI was reviewed with market speculation that Fletcher Building would be removed, and Mercury enter the index. These changes drive passive offshore investment flows into and out of shares.
In addition, both Fletcher Building and the electricity companies which represent a substantial proportion of the market index were impacted by company specific events. Fletcher Building’s convention centre project for Sky City suffered a fire which will delay completion of the project. As the insurance position of the respective companies is unknown the financial impact of the fire remains uncertain. Nevertheless, the issue will likely impact sentiment for a lengthy period of time as the parties’ dispute liability for the actual and consequential costs of the fire.
The electricity companies have been impacted by a reopening of negotiations by Rio Tinto over the price of electricity supplied to their aluminium smelter at Tiwai Point in Bluff. The smelter is a sufficiently large electricity consumer that if the smelter closes it will result in a fall in power prices for several years. All power companies are impacted by a market wide fall in electricity prices. Although closure is thought to be a low probability outcome, ongoing uncertainty will hang over company share prices until resolution.
Long-term interest rates in New Zealand and the United States rose slightly over the month. Longer term interest rates globally are impacted by US rates although the strength of the correlation fluctuates over time. Investors in fixed interest became less pessimistic as to the outlook for growth (trade negotiations between the US and China appeared to make progress) and the supply of bonds continued to expand. New Zealand interest rates reached a six-week high with the government 10-yearbond at 1.27% on 29 October. This is a large move in interest rates in a short time period but is still outweighed by falls earlier in the year. Bond fund returns were adversely impacted as a result. Market pricing in relation to a further cut in the Official Cash Rate moderated over the month but an overall expectation of a further cut remains.
Like New Zealand,the Australian share market was flat over the month. The Australian economy is providing mixed signals. There are a number of positive signs. Residential housing prices in the major Australian cities appear to have bottomed, but building consents declined 23% last month relative to the previous comparable period.
The Australian business outlook per Reuters forecast poll is for GDP to print at 1.9% for 2019 and for the Australian economy to pick up in 2020 to 2.5%. Positively, investors in Australian equities are paying a much lower average price earnings multiple than New Zealand although this is distorted by the preponderance of banking and resources stocks.
Performance of the Australian share market was held back by the major Australian banks taking further substantial customer remediation charges, and a further inquiry into bank’s mortgage pricing. Uncertainty over the Australian bank’s capital positions in response to changing regulatory requirements is also impacting bank share prices. The major mining companies, BHP and Rio, continue to be affected by a weakening iron ore price. Rio also owns aluminium smelters (including Tiwai Point) and clearly weak aluminium profitability is also a drag.
A feature of the month in Australia was the withdrawal of six company listings, including Latitude, a consumer finance business. The current biggest uncertainty in Australia is the Australian consumer who remains subdued, impacting consumer finance demand and discretionary retailers. To combat the absence of strong consumer demand, below target inflation and higher level of unemployment compared to New Zealand, the Reserve Bank of Australia reduced the cash rate to 0.75% at the beginning of the month. The withdrawal of the floats is being interpreted as exhibiting healthy tension between investors and promoters rather than symptomatic of inherently weak demand for new issues.
New Zealand Property
The returns from New Zealand commercial property in the last year have been exceptional, at over 30% including dividends. The domestic property market is not homogeneous, and returns can vary depending on geography and property type. Although high returns have been achieved rental growth has not kept pace and yields have fallen. While there appears to be strong demand for industrial property, extra supply of office property in the major centres may result in higher vacancy and minimal near-term rental growth in this market segment. While property may remain attractive to yield investors relative to fixed interest, continued gains of the past magnitude are unlikely.
International Interest Rates
International interest rates outside of the US look likely to remain at low levels in the year ahead with minimal signs that central banks will pull back from quantitative easing. The outlook appears to be asymmetric in terms of investor risk from a yield and capital appreciation perspective. The ECB kept rates unchanged at Governor Draghi’s last meeting on 25 October. One example of the extremes now occurring are interest rates in Greece. Greek 3-month Treasury Bills were issued at an average negative yield during the month. This contrasts starkly with the situation several years ago when Greek rates surged, and it was feared a Greek default would lead to a widespread collapse.
Despite the caution arising from the subdued industrial outlook and lower prevailing business confidence ,share values could be justifiable. The immediate outlook for short-term interest rates is for them to remain anchored at current levels due to central bank actions attempting to lift prevailing inflation rates. There is some scope for longer term interest rates to rise as markets re-assess the growth outlook and conclude that it is not as bleak as pre-supposed. A steepening of the yield curve is not to be discounted but any increase in interest rates is unlikely to be large. Equally, interest rates may continue to remain around present levels. Less likely is a scenario where rates diminish materially from current levels. That being the case it is unlikely that investors will experience the same level of capital return from yield sensitive stocks. In particular given the high rate of capital appreciation from property that is unlikely to be repeated, client portfolios that have been overweight property might bank some of these gains. Given the better potential returns from equities and what appears to be a benign forward outlook a higher allocation to equities appears to provide greater scope for portfolio accretion.
In an environment where GDP growth and general earnings growth is likely to be more subdued, that is all boats will not be lifted to the same extent by the economic tide, selective share positioning will be increasingly important to optimise portfolio returns. We increasingly believe an active rather than a passive approach is desirable.
Information and Disclaimer:
Source:JMI (previously JMIS), the investment consultant to the Select Wealth Management service.
This report is for information purposes only. It does not take
into account your investment needs or personal circumstances and so is
not intended to be viewed as investment or financial advice. Should you
require financial advice you should contact Miles Flower on 021 645 000.
The risk of President Trump’s
impeachment increased in September with Democrats instigating the first stages
of the process. The seriousness for US markets will take time to play-out but
political focus is likely to drift from the economy and the US budget. In the
United Kingdom the Brexit outcome remains chaotic making it difficult for
investors to have confidence.
The continuing threat of
geopolitical conflict disrupting the smooth functioning of economies was also
evident in September. The attack on the Saudi Arabian oil refineries resulted
in the oil price spiking short-term. Oil reserves and the ability to repair the
damage quickly alleviated the immediate impact.
Interest Rate Bounce
Interest rates in the US bond market fell dramatically in August. The US 10-year government bond rate fell half a percent, one of the largest monthly falls since the Global Financial Crisis (GFC). This resulted in a predictable response from borrowers in early September to the low rates with a rash of bonds being sold into the market. The US corporate bond market had record issuance on 8 September with 49 deals in 30 hours totalling US$54 billion. Even cash rich Apple took advantage issuing US$7 billion of bonds including a US$1.5 billion 30-year bond paying 2.99%. The US Government was also encouraged by the low rates to refloat the proposal to issue very long-term bonds of 50 years.The overall trend in interest rates remains “lower for longer” but the trend has not been smooth. United States interest rates bounced back in mid-September. This unsettled the share market and investors switched from high priced revenue growth shares to more traditional profit generating companies.
Over recent years markets have been
focused on growth over value. September may represent the first signs of a
pivot between these two strategies.
Central banks are concerned with the
long-term management of financial conditions focusing on inflation and
employment levels. In doing so they look through the short-term fluctuations
experienced in the market. A number of central banks delivered policy
statements in September. Generally, these statements were consistent with
investor expectations. The Federal Reserve delivered a quarter percent cut in
line with market pricing. The Bank of Japan kept monetary policy steady but
signalled it could ease next month. The Bank of England kept rates steady at
0.75% and the RBNZ similarly held the Official Cash Rate (OCR) at 1%. Post its decision to reduce the US benchmark
rate the Federal Reserve has had to intervene in the overnight cash market on
numerous occasions and provide additional cash injections as cash rates rose
above the target levels. This is the first time the Federal Reserve has had to
intervene in this manner since the GFC. The liquidity problem appears to be
more technical rather than a reflection of wider fundamental problem but may require the Federal Reserve to once again expand its
Central bank monetary policy
implementation reflects actual and anticipated conditions in the real economy.
Increasingly, the economic outlook is subdued, and hence central banks are
continuing monetary stimulus. However, economists are challenging the
effectiveness of such policies in isolation. The effectiveness of monetary
policy alone is diminishing, and central banks are calling on governments to
undertake more fiscal policy (increased government spending or tax cuts) to
The US economy has been only
moderately impacted by the trade war to date, but the signs of increasing
effects are becoming apparent. US GDP growth and inflation remain reasonable
but below target and below prior levels. US GDP for the second quarter remained
at a 2% annual rate. Inflation using the Federal Reserves’ favoured measure was
1.9% annualised just below the 2% target. US job growth in August was lower
than expected but unemployment has held at a steady and very low level of 3.7%.
The US consumer remains healthy, but consumer confidence slipped in September.
Signs in the industrial segment are less positive. The Cass freight index
dropped 3% in August the 9th month of consecutive declines. Surveyed
manufacturing activity declined in August for the first time since early 2016.
China is also experiencing a slowing
of its economy. The Chinese manufacturing index for August showed contraction
whereas non-manufacturing in August was expansionary. Exports fell in August by
1% year on year. The Chinese economy perhaps is not being as severely impacted
as expected as the Chinese government took early action. Monetary stimulus is now
being followed by fiscal stimulus and the authorities have further levers to
pull. China appears to be positioning itself for a long-term impasse with the
US developing technology internally and diversifying external trade relations
so as not to be as reliant on the US.
The health of the Chinese economy
directly impacts on the export earnings of Australia and New Zealand and the
general buoyancy of the Australasian economies. Australia achieved a current
account (trade in goods and services) surplus of A$5.9 billion in the June
quarter, the first current account surplus in 44 years. This result occurred
despite the fall in coal and iron prices which may show up in future quarters.
Australian GDP continued to grow at a rate of 1.4% year on year, but this is
the slowest rate of growth in 10 years. The jobless rate has remained above 5%
in Australia despite the cuts in interest rates by the RBA.
New Zealand similarly has a positive
but slowing rate of GDP growth. In the June quarter GDP growth slowed to 2.1%
annually, a five-year low. Services sector activity remained buoyant in August,
but the manufacturing index contracted.
Similar to the United States New
Zealand borrowers were active. There was overall bond issuance of $3.2 billion
in September and bond maturities of $314 million. The New Zealand Government issued $2 billion
of bonds in September including $250 million of 2025 bonds. Demand for the 2025
bonds was strong with $810 million bid. However, despite the 3 times cover, the
interest rate was not bid lower for the first time in 8 consecutive bond
Continues to Slow
European markets appear to be more
adversely affected by the trade war and their own local economic issues.
Germany’s manufacturing sector, the engine of Europe dropped to its lowest
level since the GFC. The Bundesbank projected that the German economy has
entered a mild technical recession. The European Community reflected global
trends with the services sector remaining in mild expansion but the
manufacturing sector contracting.
We continue to be cautious in our
outlook. In isolation events such as US Presidential impeachment proceedings
are unlikely to be overly disruptive, but the weight of factors combined
requires ongoing vigilance. In the fixed interest market sentiment remains for
low rates to prevail. Potentially short-term rates in New Zealand will likely
continue to decline but some steepening of the yield curve could occur as
short-term rates fall further, and longer-term rates do not decline to the same
extent. The market currently prices an aggressive reduction in the OCR over the
next year of a further 0.40%. That said the possibility of negative rates has
diminished over the last month. RBNZ Governor Orr in his most recent speech
stated “…in our current view we are unlikely to need unconventional monetary
policy tools.” Similarly, global interest rates appear likely to continue to
moderately decline/remain with current trading ranges. In an absolute sense
interest rates have limited scope to decline further. While the tail winds for
the fixed interest rate markets are dissipating there appears minimal risk that
rates will lift materially in the near term.
Although economies are slowing, they
are not in recession. Within stock markets non-cyclical growth at reasonable price
is becoming more difficult to identify. However, earnings yields remain
positive and equity values are supported by interest rates. Given the
differential in yields between fixed interest and shares is likely to persist,
the relative attractiveness of shares is preserved.
Globally, the Fed and US-China trade relations continue to take centre stage in the economic theatre of 2018 (so far a drama not a tragedy) while Brexit and Italy present challenges to the European outlook.
US / China Trade
In a much-anticipated working dinner in Buenos Aires following the G20 summit, Mr Trump and Mr Xi agreed to a temporary ceasefire, in which the US president suspended his decision to impose higher tariffs, from 10% to 25% on $200bn on Chinese imports until March 1st, 2019 at the earliest. In exchange, China will increase its purchase of American farm produce, energy and some industrial goods. However the truce is fragile and formal talks between the two countries could well fail due to the high hurdles that stand in the way of agreement. First, the Chinese commitment to raise purchases of American goods is by an amount “not yet agreed upon, but very substantial” is unlikely to reduce America’s bilateral trade deficit with China by a significant amount. Second, the challenge that negotiators now have 90 days to agree “structural changes with respect to forced technology transfer, intellectual property protection, non-tariff barriers, cyber intrusions and cyber theft, services and agriculture” is ambitious, particularly when levels of trust between the two sides are so low. It is evident that this theme will continue into 2019.
China’s recent slowdown in gross domestic product growth is unsettling global markets and testing the Communist party leadership. Beijing is determined to keep its economy stable but doing so means tackling the politically sensitive issue of its private sector. Private enterprises are China’s economic mainstay, contributing about two-thirds of output and investment and the lion’s share of jobs. They drive the prosperity upon which the Communist party’s legitimacy rests. Yet Mr Xi has favoured state-owned firms since he took power in 2012 and clipped the wings of several high-flying private entrepreneurs. Now, as Beijing seeks to stiffen its resolve in the US-China trade war, the private sector’s dynamism is flagging, creating economic headwinds. Third-quarter GDP growth slipped to 6.5 per cent, year on year, its slowest since 2009. While this is by no means lacklustre, there are signs momentum could slackenfurther.
We expect flexible policy to come from Beijing as it attempts to manage headwinds associated with trade disputes, slowing demand and negative sentiment toward its equity markets causing investment outflows. China has accounted for 36% of global GDP growth since 2010 and has played a vital role in the economic recovery. This too will be a key focus for the global economic outlook in 2019.
Political uncertainty in the UK is extreme currently and reflected in investor positioning in sterling and UK equities.
Theresa May is battling to save her Brexit deal and her own position as Prime Minister after a series of ministerial resignations and the threat of a Eurosceptic coup left the Conservative party on the brink of civil war. Mrs May insisted she would stick to her plan, which would keep Britain closely tied economically to the EU, and said she was not about to quit in spite of growing criticism from Brexiters in her own party. Mrs May warned that Britain would embark on “a path of deep and grave uncertainty” if it abandoned the withdrawal deal it had agreed with the EU.
It’s unclear whether the refusal of May’s deal by British parliament would turn into a ‘hard’ Brexit (i.e. with no deal). The crucial vote in Parliament is on December 11th. May said there was no plan B, however, some commentators suggest that the transition period may get extended again due to the complexities of reaching a deal. The more it is extended, the closer it gets to the June 2022 election, increasing the likelihood of a potential second referendum.
Britain’s Treasury estimated that GDP will be 3.9% smaller in 15 years’ time than it would otherwise have been if the country leaves the European Union under the deal recently agreed with EU leaders. Under a no-deal Brexit, it would be 9.3% smaller.
The Fed’s tightening path had fuelled fears about a sharp downturn in the US housing sector. Home sales have slowed, inventories are rising, and homebuilder equities have sold off over 30% YTD.
However, the recent market reaction to a statement from the Federal Reserve Chairman Jerome Powell that we are approaching neutral shows how critical investors see this current period of tightening. Sharemarkets rallied as Jerome Powell said he sees current interest rates “just below” neutral. That proved to be significant because the language Mr. Powell used 6 weeks earlier indicated a view that the fed funds rate was “a long way from neutral.” Powell added that there is no pre-set policy path, and the Fed will be data-dependent in its decision making, which pleased investors. By highlighting risks, though, that included previous rate increases, trade disputes, and Brexit/EU political uncertainty, the market chose to read between the lines that the Fed chair isn’t wedded to three rate hikes in 2019.
The results for the recent US midterm elections were widely predicted (which is a surprise by itself). Democrats took the House of Representatives which will provide some oversight of the White House when members of the new Congress take their seats in January. Republicans held the Senate—with a bigger majority, which will make presidential appointments easier to confirm. Both sides declared victory. A starkly divided country now has a divided government. Underpinning the results, though, is the deepening of a structural shift in American politics that will make the country harder to govern for the foreseeable future.
The fate of the euro strongly depends on Italy. With annual GDP of more than €1.6trn ($1.9trn), about 15% of euro-area output and debt of nearly €2.3trn, it poses a challenge to the single currency that Europe seems unable to manage but cannot avoid. Matters are now coming to a head, as Italy’s new coalition government instigates a showdown over the European Union’s fiscal rules. The disagreement might well become disastrous. But it is also an opportunity for the euro zone to begin building a better, more durable approach to fiscal policy.
Trouble began earlier this year when the populist Five Star movement, led by Luigi Di Maio, formed a government with the right-wing Northern League, led by Matteo Salvini. Both promised budget goodies: Mr Salvini a hefty tax cut and Mr Di Maio a basic minimum income. Such a bounty may test the deficit limit of 3% of GDP set by the EU’s stability and growth pact and it seems certain to break other fiscal rules set by the bloc: the government’s initial budget plan is forecast to raise borrowing to 2.4% of GDP in 2019, above the 0.8% target to which Italy previously committed itself and enough to reverse recent, modest declines in its debt burden.
The EU did not take the news well. On November 5th other countries’ finance ministers warned that failure to revise the budget would lead to an “excessive deficit procedure” and possible sanctions.
We expect real GDP growth of around 3% by end-2018. Such a pace of growth should see the unemployment rate largely track sideways over 2018. Household incomes and consumption growth remain weak, possibly due to a weaker housing market, particularly in Sydney and Melbourne.
While actual economic output continues to grow a persistent downturn in business sentiment has emerged. The ANZ business outlook survey reported that headline business confidence remained stubbornly low, with a net 37% of respondents reporting they expect general business conditions to deteriorate in the year ahead. The likely explanation for which confidence is being rocked is a combination of policy uncertainty, capacity restrictions and margin pressure.
Labour market conditions have now tightened to a point where we expect wages to (finally) begin to move higher. However the RBNZ took an unexpectedly dovish turn in the August MPS, despite expecting modestly higher inflation in the near-term, and it has reiterated this approach recently.
For New Zealand, our economy has been supported by the tailwinds of record-high Terms of Trade, low interest rates and strong population growth. Nonetheless, business confidence remains weak and points to an upcoming slowdown in growth led by a fall in business investment.
Globally the combination of strong growth and loose financial conditions was highly supportive for equities in 2017. This year we have seen a tightening of financial conditions alongside a divergence of global growth, with the US outperforming. In 2019, we see renewed economic convergence driven mainly by the US economy slowing at a time when inflation pressures and interest rates are increasing. We do not see a recession as likely in 2019. Without a recession, it is unlikely that profits fall. Without profits falling, it is unlikely that we see a sustained equity bear market.
There has been a cyclical increase in global economic activity over the past couple of years, but we believe the longer-term outlook for economic growth remains subdued with risks to the downside because of structural headwinds. The US – China trade talk news will underpin investor sentiment in the short term. In 2019, investors should ensure that their portfolios have a risk exposure consistent with their risk tolerance.
Information and Disclaimer:
Source:JMI (previously JMIS), the investment consultant to the Select Wealth Management service.
This report is for information purposes only. It does not take into account your investment needs or personal circumstances and so is not intended to be viewed as investment or financial advice. Should you require financial advice you should contact Miles Flower on 021 645 000.
The near-term outlook for the world economy is still positive, however, mounting tensions over a potential US-China trade war suggests an elevated risk to the medium term outlook. We expect events in early July will likely be the key to understand the effect of this potential trade war, as the US is poised to impose the first significant tariffs at that time.
In the US, strong economic growth and low unemployment will likely prompt the Fed to raise rates two more times this year while, in the euro-zone, the ECB is on track to end its asset purchases by December. Any trouble in emerging markets could be largely confined to Argentina and Turkey.
While world trade has softened in recent months, the stability in trade volumes recent months offers some reassurance. Although the protectionist measures and rhetoric have escalated in recent weeks, the consequences do not yet point to anything worse than a modest slowdown of a resilient global economy, supported partly by household spending expanding at a decent pace. Further ahead, however, with monetary tightening set to take a toll on the US economy next year and China losing some momentum, global growth is predicted to slow in 2019 and 2020. This assumes no catalyst. such as a severe trade war, eventuates prior to then.
GDP growth should rebound in the second quarter, helped by the fiscal stimulus of recent tax cuts. This should keep pressure on the Fed to continue gradually hiking interest rates. Markets anticipate a total of four hikes this year and another two in the first half of 2019. As the stimulus fades and the cumulative monetary tightening bites, however, a slowdown in GDP growth could eventually force the Fed to reverse course by cutting rates around 2020.
In June, the Federal Reserve lifted its benchmark interest rate by a quarter of a percentage point, to a range of between 1.75% and 2%, the second rise this year. The last time the rate reached 2% was mid-2008, before the worst of the financial crisis. The Fed hinted at two more rises this year and dropped its statement that monetary policy would remain stimulative for some time.
The UK’s Monetary Policy Committee (MPC) is unlikely to wait too much longer before adopting more hawkish measures and increasing interest rates. Although the beneficial effects on exports of the pound’s fall may be fading, it is not clear that the sterling boost to growth is over. With sustained rises in real wages anticipated, real
GDP is likely to rise by around 1.5% to 2% over 2018/19. This should allow the MPC to raise interest rates at a faster pace than markets expect. Indeed, the Committee could hike rates in August, and by a further three times by the end of 2019.
The ECB recently announced its plans to end asset purchases this year, but it also clearly outlined that it is in no rush to raise interest rates. Investors’ expectations have now shifted to the view that the expansionary policy is set to continue and that the ECB will wait until late 2019 before raising interest rates.
The Italian financial markets are likely to remain under pressure in the coming months due to concerns about the new government.
The growing threat of a US-China trade war and a strong US dollar
are the key risks to emerging markets. Even if trade tensions don’t worsen, GDP growth in Emerging Asia has peaked and is likely to ease over the coming year. Central banks in Indonesia, Korea and the Philippines are likely to raise rates further before the end of the year, but other central banks in the region will be in no rush to follow.
Regional growth is likely to slow over the course of 2018-19 in Emerging Europe. The sharpest slowdown will come in Turkey, where the recent tightening of financial conditions will feed into weaker economic activity. Meanwhile, Argentina’s recently agreed IMF deal imposes an aggressive tightening of fiscal policy, which could push the economy into recession.
Although GDP remains strong, the end of the mining, housing and migration“booms” has softened the outlook for the economy and the financialmarkets. The result is that interest rates are unlikely to rise soon and the Australian dollar could weaken in response to rising US rates. There is a risk that tightening credit controls in response to the Royal Commission into Banking may conspire to weaken Australian housing.
The escalating trade spat between the US and China could potentially boost the Australian economy in the near-term, but any reduction in global trade would be bad news for Australia in the long-term.
Governor Lowe outlined in a speech in late June that, before interest rates are raised from their record low of 1.5%, the RBA will want to have“reasonable confidence that inflation is picking up to be consistent with themedium-term target and that slack in the labour market is lessening”. Weexpect rates to remain on hold until at least the second half of 2019.
In June, the AUD depreciated against the USD by -2.15%.
At home. the Reserve Bank of New Zealand left interest rates on hold at 1.75% in late June. Governor Orr repeated that the OCR will stay at the current expansionary level for a considerable period. Comparing this with the federal funds rate, which pushed higher in June to a target range of 1.75 to 2%, it is the first time since late 2000 that the OCR is lower than the Fed funding rate. In June, the NZD depreciated against the USD by -3.33%.
Global markets continue to face a more balanced set of tailwinds and headwinds than was the case a year ago. While the economic and earnings outlook remains relatively strong, the peaking of leading economic indicators and earnings revisions suggest a more challenging environment as momentum for both slows.
Monetary policy generally remains accommodative and the expectations are for future policy direction to be neutral at best, but more restrictive in the US with multiple rate hikes planned over the balance of 2018. We expect events in July are likely to be key to understand the extent of the impact of the US-China trade negotiations as the first significant tariffs are implemented. We will continue to monitor these events carefully to consider investment risk.
Also, geopolitical risks such as the instability in Italy endangering eurozone stability and the overhang of Brexit negotiations will be important to watch too.
Given the extended period of strength from investment markets, it is important that the risk levels in clients’ portfolios are appropriate.