Noise or signal – is the market downturn a cause for concern?

IMPORTANT, PLEASE READ: This material is provided for information only. It is not personal financial advice. No account has been taken of the objectives, financial situation or needs of any particular person. Accordingly, to the extent this material constitutes general financial product advice, you should, before acting on the advice, consider the appropriateness of the advice, having regard to your investment objectives, financial situation and needs. If you need to speak with an adviser, please contact Miles on 021 645 000 or miles@moneyplanners.co.nz.


I’ve fielded a number of calls in recent weeks from clients who are concerned about the current market turmoil. There’s no doubt that 2022 from an investment perspective has not gone well – with double-digit negative returns since the start of the year. With an almost incessant barrage of negative economic news and increasing geopolitical turmoil and unrest, its hard to see any positives on the horizon. The thing is – the markets have reacted accordingly and the downturn reflects the market’s assessment of the current outlook. Does that mean that it will get better from hear on in? No – but, neither does it mean it will get worse – the markets will do what the the markets do – respond to price signals.

What does that mean for your KiwiSaver or other investments? Should you make any changes?

Our advice is always to consider the goals you have for your KiwiSaver/Investment and ask yourself two questions –

  1. have the goals for your KiwiSaver or Investment changed since the beginning of the year? and,
  2. Have your time horizons changed?

If the answer to either of these questions is “Yes” (or “possibly) – please get in touch so we can help you determine whether any changes are appropriate. If you answered No to both questions – then sit tight – it could be a bit of a bumpy ride but by focussing on the long term (signal) as opposed to current market turmoil (noise), you will be able to take advantage of the recovery when it comes around.


Further Reading

Investment Update – The conflict in Ukraine

The conflict in Ukraine has added to the increased level of uncertainty prevailing in financial markets this year, which were already grappling with concerns over high inflation and the expectation of higher interest rates. However, until yesterday it was unknown whether an all out war would occur. Consequently when it was announced that Russia had invaded Ukraine, share markets fell sharply and commodity prices including oil rose. Even the New Zealand market was impacted with the S&P NZX50 index falling 3.3% and the Australian share market falling 2.2%.

A fall in share values has been the markets’ historical response to the threat of war. Yet perversely once the campaign has started, the focus of markets moves on to other issues and share markets have typically rebounded. This theme occurred last night when the S&P 500 was initially down 2.6% only to end the day up 1.5%.

Clearly there will be some longer lasting economic and political impacts of the conflict. The extent of the economic sanctions and the removal of financial linkages with Russia are designed to punish Russian aggression and will likely draw a commensurate response from Russia. The imposition of sanctions will likely persist over the long-term. However, the economic impact is likely to be more punitive on Russia than on western economies.

From a New Zealand perspective, the extent of trade with both Russia and Ukraine is limited.  Russian exports to New Zealand during 2020 were approximately US$252 million, overwhelmingly mineral fuels and oil. New Zealand exports to Russia consist primarily of dairy products and are of a similar order of magnitude in terms of value. Trade with Ukraine is insignificant.

Wider implications might be drawn in terms of the price of globally traded commodities most notably oil. The oil price has already surged with Brent crude trading at over US$100 per barrel. Given Germany’s dependency on Russian natural gas, continued elevated electricity prices are likely in Europe. However, natural gas is not yet an internationally traded commodity so this impact should be limited to just Europe.

A rise in the price of energy is a two-edge sword from a monetary policy setting perspective. While it feeds through into a higher inflation rate, it also depresses discretionary spending. This means that central banks may not have to increase interest rates as rapidly or as high given the increased cost of oil will reduce demand for other goods and services.

Other commodities that could be impacted include grain – Ukraine is the bread basket of Europe – aluminium and nickel. Russian based Rusal is one of the largest global aluminium producers, while Norilsk Nickel is the world’s largest Nickel miner. The conflict may therefore have second round effects and some unexpected consequences.

Importantly, there are many companies that will not be impacted by the conflict. Exactly why both the New Zealand and Australian share markets should fall so sharply is perplexing. The impact on both economies is likely to be limited with the direction of interest rates and the return to normality post COVID much more important. Similarly, the United States, the largest global share market, will only be marginally impacted. Again, the direction of inflation and interest rates will be more important in the long term to this market.

In summary, outside the significant human cost and the possibility for further increases in the price of petrol, the impact on the global economy is likely to be minimal. This implies the long-term impact on client’s portfolios is also likely to be minor. Share markets experienced a similar fall in 2014 when there was unrest in the Ukraine and Russia annexed Crimea. Yet after the initial decline, share markets rebounded and largely forgot about the ongoing conflict. Therefore, we believe the prudent course of action is to look through any immediate tendency to over react and focus on core investment drivers such as what is happening to inflation and interest rates and how are companies reacting to the economic environment.

 – Source: Select Wealth Management


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.

Monthly View – October 2020

Interest Rates continue to fall

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.

Term 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 will follow.

The 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

the 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 conditions.

In the 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.

Global 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 prices.

Conclusion

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.

Investment Update – November 2019

Heightened Sensitivity

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.

Outlook

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.

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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.

Investment Update – October 2019

Politics Intrudes on Markets

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.

US 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 Bank Policy

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 balance sheet.

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 support economies.

Trade War Impact

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.

Australasian Effects

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 tenders.

Europe 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.

Summary

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.