The Month Ahead

Financial markets faced a more challenging backdrop in July as renewed tensions in the Middle East and persistent inflation concerns weighed on sentiment. Hopes of a lasting easing in hostilities between the US and Iran proved short-lived, with conflict again intensifying towards month-end. This pushed energy prices higher and reinforced concerns that inflation could remain elevated for longer.

Bond markets were particularly sensitive to these developments. Government bond yields moved higher across most major markets as investors reassessed the inflation outlook and the prospect that central banks may need to keep interest rates restrictive for longer than previously expected. The US Federal Reserve's latest policy meeting reinforced those concerns, contributing to a further rise in longer-dated bond yields. When bond yields rise, their prices fall.

Equity market performance was mixed. While many markets proved resilient through much of the month, sentiment deteriorated towards month-end. US share markets moved into negative territory, with the Dow Jones Industrial Average down 1.4%, the S&P 500 Index down 2.4%, and the technology-heavy Nasdaq 100 Index down around 10%, as at 29 July. Asian markets were generally weaker, reflecting ongoing pressure on technology and semiconductor stocks and greater sensitivity to higher energy prices.

New Zealand markets were also mixed. In equities, the NZX 50 Index traded to a record high, reflecting investor demand for defensive companies, while bond markets underperformed after the Reserve Bank of New Zealand (RBNZ) lifted the Official Cash Rate (OCR) and economic data showed annual inflation rose to 4.1%, remaining well above the central bank’s 1-3% target range.

Geopolitical developments in the Middle East remained a dominant influence on financial markets during July. While hopes of a diplomatic solution between the US and Iran improved sentiment at various points during the month, recent events have highlighted the fragility of that progress and the absence of a lasting resolution.

For investment markets, the key concern continues to be the potential impact on global energy supplies and shipping routes. The Strait of Hormuz remains strategically important, and any disruption to the movement of oil and gas through the region has the potential to place upward pressure on energy prices and inflation.

While markets have, at times, looked through the conflict and focused instead on economic fundamentals and corporate earnings, renewed military activity serves as a reminder that geopolitical risks remain elevated. As a result, investors should expect periods of volatility, particularly across energy markets, bond markets and other inflation-sensitive assets.

In New Zealand, elevated inflation is weighing on growth prospects and leaving the RBNZ with a difficult policy trade-off. Most recently, annual inflation rose to 4.1%, remaining well above the central bank's 1-3% target range and reinforcing concerns that price pressures may take longer to subside.

Following its 25 basis point hike in July, markets expect further increases later this year. The extent of any further tightening, however, will depend on how growth and inflation evolve over the coming months. At its July meeting, the central bank acknowledged that the economy had “lost momentum in the June quarter as the oil shock weighed on economic activity.” While the RBNZ expects growth to resume in the third quarter, this projection assumes that the economic effects of the war gradually fade.

On the data front, August is relatively light. Indicators such as business inflation expectations, food price inflation, and retail sales will provide further insight into the state of the economy and help shape expectations for the outlook for the OCR.

At a tactical asset allocation level, we maintain our overweight positions in long-dated US and UK government bonds. Bond yields in both markets remain attractive and, in our view, continue to reflect expectations for inflation and policy rates to remain elevated for longer than is ultimately likely.

Within equities, our positioning remains broadly neutral. With corporate earnings season underway, we are watching closely how investors respond to those results from the major technology companies, particularly given ongoing questions around the returns that can be generated from substantial AI-related investment.

In currency markets, we remain overweight the New Zealand dollar relative to the Australian dollar. New Zealand is still in the early stages of monetary tightening, while Australia appears closer to the end of its rate-hiking cycle. Relative economic and housing market trends also support this view, with weakness emerging in Australia after the introduction of recent capital gains tax policy there.