We hold a modest overweight to international equities and are overweight listed infrastructure, while in fixed interest, we are slightly overweight domestic fixed interest and are modestly underweight international fixed interest. In property, we are neutral Australasian listed property, while we still have a small overweight to international listed property.
Inflation remains front of mind, with headline levels holding at multi-decade highs, frustrating central banks, which are aggressively tightening policy to alleviate the pricing pressures.
As we look ahead, we note two scenarios around inflation and financial markets:
- If inflation remains stubbornly elevated, central bankers and markets may price in even more rate hikes. This would mean more pain for bond and equity markets, but we don’t think this is likely. If the economy is tipped into recession, interest rate hikes could be priced out, which may be good for bonds, but not for equities.
- If inflation shows signs of peaking, and starts falling meaningfully, we think central bankers will slow down the pace of tightening, rather than keep hiking and risk pushing the economy into recession. This would be supportive for bonds and equities, and we see this as the most likely scenario.
Given all this, our base case is that inflation remains elevated in the short-term, which will see the Fed continue to raise the fed funds rate to around 3%. However, we believe due to both interest rate hikes and a normalisation of supply chains and end demand, inflation will start to moderate, which is already being reflected in long-dated bond yields that have drifted off recent highs.
In equity markets, the key will be second-quarter earnings. If consumer spending and end demand has held up, and companies have managed to navigate the challenge of rising input prices, then equities are somewhat attractive on a valuation basis.
As we take a step back and look at the economy more broadly, the labour market is a key pillar. If it remains strong then the equity market should be able to handle a period of weakness, however, if labour market dynamics abruptly change and we start seeing lay-offs due to weaker-than-expected earnings, then we could see more challenging times ahead.
Domestically, there are signs that the New Zealand economy is deteriorating fast with consumer and business sentiment levels declining rapidly. Moreover, recent growth data suggests the economy is at risk of entering a recession. Given this, we believe it is unlikely the OCR will reach levels the RBNZ has forecasted, which is represented by our overweight to New Zealand fixed interest.