Investment Update

July Quarter 2022

Global markets

It was a challenging three months for most global markets as rising interest rates and concerns around slowing global growth weighed on investor sentiment, leading to declines across most equity and bond markets. Against the backdrop of a worsening outlook for the global economy, the MSCI All Country World Index declined 14.1%, in local currency terms.

Key themes for the second quarter of 2022 included:

Central banks hike rates to slow inflation

The second quarter was dominated by central banks aggressively raising policy rates as inflation remained persistently high. Inflation has become the bellwether for financial markets, with central banks now conceding that the post-COVID price rises are not transitory, and are here to stay – at least over the short to medium term.

This acknowledgement saw some sizeable interest rate hikes, beginning with the US Federal Reserve (‘the Fed’). After a 50 basis point rise in May, investors were prepared for a further 50 basis point hike in June, but the Fed somewhat surprised markets when it hiked by 75 basis points, the biggest single hike since 1994. While it’s widely accepted that interest rates need to move higher, one consequence of a swift period of tightening could be a hit to the economy, which many now fear is in for a slowdown. Nevertheless, Fed officials remain confident they can slow inflation without damaging the economy. “We’re not trying to induce a recession now. Let’s be clear about that… We’re trying to achieve 2% inflation with a strong labour market — that’s what we’re trying to do,” Fed Chair Jerome Powell said in a press conference following the 75 basis point hike.

Elsewhere, the second quarter saw further interest rate hikes by the Bank of England and Bank of Canada, a surprise first hike of this cycle by the Swiss National Bank, while the European Central Bank committed to begin lifting its policy rate in July, saying it will be the first in a series of interest rate hikes. “Beyond September, based on its current assessment, the Governing Council anticipates that a gradual but sustained path of further increases in interest rates will be appropriate,” the ECB said in its June policy statement.

Recession risks increase

As central banks embarked on tightening policy, concerns mounted that it could cause a slowdown in economic activity, and could even lead to a recession. A combination of higher interest rates, which increases companies’ borrowing costs, and rising input prices from inflation weighed on sentiment, with many consumer and business confidence surveys hitting record lows.

Economic data confirmed this, when in June, the Commerce Department revised down US first quarter GDP to an annual rate of -1.6%, its first quarterly drop since the second quarter of 2020.

The fear of a recession, coupled with surging inflation have some drawing comparison to the 1970s and early 1980s when the Fed had to move interest rates higher to curb inflation, which caused a deep recession, and a sharp rise in unemployment.

Bear market for several indices

All told, rising interest rates, surging inflation and recession concerns lead to significant declines in equity markets, with some benchmarks entering ‘bear market territory’ – a 20% decline from a recent peak.

Growth stocks were the biggest underperformers, with the NASDAQ 100 Index ending the quarter down more than 20%. Growth stocks had been the biggest winners in the post-COVID rally as record-low interest rates saw cheap money pour into companies with higher valuations, which were seen as having more upside potential. However, as interest rates reversed higher, so did the attractiveness of many of these stocks.

New Zealand market

The Reserve Bank of New Zealand (RBNZ) dominated headlines during the second quarter with two interest rate hikes of 50 basis points each, which saw the Official Cash Rate (OCR) hit 2%. The two hikes and prospects for more, saw the RBNZ lift its forecast peak in the OCR to 3.95%, up from 3.35%, as it projected inflation to hit 7%.

The RBNZ has been one of the most aggressive central banks in the developed world in normalising policy in the post-COVID environment. However, it did recognise that the economy is set to face headwinds in the near to medium-term future.

“A larger and earlier increase in the OCR reduces the risk of inflation becoming persistent, while also providing more policy flexibility ahead in light of the highly uncertain global economic environment… The pace of global economic growth is slowing. The broad-based tightening in global monetary and financial conditions is acting to slow spending growth, accentuated by the high costs of basic food and energy staples,” the RBNZ said in its statement.

Fears of a slowing domestic economy were confirmed when economic data showed that the economy contracted 0.2% in the first quarter, well below the 0.7% increase the RBNZ had forecast. This means, if GDP declines in the second quarter, the economy will officially be in recession.

Elsewhere, house prices continued to come under pressure with Real Estate Institute of New Zealand (REINZ) data showing that New Zealand house prices fell 4% in May from the month prior, this after a 1.7% decline in April. In Auckland, year-on-year median price growth fell 2.2% - the first annual median price decline in Auckland since October 2019.

Sector review

International equities

US equities were again some of the worst-performing, highlighted by the sell-off in growth stocks. Growth stocks had benefited from the record-low interest rates of 2020 and 2021, which cheapened the cost of capital, resulting in an influx of money to the sector. However, the tide has well and truly shifted with rising bond yields unable to support the already high valuations that many of these companies exhibit.

Exemplifying these reversals were companies such as PayPal, Shopify and Netflix, which, as at 30 June, are down around 75% from their all-time highs made in 2021, this after posting immense returns from the March 2020 lows.

The broader S&P 500 Index fared marginally better, but still ended with double-digit losses. Some bright spots over the quarter were the energy sector, which was helped by rising commodity prices, and the consumer staples sector. In times of uncertainty, investors find companies that sell day-to-day household products attractive for their steady business growth and dividend yields.

European stocks also ended the quarter lower, with the ongoing war in Ukraine dampening the economic outlook. Rising energy prices have hit European households in the pocket, which has flowed through to worsening sentiment as consumer spending is expected to fall.

The outlier over the quarter was the Shanghai Composite Index, which finished more than 4% higher. The outperformance was largely due to the accommodative monetary policy enacted by its central bank to support the struggling housing sector.

New Zealand equities

New Zealand equities continued to struggle against the backdrop of rising interest rates, with the defensive dividend-paying index unable to keep up with returns offered by government bond yields. Despite a mild bounce to close out the quarter, it was relatively one-way traffic, with the NZX 50 Index ending the quarter down more than 10%.

The downbeat quarter saw just 5 of the 50 companies that make up the index finish higher, and more than half finished with double-digit losses.

In sector performance, growth and cyclical stocks were some of the worst-performing, while the defensive yield sector outperformed, although it still produced a negative return.

In company specific news, PushPay continued to be the one standout as takeover interest grew, while Eroad, the fleet-tracking company, was the worst-performing, ending the quarter down more than 65% after news the company’s CEO abruptly, and surprisingly, left the company. 

International fixed interest

Global bond markets continued to decline during the second quarter as global central banks forged ahead with their aggressive monetary policy tightening to combat record levels of inflation. Global bonds fell 4.5% over the quarter, as measured by the Bloomberg Barclays Global Aggregate Bond Index (100% hedged to the New Zealand dollar). In the US, the year-on-year Consumer Price Index (CPI) hit 8.6% in May, which was the third-consecutive monthly reading above 8% and the highest in 40 years.

The interest rate hikes in May and June saw the fed funds rate back to its pre-pandemic level of 1.75%, while the rise in short-end rates saw a closely-watched part of the yield curve (10-year versus 2-year) briefly invert, which has in the past, but not always, been a precursor to a recession.

Liquidity, or lack thereof, was another highlight of the quarter with significant intraday swings highlighted by a spike in the US 10-year government bond yield in June towards 3.5%, its highest level in more than a decade. By the end of the quarter, the 10-year yield had risen 67 basis points to 3.01%.

In Europe, while the European Central Bank left the eurozone policy rate unchanged, its hawkish rhetoric saw yields across the continent move higher too. The German 10-year government bond yield hit an eight-year high, near 1.8%, after beginning the year in negative territory.

New Zealand fixed interest

The sell-off in New Zealand bonds showed no signs of slowing with the RBNZ one of the more aggressive central banks in raising interest rates to combat inflation. After lifting the OCR 100 basis points during the second quarter, the market is pricing in a further 100 basis points of hikes during the coming quarter, which would take the OCR to 3%.

Although the RBNZ’s forward track shows the central bank expects the cash rate to reach nearly 4%, slowing economic activity could see the OCR fall short of this level– this is under the assumption that inflation can drift back towards manageable levels.

Against the backdrop of further interest rate hikes, the yield on the New Zealand 10-year government bond yield ended the quarter up 64 basis points, at 3.86%.

Listed property and infrastructure

The Australasian listed property sector had a challenging quarter as rising bond yields tend to reduce the attractiveness of the sector – which offers steady income streams through rents and dividends. Furthermore, as the gap between bond yields and rents grows wider, it can also hit the valuation of property assets.

Both the Australian (-17.7%) and New Zealand (-12.2%) listed property indexes ended the quarter with steep losses, and underperformed their respective broader equity benchmarks.

In New Zealand, all companies that make up the index ended the quarter lower. 

Meanwhile, some infrastructure assets continued to outperform due to their ability to pass through inflation costs. Furthermore, with the economic outlook worsening, and signs that demand is starting to slow due to higher borrowing costs, the outlook should favour this asset class on a comparative basis because it doesn’t overly rely on discretionary spending.

Outlook and base case

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:

  1. 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.
  2. 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.

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