Investment Update

Despite a sell-off early in April, most global equity markets finished the quarter higher as concerns around a potential US debt default abated and on evidence the global economy was holding up in the face of higher interest rates. Against this backdrop, the MSCI All Country World Index rose 6.0%, in local currency terms.

Highlights from the quarter included:

The early weakness in equities came amid concerns the Democrats and Republicans were on a collision course to breach the US debt ceiling (the total amount the government can borrow), as both parties showed no signs of budging.

However, late in May, as the so-called X-date (the date at which the US would run out of money) was approaching, an agreement was reached in principle to raise the debt ceiling for two years, and to cap some government spending.

After more than a year of consecutive interest rate hikes, the US Federal Reserve (the Fed) left its policy rate unchanged in June. In its statement, the Fed said: “Holding the target range steady at this meeting allows the committee to assess additional information.”

Despite the pause, the Fed confirmed it expects more interest rate rises this year: “Looking ahead, nearly all committee participants view it as likely that some further rate increases will be appropriate this year.”

Chinese exports in May fell at a faster pace than expected, while imports were also down, raising concerns that global demand and domestic consumption were faltering. China, which is the world’s second-largest economy, saw its exports fall 7.5% year-on-year, while imports fell 4.5%.

The weak data was consistent with China’s manufacturing activity, represented by the NBS Purchasing Managers’ Index (PMI), which fell to a five-month low in May.

The Reserve Bank of New Zealand (RBNZ) raised the Official Cash Rate (OCR) by 75 basis points across its two meetings during the quarter. However, in May, the central bank suggested that its policy tightening was over when it left its terminal rate (the rate the bank expects the OCR to peak) at 5.50%.

In making this decision, the Committee said it was pleasing that some of the data points were beginning to slow, suggesting “the interest sensitive parts of the New Zealand economy are yielding”.

The idea that the domestic economy was slowing was confirmed in June, when economic data showed the economy entered a technical recession, which is measured as two consecutive falls in quarterly GDP (Gross Domestic Product). The economy contracted 0.1% in the first quarter of this year, after a 0.7% contraction in the final quarter of last year. 

International equity markets finished the quarter higher, despite concerns around the US debt ceiling, sticky inflationary pressures and rising interest rates. US equities led the way, with the S&P 500 TR (Total Return) Index hitting its highest levels since April 2022, up 8.7%. The tech-dominant NASDAQ 100 TR Index was a notable outperformer, up 13.1% over the quarter.

The information technology sector outperformed following strong results from Alphabet, Meta and Nvidia. These have done well given investor speculation on how artificial intelligence (AI) trends may boost these companies’ future earnings.

In Asia, Japanese stocks continued their good run with the country’s Nikkei 225 TR Index rising 18.5% over the quarter, which saw it trade to its highest level since the 1990s. The Japanese economy is getting a reopening boost from tourism, while a weakening Japanese yen has boosted export-orientated companies.

It was a mixed bag in Europe. A surprise 50 basis point hike by the Bank of England, and ongoing inflation worries saw the FTSE 100 TR Index fall 1.3%, while the Euro Stoxx 50 TR Index gained 3.7%. Another laggard was the Chinese share market. The recent run of weak economic data saw the Shanghai Composite TR Index fall 1.1% over the quarter.

In contrast to their overseas counterparts, New Zealand equities had a more challenging time, with the interest-rate-sensitive NZX 50 Index gaining just 0.3% over the quarter. This came as the local economy slipped into recession and both business and consumer confidence remained weak, albeit bouncing off their recent lows.

Information technology was the best performing sector, while consumer staples was the weakest. At a company level, Serko (+56.9%), Arvida Group (+38.1%) and Ryman Healthcare (+25.3%) were the best performers, while Pacific Edge (-79.8%), Synlait Milk (-22.1%) and EBOS Group (-21.0%) were the weakest. Overall, 31 companies gained, and 19 lost ground.

Across the Tasman, the weak performance of China’s economy (and especially the trade data) weighed on the Australian equity market, with falling commodity prices also prompting weakness in this energy-heavy index. The ASX 200 TR Index gained only 1.0% over the quarter.

Global bonds had a challenging quarter. In the US, bond yields rose (and their prices fell) as the regional banking crisis receded and concerns of a credit crunch faded – lessening the perceived need for investors to hold safe-haven assets. Investors also worried that the US government could reach its debt ceiling, meaning there was a chance it could default on its debt. In the event, these concerns dissipated as both sides reached an agreement to raise the ceiling. While the Fed’s decision to hit pause on its rate hiking cycle should have been positive, sticky core inflation in most major economies meant bonds remained under pressure.

The yield on the US 10-year government bond rose 37 basis points, to finish the quarter at 3.84%. The yield on US 2-year government bond finished at 4.90%, which meant the US yield curve move further into inverted territory. Historically, an inverted yield curve has been viewed as a precursor to a recession.

Meanwhile, UK bonds were some of the worst-performers as inflation there remained stubbornly high. This saw the Bank of England lift its key policy rate by 50 basis points in June, more than the 25 basis points the market had been expecting.

New Zealand bonds also had a tough quarter, taking their lead from international markets. The market reacted to a further 0.75% of tightening from the RBNZ and, while the prospect of rates having peaked should have been a positive, investors were worried by the government’s budget – deemed inflationary due to higher-than-expected spending. Over the quarter, the yield on the 10-year government bond rose 42 basis points, to 4.62%.

The New Zealand listed property sector outperformed the broader local share market, finishing the quarter 3.3% higher. The possibility that interest rates in New Zealand may have peaked helped to boost the performance of this interest rate-sensitive sector.

Across the Tasman, the listed property sector also outperformed its broader market, up 3.4%.

Listed infrastructure stocks held up well over the quarter. While inflation in most countries has been falling, it remains well above most central bank target levels, and this has been supportive of returns from this sector.

During the quarter, we maintained our defensive strategy represented by an underweight to international equities and overweight positions to international and New Zealand fixed interest.

Economic data held up relatively well during the quarter which, along with AI-euphoria, saw equity markets move higher, putting the S&P 500 Index into overvalued territory based on a trailing p/e ratio. Despite this, we maintain our view that the global economy is set to face headwinds over the short to medium term.

Inflation continues to trend lower. In the US, the annual Consumer Price Index hit 4.0%, its lowest level since March 2021. However, the core Personal Consumption Expenditures (PCE) price index – the Fed’s preferred measure – remained sticky, at 4.6%. If we are to see inflation fall back to central bank target levels of around 2% it will likely require an easing of the labour market. However, if inflation remains persistent, central banks could restart or extend their monetary tightening.

In New Zealand, it appears that the cumulative effect of the interest rate hikes by the RBNZ is starting to flow through to the economy with benign growth, weak retail spending and overall weak business and consumer confidence – although both of the latter are off recent lows.

Our base case is that inflation falls slowly, but not fast enough to allow the Fed to reverse interest rate hikes. We expect the federal funds rate to move to 5.75%, but 10-year bond yields will remain below current cycle highs.

We expect PMIs (Purchasing Managers' Index) to remain in contractionary territory (below 50), which will lead to benign growth, and eventually see the economy go into a recession. This setup will be a challenging period for growth assets, underpinning our defensive position.

Finally, we expect oil to remain around $70/barrel and the unemployment rate to slowly rise as workers re-enter the workforce and immigration resumes.