Investment Update

Despite a weak December, most global equity markets finished the final quarter of the year higher, as inflation rates in many developed nations slowed, raising hopes the end of the global central bank tightening cycle may be near. Against this backdrop, the MSCI All Country World Index rose 7.0%, in local currency terms. However, in New Zealand dollar terms, the index was down 3.0%, a result of broad-based kiwi dollar strength as risk appetite improved.

Key themes from the quarter included:

After reaching 9.1% in the middle of 2022, annual inflation in the US dropped to 7.1% in November; the fifth consecutive monthly decline and the lowest level of the year. This was due to a decline in energy prices, which saw gasoline prices at the pump fall, while used car and truck prices also fell.

Despite the overall fall in inflation, shelter costs (rents), which make up about one-third of the overall consumer price index (CPI), continued to rise. Although anecdotal evidence suggests house prices and rents are starting to slow, it is yet to show up in the data.

Although inflation declined over the final quarter, the US Federal Reserve (the Fed) raised interest rates twice and reiterated its commitment to bringing down decades-high levels of inflation, adding that the fight is far from over. The key message from the Fed was that the main risk to the economy was if they were to under-tighten (i.e. not raise interest rates high enough), which could result in inflation becoming more embedded.

The Fed’s December meeting came with its much-anticipated quarterly economic projections. These showed that it expects the fed funds rate to peak around 5.25%, an upward revision from its September projection. The Fed also downgraded its growth forecast and projected the unemployment rate to rise to 4.6%, up from its current level of 3.7%.

It was a volatile quarter in the UK that saw inflation roar to a 40-year high of 11.1% in October. Despite the introduction of a government policy to cap household energy bills, the Office for National Statistics (ONS) said the largest contributions to the upward inflation rate came from fuels – notably electricity and gas.

Meanwhile, the political situation in the UK reached a melting point when Prime Minister Liz Truss tendered her resignation after just 45 days, becoming the shortest-serving British prime minister. Her downfall came when she announced a ‘mini budget’ that would slash taxes to help households navigate the cost-of-living crisis. However, the near-£45 billion of unfunded tax cuts would be paid for by further government borrowing – a prospect that sent UK bond yields soaring, so far and so quickly that it required the Bank of England (BoE) to intervene to ease the volatility in bond markets.

After around three years of strict lockdown measures to keep COVID-19 at bay, in December, China’s government announced it would be abandoning its so-called ‘zero-COVID’ policy. The government bowed to pressure from democracy advocates – who took to the streets in protest against the severe measures the country had taken to keep COVID from entering the community. While this has led to a widespread pick-up in COVID cases, the decision is seen as being broadly positive, as it should allow the country to return to a position of full capacity sooner, therefore leading to improved economic output and growth.

The final quarter of the year was all about the Reserve Bank of New Zealand (RBNZ) and its continued ultra-hawkish monetary policy stance. The central bank fears inflation could become embedded in the economy, leading to widespread economic consequences.

The RBNZ met twice, raising the Official Cash Rate (OCR) by a total of 125 basis points to 4.25%, its highest level in more than a decade. Furthermore, the central bank raised its expected peak in the OCR to above 5%, meaning further interest rate hikes in 2023 should be expected.

“Committee members agreed that monetary conditions needed to continue to tighten further, so as to be confident there is sufficient restraint on spending to bring inflation back within its 1-3 percent per annum target range”, the RBNZ said in its November policy statement.

The hawkish tone was vindicated when economic data showed inflation in New Zealand rose at a faster-than-expected annual pace of 7.2% in the third quarter, driven by food, construction and other household-related items.

Elsewhere, higher interest rates (and the prospect of further hikes) continued to weigh on sentiment. The ANZ Business Outlook Survey fell 14 points in November to -57, with inflation expectations hitting a fresh record high of 6.39%, and the residential construction sector continued to worsen, with the index dropping to -90. Meanwhile, consumer confidence also took a hit with the ANZ Roy Morgan Consumer Confidence Index falling seven points to 74, a new all-time low. 54% of people expect the economy to worsen over the next 12 months, while a net 10% of people expect to be worse-off this year.

Despite what felt like a downbeat quarter, there was some good news, with third-quarter growth up 2.0% from the prior quarter, and 6.4% from a year ago. The stronger-than-expected reading came from a jump in transport, postal and warehousing as the border reopening continued.

European markets were some of the better performers this quarter, with the UK’s FTSE 100 Index rebounding off a near 18-month low to finish the quarter up 8.1%. Despite the frenetic political situation, markets took news of a new Prime Minister, Rishi Sunak, and the BoE’s intervention in the bond market, well.

Over in mainland Europe, the Euro Stoxx 50 Index had an even better quarter, as it bounced off a near two-year low to finish up 14.3%, its highest level since February 2022. The gains were helped in part by optimism that the worst of the energy crisis was behind them, while news that eurozone inflation fell to 10% in the year to November, the first annual decline in over a year, also eased concerns.

In the US, the S&P 500 Index closed out a challenging year on a high note, up 7.1%. After reaching a two-year low in early October, the market rebounded thanks to further gains from the energy sector, which continued to ride the tailwinds of higher oil prices. Fears of a recession saw healthcare stocks, which tend to do well in economic downturn, add to the market’s gains.

However, the tech-heavy NASDAQ 100 Index didn’t fare so well, as some of the index’s largest contributors, including Apple, Microsoft and Alphabet (parent company of Google), underperformed the market. Over the quarter, the index was down 0.3%.

New Zealand equities ended the quarter higher, but faced headwinds as the RBNZ continued its hawkish tightening of monetary policy. The interest rate-sensitive NZX 50 Index, delivered a gain of 3.7%, thereby underperforming many of its global peers.

At a sector level, consumer staples were the best performers over the quarter (+10.9%), whilst the consumer discretionary sector performed the worst (-9.0%), probably a result of households scaling back on their non-essential spending. Over the quarter, 24 companies delivered positive returns and 24 delivered negative returns (with two delivering flat returns).

The best-performers were Tourism Holdings (+23.6%), Fisher & Paykel Healthcare (+23.5%) and a2 Milk (+20.6%). Tourism Holdings did well on New Zealand’s border reopening and the return of overseas visitors, while Fisher & Paykel Healthcare surged to become New Zealand’s largest company following a better-than-expected half-year financial result. a2 Milk did well as it revised up its revenue guidance and following news it has gained regulatory approval to sell its infant formula in the US.

At the opposite end of the spectrum, Ryman Healthcare (-36.6%), Serko (-29.7%) and Restaurant Brands (-24.9%) were the worst performers. Ryman Healthcare fell as it reported that its bottom line profit was down nearly a third compared to a year ago.

Over in Australia, the ASX 200 Index had a better quarter, up 8.7%. The utilities and materials sectors were the best performers. The Australian equity market has benefited from the prospect that China’s easing of COVID restrictions will ultimately drive demand for Australian commodities. The fact that the Reserve Bank of Australia (RBA) has also slowed down the pace of its policy tightening, has also been supportive.

Global bond markets had a somewhat mixed quarter. On the one hand central banks continued to raise interest rates, while on the other there were signs that inflation in many developed countries may be peaking.

In the US, bonds began the quarter on the back foot after headline inflation data for September topped expectations, rising at an annual pace of 8.2%, driven by rising household-related items and food. Meanwhile, core inflation, which strips out volatile food and energy prices, rose to its highest level since the 1980s. This prompted fears that interest rates may need to continue to rise, and bonds tend to underperform when interest rates are heading higher.

However, the bond market sell-off reversed in early November after US inflation slowed to its lowest level of the year (7.1% in November) thanks to a pullback in airfares and used car and truck prices – two sectors that experienced significant price rises as its economy reopened following pandemic-related shutdowns. And somewhat surprisingly, the US bond market was relatively subdued during the two Fed meetings – a sign that there were no meaningful surprises from policymakers. Over the quarter as a whole, US bonds ended higher.

In Europe, bond yields surged higher (and bond prices fell) after the European Central Bank (ECB) increased its key interest rates by 50 basis points and announced it would start unwinding its bond holdings from March 2023 – the next step in ‘normalising’ monetary policy. Moreover, the ECB said elevated inflation meant much higher interest rates are to be expected.

“The Governing Council judges that interest rates will still have to rise significantly at a steady pace to reach levels that are sufficiently restrictive to ensure a timely return of inflation to the 2% medium-term target”, it said in its statement.

UK bonds however had a good quarter, following BoE intervention to help stabilize the local bond market. Their recovery meant that UK bonds were some of the best performers this quarter.

The yield on the US 10-year government bond was broadly unchanged over the quarter as a whole, at 3.87%. Meanwhile, the yield on the European equivalent rose by 46 basis points to a 10-year high, while UK 10-year bond yields fell by 42 basis points. Bond yields and bond prices move in opposite directions to each other.

New Zealand bonds held up relatively well over the quarter, despite two sizeable interest rate hikes by the RBNZ, and news that it expects the ‘neutral rate’ (the level it expects the OCR to peak in the current cycle) to reach 5.5%.

Nevertheless, it was a volatile quarter, with both domestic and international events leading to substantial trading ranges.

In New Zealand, higher-than-expected inflation, alongside robust retail sales and economic growth data, saw sharp declines in local bond prices. However, these sell-offs were met with market rallies following lower-than-expected US inflation readings in October and November.

Against this backdrop, the yield on the New Zealand 10-year government bond rose 17 basis points, closing at 4.47%. During the quarter however, and reflecting the volatile nature of the market, bond yields traded in a range of more than 75 basis points.

The New Zealand listed property sector fell 3.4% over the quarter, underperforming the broader NZX 50 Index, as higher interest rates made defensive property companies less attractive.

Eight out of 12 constituents of the property sector fell. The biggest negative contributors to the sector’s overall return were Vital Healthcare Property Trust (-10.6) and Stride Property Group (-13.5%). Goodman Property Trust (+1.8%) was the strongest contributor.

The Australian listed property sector fared much better, and was up 11.5% over the quarter. This interest rate-sensitive sector did well on the back of broader Australian equity market strength and as the RBA delivered more modest (at least relative to previous) 25 basis point rate hikes for two months in a row.

In November, and following the strong rally in US equities, we moved to a neutral position in international equities. We then established a small underweight position in early December, taking advantage of the recent market strength to reduce risk given the global economic outlook remains tilted to the downside.

Elsewhere we retain our neutral position in international fixed interest, having scaled back our underweight position during the quarter, and we maintain a slight overweight to New Zealand bonds.

Although inflation in many parts of the world is trending in the right direction, central banks appear committed to moving interest rates into restrictive territory – and holding them there for a period of time – to ensure inflation does not become entrenched. This will likely weigh on economic activity going forward.

In fact, we are starting to see evidence that the cumulative effect of the monetary tightening over the past 12 months has begun to slow the global economy. Housing markets in developed countries are falling as mortgage rates increase, while business activity continues to slow (with Purchasing Managers’ Index data hovering in the high forties).

In New Zealand, the fundamental outlook is deteriorating fast with evidence the RBNZ will hike the economy into a recession within the coming 12-18 months. While a slowdown in the economy will likely bring inflation down, it will have some unwanted consequences – notably a higher unemployment rate.

Wrapping all this up, our base case is that central banks will keep policy rates in restrictive territory until they are satisfied that inflation will return to target levels, which will no doubt weigh on the global economy as we head into 2023.

Although we expect further interest rate hikes from central banks, 10-year yields should oscillate around 2022 highs, with downward pressure coming from a combination of the pace of the move we have already seen and uncertainty around growth.

The big risk remains persistent inflation, which would put further pressure on financial conditions, increasing the probability of a global recession. The monetary policy tightening that has occurred to date also has the potential to tip the economy into a recession, although the consensus view is that any recession would most likely be mild.