Investment Update

Global markets struggled during the third quarter as the world’s central banks ratcheted up their fight against inflation, raising policy rates that saw most equity and bond markets finish lower. Against this backdrop, the MSCI All Country World Index fell 5.3%.

Key themes over the quarter included:

During the quarter, the US Federal Reserve (the Fed) ramped up its aggressive monetary tightening, raising the fed funds rate by 150 basis points across two meetings as inflation remained stubbornly high.

Investors got a glimpse at the change in tone at the annual Jackson Hole meeting of policymakers where Fed Chair, Jerome Powell, said the central bank would “keep at it” (tightening monetary policy) until the job is done. Furthermore, Powell added that restoring price stability would require “maintaining a restrictive policy stance for some time”. This quashed the notion that the Fed would be cutting rates in 2023, which the market had been pricing in before the conference.

The prospect for a ‘soft landing’ – the scenario where interest rate hikes bring inflation back towards the Fed’s target rate without compromising growth and the employment market – also receded. During his press conference following September’s Fed meeting, Powell said “the chances of a soft landing are likely to diminish to the extent that policy needs to be more restrictive or restrictive for longer”.

Currency markets were just as volatile as equities and bonds during the quarter, with the US dollar trading higher versus most of its global counterparts as a ‘flight to quality’ saw the safe haven US dollar in favour.

The US dollar index (a measure of the US dollar versus several other major currencies) hit a near 20-year high.

One of the biggest losers was the British pound, which hit an all-time low versus the US dollar, trading towards parity as the outlook for the UK economy worsened. The UK government’s plan to increase borrowing to stimulate the economy raised fears of further interest rate hikes by the Bank of England (BoE).

On the back of the UK government’s plan to use borrowed money to pay for tax cuts, investors appeared to lose confidence in UK assets, which saw unprecedented declines in the value of UK bonds (and a rise in bond yields). The volatility resulted in the BoE intervening in the bond market to prevent disorderly trading. “Were dysfunction in this market to continue or worsen, there would be a material risk to UK financial stability,” the BoE said in a statement.

In September, Russian President Vladimir Putin escalated the already precarious situation in Ukraine, announcing he would be calling up 300,000 reservists (citizens with some military experience), as his troops came under increased pressure from Ukrainian forces.

Despite a downbeat quarter, second-quarter earnings held up relatively well. Some household names – Apple and Amazon – reported strong revenue numbers and positive guidance, while bricks and mortar companies, such as Home Depot and Walmart, also reported strong sales and revenue figures, although they noted an increase in demand for lower quality items as households feel the pinch of inflation.

New Zealand was not immune from the turbulence in financial markets with heightened volatility on the back of rising interest rates.

The Reserve Bank of New Zealand (RBNZ) continued its aggressive tightening policy, raising the Official Cash Rate (OCR) by 100 basis points across two meetings. Perhaps of more significance was that its forward track – the rate it expects the OCR to peak – moved higher, to around 4%.

The RBNZ interest rate hikes, and the prospect of more to come, continued to dampen sentiment as businesses and consumers struggle to deal with rising borrowing costs and overall higher prices. This was reflected in second-quarter inflation data, which showed prices rising at an annual rate of 7.3%, driven in part by housing-related costs including building, materials and rents.

In currency markets, the New Zealand dollar had one of its worst quarters on record versus the US dollar, falling more than 10% and trading to its lowest level since the COVID sell-off in 2020. The falling New Zealand dollar put pressure on imported inflation as goods and services coming into the country became more expensive.

Elsewhere, the New Zealand dollar also finished lower versus the Australian dollar, the Japanese yen and the euro.

After a strong July, global equity markets reversed course and fell in August and September, which resulted in most major international indices finishing the quarter lower. This was driven in part by rising global bond yields. Normally we would have expected to see growth-related stocks underperform in the rising-interest-rate environment as it weighs on valuations in that sector. However, in the US, it was the broader S&P 500 that underperformed, falling 5.3%, while the NASDAQ 100 fell 4.6%.

Against the backdrop of a turbulent quarter in Europe, European stocks also posted losses, with the Euro Stoxx 50 falling by 4.0%, and the UK’s FTSE 100 falling 3.8%.

However, it was in China where equity markets had the most challenging quarter, as concerns around its housing market and a declining outlook for growth saw the Shanghai Composite fall 11%.

For years, China’s housing market had been a pillar of their economy, but access to credit, declining prices and falling consumer confidence has rocked the once-strong sector. Moreover, the growth outlook continues to wane as the government sticks to its zero-COVID policy, stifling economic activity as any COVID outbreak brings with it strict lockdowns.

New Zealand equities outperformed most of their global counterparts, with the NZX 50 finishing the quarter up 1.8%. Although it followed a similar pattern to global equities, the late-quarter sell-off was nowhere near as deep, which saw the index hold onto some of its early quarter gains.

The strongest sector performance was energy, whilst the weakest came from the consumer discretionary sector – perhaps a sign that consumers were pulling back spending amid a worsening economic outlook.

Across the Tasman, Australian equities also had a relatively good quarter helped in part by the energy sector, which continued to receive tailwind benefits from higher oil prices this year.

Despite the sharp pick-up in equity market volatility, it was bond markets that were in focus during the quarter. Most bond markets suffered significant losses as central banks continued to raise interest rates (bond prices move in the opposite direction to bond yields).

In the US, the 10-year government bond yield rose above 4% for the first time in more than a decade, while the two-year equivalent outpaced the 10-year, further inverting the yield curve, which has in the past, preceded a recession.

Bond markets were even more volatile in Europe, with an unprecedented daily decline requiring central bank intervention. In the UK, on 28 September, the BoE stepped in to buy long-dated government bonds as the sell-off reached disorderly territory. It came as investors prepared for much higher borrowing rates amid surging inflation and a newly-announced tax cut package that would require the UK government to borrow significant sums of money.

While the intervention provided liquidity and eased volatility, the extent of the move over the quarter as a whole was unparalleled, with the yield on the UK 10-year bond finishing nearly 200 basis points higher.

New Zealand bonds followed a similar pattern to global markets, albeit with a little less volatility and tighter trading ranges. The yield on the 10-year government bond reached its highest level in about eight years, as markets priced in a further 150 basis points of hikes in the OCR by the RBNZ.

There was a spike in the bond yields in August after the RBNZ delivered a relatively hawkish Monetary Policy Statement, reiterating its intention to bring inflation back to the central bank’s target band. It said “… members agreed that monetary conditions needed to continue to tighten until they are confident there is sufficient restraint on spending to bring inflation back within its 1-3 percent per annum target range.”

Against the backdrop of higher interest rates locally and around the world, the New Zealand 10-year government bond yield rose 44 points over the quarter, closing at 4.3%.

The New Zealand listed property sector ended the quarter down 1.8%, underperforming the broader NZX 50 as higher bond yields continued to weigh on the more defensive property sector. Weakness was driven in part by two of the index’s biggest weightings – Kiwi Property Group (-6.15%) and Precinct Properties NZ (-5.11%). Kiwi Property’s decline followed the company’s investor day, while Precinct saw weakness after it reported an annual decline in net after-tax profit of 29%.

Globally, property losses were steeper, with the international listed property index (hedged to the New Zealand dollar) declining 11.5% over the quarter, with Europe – notably the UK – one of the worst performing regions.

Meanwhile, after a strong start to the year on a comparative basis, international listed infrastructure had a more challenging quarter, as broad-based equity weakness and risk-off sentiment weighed on the sector.

We moved our international equity position to neutral. While major US markets are more than 20% off their highs and are more attractive on a valuation basis, plenty of uncertainty remains. Equities have faced headwinds from rising interest rates, and despite inflation in the US showing some signs of peaking, we have yet to see a meaningful pullback. Given this, we believe a neutral position to be the most appropriate.

In terms of market outlook, the three fundamental pillars of our discussions are inflation, labour markets and earnings.

The latest US CPI data showed headline inflation was slowing, but core inflation was higher than expected. Lower commodity prices, easing supply chain issues and normalising demand for goods are factors that are helping to reduce inflation, but high wage inflation is feeding through into high services inflation and is supporting rent prices.

A stubbornly high inflation scenario is the key risk. On the contrary, a more durable drop in inflation would support risk assets and be supportive of global growth.

One framework we have discussed is that growth slowdowns often occur in stages, often starting with Housing, then slowing Orders, followed by falling company Profits and, finally, lower Employment (HOPE). Looking at historical data shows that each slowdown is unique, but focusing on these key variables is useful.

The US housing market has slowed, with the last reading for house prices down 0.6%, while the PMI New Orders component also slowed, from 61.0 at the start of the year to 51.3. Profits and the labour market have remained solid, with job growth in particular still above pre-COVID averages. However, a low unemployment rate with constrained labour supply is keeping upwards pressure on wages.

The most constructive scenario would involve an increase in labour supply due to a rise in the participation rate, leading to a higher unemployment rate without job losses.

Consensus GDP growth expectations for 2023 have fallen to 0.9% for the US and to 0.3% for Europe, yet earnings expectations for 2023 have fallen by less than 1% year-to-date. As we head into the end of the year, headwinds companies could face include new orders normalising creating an oversupply; labour shortages leading to higher wage costs; and higher borrowing costs. 

In summary, our base case is that inflation slowly normalises, but not until central banks have raised interest rates into restrictive territory. Bond yields will oscillate around year-to-date highs, energy prices will remain volatile, and earnings growth will be slightly negative due to the ongoing wage pressures.