Outlook for Investment Markets
Global equity markets continue to focus on the upside from the coronavirus vaccine rollout. Progress to date has been limited and getting to effective national-level protection will be a protracted process, but there is now a good prospect that global economic activity will gradually recover over 2021-22, providing fundamental economic support for most risk assets. Some sectors, particularly commercial property, may nonetheless take a permanent hit as a result of structural change caused by the pandemic. A strengthening world economy is less good for bonds, where a variety of channels including the possibility of higher inflation have been pushing yields higher and prices lower. New Zealand has experienced a robust V-shaped bounce back from its 2020 COVID-19 setback, and while companies' operating results may show strong near-term performance, a key issue will be the outlook for longer-term profitability as conditions normalise.
New Zealand Cash & Fixed Interest
Short-term interest rates have been steady, with the 90-day bank bill yield still just under 0.3%. Bond yields have moved a bit higher, mirroring rises in overseas bond markets, and the 10-year government bond yield, at 1.3%, is up 0.3% since the start of the year. Year to date the New Zealand dollar is slightly (0.2%) lower in overall trade-weighted value; it is unchanged in terms of its headline exchange rate against the U.S. dollar, at 72.26 U.S. cents.
Barring any renewed COVID-19 and widespread, sustained lockdown, the combination of a higher-than-expected 1.4% inflation rate and a very much lower-than-expected 4.9% unemployment rate in the December quarter means that the Reserve Bank of New Zealand, or RBNZ, is unlikely to feel the need to cut interest rates again, but it is also likely to be cautious about the pace of eventual normalisation of interest rates' rise from their current supportive levels. Both the forecasters and the financial futures market suggest that any eventual increase in the Official Cash Rate, or OCR, will not occur until the second half of 2022.
New Zealand Property
New Zealand listed property has remained out of favour, and year to date the S&P/NZX All Real Estate Index is down by 2.0% in capital value. One potential consolation is that the sector outperformed the wider market share, where the S&P/NZX 50 Index dropped by 3.8%.
The New Zealand listed-property sector has some still-unresolved structural challenges. In the office sector, Colliers in its latest (February) research report says that the vacancy rate in the key Auckland market rose from 4.9% to 8.8% in the year to December '20, partly driven by increased supply.
Even if Zoom and the like are only partial substitutes, office space will still be affected. There are bigger problems again for physical retail, excluding defensive assets such as supermarkets and the more upmarket "destination" outlets, as COVID-19 has accelerated the uptake of online shopping.
The strong industrial sector, with low vacancy, rising rentals, and strong investor interest linked to the sector's servicing of buoyant e-commerce, is not enough to carry the rest of the asset class with it. Investors may well continue to sit on the sidelines.
Australian & International Property
The A-REITs substantially underperformed the wider share market in 2020 and have continued to lag year to date. The S&P/ASX 200 A-REITs Index is down by 4.1% in capital value compared with the 3.3% gain for the S&P/ASX 200. Global listed property has performed better, and the FTSE EPRA/NAREIT Global Index in U.S. dollars has delivered a total return of 3.0%, not too far behind the 4.9% return from the MSCI World Index. One qualification, however, is that the performance relied almost exclusively on the U.S. market, which returned 5.6%: ex the U.S. the index returned a marginal 0.3%, weighed down by a 5.6% loss from eurozone REITs.
The same sectoral themes continue to play out in the A-REIT sector. For offices, the latest (January) half-yearly office market report from the Property Council of Australia, or PCA, showed large rises in vacancy--at a national level, from 9.6% to 11.7%--which one might initially have thought was down due to COVID-19. In fact, the PCA CEO said that "While it was not a surprise to see office vacancies increase in the middle of a pandemic, it is the new supply of office space that is responsible for three quarters of this impact, not reduced tenant demand." Even if COVID-19 was not the prime driver this time around, it clearly continues to be an issue until the future of work processes and the role of remote working become clearer.
In retail, there have been some winners--for example, SCA Property, which owns neighbourhood malls, found that shoppers displaced from locked-down CBDs were doing more of their shopping locally at its properties. Overall, however, the sector remains battered by the inroads of e-commerce, which had been a strategic challenge even pre-COVID-19.
Industrial remains by far the strongest sector--rentals were less affected during lockdown, and it has expanded strongly to service the increased e-commerce demand. Centuria, the largest industrial REIT, showed in its latest results presentation how the old model of industrial REITs largely housing manufacturing tenants has changed: 32% of its tenants are still manufacturers, but the large majority is now made up of distribution centres (27%), data centres (17%), transport logistics (15%), and cold storage (9%). Some of these tenants would have predated the recent surge in e-commerce but much of it is riding the e-commerce wave.
Centuria pointed to online sales growth of 32% in 2020. While there may be some mispricing opportunities if industrial is overhyped and retail is oversold, overall it is not too surprising that investors have preferred to stand aside for now and wait to see how the post-COVID-19 issues play out.
Global property's prospects will eventually improve as vaccinations roll out, but for now the asset class does not offer much investor encouragement.
Global Infrastructure
Global listed infrastructure has done very little year to date. The S&P Global Infrastructure Index in U.S. dollars has had a marginal 0.1% rise in capital value and has returned 0.5% including dividends.
Global infrastructure has suffered from some of the same issues as global property, in particular a combination of cyclical COVID-19 reductions in patronage, which have been very large for airports and toll roads, as well as longer-term structural change. Australian toll road operator Transurban, for example, had a 17.8% fall in daily traffic in the second half of 2020, largely due to the 40% drop in traffic on its Melbourne CityLink road during the Victorian lockdown. It, and other patronage-reliant infrastructure assets, will see traffic progressively recover as COVID-19 is brought under control, but investors are still not clear whether a CBD (at one end of CityLink) or an airport (at the other end) will return to how things used to be. As Duff & Phelps noted in their recent report on the outlook for global infrastructure this year, "When, or if, business travel recovers to prior levels is a heavily-debated topic by the industry and the investment community."
On the plus side, the utilities have come through COVID-19 largely unscathed, and there are the infrastructure equivalents of industrial property who have been big winners from structural change, notably data centres and cell towers. New "green" infrastructure centered around renewable energy is also in high demand. Several infrastructure managers are also arguing that a pronounced period of underperformance by the sector when compared with the wider equity universe has opened a valuation gap where infrastructure is relatively cheap. Investors, so far, have preferred to wait and see the evidence that the planes are flying again.
Australasian Equities
New Zealand shares have weakened in recent weeks, and year to date the S&P/NZX 50 Index is now down by 3.8%. Much of the reversal is down to a change in fortunes for the previously buoyant utilities sector, which is down by 9.6%, with Meridian (down 21.7%) and Contact (down 19.2%) being the big movers. Among the other big-caps there were also losses for A2 Milk (down 11.7%) and Auckland International Airport (down 9.0%). The mid-caps (marginally up by 0.1%) and the small-caps (up 2.3%) have done better than the big end of town.
Australian shares are ahead for the year, and the S&P/ASX 200 Index is up 3.3%. Consumer discretionary stocks have led the way with a 7.8% gain, slightly ahead of the 7.3% gain for the financials (excluding the A-REITs), and, as overseas, IT stocks have been doing well and are up 6.1%. The miners, which had started the year robustly, have given up some of their earlier gains, but are still up 2.2% ahead for the year. The laggards have been healthcare (down 0.4%) and the industrials (down 3.1%).
As the latest lockdown in Auckland reminded us, COVID-19 may not be finished with us yet. At the time of writing, contact tracing was revealing no spread beyond the initial community cases, and hopefully any extension of lockdown will be limited. The government is moving quickly to activate a Resurgence Support Payment, which would help firms impacted by a lockdown extension, and last year's successful wage-subsidy scheme would also be reactivated if necessary.
The New Zealand Institute of Economic Research's latest (December quarter) compilation of forecasts show that the economy is likely to have shrunk by 4.8% in the year to March '21, whereas in the previous (September) survey forecasters had thought the decline would have been an even more serious 7.2%. And the recovery from the setback is happening faster than expected:
December's large drop in the unemployment rate to 4.9% came in well below forecasters' predictions. The NZIER panel of forecasters believe that the GDP will increase by 5.4% in the year to March '22. Some parts of the economy (notably construction) are in boom-time conditions, and, remarkably, businesses are already reporting difficulty in finding staff.
There are still the sectors, such as tourism, where the longer-term effects of COVID-19 are still in play. This shows in the latest (January) BNZ/BusinessNZ Performance of Services Index, which has been in negative territory for three months in a row. BNZ said that "While it looked like domestic spending had provided a decent offset to the loss of international tourism last year (during the latter’s typical off-season), as we move through what was previously the international tourism peak period it is no surprise to see the tourism hole becoming more obvious." The first vaccines may have arrived in the country, but the prospect of widespread relief for sectors like tourism is still far away. The recent weakness of New Zealand equities may well reflect a more realistic appraisal of the economy beyond its immediate V-shaped recovery from the first lockdowns.
Australia has also sprung some unpleasant COVID-19 surprises, with a five-day West Australian lockdown starting at the end of January and, more recently, a five-day Victorian lockdown, which started on Feb. 12. At the time of writing it appeared likely that the Victorian lockdown would be lifted. Again, assuming no further COVID-19 setbacks, it looks as if the Australian economy is heading down the same path of an initial strong recovery, easing to more modest rates of growth as the year progresses.
Currently the economy is still largely in the initial V-shaped bounceback from the depths of COVID-19 lockdowns. The slump was not as bad as originally feared.
A wide variety of other indicators confirm a relatively quick and robust turnaround.
Westpac expects that by the June quarter the economy will have regained its pre-COVID-19 level of GDP, which, in the bank's view "will be an exceptional result, comparing very favourably with other developed economies."
Business confidence about COVID-19 abating looks reasonable, with a targeted goal of 4 million vaccinations by the end of April.
All of these measures look, however, as if they are starting to ease from the peak bounceback in late 2020, and the trick for investors will be distinguishing between the strong recovery in profits which is likely to be seen in the 2020-21 reporting year, and the longer-term prospects for corporate profitability beyond midyear. Pre-COVID-19, the key issue for Australian investors had been a sustained period of subpar economic growth and consequent underperformance by local equities. While the market is not overexuberantly priced, on a forward-looking P/E ratio of 20.6 times expected earnings, it will need to see corporate profit performance kick on from the easy runs scored during the immediate recovery.
International Fixed Interest
Modest rises in bond yields across most major bond markets have translated into modest setbacks for bondholders. The Bloomberg Barclays Global Aggregate Bond Index in U.S. dollars is down by 1.3% year to date. Investors in long-maturity bonds who are more exposed to duration risk have done poorly, with the Bloomberg Barclays Index of long (20 years plus) maturity U.S. Treasury bonds dropping by 6.5%. Lower quality credit has been an exception, with the Bloomberg Barclays Index of global high-yield bonds up 0.8% year to date.
In the U.S., the stated policy stance of the Fed remains, as Fed chair Jay Powell said in a recent speech, "patiently accommodative."
It plans to keep monetary policy on its current strongly stimulatory setting “until labour market conditions have reached levels consistent with the [policymaking Open Markets] Committee's assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time." That still looks some considerable distance away, and the median forecaster in the latest (February) The Wall Street Journal poll expects that the Fed will keep its current target range of 0.0% to 0.25% for the Fed funds rate all the way out to the middle of June 2023.
Other major central banks are likely to remain on hold for at least as long. Recovery in the eurozone, for example, is currently facing strong headwinds from COVID-19 lockdowns.
The recent price gains for low-quality bonds raise a separate set of questions. Even though yields on government bonds have risen slightly, this has been nowhere near enough to satisfy the high demand for yield, and a result is that normal credit spreads for lower-quality borrowers have been driven down even further.
Indicators suggest that investors may be pushing the limits of acceptable reward for risk. Investors in the higher-yield end of the asset class risk buying at or near the peak of credit optimism.
International Equities
World shares started the year well but dropped back to be roughly all square for the year at the end of January, partly due to a downbeat reminder from U.S. Fed chair Jay Powell that the U.S. economy is not out of the COVID-19 woods yet. They have moved up in more recent weeks, and the MSCI World Index of developed economy share markets is now up 5.0% in U.S. dollars. The U.S. markets have generally led the way, with the S&P 500 up 4.8% and the tech-oriented Nasdaq up 9.4%. Japan also continues to do well, and the Nikkei Index is up 7.6% (in yen). European shares have shown relatively modest gains, with the FTSE Eurofirst 300 up 3.8% (in euros).
Emerging markets have continued their strong start to the year and the MSCI Emerging Markets Index is now up by 10.7% in U.S. dollars, led by the core BRIC--Brazil, Russia, India, and China--markets, which are up by a strong 13.7%. China continues to be the strongest BRIC market, and the MSCI China Index has gained 18.1%, but there has also been a good performance from Indian shares, where the Sensex Index is up by 7.7% in rupees and by 8.3% in U.S. dollars. Russian shares are also up, with the FTSE Russia Index up 7.6% in U.S. dollars. Brazil has returned a small U.S. dollar loss, with the Bovespa Index down by 3.0%.
The path of the economy will depend significantly on the course of the virus, including progress on vaccinations.
The ongoing public health crisis continues to weigh on economic activity, employment, and inflation, and poses considerable risks to the economic outlook.
In the U.S., the latest jobs numbers were disappointing, with only 49,000 net new jobs in January. At that rate, it will take a long time to refill the 9.9. million jobs that have been lost since the start of the pandemic.
Globally there were signs that the initial V-shaped bounce in world economic activity was easing back. The latest (January) reading for the J.P. Morgan Global Composite Index (which adds up a wide variety of national business surveys) showed that the world economy was still growing, but at a slower rate than before. J.P. Morgan said that "The slowing is taking place across both the manufacturing and services sectors though it is expected to be more pronounced in the services sector, a focus of concentrated lockdowns."
Investors are focused on eventual success in bringing COVID-19 under control, on fiscal stimulus in the U.S., on good prospects for corporate profit growth, and ongoing equity valuation support from exceptionally low interest rates.
On the COVID-19 front, the news has been broadly good. Infections peaked at close to 740,000 a day in early January but have dropped steadily since to some 380,000. Deaths are also reducing, albeit more slowly, from their peak of some 14,400 people a day in late January, to under 12,000 now. The rollout of vaccinations should lead to further progress in controlling the pandemic.
Markets are expecting Biden administration's stimulus package which would be worth around USD 1.9 trillion, which would be a massive boost equivalent to about 9% of the U.S. GDP, and one which would have an early impact, with one key component being sizable cheques to less-well-off households.
Getting on top of COVID-19 worldwide, and U.S. stimulus, would form a good backdrop for corporate profitability. FactSet's latest compilation of sharebroking analysts' expectations for the companies in the S&P 500 shows that profits are estimated to have fallen by 11.4% but they are expected to come roaring back this year, with an expected 23.6% increase, and--although it is still a long way out--to increase by a further 16.0% in 2022. The analysts expect the S&P 500 to end 2021 at 4,364, which would be a gain from its current level of nearly 11%.
Although valuations are on the high side--FactSet estimates that the one year forward-looking P/E ratio for the S&P 500 is 22.2 times expected earnings, which is well above its 10-year average of 15.8 times--interest rates look likely to remain at unusually low levels by historical standards, which will support what could otherwise look like an expensive rating of corporate profits.
There are still signs that markets may be in an overly optimistic mood, and the latest price of Bitcoin (USD 48,000, up from around USD 9,600 a year ago) or the GameStop episode suggest there may be at least pockets of overexcited speculative activity. But, nonetheless, the longer-term outlook for gradual global economic recovery provides some genuine fundamental support for equity prices.
See the Full MorningStar Economic update here.
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