Morningstar Economic Update July 2021
Outlook for Investment Markets
In July there was a global increase in concern about the economic outlook, largely linked to the spread of the Delta variant of the coronavirus. Its high level of infectiousness has meant it poses greater risk to unvaccinated populations. Markets appear to be recovering from their initial anxiety, which had sent equities lower and had triggered buying of safe haven bonds. Various commentators have said that investors have taken comfort from the lessons of 2020, when there was an initial sell-off on COVID-19’s appearance, but a subsequent strong recovery.
Looking forward, the global macroeconomic outlook (excluding in the emerging markets) is still positive for growth assets, but as the initial sharp V-shaped rebound from COVID-19 winds down, there may be further episodes of volatility.
The two main uncertainties remain further twists in the COVID-19 story, as well as the outlook for inflation. If current price pressures are not merely transitory, central banks may still withdraw the liquidity that has helped sustain the valuation of growth assets.
In New Zealand, the big news was that the Reserve Bank of New Zealand started to step back from its previous level of monetary support earlier than expected, as price pressures have strengthened in an economy that has been getting close to full capacity.
New Zealand Cash & Fixed Interest — Review
After being stable all year at around 0.3%, the 90-day bank bill yield rose after the Reserve Bank of New Zealand’s Monetary Policy review on July 14, and it is now around 0.5%. Bond yields, on the other hand, have dropped, following the lead of the U.S. market, and the local 10-year government-bond yield is now 1.54%. After an initial spike immediately after the RBNZ meeting, the New Zealand dollar has weakened, and year to date is now down 1.7% in overall trade-weighted value.
New Zealand Cash & Fixed Interest — Outlook
The RBNZ surprised the market with its decision to stop its large scale asset purchase programme of bond buying by July 23. Financial markets had increasingly begun to think that gradual withdrawal of monetary support was getting closer than previously thought but had not expected a move as early as July. The RBNZ explained its move by pointing to a strong economy with inflationary pressures--“In the absence of any further significant economic shocks, more persistent consumer price inflation pressure is expected to build over time due to rising domestic capacity pressures and growing labour shortages”--an analysis, which was confirmed by the release, after its decision, of inflation data that was considerably higher than expected. Annual inflation in the June quarter was 3.3%, compared with the 2.7% that had been anticipated. Forecasters quickly reacted by bringing forward their expectations for the first RBNZ hike in the Official Cash Rate, or OCR, with all the big banks now picking a 0.25% increase at the Aug. 18 Monetary Policy Statement. Those forecasts were made, however, before the latest COVID-19 outbreak in Australia, and it is possible that the heightened risks to New Zealand may stay the RBNZ’s hand, but it still appears that we are on a path toward gradual normalising of previously very supportive monetary policy settings.
Bond yields are likely to remain closely linked to their track overseas, particularly in the U.S., as investors both there and here are grappling with the same question: are current inflationary pressures transitory and linked to shortages due to the COVID-19 disruptions to supply chains and to surges in post-lockdown consumer demand, in which case central banks, including the RBNZ, need not respond; or are they more permanent, perhaps reflecting the cumulative effect of years of very easy monetary policy, in which case central banks are likely to have to start stepping back from ultra-supportive settings. There are strong proponents of each viewpoint, and the jury is out on what the ultimate outcome will be. At this point a reasonable assessment is that not all the price pressures are transitory, and that some modest rise in local bond yields looks plausible. Although there are forecasts in the marketplace suggesting larger moves, Westpac Bank’s pick that the 10-year yield will be 2.15% in a year’s time looks like a reasonable prediction.
The outlook for the kiwi dollar remains linked to the global appetite for investment risk. It is one of the currencies that tends to do better when prospects for global growth are good and investors are more prepared to take on active foreign-exchange positions (a risk on environment). The dollar got sold down when investors became, at least temporarily, more worried (and risk off) in July, and so far, it has not recovered. On the assumption that the world economy does indeed carry on its recovery from COVID-19, then the odds are that the kiwi will eventually appreciate. For example, currently both the ANZ Bank and Bank of New Zealand see the kiwi at U.S. $0.75 in a year’s time, compared with its current 69.4 cents.
New Zealand Property — Review
The S&P/NZX All Real Estate Index has had a small capital loss of 1.7% year to date, though with the inclusion of dividends investors are marginally ahead for the year, with a total return of 0.4%.
New Zealand Property — Outlook
As a broad generalisation, the strong domestic economy has been helpful all around and (always assuming no COVID-19 outbreaks) will continue to help operating conditions for property owners. While the strength of the initial post-lockdown spending in the shops and on domestic tourism is likely to dissipate as the V-shaped recovery slows down, the economic outlook remains solid.
The overall positive outlook for the asset class conceals quite different subsector conditions.
Industrial is likely to remain in the strongest shape, although with many investors all eyeing current low-vacancy rates and ongoing strong demand for logistics to support e-commerce, there may not be a great deal of value left on the table. Colliers’ latest (July) research report noted that “The increase in competition for [industrial] assets has driven yield compression fuelling an increase in values and total returns.”
Prospects for offices and retail remain mixed, with likely changes to work habits (less-centralised offices) and increased online shopping offsetting the cyclical benefit of a strong economy. In both sectors, as Colliers notes, there are two-tier markets emerging, with office tenants regrouping their reduced demand for space in prime locations, and large-format retail and the better shopping malls pulling clear of strip-mall property.
The prospects for hotels and tourism-linked property have taken a turn for the worse, with the latest Australian COVID-19 outbreaks pushing the likelihood of border reopening and travel bubbles even further into the future.
Australian & International Property — Review
At least until the latest COVID-19 outbreaks, business conditions had been robust in Australia, and the A-REITs had been doing well. Even after the latest volatility, investors are still ahead, and year to date the S&P/ASX 200 A-REITs Index is up 5.8% in capital value and has returned 8.0% including dividends.
Global listed property has been strong overall, but with marked regional variation. The FTSE EPRA/NAREIT Global Index in U.S. dollars is up by 14.5% in capital value and has delivered a total return of 16.7%. As with the wider global equity market, however, the outcome has been heavily influenced by the U.S., where the REITs have returned 27.4%--excluding the U.S., global REITs have returned 6.7%. Also mirroring the global trend, emerging markets have been less able to cope with COVID-19 than their developed counterparts, and emerging-markets REITs have returned a loss of 5.3%.
Australian & International Property — Outlook
Before the latest COVID-19 outbreaks, property had been on the mend. The latest (June quarter) ANZ/Property Council of Australia survey, for example, had shown that confidence had risen back to pre-COVID-19 levels.
Industrial property and retirement villages clearly led the pack, and even though capital-value expectations were still negative for retail, office and hotel property, they were a good deal less negative than they had been in pandemic-affected 2020.
The impact of the latest round of COVID-19 cases and lockdowns is hard to call. It could be that the prospect of a sharp rise in vaccination rates in coming months will lead investors to focus on the upside of post-lockdown recovery in 2022. But it is also plausible that the latest episodes will intensify some of the structural challenges that COVID-19 either set in play or accelerated. The shift to work from anywhere is seeing a fundamental change in how the office is being used”.
Structural change is also probably further increasing the attraction of industrial and increasing the challenge for retail. Knight Frank’s July research insight on urban logistics said that “despite the phenomenal growth in online retail sales, online sales still only account for a small amount of overall sales in Australia. This suggests two things. Firstly, Australia is still in the early stages of this transition and two, that there is still a strong need for the centralised larger footprint and dark stores [‘a retail outlet or distribution centre that caters exclusively for online shopping’ - Wikipedia]to help businesses scale.” There may be opportunities, as there were in 2020, to pick up temporarily oversold property assets, but otherwise the increased uncertainties facing the sector suggest that a defensive subsector approach may be the best holding pattern until the post-COVID-19 landscape becomes clearer.
Overseas, the prospects for the REITs face the same set of sectoral structural challenges. Industrial will continue to be in the prime spot, and traditional retail is under pressure.
CBRE, in its June Global E-Commerce Outlook report, calculated that in 2015 the global retail market was worth USD 12.6 trillion, of which only 8%, or USD 1.0 trillion, was online. By 2020, online shopping had risen to 18% of the spend, and was worth USD 2.4 billion, and CBRE forecasts that it will continue to grow very strongly, to USD 3.9 billion by 2025, which will require some 138 million square metres of additional logistics space to service it. The traditional office will also be under pressure, although at this point it is not obvious to what extent. In the U.S., the percentage of employees working from home was as high as 37% in May 2020, at the height of the pandemic, and is down to around 15% now, which suggests that as further progress is made with vaccination, working-from-home numbers will drop even further.
The bulk of the analysis of post-COVID-19 work arrangements nonetheless suggests there has been a change of mindset for both employers and employees on how best to organise post-COVID-19 work processes, and the full-time office scenario will not look like it used to. With global REIT prices now reflecting the value of the unexpected V-shaped recovery, further large rises in REIT prices look less likely, and again the best approach may well be to take a defensive sectoral-focused holding position.
Global Infrastructure — Review
Global listed infrastructure shares have made modest progress year to date. The S&P Global Infrastructure Index in U.S. dollars is up 2.4% and has returned 3.9% including taxed dividends (5.9% hedged back into New Zealand dollars).
Global Infrastructure — Outlook
Infrastructure remains in high investor demand. The Wall Street Journal recently reported, for example, that “Investors are pouring money into infrastructure funds, which are on the rebound after proving their resiliency during last year’s pandemic-related downturn,” and examples close to home included the AUD 22 billion takeover bid for Sydney Airport and the AUD 5 billion offer for Spark Infrastructure, which has stakes in electricity transmission, distribution, and solar generation.
The subsectors most in demand have been core asset classes such as utilities, which are seen as cyclically defensive and to a degree inflation-protected, as utility regulators allow pass-through of higher input costs, and assets focused on digital infrastructure and renewable energy.
There has also been interest in picking up some of the more cyclical patronage-dependent assets, such as Sydney Airport, at temporarily COVID-19-depressed prices.
Some investors have also been hoping that the sector may get a boost from a long-overdue refurbishment of America’s rundown infrastructure, but this failed to materialise under the Trump administration and even the scaled-down programme now proposed by President Biden was, at time of writing, still struggling to get through Congress. Even without the U.S. spending, however, the asset class looks to provide some useful portfolio protection.
The yield on the S&P Global Infrastructure Index is 3.0%, which, in a world of still very low bond yields, has its attractions; but its reliability is probably more of an attraction than its level in an environment where COVID-19 has proved capable of springing further unpleasant surprises.
Australasian Equities — Review
New Zealand shares have remained weak. Year to date the S&P/NZX 50 Index has recorded a 5.1% capital loss and a 4.0% loss including dividends. The weakness has been concentrated in the biggest names, with the S&P/NZX 10 index down 9.5%--six of the constituents are down for the year, with particularly large falls for A2 Milk (negative 47.9%) and Meridian Energy (negative 28.0%). Of the remaining four which are up for the year, only one has made a strong showing, with the booming construction sector helping Fletcher Building to a 33.6% gain. The mid-caps are up 1.6%, while the small caps have done well, with a 6.7% gain.
Australian shares have been much stronger: the S&P/ASX 200 Index up is by 11.0% in capital value and has delivered a total return, including dividends, of 12.7%. The large financials sector has been an important driver, with the banks taking a much smaller hit from COVID-19 than earlier feared, and the financials (excluding the A-REITs) are up by 20.2%. Strong commodity prices have been very helpful for the miners, who are up 11.9%, and the pent-up demand of consumers emerging from lockdown has helped consumer discretionary stocks to a 13.9% gain. IT stocks have been the only weak spot, down 6.6% year to date, but strong performance last year means that they are still 36.5% up on a year ago.
Australasian Equities — Outlook
The economy looks to be in strong cyclical shape. Official data show that the economy grew by 1.6% in the March quarter, which was faster than forecasters had expected, and more recent indicators show that it is still doing well. The latest (May) readings from the BNZ/BusinessNZ surveys of manufacturing and services were strong. The BNZ said that manufacturing “maintained a very strong pulse in May” and “compares very favourably to its long-term norm.” Services are also doing well: the sector is also “well above its long-term average,” and ”New orders ...continue to be the strongest of the ... subcomponents indicating buoyant demand conditions.” In a similar vein, the early results from the ANZ Bank’s June business survey showed generally healthy readings for businesses’ expectations of their own level of activity, investment, and exports.
The outlook has one major complication: the largely COVID-19-induced disruption to supply channels, which is affecting the availability and cost of inputs (as a casual browse along any supermarket aisle will confirm).
The BNZ, commenting on the services survey, said that “Many survey respondents note issues with the likes of availability of inputs, higher shipping costs, freight delays, supply chain distortions, and cost increases.”
The ANZ said that “Shipping disruptions, rising global commodity prices, the higher minimum wage, labour shortages due to both the closed border and uneven sector growth are creating a perfect storm for the supply side of the economy at the same time as demand is holding up much more than firms (or economists!) had anticipated.” The outcome is strong cost pressure--as the ANZ put it, “Cost and inflation pressures continue to intensify. Expected costs rose another 5 points to a net 85.6% expecting higher costs ahead. A net 62.8% of respondents intend to raise their prices, up 6 points, another record in data that goes back to 1992.” Until cost pressures abate, strong consumer demand may not translate into the kind of profit growth that would support a turnaround in equity prices.
Recent Victoria COVID-19 cases have reminded us, the pandemic has not gone away completely, but on the assumption that containment in the near term and vaccination in the longer term will progressively take the COVID-19 risk off the table, the outlook for the Australian economy is looking robust. Official GDP data for the March quarter showed that the economy grew by 1.8% in the quarter, on top of a 3.2% increase in the December quarter. As brokerage CommSec commented, “The economy now exceeds the pre-pandemic highs, up 1.1 per cent on the year. It has been the fastest recovery from recession in 45 years.” CommSec thinks that the current momentum means that “the economy could grow by near 5 per cent in 2021,” and it is not alone--NAB is picking 5.1% growth, and Westpac 4.8%.
Business surveys show that the economy has remained in strong shape since the end of March. The NAB May business survey, for example, “Continues to point to strong outcomes in the business sector, with business conditions resetting their record high for the second month in a row and forward orders also holding at a record level. The employment, profitability and trading sub-components all also reset last month’s highs – with trading conditions now at exceptional levels. By state and industry, the strength in activity is evident everywhere.”
The latest (May) Westpac/Melbourne Institute leading indicator is also flashing a green light: “The Leading Index growth rate continues to point to strong above trend growth momentum carrying through the second half of 2021 and into early 2022 ... With initial reopening rebounds now largely complete, other drivers are set to take over with upbeat, cashed-up households and booming housing markets setting what will still be a strong pace for growth.” CommSec’s assessment is that “The economy is responding as hoped to unprecedented fiscal and monetary stimulus. The stimulus continues and further solid economic growth can be expected. Company revenues will continue to lift and so should profits, provided that firms have tight control of costs. Higher earnings are expected to translate to higher share prices. CommSec has lifted its end-2021 target for the ASX200 to 7350 points.” In the event the index is already there, six months ahead of schedule, the ongoing strength of the cycle looks likely to take it higher again.
International Fixed Interest — Review
Apart from some day-to-day volatility in response to new economic or financial news, bond yields have generally gone sideways in recent weeks. The outcome for investors is that the rise in bond yields, and associated capital losses, which occurred in the March quarter have not been reversed--the Bloomberg Barclays Global Aggregate Bond Index in U.S. dollars is down 2.3% year to date. Investors who took on duration risk to boost yields have been particularly impacted, with the U.S. Long Treasury (maturities of 20 years-plus) Index down 9.8%. Investors taking on higher credit risk to boost returns have fared better, with low-quality corporate bonds returning 3.1% in the U.S. and 3.7% in the eurozone.
International Fixed Interest — Outlook
Probably the biggest issue for both the bond and equity markets now is the likely evolution of inflation and the response of central banks, who, up to now, have been vigorously providing massive monetary policy support. There has been a huge debate over whether current inflationary pressures are temporary or permanent. If temporary, and inflation drops back as COVID-19 supply pressures ease and the immediate bounceback from lockdowns moderates, then central banks might well sit on their hands and leave existing levels of monetary stimulus in place, which would be helpful for both bonds and equities. But if they are permanent--some have argued for example that hugely expansionary U.S. fiscal policy, rather than COVID-19, is creating an inflation issue--then central banks might start to wind back some of the existing support earlier than previously expected.
U.S. inflation data for May showed that prices were 5% up on a year earlier, the highest inflation rate since August 2008. And even after stripping out more-volatile elements like food and energy, core inflation was 3.8%, the highest since June 1992. The issue is not confined to the U.S., as the May J.P. Morgan Global Composite activity indicator found that “Demand outstripping supply also led to increased price inflation. Input costs rose to the greatest extent since August 2008 and output charges at the quickest rate on record (since at least October 2009).”
The latest official and survey data, while, on the surface, is suggesting that inflation is becoming more of a threat, did not settle the matter, as prices now are being compared with unusually low COVID-19-era prices last year. There was, as a result, an unusually keen interest in what the Fed would make of the situation at its June meeting, which had just taken place at time of writing, particularly as the meeting would include the Fed’s quarterly update of its economic forecasts and its officials’ best estimates of when they were likely to start normalising monetary policy.
The Fed said that “Inflation has risen, largely reflecting transitory factors,” which is some comfort for the bond markets. But it also forecast that its preferred measure of inflation would be running at 2.1% in 2022 and 2.0% in 2023, while unemployment will have dropped to 3.8% (2022) and 3.5% (2023). In these circumstances, with both its inflation and unemployment targets pretty much in the bag, you might expect the Fed to be thinking of easing back on its monetary policy earlier than previously anticipated, and it is. The average expectation of the 18 Fed officials polled in the forecast is that the midpoint of the target range for the Fed funds rate (currently 0.125%) will be 0.6% by the end of 2023, which is equivalent to two 0.25% increases in late 2023. Previously, at the March meeting, officials had not expected hikes before 2024. The actuality is still a long way away, and other central banks may not be facing the same degree of inflationary pressures that the Fed is, but the main takeaway from the Fed’s latest decision is that, barring any unexpected shock to the strength of the current global recovery, the outlook for bond prices is likely to remain challenging.
International Equities — Review
May’s setback to world equities, largely a reflection of fears that interest rates might be heading higher in the wake of global inflation pressures, did not last long: the MSCI World Index of developed share markets had regained all the lost ground by the end of May and has gone on to new highs since.
Year to date the index is up 12.3% in U.S. dollars. Until recently, performance has been disproportionately dependent on the strong American market, where the S&P 500 is up 13.3% and the Nasdaq up 10.0%, but other markets, notably the eurozone and the U.K., are now making a stronger contribution. The FTSE Eurofirst 300 Index is up 15.0% (in euros) and the U.K.’s FTSE 100 Index is up 10.6% (in GBP). Japan is the only major market to lag badly, with the Nikkei up by 6.3% in yen, but the yen itself weakening by 6.1% against the U.S. dollar.
Emerging markets are also up, though not as strongly as the developed economies, with the MSCI Emerging Markets up by 7.1% in U.S. dollars. Its core BRIC--Brazil, Russia, India, China--members are up 4.4%, led by Russia (MSCI Russia up 19.5%) and India (MSCI India up 14.7%).
International Equities — Outlook
Overall the world economy continues to power back from the impact of COVID-19, although there is still a great deal of variation at a country-by-country level in how economies have coped with the pandemic. The latest J.P. Morgan Global Composite indicator reported that “May saw a further solid acceleration in the pace of expansion of global economic activity, as output and new orders rose at the quickest rates since April 2006. Growth of activity was led by survey-record increases in the U.S. and the U.K. The euro area was also a bright spot, with its rate of expansion the highest in over three years.” By sector, all 21 sectors in the Composite index are recording increased business activity, with particularly strong rebounds in the sectors that been previously been worst hit by COVID-19 (real estate, and tourism and recreation).
The OECD, in its latest update to its economic outlook, said that “Prospects for a lasting global recovery continue to improve, helped by the gradual deployment of effective vaccines, continued macroeconomic policy support and signs that economies are now coping better with measures to suppress the virus. In many countries, the scale of the economic disruption from the pandemic has been exceptionally large, and the recovery is likely to be prolonged.” The OECD now expects growth of 5.8% this year, after an estimated 3.5% decline in 2020, and growth of 4.4% in 2022.
Fund managers are also convinced that there are strong economic conditions ahead. The latest (May) Bank of America Merrill Lynch survey of global managers found that large majorities are upbeat: 69% of the managers believe that both growth and inflation will be stronger than normal, and 78% expect that global corporate profits will increase over the coming year. Unsurprisingly, they have adjusted their asset allocation toward cyclically sensitive sectors, notably commodities, banks, materials, industrials, and consumer discretionary, and toward equities in general, with reduced allocations to cash and bonds.
For the OECD, the main downside risk to this otherwise promising backdrop for equity performance is the evolution of COVID-19: “There is a possibility of new more contagious and lethal variants that are more resistant to existing vaccines, unless effective vaccinations are quickly and fully deployed everywhere. This would necessitate the reimposition of strict containment measures, with associated economic costs related to lower confidence and spending.” Even without new variants, some countries will struggle: While the global count of daily new cases has dropped, according to The New York Times tracker, from a peak of over 800,000 in April to around 400,000 now, it is still rampant in some places. The Times says that “South America is being hit harder than any other continent, with nearly all of its countries having among the highest rates of new infections and deaths,” and we have seen a serious outbreak in our own part of the world, with new cases in Fiji surging.
The OECD also sees an upside risk of consumers splurging with the pent-up savings they were forced to build up during lockdowns: “Given the amounts involved, the spending of only a fraction of accumulated ‘excess’ saving would raise GDP growth significantly.” The good news is that businesses would see even stronger spending with the world economy (if vaccination goes well and households spend up at large) growing by boom-time rates of around 6% both this year and next. There would, however, be “ensuing price pressures as spare capacity is used up,” and this is also what most worries the surveyed fund managers. In order of priority, the risks that most worry them are inflation; a bond market collapse (an inflation-linked possibility if central banks were forced to start raising interest rates); asset bubbles (fund managers are particularly sceptical of bitcoin valuation, and many other commentators have pointed to evidence of wider speculative froth); and any further complications from COVID-19.
Performance periods unless otherwise stated generally refer to periods ended June 14, 2021.
See the Full MorningStar Economic update here.
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