Morningstar Economic Update June 17 2021
Outlook for Investment Markets
The world economy continues to recover strongly from the impact of the coronavirus, although some regions are still badly affected, and the latest forecasts suggest that the upswing will continue through the rest of this year and into 2022, with the U.S. outlook particularly buoyant.
The strong business cycle is generally supportive for equities, although there is a risk that the scale of the recovery may lead to higher than expected inflation even after the current COVID-19-related cost pressures dissipate.
Central banks may start to withdraw some of their previous stimulus, which means that bonds will remain challenged. New Zealand is also recovering well, with both official data on the March quarter gross domestic product and more recent surveys showing strong business conditions, and it helps that export commodity prices are doing very well. An issue is that local companies, like those overseas, are experiencing strong input-cost pressures and a strong revenue line may not automatically flow through to the bottom line of improved profitability.
New Zealand Cash & Fixed Interest — Review
There has been no change to short-term rates, and the 90-day bank bill yield continues to track close to 0.3%. Long-term yields have maintained a close link with the evolution of U.S. bond yields, rising in the March quarter and stabilising at the new higher levels in more recent months--year to date the 10-year government stock yield has risen 0.7% to its current 1.66%. The New Zealand dollar is 1.1% lower in overall trade-weighted value, and at U.S. 74.1 cents is 1.2% lower on its headline rate against the U.S. dollar.
New Zealand Cash & Fixed Interest — Outlook
A strong post-COVID-19 economic recovery and clear evidence of rising inflationary pressures mean that monetary policy support from the Reserve Bank of New Zealand, or RBNZ, no longer needs to be quite as stimulatory as before.
The RBNZ signaled in the May 26 Monetary Policy Statement, that further cuts to the official cash rate, or OCR, are now unlikely, and that the next policy move is likely to be up.
The bank’s projection for the OCR shows it starting to rise from around the middle of next year, reaching to approximately 1% in the first half of 2022. The futures market and the bank economists are of a similar view.
If local bond yields continue to track developments in the U.S., then yields look likely to head higher, as U.S. yields look likely to rise further, reflecting the strength of the current U.S. economic recovery. Westpac Bank, for example, anticipates that the U.S. 10-year Treasury yield will be at 2.4% by the end of next year, up from today’s 1.5%, and expects the local equivalent to reach 2.3%. Bank of New Zealand, or BNZ, also expects a stronger track, with a U.S. yield of 3.0% and a local yield of 3.3%. The strong cyclical upswing, both in the U.S. and at home, is likely to remain an uncongenial backdrop for bond performance--year to date the S&P/NZX government-bond index is down negative 2.4% and more of the same headwinds look likely.
Although the kiwi dollar has been slightly weaker year to date, forecasts are generally more upbeat, likely reflecting the relatively successful containment of COVID-19 by international standards and the impact of New Zealand’s strong export commodity prices, which have moved even higher to new record levels in May. The BNZ, for example, sees the kiwi dollar at USD $0.75 in a year’s time, while both the ASB Bank and Westpac see it higher again, at USD $0.78.
New Zealand Property — Review
The wider share market has struggled all year, and the New Zealand REITs have shared in the malaise. The S&P/NZX All Real Estate Index is down 2.9% in capital value and has recorded an overall loss, including dividends of 1.1%, a somewhat better outcome than the 4.0% loss for the wider share market.
New Zealand Property — Outlook
The big picture, as with overseas property, is that the unexpectedly quick and strong recovery from COVID-19 shutdowns is boosting landlords’ operating conditions, and previously downbeat property valuations based on worse scenarios are now being revisited.
The March quarter GDP outcome was strong, and forecasters expect ongoing growth, albeit somewhat constrained by lingering supply chain disruptions and the still-distant prospect of the borders reopening, meaning that hotels and tourism-dependent retail will still struggle for some time.
While the stronger than expected economy will help all sectors, pronounced differences across subsectors will remain an important driver of returns. Colliers’ latest (June) monthly research report, for example, which analyses the MSCI/Property Council of New Zealand property index data for the year to March, shows that while all sectors registered good returns (largely driven by lower interest rates leading to revaluation capital gains), industrial and large-format retail were ahead of the pack, with retail and offices lagging, and a similar tiering looks likely to persist. For offices in particular, pre-COVID ways of working look unlikely to return in full. Colliers’ latest report on the Auckland office market, for example, shows that vacancy rates are on the rise, and “Rental values have been under pressure over the course of the year, particularly within the secondary sector. While net face rents have generally been maintained, increased incentives through rent free periods and/or fit-out contributions have been on offer.” Subsector allocation will remain a key driver of asset class performance.
Australian & International Property — Review
While not matching the even stronger returns from the overall share market, listed property shares have done well. Year to date the S&P/ASX 200 A-REITs Index has delivered a capital gain of 8.8% and an overall return, including dividends, of 9.5%.
Global listed property has done even better--the FTSE EPRA/NAREIT Global Index in U.S. dollars has returned a very strong 19.0%. A strong rise in the U.S. REITs, which have returned 26.2%, has underpinned the overall outcome, but even excluding the U.S., the Global Index has returned 12.0%, with a strong performance in the U.K. (18.4% return).
Australian & International Property — Outlook
As in many other economies, the strength of the recovery from COVID-19 has been a pleasant surprise, and there will be more shoppers through the door and more staff back at their desks than earlier thought. It is no surprise that the A-REITs have rallied in response. From here, the general upswing will remain important, but investors are likely to have to continue to pay close attention to the subsectoral trends to maximise performance.
Industrial remains likely to be the strongest performer, with high demand and limited supply. CBRE’s latest (March quarter) MarketView report on industrial and logistics property showed that demand is very high, especially for the very best “super prime” property: “The weight of capital seeking well tenanted super prime assets has seen pricing become increasingly competitive. Australian super prime yields now average 5.15%, the lowest on record. Favourable growth forecasts have seen investors seek to re-weight their portfolios to include industrial and logistics assets with demand not expected to slow any time soon.” CBRE’s recent (June) report on the outlook for e-commerce property assets says that “Australia’s current supply pipeline indicates a shortage of new space required to meet future e-commerce demand. Therefore, capital and rental value uplift will continue and vacancy is likely to remain at relatively low levels.” At the other end, there are growing questions over the future market for office space. The Property Council of Australia’s latest (May) office-vacancy survey showed that office space was still way below pre-COVID levels (in Sydney, at 68% of pre-COVID occupancy, and in more COVID-affected Melbourne, 45%). While CBD landlords are trying to refill the slack, the reality is that the office sector has been hit by a longer-term structural torpedo to the five days in the office world.
Similar developments are underway overseas. In the U.S., the swing from poor COVID-19 management to more-effective vaccination rollout (and even the ability to offer surplus vaccines to poorer countries), coupled with strongly supportive fiscal policy, has markedly improved the outlook for the asset class. No one had expected that the U.S. economy could grow by 7% in 2021 (the Fed’s latest projection). A recovery so much above previous expectations has meant that retail property REITs, for example, have been rapidly revalued to reflect the prospect of much higher consumer spending. Year-to-date regional mall REITs are up by 57.4%, and shopping centre REITs are up by 50.0%. Again, though, there are subsector cross currents swirling, particularly around office property. Fortune magazine surveyed the CEOs of the Fortune 500 firms in May and found that roughly three quarters of the respondents expected to need less office space than they used pre-COVID, and only 7% expected to use more. It looks as if the change to more decentralised work will stick: Fortune found that “The majority – 53% – believe a hybrid approach, with 2 or 3 days in the office and 2 or 3 days at home, is optimal.” Brick-and-mortar retail was originally seen as the most obvious casualty of COVID, as online shopping accelerated, and there is now a real chance that offices may take a similar kind of hit.
Global Infrastructure — Review
Global listed infrastructure has been doing well. Year to date the S&P Global Infrastructure Index in U.S. dollars is up 8.5% and, including taxed dividends, has delivered a return of 9.7% (9.6% hedged back into New Zealand dollars).
Global Infrastructure — Outlook
Asset class performance year to date has reflected a variety of drivers. The big one (as with property) has been the strengthening global cyclical outlook, which has improved the prospects for patronage-dependent infrastructure such as airports and toll roads, even if widespread border reopenings are still some time way, and even if expectations of what the post-COVID levels of use will look like have been scaled down from naive thoughts of returning to pre-COVID levels. In the U.K., for example, the government is currently in the midst of a major reorganisation of the railway regime, driven partly by the fact that changes to commuting patterns have led to sharply reduced train use--car journeys are already back to 90% of pre-COVID levels, but train use is only at 40% of what it used to be. Another driver is the potential portfolio role of infrastructure as an inflation hedge. As noted later in the International Equities section, fund managers’ top risk is currently higher than expected inflation, and an advantage of infrastructural assets, particularly for regulated entities such as utilities, is that they tend to be able to pass on increased costs in their access charges. A final contributor to performance has been the growing popularity of two future friendly themes: digitalisation, remote working, and data transport and storage, all of which came into particular focus during COVID; and the transition away from fossil fuels to renewable resources as governments (including New Zealand, with its Climate Change Commission) start to tackle global warming.
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.
In Australia, as the 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.
The debate intensified after the release of the U.S. inflation data for May, which 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 outlook from here is also promising. 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.
DISCLAIMER: All care has been taken in preparing this information but to the extent that it is based on information received from other parties no liability is accepted by MorningStar or Tōtara Wealth Management for any errors or omissions. Morningstar and Tōtara Wealth Management give neither guarantee nor warranty nor make any representation as to the correctness or completeness of the information presented. Past performance is no guarantee of future performance. The material contained on this website is for general information purposes only and is not intended as, nor capable of being, financial advice or advice on any specific problem or any particular situation. Please read our full disclaimer.