Morningstar Economic Update October 2021
Outlook for Investment Markets
World equity markets have been recovering from their September 2021 sell-off and are back close to their previous peak, as 2022 looks to be a year of ongoing recovery from the setbacks of the coronavirus. In New Zealand, while it is early days on the path toward removal of pandemic restrictions, business prospects also look good for the coming year. The key uncertainties ahead, other than any new mutation of the virus, are the rate of inflation (it is not clear how much of the current pricing pressures are permanent or transitory); the longer-term impacts of the pandemic (such as the eventual state of the office market); and the eventual removal of previously generous levels of fiscal and monetary policy support. Surveys of global fund managers show that they are adjusting their strategies to include more hedges against inflation and avoiding asset classes and sectors more exposed to higher interest rates.
New Zealand Cash and Fixed Interest — Review
Short-term interest rates have risen a bit further, and the 90-day bank bill yield is now 0.75%. Bond yields have risen significantly: At 2.35% the 10-year government bond yield is now up by nearly 1.4% year to date, having started the year just below 1.0%. The kiwi dollar has strengthened, particularly since Oct. 12. Since then, it is up by 2.6%, and year to date it is up by 1.1%.
New Zealand Cash and Fixed Interest — Outlook
Two factors explain the recent rise in rates. The Reserve Bank of New Zealand, or RBNZ, had signalled that it was likely to embark on a path of gradual rate increases, but the news on Oct. 18 that inflation in the year to September was a much higher-than-expected 4.9% meant that interest-rate hikes were likely to be earlier and larger than previously expected. The short-term inflation news might get even worse again. ANZ Bank, for example, thinks it will top out at 5.8% in March 2022. While there is still a chance that much of the inflation is transitory and reflects global supply chain shortages and a sharply higher oil price, both the RBNZ and the wider financial markets think it will continue to translate into higher interest rates. The futures market, for example, expects the 90-day bill yield to be around 1.5% in a year's time, ANZ is picking the official cash rate to reach 2.0% by August next year, and the BNZ thinks the 10-year bond yield will crack 3.0% in September next year. Depositors in the banks will be happier, but bondholders will have a tougher time. The S&P NZ Aggregate Bond Index is down 5.3% year to date, of which 1.7% occurred in October alone, and absent any strong evidence of a quick reversal of transitory inflation pressures, the prospect is for further capital losses.
The recent strength of the currency could well continue in the near term, given that the RBNZ is ahead of most other central banks in raising rates, and that its cumulative hikes over the next year look likely to maintain interest-rate differentials in favour of the kiwi even after other central banks also start to move. It also helps that global financial markets are in a more risk-friendly mood, as witnessed by the recent recovery in world equity markets: The kiwi tends to do better in more "risk on" times. Precise foreign-exchange forecasts are always precarious, but Westpac's sighting shot of USD 0.74 in a year's time, up from the current USD 0.71.6 cents, looks a plausible assessment.
New Zealand Property — Review
New Zealand listed property has struggled year to date. The S&P/NZX All Real Estate Index has made a small capital loss of 2.2% and delivered a minimal overall return including dividends of 0.2% (0.7% with imputation credits).
New Zealand Property — Outlook
Like the rest of the economy, property is having its issues during the current lockdown. The NZ Property Council, for example, calculates that its (typically large) commercial landlords have had to extend some NZD 650 million of rent relief since the first outbreak of COVID-19 in 2020. But unlike the wider equity market, which (with the exception of specific issues at a couple of the big caps) looks to be anticipating a better 2022, listed property is not currently showing signs of optimism. It may be that some COVID damage may be irreversible. A recent (October) survey by Retail NZ found that "more than a third of retailers are not sure if their businesses will survive the next 12 months." But the biggest driver appears to be bond yields, which have risen faster and further than anticipated in the wake of the surprisingly high September inflation outcome. Since the end of August, the 10-year bond yield has risen by 0.65%: over the same period the All Real Estate Index had dropped by 4.8%. The sector's 4% yield is clearly finding fewer takers, and further rises in bond yields likely mean continuing headwinds ahead.
Australian & International Property — Review
The A-REITs have done well year to date. A 12.4% capital gain and a 15.4% total return including dividends means that the S&P/ASX 200 A-REITs index has effectively matched the strong performance of the overall share market.
Overseas REITs have also delivered good results. Year to date, the FTSE EPRA/Nareit Global Index in U.S. dollars has logged a 15.5% capital gain and returned 18.7% including dividends, again broadly in line with the wider global share market. The outcome has been hugely influenced by the U.S. market, where prices rose by 32.1%; ex the United States, the index was up by 6.4%. The U.K. market (up 20.2%) also did well, but there were very modest outcomes around the Asia-Pacific region (up 2.0%) and in the eurozone (1.5%), while emerging markets were very weak (down by 9.3%).
Australian & International Property — Outlook
Operating conditions are turning for the better for commercial landlords. As one example, during lockdown, office owners in the big markets of Sydney and Melbourne had been under rental pressure and were having to pay higher levels of incentives (discounts off face rents) to attract or keep tenants. According to Knight Frank, net effective rents dropped 10.6% for prime Sydney CBD offices and 10.0% for secondary properties. Now, however, "as sentiment and demand look likely to improve on the back of the vaccination rollout, incentives will likely peak at year end and then decline slowly [that is, effective rents will rise]." Institutional investors of property have been active in anticipation of the improved conditions. According to Cushman & Wakefield, "Office volumes have continued to step up each quarter this year with activity rebounding ahead of the reopening of the Sydney and Melbourne." Early reports on foot traffic through the malls after "Freedom Days" are also encouraging for the retail subsector, while industrial property had remained very strong throughout COVID on e-commerce logistics demand. REITs oriented to housing development can also look forward to a busy year. While the eventual level of post-COVID office tenancy remains uncertain, in general the near-term business upswing will provide support for REIT performance. The major challenge will be the impact of any further rise in bond yields, which could threaten the investor appeal of the current 3.75% yield.
Globally, it is the same outlook, with improved operating conditions as the world economy continues to recover. Industrials will remain in strong demand; housing developers will continue to benefit from strong housing markets (the residential-oriented REITs in the U.S. are up 44.6% year to date); retail (at least in the earlier stage of recovery) will continue to benefit from the release of previously pent-up demand; and office occupancy will pick up from lockdown levels, though the jury is out on ultimate uptake levels as at least some companies are likely to move to a hybrid mixture of remote and in-office work. Likely rises in bond yields are the main challenge to the asset class. The yield on global REITs, according to Standard & Poor's, is 3.3%, and with the 10-year Treasury bond yield in the U.S. already at 1.65% and likely to rise further, income-oriented support for REITs will be under pressure. On the other hand, as shown in the latest (October) survey of global fund managers run by Bank of America Merrill Lynch, or BAML, the current surge in global inflation pressure is a strong plus, as property is seen as an effective inflation hedge. Fund managers' allocations are currently moving heavily into more inflation-proofed sectors, and in October, REITs were the third-most overweight sector relative to fund managers' historical patterns.
Global Infrastructure — Review
Global listed infrastructure has performed well as the world economy has continued to pull out of last year's COVID-19 setback. The S&P Global Infrastructure Index in U.S. dollars is up 9.5% and has returned 11.7%, including taxed dividends (13.2% hedged into New Zealand dollars).
Global Infrastructure — Outlook
With one major exception the ongoing global recovery is supportive for infrastructure. The subsector that is likely to miss out is utilities, which are always at risk in a period of rising interest rates: their (typically regulated) prices tend to adjust slower than bond yields. Year to date, they have been doing badly in New Zealand (S& /NZX All Utilities down 11.9%), in Australia (S&P/ASX 200 Utilities down 3.2%) and globally (the FTSE Global Utilities Index in U.S. dollars is marginally up 0.8% for the year but has very significantly underperformed the FTSE World Index gain of 15.4%). It is not surprising that the BAML survey found that fund managers are avoiding the sectors most exposed to interest-rate rises, and utilities are now one of the most underweight asset classes.
Other sectors, however, face clearly better prospects. As borders reopen, previously shuttered facilities like airports will come back on stream, while shipping and seaports will benefit both from increased volumes and their current pricing power in still constrained supply chains. The recent rise in oil prices has also been good news for energy infrastructure (the FTSE Oil Equipment and Services Index is up 37.2%). And in the background, there continues to be strong investor demand for Internet and data infrastructure and for renewable energy assets. The cyclical upswing should be the dominant driver, but, as with property, it may be tempered by rising bond yields, which will increasingly compete with infrastructure's 3.1% yield.
Australasian Equities — Review
Going by the benchmark S&P/NZX 50 Index, New Zealand equities have missed out on what has been a good year for many other equity markets. Year to date, the index is down 1.9% in capital value and barely in positive territory (up 0.2%) after adding on dividend income. The headline result, however, continues to reflect the heavy impact of large caps A2 Milk and Meridian, which have contributed to the S&P/NZX 10 Index losing 5.7%. Elsewhere, the market better reflects the recovery (at least before the latest lockdown) from the 2020 COVID setback. Mid-caps are up 3.9%, and small caps are up 12.0%.
Australian shares, on the other hand, have followed the wider global pattern and are well ahead for the year. The S&P/ASX 200 Index is up by 12.5% and has returned 16.1%, including dividends. The key contributions have come from two sectors: the banks, with financials ex A-REITs up 26.1%, and consumer discretionary shares, which have ridden the wave of pent-up consumer demand from the 2020 shutdowns and are up 20.8%. The miners have struggled, especially in the wake of a collapse in the price of iron ore, and are down by 4.2%.
Australasian Equities — Outlook
Surveys of current business conditions show that the current lockdowns are having a substantial effect on business activity. As one example, the September BNZ / Business NZ survey of the services sector (by far the biggest chunk of the economy) showed that it was going through a large contraction, with the accommodation, restaurant, retail, and entertainment trades in especially weak shape. There were some hopeful signs in the otherwise poor data: service firms' employment is holding up, reflecting in the BNZ's view that "firms expecting activity to bounce once restrictions are eased, fiscal support from government, and a reluctance to let staff go." The September quarterly survey from the NZ Institute of Economic Research found the same thing: "Firms are feeling more positive about increasing head count in the next quarter, particularly among retailers. This suggests that businesses are planning for a rebound in demand when alert level restrictions are relaxed."
The likelihood is that the economy will bounce back. The preliminary results from the ANZ Bank October business survey showed that businesses, already optimistic about their own likely activity, became a bit more positive again. Encouragingly, they also became more optimistic about their profitability, despite intense cost pressures. In the near term, the economic backdrop is likely to be positive for equity performance. The crunch point will come when existing levels of fiscal and monetary support progressively drop away through 2022, especially if the country is slow to move through the new "traffic light" process of progressive removal of domestic and borders restrictions.
The same patterns of an immediate hit from restrictions, but firms preparing for a recovery beyond lockdown, can be seen in Australia. The minutes of the latest RBA meeting, for example, noted that "some firms in New South Wales were preparing to step up hiring ahead of the easing of restrictions in October ... the central forecast scenario envisaged the level of employment, unemployment, and participation to have broadly recovered to pre-delta levels by around the end of the year."
NAB's latest (September) quarterly business survey acknowledged the immediate impact of COVID restrictions: "With lockdowns in place for most of Q3, it's unsurprising to see both business conditions and confidence take a fairly large hit for the quarter." But NAB also said that firms appeared to be better prepared (given their 2020 experience) this time around and that although business expectations for the immediate months ahead are still weak, businesses appear to be looking to better times next year: “Expectations for capital expenditure over the next 12 months remained healthy, as did expectations for employment over the longer horizon. These results support the view that the economy is well placed to rebound when lockdowns are lifted." As NAB noted, the survey was taken before the latest reopenings in New South Wales and Victoria, and the likelihood is that business conditions will have firmed further since. With the exception of those areas of the resources sector most exposed to potential slowdowns in Chinese demand, the economic environment should be conducive to further equity performance in coming months, though there will be some uncertainty later in 2022 once the current levels of COVID policy support start to be withdrawn.
International Fixed Interest — Review
International bonds have had a difficult year. While an early-year rise in bond yields had reversed by August, leaving bond yields only modestly higher than where they started the year and reducing the scale of capital losses, more recently bond yields have headed back up again and are close to revisiting their earlier peaks. In the U.S., for example, the 10-year Treasury yield started off at 0.9%, peaked at 1.75% at the end of March, was back down to under 1.2% in early August, but has more recently risen all the way back up to its present 1.65%. There were similar, if smaller, cycles in other major bond markets. The upshot is that bond investors have lost ground, with capital losses outweighing very modest running yields. Year to date, the Bloomberg Global Aggregate Index in U.S. dollars has lost 4.3%, with government bonds losing 6.1% and corporate bonds 2.1%.
International Fixed Interest — Outlook
The outlook for bonds remains difficult, with the prospect of further increases in yields. One reason is that as the world economy continues to recover out of its 2020 COVID-19 slump, there is progressively less and less need for central banks to maintain their previously ultra-easy supportive monetary policies. And the second is that the global economy is currently going through a period of strong price pressures. It is still not clear how much of these pricing pressures will be transitory, linked to temporary collisions between unusually strong post-COVID demand and unusually constrained supply chains, and how much might be longer lasting, but either way higher inflation is the proverbial enemy of the fixed-coupon bondholder.
The latest (October) quarterly The Wall Street Journal survey of U.S. forecasters makes the points clear. At the end of next year, if the median forecast pans out, the U.S. economy will have had a year when gross domestic product will have grown by 3.6%, unemployment will be down to 3.9%, but inflation will be running at 2.5%. No central bank pursuing a conventional monetary policy will leave monetary policy on an ultra-supportive setting when an economy is effectively at full employment and inflation is well within its target range. It will move to normalise policy. The Fed has already said it is limbering up to buy fewer bonds (meaning it is less inclined to keep bond yields down), and in the Journal survey the forecasters expect that it will move further and actually start increasing interest rates before the end of next year. By the end of 2022 the 10-year yield is expected to have reached 2.15%. For similar reasons the markets expect the Bank of England to start tightening, too, with the latest futures pricing suggesting the first move could be as early as this December.
The probability is that bondholders will be looking at a period of further capital losses, and that is certainly the view of the global fund managers polled in the October BAML survey. They see higher inflation as the biggest risk ahead, and while a majority (58%) are inclined to think it is mostly transitory, they are taking no chances in case it is indeed permanent. Their allocation to bonds in October (a net 80% said they were underweight) was the lowest allocation in the 20-year history of the survey.
International Equities — Review
World share markets have regained confidence after their September sell-off. Prices bottomed out in early October, and since then the MSCI World Index in U.S. dollars has risen by over 5% and is nearly back to its all-time peak in early September. Year to date, the index is up by 17.0%. Performance remains significantly dependent on the U.S. market, where the S&P 500 is up 20.8% and the Nasdaq is up 17.3%, but even outside the U.S., equities have done well, and the MSCI World ex USA Index is up 10.4%. European shares have been strong, and the FTSE Eurofirst 300 Index is up 18.5% (in euros). Japan continues to be the main drag on developed market performance, with the Nikkei up by 6.6% in yen but down 3.7% in U.S. dollars.
Emerging markets however had made little progress. The MSCI Emerging Markets Index is up by a scant 0.8% year to date, and its core BRIC constituents (Brazil, Russia, India, China) are down by 2.9%, mainly owing to weak Brazilian shares (the MSCI Brazil Index is down 17.8%). Russia has done very well, buoyed by the strong oil price, and the MSCI Russia Index is up 35.9%, and India is also well ahead (the MSCI India Index is up 28.5%). How China went very much depends on which index you prefer: The Shanghai Composite is up by 5.6% in U.S. dollars, but the MSCI China is down by 11.4%. Either way, it took a back seat to the larger moves in the other BRIC markets.
International Equities — Outlook
The recovery in equity prices reflects growing evidence that the global economy is continuing to emerge from its COVID-19 setbacks. The September J.P. Morgan Global Composite Global Activity Index showed an ongoing and broad expansion across most economies, and the same data at a sector level, as the IHS Market global sector indexes also showed a broad-based recovery, with 18 of the 21 sectors increasing output during the month. The only major exception was car production, which has been particularly badly affected by supply chain interruptions.
The latest updates from the big international institutions have also been encouraging. The OECD, for example, in its latest (September) update to its economic outlook, estimates that the world economy contracted by 3.4% in 2020 but will bounce back by 5.7% this year and follow up with another good year of 4.5% in 2022. One qualification is that they expect some emerging economies to lag, largely because they are less well placed to handle COVID-19 challenges: "There are marked differences in the pace of vaccinations and the scope for policy support across countries, particularly in many emerging-market and developing economies." This (going by year-to-date share market patterns) is the same conclusion that equity investors have come to.
In terms of risks, the OECD said that "the distribution of risks is now better balanced than a year ago, but significant uncertainty remains." On the plus side, faster vaccination rollouts could produce an even better year ahead, but in those buoyant conditions, central banks would need to keep markets calm: “Clear guidance by the monetary authorities that the additional inflation pressures were only temporary would help to anchor inflation expectations and limit financial market repricing." The major downside risk to this otherwise positive outlook is some further mutation of the virus: “In such circumstances, stricter containment measures might need to be used again, confidence and private sector spending would be weaker than in the baseline, and some capital would be scrapped. In such a scenario, output would remain weaker than the precrisis path for an extended period. World GDP growth could drop to under 3% in 2022."
The International Monetary Fund, in the forecast update for its annual meeting in October, also sees ongoing global growth and has very similar numbers in mind: a drop of 3.1% last year, followed by a 5.9% rebound this year and a further 4.9% in 2022. The IMF also agreed with the OECD that, while the baseline scenario is positive, uncertainty remains high: "The balance of risks suggests that growth outcomes—over both the near and medium term—are more likely to disappoint than to register positive surprises." It pointed to much the same menu as the OECD: the emergence of more transmissible and deadlier virus variants and, if inflation remains high (because of supply chain issues or otherwise), the risk of "a faster-than-anticipated monetary normalization in advanced economies." In current market conditions, that would not go down well: "Compressed volatility and elevated equity price valuations point to the possibility of rapid repricing of financial assets in the event of a reassessment of the outlook."
By and large, the global fund managers in the October BAML survey also buy the ongoing growth story: a net 50% remain overweight to global equities. But they also feel that the peak period of GDP and profit growth is behind us, and they are particularly keen to be well positioned if inflation remains high, which is by far the biggest risk on their horizon (the top choice for 48%). The survey found that allocations to inflation-linked assets such as commodities, energy, and banks were at historically very high levels. The other main risks they mentioned were the ramifications of a slowdown in China (the knock-on impact of Evergrande may also have been in that basket, picked by 23%), the existence of asset bubbles (9%), and the impact of any Fed taper (less support for bond yields, also 9%). Oddly, given the thinking of the likes of the OECD and the IMF, the risk of COVID mutating was way down the list (picked by only 3%). It would be nice if the fund managers proved right.
Performance periods unless otherwise stated generally refer to periods ended Oct. 20, 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.