Morningstar Economic Update December 2021
Outlook for Investment Markets
Despite the emergence of the new omicron variant of coronavirus, the global economy has continued to recover from the pandemic, and improving operating conditions provide a useful supportive backdrop for growth assets. Inflation has continued to surprise on the upside, and a range of central banks are likely to have to respond with higher interest rates, which means bonds (barring some resurgence in COVID-19 virulence and a consequent search for safe-haven assets) look to be facing ongoing difficult conditions. Higher interest rates also pose a valuation challenge to other asset classes, given that several look expensive. The other main risks on the international horizon are ongoing supply chain disruption and strong pressure on companies’ input costs. While it is early days in New Zealand’s lifting of lockdowns, it is likely that the economy will see a strong rise in activity in 2022 and into 2023, though it is likely to share the same issues of higher interest rates and pressure on corporate profitability from more expensive inputs.
New Zealand Cash and Fixed Interest — Review
As expected, on Nov. 24, the Reserve Bank of New Zealand, or RBNZ, raised the official cash rate, or OCR, by 0.25% to 0.75%. The 90-day bank bill now yields 0.87%. Bond yields have also headed higher: The 10-year government bond yield may have eased back from its recent high (2.7% on Nov. 17) but at 2.4% is still well up on where it started the year (just below 1.0%). The kiwi dollar has weakened in recent weeks and for the year to date is down by 3.3% in overall value. Part of the weakness reflects the global strength of the U.S. dollar: The kiwi was worth 71.6 U.S. cents at the start of November but has fallen to 67.5 cents now.
New Zealand Cash and Fixed Interest — Outlook
Barring some future COVID-19 setback, further increases in short-term rates are highly likely. The RBNZ is confronted by an economy with a very tight labour market—unemployment is lower than the bank thinks can be maintained over the long haul—and inflation is becoming worrisome. The Treasury in its Half Year Economic and Fiscal Update, or HYEFU, on Dec. 15 said that inflation will average 5.1% in the June 2022 year and will still be running at 3.1% in the June 2023 year, above the RBNZ’s 1% to 3% target range. A protracted series of 0.25% hikes in the OCR looks on the cards: Treasury thinks the 90-day bank bill yield will reach 3.2% in the June 2023 quarter, and both other forecasters, and the futures market, see things similarly.
In this inflationary economy, bond yields also look set to rise further. Treasury expects the 10-year yield to be 2.9% by mid-2023, and again other forecasters tend to agree: The ANZ expects 2.8%, Westpac 3.0%, and the BNZ 3.2%. Even then, yields will at best match the likely rate of inflation, and Treasury reckons that further increases will be needed: It sees the 10-year yield reaching 3.4% by mid-2025.
The recent weakness of the kiwi dollar has been somewhat surprising, given that the RBNZ looks to be one of the more activist central banks in raising rates through 2022 and 2023 and that other indicators also look supportive, including historically high commodity prices. Exchange-rate forecasts are always problematic, but for now forecasters are leaning towards the view that the recent weakness will be reversed. Westpac does not expect much of a rebound, to 69 U.S. cents by the end of 2022, but the other big banks see a somewhat stronger outcome: ANZ, ASB, and the BNZ expect the kiwi to be trading around the 72 to 74 cents mark.
New Zealand Property — Review
New Zealand listed property has not shone in absolute terms. For the year to date, the S&P / NZX All Real Estate Index has made a small capital loss of 0.5% and delivered an overall return including dividends of 3.1% (3.7% including the value of imputation credits). On the plus side, however, it has outperformed the wider equity market and has played a useful role on the defensive side of the portfolio, outperforming both cash and bonds (the S&P New Zealand Aggregate Bond Index lost 5.2%).
New Zealand Property — Outlook
Colliers’ end-year research report on the outlook for property in 2022 is positive on the economic fundamentals: Always assuming that COVID-19 does not offer new surprises, reduced restrictions and eventual border reopening will “combine to help strengthen property sector demand fundamentals. We will see population gains, increased domestic and international tourism, a lift in overall business activity and higher spending levels online and instore”. There will continue to be a pronounced subsector tiering, with industrial still best placed; offices will be adapting to more flexible working practices, but Colliers expects that vacancy rates will not rise and the high-quality end could do quite well. There will be some respite for the retailers, with previously pent-up demand helping a wide range of retailers and, Colliers expects, leading to a stabilisation of effective retail rents.
But while operating conditions for their properties are clearly improving, the big issue for the listed sector is the threat from interest-rate differentials. The yield from the sector (4.2% at the end of November according to S&P, but 4.0% now after prices rose in December) will not look competitive if, as seems likely, bond yields continue to rise. Its defensive success in 2021 may still attract some investor support, and higher rents in a stronger economy provide an inflation hedge, but the yield differential will be an ongoing challenge.
Australian & International Property — Review
The A-REITs have had a very good year. The S&P / ASX200 A-REITs Index has made a capital gain of 22.1% and has delivered a total return including dividends of 25.4%, significantly outperforming the 16.1% total return from the S&P / ASX 200.
Overseas REITs have also done well. For the year to date, the FTSE EPRA/NAREIT Global Index in U.S. dollars has delivered a 14.4% capital gain and has returned 18.0% including dividends, close to the 18.7% total return from the MSCI World Index. Performance has, however, been even more dependent on the U.S. market than the overall share market has been: Ex the U.S., the index returned only 1.8%. The U.K. was the only other major market to do well, with a 20.7% return; there were losses in the Asia-Pacific (negative 2.6%), in the eurozone (negative 5.5%), and the emerging markets (negative 14.0%).
Australian & International Property — Outlook
There was likely an element of correcting previously oversold A-REITs in the recent rally, but the main factor was the big improvement in the operating outlook following the lifting of lockdowns. The December quarter ANZ Bank / Property Council of Australia survey of commercial property found that “Commercial sentiment rose strongly and is now at its highest level since June 2018” and that “Optimism about the economic outlook is underpinning a lift in sentiment across all property segments; residential, office, hotels, retail and industrial, despite the uneven and lingering impacts of COVID on the hotel and office sector”. Up to December, respondents had been pessimistic about capital values in the office, tourism, and retail sectors; now, they see valuations stabilising for offices and retail and improving for tourism (they were highly bullish all along about industrial and have remained so). All good news, but a repetition of the recent A-REIT performance seems unlikely if interest rates continue to rise, as the survey respondents expect they will. The Property Council noted that “Interest rate expectations have lifted strongly, with nearly 60% of firms now expecting rate hikes over the next year. While this is consistent with market pricing … it contrasts with the RBA’s insistence that the cash rate is likely to remain unchanged until well into 2023”.
Much the same factors apply to the global asset class. There is the immediate impact of economic recovery: The U.S. trade group NAREIT in its outlook for 2022 said that “Assuming COVID-19 variants remain largely in check, this will be a period of economic growth that will drive recovery across a broad range of real estate and REIT sectors”. Within the broad uplift, there will be some ongoing structural change, notably around flexible work practices (for the office sector) and online shopping (for retail), though NAREIT makes a good point that the view that has become conventional—that brick-and-mortar and online are competing substitutes—may be too simplistic: “Brick-and-mortar sales came back with a vengeance as stores reopened … Consumers have demonstrated that they still appreciate in-store shopping for certain items, even as they prefer the convenience of online purchases for others … This consumer preference for ‘more of both’ will likely boost the recovery of the brick-and-mortar retail sector in 2022 and also support the continuing long-term growth of REIT sectors that support the digital economy, including industrial/logistics, data centres, and infrastructure/communications towers”. While the operating outlook has improved, again the big challenge will be the impact of higher interest rates, particularly as the U.S., which has driven nearly all of the 2021 REIT gains, is likely to see a series of monetary policy tightenings by the Fed.
Global Infrastructure — Review
The S&P Global Infrastructure Index in U.S. dollars for the year to date is up by 4.3% in capital value and has returned 6.7% including taxed dividends (10.4% hedged into New Zealand dollars).
Global Infrastructure — Outlook
As with global property, the outlook varies by subsector. It is positive for previously locked-down activities, where the removal of restrictions and the global economic upswing are likely to boost the likes of airports, railroads, and toll roads, though possibly not to prepandemic levels if (for example) people are now wary of international travel or (for toll roads) no longer have to travel as often into the central business district to work. It is also positive for companies that will be beneficiaries of President Biden’s planned spending of USD 1 trillion on new and updated infrastructure. And it is strongly positive for subsectors with currently high thematic appeal, notably anything to do with renewable energy, decarbonisation, or supporting the digital and Internet economies. It is less positive for the utilities: Although they offer a high degree of defensive downside protection, their valuations tend to struggle in a period when interest rates are on the rise. Rising interest rates also affect the asset class more widely: A yield of only 3.1% (slightly lower than that available from listed property) may progressively lead income-oriented investors to become more tempted by improving returns from bonds.
Australasian Equities — Review
The New Zealand share market has not travelled well in 2021, and for the year to date, the S&P / NZX50 has made a capital loss of 3.7% and returned an overall loss including dividends of 1.2% (0.6% including imputation credits). The headline result reflects the impact of two large top 10 shares: A2 Milk (down by 52.0%) and Meridian (down by 38.0%). Elsewhere, returns have been rather better. The mid-caps are up by 3.6%, and the small caps have had a good year, with a gain of 11.5%.
Australian shares, on the other hand, have performed well, and the S&P / ASX200 Index is up by 12.0% and has returned 16.1% including dividends. The three big sectoral winners were the A-REITs (up 22.1% as noted earlier), consumer discretionary (up 20.8% on expectations of post-COVID-19 pent-up spending), and the financials ex the A-REITs (up 18.5% after the banks look to be managing their way through the pandemic better than originally feared). The miners look to be finishing 2021 with a small gain: The S&P / ASX300 Metals and Mining Index is up by 2.1%.
Australasian Equities — Outlook
The New Zealand economy has clearly been battered by the COVID-19 lockdowns: Gross domestic product dropped by 3.7% in the September quarter, the latest (November) BNZ / BusinessNZ surveys showed manufacturing barely growing and the (larger) services sector going backwards, and the final results from the November ANZ business survey showed that firms were becoming less confident about the economy in general and about their own expected levels of activity.
The better news is that the outlook is promising. Barring any resurgence in COVID-19 virulence, forecasters are expecting a sizable rebound in activity. Treasury, for example, said in the HYEFU that “The recovery is underpinned by pent-up demand, higher employment, continued strength in building consents, and the more permissive COVID-19 Protection Framework boosting activity at the start of 2022” —the ‘Framework’ being the official name for the traffic light system that has replaced the Alert Level lockdown regime. It expects the recovering domestic economy, and progressive opening of the borders, to translate into 4.9% GDP growth in the June 2023 year. Unemployment will remain very low in a strong economy and is expected to be only 3.3% in mid ’23.
This is broadly supportive for equity performance as consumers resume spending in an economy effectively at full employment. The main near-term qualification (apart from COVID-19 possibly intensifying again) is that companies will be under significant cost pressure from more expensive input materials, rising wages, and higher financing costs, and companies less able to pass those costs on will find it tough going. Further down the track, the equity market may also start wondering about the shape of the business outlook beyond mid-2023, as the immediate rebound from COVID-19 winds down and fiscal and monetary policy support is gradually withdrawn.
In Australia, the economy has been recovering strongly as lockdowns have been lifted. The IHS Markit composite index (covering both services and manufacturing) for November showed “a faster rate of private sector output growth in November following three months of contraction between July and September”. NAB’s November business survey showed the same picture of improvement: All three components of business conditions (trading, profitability, hiring) have increased significantly from their September levels, and business conditions overall are now modestly above their long-term average.
COVID-19 permitting, there is further growth ahead. As Treasury’s Dec. 16 Mid-Year Economic and Fiscal Outlook, or MYEFO, put it, “The Australian economy is rebounding strongly from the impact of the Delta outbreaks … Real GDP is forecast to grow by 3¾ percent in 2021-22 and by 3½ percent in 2022-23. While the Delta outbreaks disrupted activity in the September quarter and dampened growth over 2021-22 relative to Budget, the effect on growth was less than initially expected and the economy is rebounding strongly in the December quarter. The recovery is being supported by broad-based momentum across both private and public demand”.
As in New Zealand, this is a helpful overall macroeconomic backdrop for equities, but also as in New Zealand, strong cost pressures mean that good top-line revenue growth will not always translate into good bottom-line earnings growth. In the MYEFO, for example, there are forecasts for “corporate gross operating surplus”, essentially profits before depreciation. They are on the modest side: a 2.25% increase in the June ’22 year, an 8.25% decline to June ’23 (likely linked to assumed lower commodity prices), and then modest growth of 3.25% to June ’24 and a pickup to 5.0% in the June ’25 year. The likely equity winners in this world will be those best placed to defend their profit margins.
International Fixed Interest — Review
It has been a difficult year for fixed interest. Global inflation has unexpectedly surged, investors are none too sure whether the rise in inflation is temporary (and ongoing low bond yields might consequently be tolerable) or more permanent (in which case investors will hold out for higher yields), and, in general, recovery from COVID-19, despite the emergence of the omicron variant, has reduced the attractiveness of bonds as a safe-haven option. Bond yields have risen virtually everywhere (though minimally in Japan), inflicting capital losses, and for the year to date, the Bloomberg Barclays Global Aggregate index in U.S. dollars is down by 4.4%, with government bonds down by 6.0% and corporate bonds down by 3.0%.
International Fixed Interest — Outlook
Inflation has continued to surprise on the upside, with the most dramatic example being the 9.6% year-on-year increase in producer prices in the U.S. in November, a result that was way above market expectations. Even discounting the impact of traditionally volatile elements like food and energy, the year-on-year rise in “core” producer prices was a startlingly high 6.9%. Until quite recently, central banks were facing the challenge of trying to boost inflation to get it up to where they would prefer it to be (typically around 2%). Virtually out of nowhere, they are now trying to force it back down from unacceptably high rates.
The Fed has been in a particularly difficult position, with the U.S. economy generating stronger inflationary pressures than most: Its latest rate of consumer price inflation (6.2%) is above the 4.8% average inflation rate in the big G7 economies and the 5.25% inflation rate in the wider G20 group of large economies. At its December 14-15 meeting, the Fed unsurprisingly made it clear that, by the end of March, it would wind up its bond-buying programme, which had been designed to help keep bond yields low, and would subsequently start raising short-term rates as well. It is likely to increase its target for the federal funds rate by 0.75%, from its current 0% to 0.25% range, to 0.75% to 1.0% by the end of 2022. Other major central banks are not quite as pressured as the Fed but face similar issues with unexpectedly high inflation and are also likely to start winding back bond-buying programmes and to move towards raising their policy rates.
Bond yields had been poor value even before this latest increase in inflation and have become even more inadequate now: The OECD reckons that inflation across its member countries (largely developed economies) will have averaged 3.6% this year and will pick up to 4.4% next year. Some of the COVID-19-related upward pressures on prices will ease in time, and there is still some merit in the value of bonds as insurance if the COVID-19 pandemic were to take a darker turn or geopolitical tensions were to spring any unpleasant surprises, but otherwise the outlook for fixed interest remains challenging.
International Equities — Review
The world economy is doing well, despite the uncertainties posed by the latest omicron variant of COVID-19. The November J.P. Morgan Global Composite Index of business activity found that “The rate of global economic expansion edged higher in November, as output rose at the quickest pace for four months. Growth was underpinned by rising intakes of new business, stronger inflows of new export business and continued job creation”. It is not completely plain-sailing, as there are still pronounced supply chain disruptions, and stronger business activity has been accompanied by heavy pressure from input costs: “Average input costs rose at the fastest rate since July 2008, while output charges increased at a pace close to October's series-record high”. But the progressive emergence from the COVID-19 restrictions has nonetheless been a big plus, and companies are upbeat about the outlook: “Business optimism rose to a five-month high in November, with optimism improving in five of the sub-industries covered by the survey (business services, consumer goods, consumer
services, financial services and investment goods) and was unchanged in the other (intermediate goods)”.
It is also helpful that the U.S. equity market, which has been the mainstay of global equity outcomes, looks likely to make some further progress. Data company FactSet collates the individual company share price forecasts that share market analysts make and aggregates them to produce a “bottom up” forecast for the S&P 500. At the time, the S&P 500 was at 4,667.45, and the bottom-up forecast for the index in a year’s time came out at 5,225, which would be an 11.9% gain. FactSet notes, however, that analysts tend to be on the optimistic side, and in normal circumstances (for example, the global financial crisis in 2008, which threw off their forecasts much more than usual), they tend to shoot 1.6% too high. Knocking 1.6% off the 5,225 target brings it back to 5,141, which would represent a gain of 10.2%. The expected gain is broadly in line with the 9.0% expected rise in S&P 500 profits in 2022, with industrials, consumer discretionary, and energy expected to be the strongest sectors.
Global fund managers are also cautiously optimistic about 2022, according to a large poll of institutional investors run by Natixis, a French investment bank and fund managers. COVID-19 has not gone away but is becoming more manageable: “58% say they believe that life will return to pre-Covid normal after the pandemic”, compared with “42% believe that Covid variants will continue to disrupt the return to normal”. The fund managers are keen on the “reopening trade”: “64% of institutions anticipate that the reopening trade such as restaurants, theatres, and travel will outperform a stay-at-home trade (36%) focused on Netflix, online shopping and other touchstones of quarantine life”.
But there are risks. The fund managers were asked about the big risks on the economic front and to their portfolios. On the economic front, COVID-19 still could have a sting in its tail and came out as the top risk: 56% mentioned ongoing supply chain issues, and 41% picked COVID-19 variants. The other top risks were less supportive monetary policy (47%), worsening U.S. – China relations (32%), and a potential slowdown in the Chinese economy side (27%). For portfolios, again the potential response from central banks was to the fore, with the top risks being the interrelated issues of inflation (69%), interest rates (64%), and valuation (45%).
In response, the fund managers plan to take an active rather than a passive investment approach, mainly with a view to earning better risk-adjusted returns, but are otherwise on the cautious side, favouring defensive over aggressive portfolios and value over growth. By region, there may be some relief in sight for emerging-markets investors: It is the favoured region for investment, with 41% planning to increase allocations and only 18% planning to reduce them. Asia-Pacific (34% increase, 16% decrease) and Europe (33% increase, 20% decrease) are also in favour, but this panel of fund managers did not share the U.S. analysts’ optimism that FactSet described. The U.S. (25% increase but 36% decrease) is on the outer, very likely because it looks relatively more exposed to any valuation correction.
Performance periods unless otherwise stated generally refer to periods ended Dec. 14, 2021.
See the Full MorningStar Economic update here.
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