Morningstar Economic Update January 2022
Outlook for Investment Markets
World and local equity markets have started 2022 badly, as valuations in some expensive sectors such as tech unravelled, triggering a wider sell-off in equities as a whole, against a background of rising interest rates and ongoing uncertainties about the short- and medium-term impacts of the pandemic. Despite these setbacks, the outlook for business activity both globally and domestically is still positive. And barring some virulent mutation of the coronavirus, the reopening trade should see strong economic growth this year, although the pace of growth is likely to ease back in 2023. The big issues for investors, again both overseas and at home, are inflation and interest rates. Also, rising cost pressures are making it an ongoing challenge for companies to translate higher sales into higher profits. Higher interest rates, as central banks battle the war on inflation, make bonds an unattractive option and also threaten the valuations of other asset classes.
New Zealand Cash and Fixed Interest — Review
Short-term rates have edged up a little since the start of the year and the 90-day bank bill yield is up 0.1% at just under 1.1%. Longer-term rates have also risen, and the 10-year government bond yield is 0.2% higher at 2.57%. The currency has weakened, and the kiwi dollar year to date is down 1.5% in overall trade-weighted value; in terms of its headline rate against the U.S. dollar, it is down 1.4% to 67.3 U.S. cents.
New Zealand Cash and Fixed Interest — Outlook
Forecasters and the futures market are unanimous that the Reserve Bank of New Zealand, or RBNZ, will continue tightening in coming months. The futures market, for example, expects that the 90-day bank bill yield will be 1.5% higher by the end of this year, and ANZ Bank recently increased its forecast for how high the official cash rate, or OCR, will go and now expects it to reach 3% by mid-2023. Savers will see better returns from money in the bank, although the return may still not compensate for the impact of inflation.
Longer-term rates are also likely to increase, reflecting RBNZ tightening, rising bond yields overseas, and investors’ need for better returns in the current inflationary climate. A yield somewhere around a low three looks plausible by the end of this year--Westpac expects 3.0%, the BNZ 3.2%, and ANZ 3.4%. Last year was a difficult year for local bonds (the S&P New Zealand Aggregate bond index lost 5.2%), and market conditions look to remain difficult in 2022.
The opening weeks of the year confirmed that the kiwi dollar tends to do worse than most when global financial conditions are unsettled (equity markets have been very weak to start the year). In this risk-off environment, the kiwi dropped against all its major counterparts. The big bank forecasters currently expect some recovery from the recent sell-off. And they may be right, as both the strength of New Zealand’s commodity prices and the scale of the likely RBNZ monetary policy tightening could help it appreciate. But any recovery will only eventuate once international foreign-exchange investors are in a more risk-on frame of mind.
New Zealand Property — Review
Listed property has not been immune from the wider equity market weakness, and year to date the S&P/NZX All Real Estate Index has made a capital loss of 2.6%. On the positive side, its relative defensiveness means it outperformed the wider share market’s 5.3% decline.
New Zealand Property — Outlook
While it is early days, the relative resilience of listed property is modestly encouraging. In principle, the prospect of interest rates rising ought to have taken a heavier toll on the sector, given that the yield on the sector (4.2% at the end of 2021, according to Standard & Poor’s) looks increasingly vulnerable to the strong prospect of rising bond yields. On the other hand, investor sentiment appears to have remained positive: Colliers’ roundup of 2021 transactions shows that it hit a record level of USD 12 billion, and that “While safe haven assets, particularly prime grade industrial, supermarket and large format retail premises, have continued to attract the highest levels of investor interest, improving sentiment has seen competition emerge for a broadening range of assets.” Omicron, which had just arrived in New Zealand at time of writing, may however cause reassessment of the commercial impact on property of ongoing countermeasures, such as limits on numbers of customers.
The latest bout of wider equity market weakness may have increased the appeal of more defensive assets, and the operating outlook is reasonably good--Colliers pointed to “a strongly performing economy, high levels of employment, and the likely relaxation of border restrictions.” And with inflation a hot issue, resets of rentals provide a degree of inflation hedging. But whether these positives will continue to outweigh the impact of bond yields rising above 3%, as seems likely, or the spread of omicron, remains to be seen.
Australian & International Property — Review
After a very strong 2021, when the S&P/ASX200 A-REITs index made a capital gain of 21.6% and returned 26.1% including dividends, the sector has done badly in the opening weeks of 2022, and the index is down by 8.9%, underperforming the wider share market’s 3.6% decline.
Overseas REITs have also weakened, though they have done slightly better than world shares as a whole. The FTSE EPRA/NAREIT Global Index in U.S. dollars is down by 5.1%, modestly less than the 6.4% decline in the MSCI World Index. As with the wider equity market, weakness was concentrated in the U.S. REIT market, where prices fell by 7.6%. Excluding the U.S., the sector turned in a usefully defensive decline of only 1.8%.
Australian & International Property — Outlook
The weakness of the A-REITs has been somewhat surprising. Unlike in the U.S., the U.K., or New Zealand, where central banks are in the early stages of multi-hike tightening of monetary policy, the Reserve Bank of Australia has been keen to avoid early rate rises, and the A-REITs might have been expected to do better than their overseas counterparts. One possibility is that investors have started to suspect that the RBA will have to act earlier than it planned, a view vindicated by December’s higher than expected inflation rate, and that the yield on the sector (3.6%) is now at greater risk than originally thought. It may be that the huge surge in the Australian omicron variant led investors to take a more downbeat view of property owners’ revenues. Another possibility is that there may have been an element of profit-taking after the strong performance of last year. Whatever the reasons, the decline looks unusually large, as the operating outlook in what is likely to be a good year for economic growth is supportive, and the reopening trade, as COVID-19 becomes more of an endemic nuisance than a virulent pandemic and borders reopen, could well benefit previously battered subsectors, such as shopping malls and tourism. The A-REITs may well do better in the rest of the year than their opening weakness might suggest.
The same factors are playing out overseas. There are generally supportive economic fundamentals as the impact of COVID-19 diminishes, but with strong subsectoral differentiation. Industrial is still strong virtually everywhere, but there are lingering challenges for offices and retail as a result of pandemic-accelerated behavioural changes to work and shopping. On the other hand, there is the offsetting issue of rising bond yields. So far, global REITs have done reasonably well in the wider equity sell-off, and property company CBRE may be right (when arguing about the U.S. market) that there is enough of a yield cushion to fend off the threat from bonds, and that the operating outlook will win for the time being: “Rents should continue rising, supporting higher property net operating income (NOI) for most asset types. Although cap rates [capitalisation rates, the interest rates used to value property] typically follow the direction of real interest rates in the long run, NOI expectations are more influential in the short term.”
Global Infrastructure — Review
Global listed infrastructure has held up impressively well during this month’s wider equity sell-off. The S&P Global Infrastructure index in U.S. dollars year to date is down by a marginal 0.4%.
Global Infrastructure — Outlook
One of the conventional portfolio advantages of infrastructure is its capacity to provide a bet each way: the combination of defensive sectoral assets like utilities with more cyclically sensitive sectoral assets like airlines provide some downside protection in rougher times (utilities will be relatively unscathed) but with some participation in better times (when patronage of the cyclical assets picks up). At the moment, utilities are a drag on performance, but the cyclical end is delivering good returns as the world continues to recover from COVID-19 and the reopening trade becomes more important. As one example, passenger volumes through Sydney Airport doubled in December as restrictions have eased. There is still a long way to go--the airport’s traffic in 2021 was only 18% of what it had been in pre-COVID 2019--but it, and similar patronage infrastructure assets, are on the mend. The asset class may also benefit as a conservative parking space if there is ongoing volatility in the wider equity markets, given that the traditional safe haven asset (bonds) is currently an unattractive option.
Australasian Equities — Review
New Zealand equities have shared in the global equity weakness of early 2022, and the S&P/NZX50 index is down 5.3%. Among the big names, the largest losses were for Fisher & Paykel Healthcare (negative 10.4%), Ryman Healthcare (negative 8.9%), and A2 Milk (negative 7.6%), but the weakness extended beyond the large caps--the mid-caps were down by 4.6% and the small caps by 3.5%.
Australian shares have also weakened, and the S&P/ASX200 index is down 3.6%. Globally, tech shares have been under pressure this year, and the local sector followed suit, with IT stocks down 14.4%. Most other sectors are also in the red, though the banks (likely beneficiaries of rising interest rates) did relatively well, with the Financials, excluding the A-REITs, down by a smaller than average 2.8%. The miners, on the other hand, have profited from ongoing strong world commodity prices, and while the S&P/ASX300 Metals and Mining Index is up 6.2%.
Australasian Equities — Outlook
At this early stage of the year there are not many surveys available of how the business sector is performing. The most recent is the December Quarterly Survey of Business Opinion, run by the New Zealand Institute of Economic Research, or NZIER. It was a mixed bag, with news that omicron was starting to circulate as the survey was circulating, and unsurprisingly business confidence took a knock; but, on the other hand, firms were still looking to invest and to hire, even though the degree of difficulty in finding staff is at extraordinarily high levels (the toughest in over 30 years). The other key result was pressure on costs: “Acute labour shortages are underpinning a lift in wage growth, and this is contributing to higher costs for businesses. A net 61 percent reported increased costs in the December quarter – the highest level since June 2008.”
On the plus side, a bounceback from the severity of COVID-19 lockdown restrictions should be good for business revenue, and there has been a hint that border closures may be relaxed by midyear, which would also help. ASB Bank and Kiwibank think the economy could grow by 4.1% this year, Westpac is picking 4.4%, and the BNZ is more optimistic again, at 4.9%. On the other hand, omicron has arrived, and at time of writing the whole economy had just received the red light, in that businesses may be in a better place than under outright lockdown, but omicron will pose its own challenges, notably from supply shortages and staff absences. Strong input cost pressures will crimp profitability, as will rising borrowing costs. The immediate outlook is for limited growth in profits and some headwinds for equity performance.
In Australia, we have also yet to see the first business surveys of 2022, but what was available at the end of 2021 was reasonably encouraging. NAB’s November business survey, for example, found that: “Overall, the results suggest a strong recovery is continuing as reopening progresses, with activity now settling at a more ‘normal’ post-lockdown level. Conditions remain below the levels seen in early 2021 but forward indicators point to momentum continuing into 2022.” There was also a major positive surprise in the labour market in November, when there were 366,100 more people employed. Forecasters had expected a big number--they predicted around 220,000 people would come back to work post-lockdown--but the actual result blew well past all expectations, with the unemployment rate consequently dropping to an unexpectedly low 4.6%.
While omicron will complicate the outlook, and it has, for example, knocked back the early 2022 readings on consumer confidence in the most recent ANZ/Roy Morgan poll, the best take at the moment is that the economy should experience a strong year of post-lockdown recovery. The Australian Financial Review’s survey of 30 economists published in early January found the median expectation for GDP growth this year is 5.0%, with growth continuing, albeit at a slower 3.0% rate, through to mid-2023. Australian businesses will face the same input cost pressures being experienced globally, so strong top-line sales growth will not translate straight into strong profit performance. CommSec’s outlook for 2022 noted the challenges of “Persistent virus mutation risks, rising interest rates and elevated inflation,” but concluded that, “Aussie shares could outperform their global counterparts in 2022, supported by stronger relative economic growth and higher relative dividend yields. CommSec expects the ASX 200 index to end 2022 between 7,600-7,800 points.”
International Fixed Interest — Review
Bonds lost ground in 2021, with the Bloomberg Barclays Global Aggregate index in U.S. dollars losing 4.7%. The early weeks of 2022 have also been difficult, as the Global Aggregate year to date is down by 0.9%, with government bonds losing 0.6%, and corporate bonds down 1.9%. Higher-yielding riskier subsectors, where investors have looked for better returns in a world of otherwise very low yields, have also gone backward, with emerging-markets bonds down 2.3% and global high-yield (low credit quality) down by 1.5%.
International Fixed Interest — Outlook
Bonds continue to face difficult conditions as inflation has unexpectedly risen to high levels by recent standards. The first of the big flagship forecasts for 2022 from the international organisations--January’s Global Economic Prospects from the World Bank--said that “The rebound in global demand and activity since mid-2020, together with supply disruptions and rising food and energy prices, have pushed headline inflation to decade highs across many countries. Core consumer price inflation — excluding food and energy — has also increased globally; in some economies, this has in part reflected rising housing price inflation. The increase in inflation has led various central banks to partially unwind their accommodative monetary policies.” The OECD estimates that inflation in the developed economies was 5.8% in November, and it has likely become worse since. In the U.S., for example, November’s 6.8% inflation rate rose to 7.0% in December.
With inflation higher, central banks have had little option but to change monetary policy tact and have started to wind back previous programmes of bond-buying (which kept bond yields lower than otherwise) and are likely to progressively raise policy interest rates through 2022. Some have moved already, with the Bank of England, for example, raising its policy rate from 0.1% to 0.25% on Dec. 16. Even without the central banks moving, bond market investors may well have held out for higher returns on bonds to preserve their purchasing power against the surge in inflation.
The outlook is for further monetary policy tightening, although opinions vary on how much. In the key U.S. market, for example, the futures market is confident about a March hike. The Chicago Mercantile Exchange’s FedWatch tool, based on the futures pricing, puts an 89% probability on a 0.25% increase in the Fed’s target cash rate range (currently 0% to 0.25%) at the Fed’s March 16 meeting and expects a string of rate rises for the rest of the year, but is not sure how many. The best guess at the moment is four 0.25% increases (31.5% probability), but it could easily be three (27%) or five (20%). Either way, global economic conditions at the moment remain difficult for fixed interest.
International Equities — Review
World shares have had a rocky start to 2022. The MSCI World Index of developed markets in U.S. dollars has dropped by 6.4%. American shares have done especially badly--the S&P 500 is down 7.7% and the Nasdaq is down 12.2%--but many other major markets have also been weak, with Japan’s Nikkei index down 4.4%, Germany’s DAX down 1.8%, and France’s CAC down 1.2%. The U.K. has been a rare exception, with the FTSE100 up 1.5%.
One thing that is comforting is that one of 2021’s laggards, the MSCI Emerging Markets Index--down 4.6% last year--is up so far, with a modest 1.0% gain. The gain was largely down to a surprising turnaround for Brazilian shares. The MSCI Brazil had lost 23.5% in U.S. dollars in 2021 but is up 7.7% year to date, as buyers were attracted by cheap Brazilian energy and commodity stocks in an environment of strong global commodity prices.
International Equities — Outlook
The world economy is still growing, although the impact on staffing levels with the surge in omicron cases, other lingering supply chain issues, and some inevitable slowdown from the original rebound from the severe COVID-19 setback, have combined to slow down the rate of growth. The December J.P. Morgan Global Composite Index of business activity was 54.3, consistent with ongoing growth at a respectable rate, though down from the 54.8 registered in November.
Global businesses remain optimistic about the outlook. In the Global Composite survey, it was reported that they are planning to take on more staff: “Companies maintained a broadly positive outlook for output levels over the coming year, with the overall degree of optimism ticking up to a six-month high.”
The World Bank’s Global Economic Prospects forecasts are also picking ongoing growth, but at a slowing rate: “Global growth is projected to decelerate from 5.5 percent in 2021 to 4.1 percent in 2022, reflecting continued COVID-19 flare-ups, diminished policy support, and lingering supply disruptions. Growth is envisioned to slow further in 2023, to 3.2 percent, as pent-up demand is depleted and supportive macroeconomic policies continue to be unwound.” The good news is that if something like the World Bank’s expectations come to fruition, next year the developed world will have returned to where it would have been pre-COVID-19: “Despite the slowdown, the projected pace of expansion will be sufficient to return aggregate advanced-economy output to its pre-pandemic trend in 2023 and thus complete its cyclical recovery.”
All that said, there are clearly risks to this good economic outcome. Beyond some further malign evolution of COVID-19, the World Bank said that risks are tilted to the downside: “The recovery is also at risk from more persistent supply disruptions, mounting inflationary pressures, financial stresses, climate-related disasters, and weaker-than-anticipated long-term growth drivers.” Among the potential financial stresses, the World Bank mentioned central banks withdrawing monetary policy support in an “inadequately forewarned” way. But even if central banks do a fine job of explaining their intentions, less liquidity and higher interest rates have the potential to undermine global share markets. The recent sell-off in equity markets has partly been down to investors readjusting equity valuations in a world of rising interest rates, especially given that some sectors of the market (notably tech) had been priced on very expensive valuations. Other higher-risk assets such as cryptocurrencies have been heavily sold off for the same reason.
If all goes well, ongoing growth will support improved corporate performance, though profit growth will be harder to come by in 2022 than in 2021. Data company FactSet’s latest collection of sharebrokers’ profit forecasts for the U.S. market suggests that earnings at the S&P 500 companies are expected to grow by 9.4% this year, compared with an estimated 45.3% in 2021. The numbers exaggerate the likely slowdown (2021 numbers were bloated by a sizable loss-to-profit turnaround in the energy sector), but the core proposition of slower profit growth is likely correct against a background of top-line sales growth slowing and cost pressures rising. The big risk remains investors’ valuation of corporate profits as bond yields continue to rise.
Performance periods unless otherwise stated generally refer to periods ended Friday, Jan. 21, 2022.
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