Morningstar Economic Update February 2022
Outlook for Investment Markets
Both bonds and equities have lost ground for the year to date. Bonds have weakened in a world of unexpectedly high inflation, which has prompted central banks to start raising interest rates. Equities have suffered as monetary policy looks to tighten more than previously anticipated, surging omicron cases have resulted in a new round of setbacks to production and spending, and the crisis over Ukraine has raised serious geopolitical concerns with potential outcomes that are hard to predict. The outlook is still, at both a global and a domestic level, for economic growth to re-emerge on the other side of omicron, though New Zealand is still in the early stages of what looks very likely to be a large increase of cases and the timing of eventually more normal trading is not at all clear. The major risks to the outlook are central banks having to raise rates more aggressively again, the potential impact of inflation on corporate profit margins, and the unknowable end point of the Ukraine flashpoint.
New Zealand Cash and Fixed Interest — Review
Short-term rates have been rising, and the 90-day bank bill yield is now a little over 1.2%, a 0.25% increase since the start of the year. Longer-term rates have also increased, and the 10-year government-bond yield has moved 0.45% higher to just over 2.8%. The kiwi dollar has dropped and year to date is down 2.9% in overall trade-weighted value; its headline rate against the U.S. dollar has dropped by 3.1% to U.S. 66.2 cents.
New Zealand Cash and Fixed Interest — Outlook
No change to the outlook: The Reserve Bank of New Zealand, or RBNZ, is facing the same challenge as many other central banks overseas, and there is a strong consensus expecting a series of interest-rate rises as it pulls back from the previously ultra-stimulatory era of near-zero interest rates. At the moment, the futures market pricing is consistent with the RBNZ raising the official cash rate, or OCR, from its current 0.75% to 2.25% by the end of this year, with some further modest increases likely into 2023.
For the year to date, the S&P New Zealand Aggregate Bond Index has lost 1.6%, and market conditions are likely to remain challenging as bond yields rise further in the current inflationary environment. The only good news is that the bulk of the move may have already taken place and the pace of losses may ease back. The BNZ and Westpac, for example, expect the 10-year yield to move only modestly higher, to around the 3% mark, by the end of this year.
Heightened geopolitical tension around Ukraine, and the global weakness of equity markets, have meant that investors have been in a nervous mood, and once again the kiwi dollar has shown that it tends to fare badly in a ‘risk off’ environment where investors are minded to hunker down at home and run less foreign-exchange risk. The forecasters at the big banks typically expect the current weakness to reverse during the rest of this year, with (for example) the ANZ Bank picking the kiwi to get back up to U.S. 70 cents, and the prospect of higher local interest rates and strong commodity prices (reaching a new all-time high on the ANZ’s index in January) could help get it there. But any recovery remains conditional on a return to stronger levels of investor confidence.
New Zealand Property — Review
Against the background of the wider New Zealand equity market performing poorly, listed property also took a hit, and for the year to date the S&P / NZX All Real Estate Index has recorded a capital loss of 5.9%. It fared better than the wider share market’s 8.4% decline.
New Zealand Property — Outlook
Colliers’ latest (February) research report acknowledges that property faces some issues, notably higher interest rates and tight credit availability, but argues that nonetheless, “There are a number of significant factors that continue to underpin both occupier and investor demand for commercial and industrial property. While interest rates are rising, they are doing so from historic lows and remain below long-term average levels”; it is also true that interest-rate rises in New Zealand have been more obviously on the horizon than in, say, Australia or the U.S. and are likely already allowed for in current REIT prices.
Colliers also points to a likely gross domestic product rebound, a strong labour market, high vaccination levels, and progressively easing public health restrictions, although these supportive factors will have to take a back seat for the time being, as the omicron case load looks likely to continue to rise rapidly along the lines already experienced in Australia. Overall, the immediate operating outlook is mixed: Industrial is very strong – a recent CBRE research report found that the vacancy rate in the key Auckland market is only 0.5% – but retail and office will be pressured while omicron runs its course. There is the prospect of better conditions later this year, but in the interim the main attraction of the sector is likely to be as a defensive option in wider share market volatility.
Australian & International Property — Review
Although not quite in the league of IT or healthcare stocks, both of which have had large double-digit declines, the A-REITs have been one of the larger sectoral losers for the year to date, and the S&P / ASX200 A-REITs Index has made a capital loss of 9.6%.
Overseas REITs have also been weak, and the FTSE EPRA/NAREIT Global Index in U.S. dollars is down by 6.8%, a shade worse than the 5.5% decline in the MSCI World index. The U.S. market was especially weak, with a 9.6% loss: Ex the U.S., the asset class was down by a relatively modest 2.9%.
Australian & International Property — Outlook
The prime driver of the A-REITs’ weakness looks to have been a change in investors’ expectations about monetary policy. As Morningstar commentary (Feb. 18) said, “The sector was caught up in January’s global sell-off as investors repriced assets in expectation of faster than expected rate hikes in the US and Australia. Higher rates hit REIT earnings by increasing debt payments in the highly leveraged sector. They also squeeze valuations by decreasing the value of future earnings, a similar dynamic seen in January’s technology sell-off”. Another contributory factor has been the sheer scale of omicron cases. This has raised issues about immediate performance – according to property management software company Re-Leased, national rent collection in December was only 81% for retail property, 84% for industrial, and 86% for offices and likely has weakened further since – as well as rekindling longer-term concerns over the future of the office and of brick-and-mortar retail. The long-term structural issues will not go away, but with the reassessment of interest rates out of the way, and as a post-omicron recovery comes closer, the A-REITs may look a better prospect as a defensive option.
Internationally, market sentiment appears to be improving. The latest (December ’21 quarter) survey of global commercial property run by the Royal Institution of Chartered Surveyors, or RICS, showed that investment demand had picked up during the quarter and expectations about capital returns have improved, albeit with a pronounced sectoral tiering. Prime industrial and data centres are very much in favour – “A constant theme in much of the anecdotal feedback does appear to be the failure of the supply of new logistics facilities to keep pace with growing demand” – and multifamily residential and aged-care facilities are also expected to do well, but the outlook for secondary offices and secondary retail remains depressed, with expectations of further capital losses. For the right sectors, the outlook is reasonably good, but the asset class remains vulnerable to further interest-rate surprises, particularly in the U.S. where there is a real risk that the Fed’s scale of tightening may spring another revaluation reassessment. It does not help that only 10% of the RICS respondents believe that property in their market could be described as cheaply valued.
Global Infrastructure — Review
Global listed infrastructure has been relatively resilient against the recent background of equity weakness, and for the year to date, the S&P Global Infrastructure Index in U.S. dollars has delivered a marginal 0.6% capital loss and a net return loss (including taxed dividends) of 0.3%. Hedged back into kiwi dollars, the sector is marginally in the black for the year with a 0.2% hedged net return.
Global Infrastructure — Outlook
The asset class has experienced a mix of operating conditions at a subsectoral level. Omicron has meant that patronage-dependent assets like toll roads and airports have struggled, and even as omicron wanes, it could be some time before they see a recovery. Auckland Airport, as one example, will see the borders fully open by October, but the residual requirement of one week’s isolation means that tourists will still be unlikely to come. Marine ports are also struggling with ongoing supply chain blockages. But other sectors are doing well, particularly anything to do with data transmission or storage, and this year’s equity market volatility has seen increased demand for defensive subsectors such as water and electricity utilities. This mix of cyclical and defensive patterns is likely to have ongoing appeal, especially as bonds remain deeply unattractive as an alternative defensive option. It helps that there are large pots of private equity money sitting on the sidelines and interested in listed infrastructure. The upside can be immediate large cash payouts (Sydney Airport went to AUD8.70 from AUD5.80), but the downside is a progressively shrinking investment universe for listed infrastructure: Sydney Airport delisted on Feb. 9.
Australasian Equities — Review
New Zealand shares have had a rocky start to 2022, and for the year to date, the S&P / NZX50 Index is down 8.4%. As in 2021, there has been a contributory element of company-specific price weakness at some of the biggest-cap stocks: The top 10 index is down 9.1% due to large setbacks for Ryman Healthcare (down 24.2%), Fisher & Paykel Healthcare (down 13.9%) and Mainfreight (down 12.5%). But the weakness has otherwise been more general: The mid-caps are down by 7.8%, and the formerly resilient small caps, which had gained 15.2% last year, also joined the retreat, with a 7.1% loss.
Australian shares have also weakened but relatively modestly by global standards, and the S&P / ASX200 Index is down by 3.2%. The sectoral patterns have mirrored those overseas, notably the sharp sell-off of tech stocks, with the local IT index down by 18.6%, and the strength of commodity producers, with the local miners up 6.5%. The banks have also held up in a difficult market, and the financials ex the A-REITs are narrowly up for the year, by 0.6%. Consumer-oriented stocks have weakened, with consumer staples down by 8.7% and consumer discretionary by 6.0%.
Australasian Equities — Outlook
The operating outlook for New Zealand corporates is trickier to call than usual: As the ANZ Bank said in its latest (February) economic outlook, “practically all key economic drivers we pay attention to are either navigating a turning point, or are expected to transition through one or more turning points over the next few years”. On the plus side, there are remarkably strong export commodity prices, which have included a record expected payout to farmers from Fonterra, and a tight labour market, which supports consumer spending. This year’s budget may also provide some helpful fiscal stimulus. On the negative side, however, there are ongoing supply disruptions; intense input cost pressures; worse levels of disruption ahead as omicron inevitably spreads (at time of writing, the case numbers were rising sharply), particularly if customers elect to hunker down even if formal restrictions allow them to go out; monetary policy is becoming tighter; there is a notable credit squeeze (very evident in ANZ’s December business survey); house prices have started to ease back; and some sectors are still in poor shape as a result of ongoing border controls.
On balance, the negatives look to be the stronger side, and the first business surveys of this year suggest they are taking a toll. The BNZ – Business NZ Performance of Services index for January showed that the services sector “slipped a big cog in January, to 45.9 … the long-term average of the PSI is 53.6, which is starting to feel some distance away. So much for the new traffic light system releasing the brakes on activity”. The forward-looking components were especially weak: New orders “tanked to 41.8, when its trend is 57.5. That’s a bad look around bookings”. While it is easy to get overfixated on omicron while in the thick of it, there is no immediately obvious catalyst for greater equity market confidence, and a transition into more-normal conditions still looks some way off.
There are also strong crosscurrents in Australia. Omicron is clearly having a major near-term impact: The IHS Markit indicator of overall economic activity in January showed that “Both manufacturing and service sectors output declined in January amid the surge in COVID-19 infections”. The most recent (December ’21) NAB business survey also found that “Business confidence fell sharply in December as the spread of the Omicron variant threatened to dampen the economy’s post-lockdown momentum”.
But better business conditions look to be coming into view. Commenting on the surprisingly strong jobs report for January – 12,900 more jobs, and unemployment steady at 4.2%, all in the middle of the omicron outbreak – CommSec said that “with the economy rebounding, confidence returning and disruptions to the labour market abating as Omicron cases peak, Commonwealth Bank (CBA) Group economists expect wages and inflation growth to accelerate further in the coming months”. A similar conclusion emerged from the latest (January) Westpac / Melbourne Institute leading indicator, which signalled that “the growth outlook has improved with above trend growth over the next three to nine months likely.
While Westpac expects that the contraction in spending in January due to the omicron variant will see zero growth in GDP in the March quarter, the economy is likely to bounce back strongly over the remainder of 2022, registering a solid 5.5% growth rate for the year overall”. Equity markets may start to feel more comfortable about the outlook, with the provisos that the RBA may yet be prodded into earlier interest-rate hikes than the market currently expects and that geopolitics may still override any domestic upturn.
International Fixed Interest — Review
Conditions remain difficult for bonds. Yields have risen in all the major developed economies: The yield on the key 10-year Treasury note in the U.S. has risen to just over 2.0%, a 0.5% increase since the start of the year, and there have been similarly sized increases in the eurozone and the U.K. As a result, the Bloomberg Global Aggregate Index in U.S. dollars is down 3.5% for the year to date, with government bonds down 3.2%, and corporate bonds down 5.0%. Popular options aimed at boosting yield – low credit-quality, high-yield bonds, and emerging-markets debt – have also disappointed, with the Global High Yield Index down 4.0% and the Emerging Markets Index down 4.2%.
International Fixed Interest — Outlook
The rises in bond yields reflect both ongoing high rates of inflation and a strong expectation that major central banks will tighten monetary policy to combat it, including through jettisoning previous programmes of ‘quantitative easing’ that had been keeping bond yields unusually low.
The epicentre of the inflation problem is the U.S. In January, consumer prices rose by 7.5% on a year earlier, and even after stripping out some of the more volatile items such as food and energy, the residual ‘core’ inflation rate was 6.0%, the highest in almost 40 years. Producer price inflation – which tends to be an advance signal of future consumer price inflation – ran at an even higher 9.7% annual rate in January.
There is still no clear way of telling how much of the current price pressures in the U.S. and elsewhere is transitory (for example, caused by supply shortages due to the coronavirus or temporarily high oil prices) and how much is permanent. But inflation is now way beyond what the major central banks are prepared to tolerate, and in any event central banks need to push back even against temporary inflation in case people start building it into their longer-term expectations and setting off a cycle of faster wage inflation.
The latest futures market pricing in the U.S., going by the Chicago Mercantile Exchange’s FedWatch tool, now shows that the market is 100% certain that the Fed will start raising rates at its next meeting, which is on March 16. The only issue is whether the Fed will raise its target range for the federal-funds rate, currently zero to 0.25%, by the conventional 0.25% (63% probability) or move more aggressively with a 0.5% hike (37% probability). A month ago, the market expected a cumulative 1% of tightening during this year; now its best guess is 1.25% (31% probability), and it could be more (there is a 28% chance of 1.5%).
Other central banks face similar issues. In the U.K., for example, the latest inflation rate is 5.5% and the Bank of England thinks it will reach 7.5% in April; unsurprisingly, the bank raised its key ‘bank rate’ by 0.25% to 0.5% on Feb. 3 (in a tight 5:4 decision, with the minority favouring a 0.5% hike). The futures market thinks it will be 1.0% by May and 1.5% by the end of this year. In the eurozone, inflation was 5.1% in January, and although the European Central Bank’s official line is that interest-rate hikes are not planned this year, the futures market is doubtful and is more inclined to see some modest increase in the bank’s still policy rate of negative 0.5%, which would take it to negative 0.1% by the end of the year. Ongoing inflation above the central banks’ comfort zones, and actual and prospective interest-rate hikes, make the outlook for bonds challenging.
International Equities — Review
World shares continue to have a hard time. Although there has been some recovery from its recent low point on Jan. 26, the MSCI World Index of developed markets in U.S. dollars is down by 5.5% for the year to date. The U.S. market has continued to have a strong impact. In 2021, it led global shares up, and in 2022 it has led them down, with the S&P 500 down 6.2% and the Nasdaq down 9.6%. Ex the U.S., the MSCI World is still down but by a smaller 3.2%. Japan (Nikkei down 6.6% in yen) and Europe as a whole (FTSE Eurofirst 300 down 3.3% in euros) have been weak, while the U.K. is a rare example of a major market ahead for the year, with the FTSE 100 up 3.0% in sterling terms.
Emerging markets have been relatively unscathed, and year to date the MSCI Emerging Markets index in U.S. dollars is down by a marginal 0.2%, as is its core ‘BRIC’ (Brazil, Russia, India, China) component. All of the performance is down to Brazil: The MSCI Brazil index is up by 18.7% in dollars on the back of strong investor interest in Brazilian commodity producers, and it has offset modest declines in the other BRIC members.
International Equities — Outlook
World equities are struggling with, if not the perfect storm, certainly a strong gale of headwinds: the disruptive effects of omicron, the potential impact of higher interest rates on corporate profitability and equity valuations at a time when valuations were on the expensive side to start with, the risk that input cost inflation will erode profit margins for some companies or sectors, and the ongoing geopolitical uncertainty over a potential invasion of Ukraine after an extended period where geopolitical risks had been quiescent.
The immediate effect of omicron can be seen in the January readings from the J.P. Morgan Global Composite Index of economic activity: The world economy is still growing and has now managed 19 months in a row of recovery from the initial COVID-19 blow, but the rate of growth has dropped significantly to the slowest in 18 months due to, as J.P. Morgan said, “significant virus deterioration”.
But omicron, even if it is front and centre of the news stream now, may be leading investors to take an unduly pessimistic view of the underlying economic backdrop for shares. Hopefully, the employees off sick, and the other disruptions and restrictions that omicron is currently causing, will ease as the year goes on. The latest forecast from the big multilateral institutions, January’s World Economic Outlook from the IMF, is still picking that, despite the latest pandemic setbacks, 2022 and 2023 will be solid years for the world economy, with GDP growth expected to be 4.4% this year and 3.8% in 2023.
The latest (January) survey of institutional investors run by Bank of America Merrill Lynch, or BAML, showed that the professionals are still of the view that the world economy will be supportive for equities. Respondents are “showing faith in the global reopening story”, as Bank of America summarised it. They have moved even more overweight to equities and see a very low risk of a global recession in the coming 12 months. Within this overall optimistic view, there have, however, been pronounced sectoral shifts: The global reopening trade has encouraged the big fund managers to increase their allocations to more cyclical sectors like the banks and sharply away from growth sectors like tech, and they are riding the current inflationary pressures with a big bet on commodities, which are now at an all-time high level of tactical allocation.
Even with this underlying backdrop of growth, however, risk remains high. The IMF said that “Risks to the global baseline are tilted to the downside. The emergence of new COVID-19 variants could prolong the pandemic and induce renewed economic disruptions. Moreover, supply chain disruptions, energy price volatility, and localized wage pressures mean uncertainty around inflation and policy paths is high. As advanced economies lift policy rates, risks to financial stability and emerging market and developing economies’ capital flows, currencies, and fiscal positions—especially with debt levels having increased significantly in the past two years—may emerge. Other global risks may crystallize as geopolitical tensions remain high and the ongoing climate emergency means that the probability of major natural disasters remains elevated”.
In the immediate future, the two that look to have the greatest potential for ongoing weakness or volatility are interest rates and Ukraine. The BAML survey respondents expected three rate rises from the Fed this year. That looks on the low side, and there may be ongoing questioning of equity valuations if rates rise more than currently expected. And the Ukraine outlook remains unknowable: At the time of writing, there were conflicting stories about whether Russia had or had not reduced the number of troops near the Ukraine border. It continues to have the potential to produce an unpleasant shock.
Performance periods unless otherwise stated generally refer to periods ended Tuesday, Feb. 15, 2022.
See the Full MorningStar Economic update here.
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