Morningstar Economic Update April 2022
Outlook for Investment Markets
The global economic outlook has become more difficult. Inflation has proved to be a bigger problem than expected, and financial markets are now more concerned that central banks, in their efforts to bring inflation down, may raise interest rates to the point where they choke off the post-coronavirus cyclical recovery of the global economy (excluding China, where lockdowns have been slowing its economy). Geopolitical risk also remains elevated: Ukraine’s doughty defence was good news, but more recently Russia has upped its offensive in eastern Ukraine, and the ultimate political, economic, and financial outcomes are still very unclear. In the meantime, the war-related disruptions to commodity and energy markets have furthered boosted short-term inflationary pressures and added to the residual supply chain issues caused by the pandemic. Both bonds (wary of higher interest rates) and equities (wary of a weakening economic cycle) are down for the year, and the near-term outlook is unlikely to support any quick turnaround. In an environment of higher than usual uncertainty, prudent portfolio diversification remains key, including exposure to more-defensive sectors and inflation hedges.
New Zealand Cash and Fixed Interest — Review
Short-term interest rates have continued to rise, reflecting another monetary policy tightening by the Reserve Bank of New Zealand: It increased the official cash rate by 0.5% to 1.5% at its monetary policy review on April 13. The 90-day bank bill yield is now just shy of 1.8%, up by 0.8% for the year to date. Long-term interest rates have also risen further, and the 10-year government bond yield is just below 3.5%, up 1.1% this year.
The kiwi dollar is up slightly, by 0.5%, in overall trade-weighted value and is essentially unchanged on its headline rate against the U.S. dollar, at 68.2 U.S. cents.
New Zealand Cash and Fixed Interest — Outlook
The only uncertainty at the RBNZ’s latest policy meeting was whether it would hike by 0.25% or by 0.5%: In the event it went large, and is likely to continue to do so, saying that “it is appropriate to continue to tighten monetary conditions at pace”. The bank has little option: The March quarter inflation rate was 6.9% and may rise further. Both ANZ and BNZ see the OCR at 3.0% by the end of this year.
The bulk of the rise in bond yields, however, may be behind us: ASB and BNZ, for example, expect the 10-year yield to still be around current levels at the end of this year, and Westpac actually expects a modest decline, to 3.2%. That would potentially be good news for bond investors, who have suffered a 4.3% loss year to date (going by the S&P New Zealand Aggregate Bond Index). Given the recent unexpectedly strong surge in inflation, however, it may be on the optimistic side to expect bond yields to have already done their dash, and ANZ may yet be right with its view that the 10-year yield will hit 4.0% by the middle of next year.
The big banks currently expect some appreciation of the kiwi dollar to anywhere between 70 cents (ANZ) and 75 cents (ASB) by the end of this year. If they prove to be right, the likely drivers will be a reasonably rapid schedule of OCR hikes from the RBNZ, and record New Zealand commodity prices (which hit a new high in March on the ANZ’s index). But not all the moving parts are aligned: The Fed is on its own significant tightening path, the ongoing war in Ukraine is not helpful for currencies like the kiwi that tend to do better in less unsettled times, and countries like New Zealand will be affected by the current slowdown in the Chinese economy. The latest (March) consensus forecasts collected by the NZ Institute of Economic Research, which suggest a stable kiwi dollar in overall value terms over the next two years, may prove nearer the mark.
New Zealand Property — Review
The S&P/NZX All Real Estate Index this year to date has weakened, much in line with the wider share market: The sector is down 8.8% in capital value and by 8.0% including dividends, marginally outperforming the overall market’s 9.5% capital loss and 8.8% loss including dividends.
New Zealand Property — Outlook
Operating conditions continue to be mixed by subsector. Industrial remains very strong, with Colliers’ April research report pointing to “high occupier and investor demand and low building and land supply”. Offices have been buffeted by working from home, though Colliers, pointing to data such as prime office vacancy starting to fall in Auckland, believe that “the worst of the vacancy rate hike is likely over and therefore 2022 will become a pivotal year of change”. Retail is very mixed: “strip of shops” retail in the Auckland CBD, for example, has been absolutely hammered by COVID-19, where “Over the December 2019 to December 2021 period, vacancy within the Auckland CBD, where the reduction in foot traffic has been exacerbated by work from home guidance, has increased from just 1.4% to 14.4%”. Prospects look better, however, for the likes of supermarkets, bulk retail, and “destination” malls.
The sector has some attraction from a valuation perspective: REIT prices are now trading at a small discount to the book value of their assets. And the inflation hedging protection from rental reviews also has some appeal. But the yield (4.15% on Standard & Poor’s estimate) is not compelling given the strong rise in local bond yields and the potential for further rises. With a mixed bag of valuation indicators, and a mixed operating outlook, there is no clear investment case for the sector, and ongoing performance in line with the wider market looks the most likely scenario for now.
Australian & International Property — Review
The A-REITs have been one of the weaker ASX sectors this year to date. The S&P/ASX200 A-REITs Index is down by 9.0% in capital value and by 8.4% including dividends, well adrift of the wider sharemarket’s 1.1% capital gain and 2.6% total return.
Overseas REITs have broadly tracked the wider global share market, picking up in March after the late February selloff on news of the Ukraine invasion, but drifting down again in April. This year to date, the FTSE EPRA/NAREIT Global Index in U.S. dollars including dividends returned a loss of 4.3%, outperforming the 8.0% loss for the MSCI World Index.
Australian & International Property — Outlook
The latest (March quarter) ANZ—Property Council of Australia survey showed strongly positive overall industry sentiment as the immediate impact of COVID-19 wanes, though with the now familiar pattern of divergent subsector trends. ANZ said that “Industrial property sentiment continues to power ahead, with the strong construction outlook backed up by the sharp lift in building approvals over the last few years. The opening of international borders has buoyed tourism sentiment, lifting it to its highest level since 2018. While retail and office property sentiment remain in positive territory, they face headwinds, particularly office property, where sentiment declined in the March survey. Uncertainty over the medium-term demand for office space is likely to continue, as firms gradually embed more permanent arrangements around work-from-home and work-from-office”.
The big issue, however, is the turnaround in the Reserve Bank of Australia’s likely monetary policy stance, from originally planning to defer interest-rate increases until 2023, to its likely starting to hike interest rates from the middle of this year. This will feed through to higher cap rates (the rates used to value property), and will also affect the relative attractiveness of the A-REITs relative to bonds: There is already not much of a margin between the yield on the A-REITs (3.8% according to Standard & Poor’s) and the 3.1% available on a 10-year Commonwealth bond. The sector could well remain weak until investors are more comfortable that interest rates are nearer their peak.
Global REITs at one point looked like being one of the preferred defensive strategies in this year’s unsettled financial markets. IHS Markit’s March survey of U.S. institutional investors, for example, had found that real estate was one of the sectors that fund managers were overweighting. Its April survey, however, showed a more downbeat picture, with managers now moving to underweight. The biggest moving part has been increased concerns about the scale of central bank monetary policy tightening as inflation outcomes have proved to be worse than expected, with assists from increased geopolitical uncertainty and a more uncertain global macroeconomic outlook.
Similar issues were identified in CBRE’s latest poll of U.S. real estate investment intentions. Property investors’ biggest headwind was poor value, from property prices having been bid up aggressively during the period of effectively zero interest rates, but their next three big risks mirrored the HIS Markit results: higher than expected inflation, an uncertain economic environment, and earlier than expected higher interest rates (the survey was taken before the Ukraine invasion, and geopolitics has likely increased as a factor since then). While still generally positive about the asset class, investors were winding back the returns they expected to receive. Overall, global REITs look likely to remain out of favour in coming months.
Global Infrastructure — Review
Global listed infrastructure has done well this year to date. The S&P Global Infrastructure Index in U.S. dollars has made a capital gain of 7.6%, and delivered a net return (including taxed dividends) of 8.1%. Hedging the net return into New Zealand dollars boosted the return to 9.8% in kiwi dollar terms.
Global Infrastructure — Outlook
Infrastructure has ticked several boxes for investors in this year’s troubled markets. Some subsectors have benefited from the boom in energy prices: The FTSE Global Index of oil equipment and oil services, for example, is up by 28.9% in U.S. dollars. Very defensive subsectors have been in demand as fears about future economic activity have grown. The FTSE Global Index of electricity companies is up by 2.4%, and utilities are up by 1.8%. Telcos have done well, both as a cyclically defensive option and as part of a wider theme of building out stronger digital infrastructure: The FTSE Global Index of telecommunication is 4.0% ahead for the year. Another popular theme has been decarbonisation and renewable energy, which has been given an extra nudge as Europe realises the risks of being dependent on Russian oil and gas, though so far it has not put money in its backers’ pockets. The FTSE Global Index of alternative energy companies is down by 6.1% for the year to date, which looks anomalous in a world where oil trades at over USD 100 per barrel (currently USD 107.60). And there has been a weight of private equity money on the sidelines, looking to be deployed into the asset class. The latest example was the bidding war by two private consortia for listed Australian telco Uniti. Valuation is getting expensive—the yield on the S&P Global Infrastructure companies is only 3.2%, only slightly ahead of the 2.9% now available on a 10-year U.S. Treasury bond—but investors may well be prepared to continue to pay up for the defensive attributes of the asset class while the economic and geopolitical outlook remains unsettled.
Australasian Equities — Review
It has been a generally tough year for equities globally, and New Zealand has been no exception. The S&P/NZX 50 Index is down 9.5% in capital value for the year to date, and has returned an overall loss including dividends of 8.8%. Losses have been marketwide, with the top 10 down 10.1%, the mid-caps down 9.2% and the small caps down 10.0%. Among the big names, only Spark (up 8.0%) and Infratil (up 2.6%) are ahead for the year, while there have been big losses for Fisher & Paykel Healthcare (down 30.4%) and Ryman Healthcare (down 23.0%).
Australian shares have bucked the global bear market and are modestly ahead for the year. The S&P/ASX 200 Index has made a small capital gain of 1.1% and delivered a total return including dividends of 2.6%. The booming resources sector has been an important contributor: The S&P/ASX 300 Index of metals and mining is up 17.4%, and the heavy weighting in the benchmark index of the banks has also helped, as the financials ex the A-REITs are up by 4.0%. At the weaker end, the IT sector is down 17.5% and consumer discretionary stocks are down 14.5%.
Australasian Equities — Outlook
At its latest monetary policy decision, the RBNZ took a reasonably upbeat view of the economy: “Underlying strength remains in the economy, supported by sound balance sheets, continued fiscal support, and strong export earnings. There has been some economic disruption due to the outbreak of Omicron. However, the high vaccination rates across New Zealand are assisting to reduce this disruption”. It is certainly true that the latest (March) BNZ/BusinessNZ surveys of activity in manufacturing and services showed both sectors growing, while the prospect of further fiscal support at the May 19 Budget and the boost to incomes from record commodity prices are indeed valuable.
But other surveys show a more questionable outlook. The ANZ’s March business survey was weak. Although a tad better than February’s reading, its showed that businesses are ho-hum about the outlook for their own levels of activity (they were marginally negative in February, marginally positive in March) and are pessimistic about the outlook for their profitability, given strong pressure on input costs.
Similar issues surfaced in the NZ Institute of Economic Research’s March quarter business survey. Respondents were somewhat more negative about activity than the ANZ’s were—“A net 33 percent of businesses surveyed expect a weakening in general economic conditions over the coming months on a seasonally adjusted basis, while a net 9 percent of businesses reported weaker activity in their own business in the March quarter”—and shared the same view about a challenging profit outlook: “A net 34 percent of firms report reduced profitability in the March quarter, while a third expect weaker profitability in the next quarter”. This is not an environment that looks helpful for any immediate turnaround in the performance of local equities.
In Australia the central bank was also upbeat. At its April policy meeting the RBA said that “The Australian economy had been resilient in the face of global and domestic supply shocks, including the war in Ukraine, the Omicron outbreak and the floods along Australia's east coast. Policy settings remained supportive of the recovery and national income had been substantially boosted by the large increases in commodity prices; it was likely that the terms of trade would exceed previous highs. Overall, the growth outlook remained positive for this year and next”.
Business surveys tend to support this view. The Ai Group’s activity March indexes for manufacturing, services, and construction showed all three sectors growing (growth accelerated in construction and manufacturing, while services grew a bit more slowly). In addition, the March National Australia Bank business survey found that “Business conditions surged higher in March and confidence also strengthened. Trading conditions and profitability rose markedly, suggesting demand remains strong, and employment also rose”. The Westpac/Melbourne Institute leading indicator, which aims to get an early read on the activity outlook over the next three to six months, also strengthened in March, with Westpac commenting that the data “are consistent with Westpac's upbeat view of the growth momentum in the economy for most of 2022”.
If there is an issue on the horizon, it is around consumer spending. The recent weakness of consumer discretionary shares mirrors households’ wariness: Consumer confidence on both the Westpac/Melbourne Institute and ANZ/Roy Morgan indexes remains low, with families evidently feeling pressured by the prospect of higher interest rates and by the impact of inflation on their purchasing power. In the ANZ/Roy Morgan poll, for example, only 13% of respondents expected “good times” for the Australian economy over the next year compared with 28% expecting “bad times”. Sectors most exposed to consumer spending may consequently continue to underperform, but otherwise the stability of the banks and the ongoing commodity boom suggest that Australian equities may well be able to continue to outperform overseas counterparts.
International Fixed Interest — Review
Global bond yields have continued to grind higher, and bond investors are suffering substantial capital losses. This year to date, the Bloomberg Global Aggregate in U.S. dollars has returned an overall loss of 9.2%. The pain has been widely distributed across subsectors, with global government bonds down by 9.5%, global corporate bonds down by 7.9%, “high yield” (low credit quality) debt down by 7.8%, and emerging-markets debt down by 11.3%. Investors aiming for some reasonable level of yield by going out the long end of the yield curve have been especially badly hit. The rise in the 30-year U.S. Treasury yield from 1.9% at the start of the year to just shy of 3% now has meant that the Long Treasury Index has returned a year-to-date loss of 17.7%.
International Fixed Interest — Outlook
The bad news keeps coming on inflation. In March, consumer price inflation in the U.S. was 8.5%, the highest rate since December 1981, and even excluding the volatile food and energy components, “core” inflation came in at 6.5%, the fastest since August 1982. Across the OECD economies as a whole, inflation in February was 7.7%, the highest since December 1990, and “core” inflation was 5.5%.
The IMF, in its latest (April) World Economic Outlook forecasts, expects that inflation will peak this year in the advanced economies at 5.7%, and ease back to 2.5% in 2023 and to 1.9% in 2024. Even if this relatively benign outcome materialises, central banks will need to raise interest rates from the levels that were appropriate when inflation was low (it was only 0.7% across the developed economies in 2020). On the IMF’s forecasts it will be at or slightly above the 2% or so the big central banks are meant to target, meaning that interest rates ought to be at neutral rather than at their current still-stimulatory levels. And the risks to inflation are on the upside: The IMF said that “Conditions could significantly deteriorate. Worsening supply-demand imbalances—including those stemming from the war—and further increases in commodity prices could lead to persistently high inflation, rising inflation expectations, and stronger wage growth”.
At some point, the bond markets will start looking ahead to a world where inflation pressures from COVID-19 supply chain shocks, the Ukraine war, and capacity-constrained economies begin to abate, but that still looks some time away. In the interim both short- and longer-term yields look likely to continue to climb in the U.S., the eurozone, and the U.K., and the focus will remain on the extent to which central banks are likely to push rates higher. In the U.S., for example, the current target range for the fed-funds cash rate is 0.25% to 0.5%. The latest pricing from the futures market is that it will be over 2% higher by the end of this year (opinion is split between 2.5% to 2.75%, and 2.75% to 3.0%). Fixed interest continues to face headwinds.
International Equities — Review
World shares started to recover in March after the initial shock of the invasion of Ukraine, but have relapsed since the end of March. For the year to date, the MSCI World Index of developed economy share markets is now down by 8.6% in U.S. dollars. Only the U.K. is ahead, with the FTSE100 Index up 3.1% thanks to the London listings of some big beneficiaries of global inflation (notably oil and gas producers, up 30.4% year to date, and miners, up 30.2%). Elsewhere, in the U.S. the S&P 500 is down 7.9% and the Nasdaq down 14.8%, in Europe Germany’s DAX is down 10.8%, and France’s CAC down 7.9%, while in Japan the Nikkei is down 6.9% in yen terms, with the loss compounded by a depreciating yen (down 9.4% against the U.S. dollar for the year to date).
Emerging markets are down 10.2% in U.S. dollars. The only bright spot has been commodity beneficiary Brazil, where the Bovespa Index is up 32.1% and the MSCI Brazil up 30.2%. In U.S. dollars, Indian shares are down a little (MSCI India down 2.8%), and Chinese shares have been weak (MSCI China down 16.2%). Unsurprisingly, Russian shares have tumbled: The FTSE Russia is down 27.7% and the RTS Index is down 42.0%.
International Equities — Outlook
The global economy is still growing. The J.P. Morgan Global Composite Index in March came in at 52.7, where numbers greater than 50 indicate ongoing expansion. J.P. Morgan commented that the waning of Omicron has allowed activity to recover in much of the developed world, though its outbreak in China and the associated lockdowns has resulted in a sizeable setback to Chinese growth, while activity has also weakened very significantly in Russia.
But the outlook from here is becoming more challenging. The IMF in its World Economic Outlook forecasts now expects 2022 to be tougher going than it previously anticipated. The world economy should still grow by 3.6% this year, but that will be 0.8% slower than the IMF had expected back in January, and a full 1.3% slower than it had expected a year ago. And the 3.6% is by no means guaranteed: The IMF said that “The risks to the outlook are to the downside. Although a fast resolution of the war in Ukraine would lift confidence, ease pressure on commodity markets, and reduce supply bottlenecks, it is more likely that growth could slow further and inflation turn out higher than expected. Overall, risks are elevated and broadly comparable to the situation at the start of the [COVID-19] pandemic—an unprecedented combination of factors shapes the outlook, with individual elements interacting in ways that are inherently difficult to predict”. The IMF’s long list of things that could go wrong includes a worsening of the Ukraine war, increased social tensions (for example in response to more expensive food), a resurgence of COVID-19, a sharper slowdown in China, higher inflation expectations requiring a stronger monetary response, debt fragilities in the wake of higher interest rates, geopolitical tensions spreading, and climate change events.
Fund managers have also turned markedly downbeat. In the latest (April) Bank of America fund manager survey, the percentage of managers pessimistic about the global growth outlook has fallen to the lowest level ever recorded in the survey (which dates back to 1994), and is even lower than the depths of pessimistic sentiment recorded through the global financial crisis in 2006-08. Their top fear is now a global recession (mentioned by 26%), followed by the twin issues of hawkish central banks (25%) and inflation (21%). These macroeconomic issues have displaced the war itself (16%) and asset bubbles popping (7%), while COVID-19 is now seen as a distinctly secondary risk compared with everything else going on (1%).
The fund managers’ response to this outlook is to ride the current boom in commodity prices—they are at a record level of overweight allocation to commodities, and are also keen on energy and materials—while taking a distinctly defensive approach to the rest of their portfolios. They are heavily overweight cash and given the poor outlook for the asset class (as discussed in “International Fixed Interest”), they are heavily underweight bonds. And they are broadly positioned towards the sectors that might weather a recession better than others: Consumer staples, for example, are modestly overweight, while the more-cyclical consumer discretionary sector is underweight.
Performance periods, unless otherwise stated, generally refer to periods ended Monday April 18 2022.
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