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.
The current upswing looks likely to continue through 2022
2022 looks to be a year of ongoing recovery from the setbacks of the coronavirus
Morningstar Economic Update October 2021
Outlook for Investment Markets
World equity markets have been recovering from their September 2021 sell-off and are back close to their previous peak, as 2022 looks to be a year of ongoing recovery from the setbacks of the coronavirus. In New Zealand, while it is early days on the path toward removal of pandemic restrictions, business prospects also look good for the coming year. The key uncertainties ahead, other than any new mutation of the virus, are the rate of inflation (it is not clear how much of the current pricing pressures are permanent or transitory); the longer-term impacts of the pandemic (such as the eventual state of the office market); and the eventual removal of previously generous levels of fiscal and monetary policy support. Surveys of global fund managers show that they are adjusting their strategies to include more hedges against inflation and avoiding asset classes and sectors more exposed to higher interest rates.
New Zealand Cash and Fixed Interest — Review
Short-term interest rates have risen a bit further, and the 90-day bank bill yield is now 0.75%. Bond yields have risen significantly: At 2.35% the 10-year government bond yield is now up by nearly 1.4% year to date, having started the year just below 1.0%. The kiwi dollar has strengthened, particularly since Oct. 12. Since then, it is up by 2.6%, and year to date it is up by 1.1%.
New Zealand Cash and Fixed Interest — Outlook
Two factors explain the recent rise in rates. The Reserve Bank of New Zealand, or RBNZ, had signalled that it was likely to embark on a path of gradual rate increases, but the news on Oct. 18 that inflation in the year to September was a much higher-than-expected 4.9% meant that interest-rate hikes were likely to be earlier and larger than previously expected. The short-term inflation news might get even worse again. ANZ Bank, for example, thinks it will top out at 5.8% in March 2022. While there is still a chance that much of the inflation is transitory and reflects global supply chain shortages and a sharply higher oil price, both the RBNZ and the wider financial markets think it will continue to translate into higher interest rates. The futures market, for example, expects the 90-day bill yield to be around 1.5% in a year's time, ANZ is picking the official cash rate to reach 2.0% by August next year, and the BNZ thinks the 10-year bond yield will crack 3.0% in September next year. Depositors in the banks will be happier, but bondholders will have a tougher time. The S&P NZ Aggregate Bond Index is down 5.3% year to date, of which 1.7% occurred in October alone, and absent any strong evidence of a quick reversal of transitory inflation pressures, the prospect is for further capital losses.
The recent strength of the currency could well continue in the near term, given that the RBNZ is ahead of most other central banks in raising rates, and that its cumulative hikes over the next year look likely to maintain interest-rate differentials in favour of the kiwi even after other central banks also start to move. It also helps that global financial markets are in a more risk-friendly mood, as witnessed by the recent recovery in world equity markets: The kiwi tends to do better in more "risk on" times. Precise foreign-exchange forecasts are always precarious, but Westpac's sighting shot of USD 0.74 in a year's time, up from the current USD 0.71.6 cents, looks a plausible assessment.
New Zealand Property — Review
New Zealand listed property has struggled year to date. The S&P/NZX All Real Estate Index has made a small capital loss of 2.2% and delivered a minimal overall return including dividends of 0.2% (0.7% with imputation credits).
New Zealand Property — Outlook
Like the rest of the economy, property is having its issues during the current lockdown. The NZ Property Council, for example, calculates that its (typically large) commercial landlords have had to extend some NZD 650 million of rent relief since the first outbreak of COVID-19 in 2020. But unlike the wider equity market, which (with the exception of specific issues at a couple of the big caps) looks to be anticipating a better 2022, listed property is not currently showing signs of optimism. It may be that some COVID damage may be irreversible. A recent (October) survey by Retail NZ found that "more than a third of retailers are not sure if their businesses will survive the next 12 months." But the biggest driver appears to be bond yields, which have risen faster and further than anticipated in the wake of the surprisingly high September inflation outcome. Since the end of August, the 10-year bond yield has risen by 0.65%: over the same period the All Real Estate Index had dropped by 4.8%. The sector's 4% yield is clearly finding fewer takers, and further rises in bond yields likely mean continuing headwinds ahead.
Australian & International Property — Review
The A-REITs have done well year to date. A 12.4% capital gain and a 15.4% total return including dividends means that the S&P/ASX 200 A-REITs index has effectively matched the strong performance of the overall share market.
Overseas REITs have also delivered good results. Year to date, the FTSE EPRA/Nareit Global Index in U.S. dollars has logged a 15.5% capital gain and returned 18.7% including dividends, again broadly in line with the wider global share market. The outcome has been hugely influenced by the U.S. market, where prices rose by 32.1%; ex the United States, the index was up by 6.4%. The U.K. market (up 20.2%) also did well, but there were very modest outcomes around the Asia-Pacific region (up 2.0%) and in the eurozone (1.5%), while emerging markets were very weak (down by 9.3%).
Australian & International Property — Outlook
Operating conditions are turning for the better for commercial landlords. As one example, during lockdown, office owners in the big markets of Sydney and Melbourne had been under rental pressure and were having to pay higher levels of incentives (discounts off face rents) to attract or keep tenants. According to Knight Frank, net effective rents dropped 10.6% for prime Sydney CBD offices and 10.0% for secondary properties. Now, however, "as sentiment and demand look likely to improve on the back of the vaccination rollout, incentives will likely peak at year end and then decline slowly [that is, effective rents will rise]." Institutional investors of property have been active in anticipation of the improved conditions. According to Cushman & Wakefield, "Office volumes have continued to step up each quarter this year with activity rebounding ahead of the reopening of the Sydney and Melbourne." Early reports on foot traffic through the malls after "Freedom Days" are also encouraging for the retail subsector, while industrial property had remained very strong throughout COVID on e-commerce logistics demand. REITs oriented to housing development can also look forward to a busy year. While the eventual level of post-COVID office tenancy remains uncertain, in general the near-term business upswing will provide support for REIT performance. The major challenge will be the impact of any further rise in bond yields, which could threaten the investor appeal of the current 3.75% yield.
Globally, it is the same outlook, with improved operating conditions as the world economy continues to recover. Industrials will remain in strong demand; housing developers will continue to benefit from strong housing markets (the residential-oriented REITs in the U.S. are up 44.6% year to date); retail (at least in the earlier stage of recovery) will continue to benefit from the release of previously pent-up demand; and office occupancy will pick up from lockdown levels, though the jury is out on ultimate uptake levels as at least some companies are likely to move to a hybrid mixture of remote and in-office work. Likely rises in bond yields are the main challenge to the asset class. The yield on global REITs, according to Standard & Poor's, is 3.3%, and with the 10-year Treasury bond yield in the U.S. already at 1.65% and likely to rise further, income-oriented support for REITs will be under pressure. On the other hand, as shown in the latest (October) survey of global fund managers run by Bank of America Merrill Lynch, or BAML, the current surge in global inflation pressure is a strong plus, as property is seen as an effective inflation hedge. Fund managers' allocations are currently moving heavily into more inflation-proofed sectors, and in October, REITs were the third-most overweight sector relative to fund managers' historical patterns.
Global Infrastructure — Review
Global listed infrastructure has performed well as the world economy has continued to pull out of last year's COVID-19 setback. The S&P Global Infrastructure Index in U.S. dollars is up 9.5% and has returned 11.7%, including taxed dividends (13.2% hedged into New Zealand dollars).
Global Infrastructure — Outlook
With one major exception the ongoing global recovery is supportive for infrastructure. The subsector that is likely to miss out is utilities, which are always at risk in a period of rising interest rates: their (typically regulated) prices tend to adjust slower than bond yields. Year to date, they have been doing badly in New Zealand (S& /NZX All Utilities down 11.9%), in Australia (S&P/ASX 200 Utilities down 3.2%) and globally (the FTSE Global Utilities Index in U.S. dollars is marginally up 0.8% for the year but has very significantly underperformed the FTSE World Index gain of 15.4%). It is not surprising that the BAML survey found that fund managers are avoiding the sectors most exposed to interest-rate rises, and utilities are now one of the most underweight asset classes.
Other sectors, however, face clearly better prospects. As borders reopen, previously shuttered facilities like airports will come back on stream, while shipping and seaports will benefit both from increased volumes and their current pricing power in still constrained supply chains. The recent rise in oil prices has also been good news for energy infrastructure (the FTSE Oil Equipment and Services Index is up 37.2%). And in the background, there continues to be strong investor demand for Internet and data infrastructure and for renewable energy assets. The cyclical upswing should be the dominant driver, but, as with property, it may be tempered by rising bond yields, which will increasingly compete with infrastructure's 3.1% yield.
Australasian Equities — Review
Going by the benchmark S&P/NZX 50 Index, New Zealand equities have missed out on what has been a good year for many other equity markets. Year to date, the index is down 1.9% in capital value and barely in positive territory (up 0.2%) after adding on dividend income. The headline result, however, continues to reflect the heavy impact of large caps A2 Milk and Meridian, which have contributed to the S&P/NZX 10 Index losing 5.7%. Elsewhere, the market better reflects the recovery (at least before the latest lockdown) from the 2020 COVID setback. Mid-caps are up 3.9%, and small caps are up 12.0%.
Australian shares, on the other hand, have followed the wider global pattern and are well ahead for the year. The S&P/ASX 200 Index is up by 12.5% and has returned 16.1%, including dividends. The key contributions have come from two sectors: the banks, with financials ex A-REITs up 26.1%, and consumer discretionary shares, which have ridden the wave of pent-up consumer demand from the 2020 shutdowns and are up 20.8%. The miners have struggled, especially in the wake of a collapse in the price of iron ore, and are down by 4.2%.
Australasian Equities — Outlook
Surveys of current business conditions show that the current lockdowns are having a substantial effect on business activity. As one example, the September BNZ / Business NZ survey of the services sector (by far the biggest chunk of the economy) showed that it was going through a large contraction, with the accommodation, restaurant, retail, and entertainment trades in especially weak shape. There were some hopeful signs in the otherwise poor data: service firms' employment is holding up, reflecting in the BNZ's view that "firms expecting activity to bounce once restrictions are eased, fiscal support from government, and a reluctance to let staff go." The September quarterly survey from the NZ Institute of Economic Research found the same thing: "Firms are feeling more positive about increasing head count in the next quarter, particularly among retailers. This suggests that businesses are planning for a rebound in demand when alert level restrictions are relaxed."
The likelihood is that the economy will bounce back. The preliminary results from the ANZ Bank October business survey showed that businesses, already optimistic about their own likely activity, became a bit more positive again. Encouragingly, they also became more optimistic about their profitability, despite intense cost pressures. In the near term, the economic backdrop is likely to be positive for equity performance. The crunch point will come when existing levels of fiscal and monetary support progressively drop away through 2022, especially if the country is slow to move through the new "traffic light" process of progressive removal of domestic and borders restrictions.
The same patterns of an immediate hit from restrictions, but firms preparing for a recovery beyond lockdown, can be seen in Australia. The minutes of the latest RBA meeting, for example, noted that "some firms in New South Wales were preparing to step up hiring ahead of the easing of restrictions in October ... the central forecast scenario envisaged the level of employment, unemployment, and participation to have broadly recovered to pre-delta levels by around the end of the year."
NAB's latest (September) quarterly business survey acknowledged the immediate impact of COVID restrictions: "With lockdowns in place for most of Q3, it's unsurprising to see both business conditions and confidence take a fairly large hit for the quarter." But NAB also said that firms appeared to be better prepared (given their 2020 experience) this time around and that although business expectations for the immediate months ahead are still weak, businesses appear to be looking to better times next year: “Expectations for capital expenditure over the next 12 months remained healthy, as did expectations for employment over the longer horizon. These results support the view that the economy is well placed to rebound when lockdowns are lifted." As NAB noted, the survey was taken before the latest reopenings in New South Wales and Victoria, and the likelihood is that business conditions will have firmed further since. With the exception of those areas of the resources sector most exposed to potential slowdowns in Chinese demand, the economic environment should be conducive to further equity performance in coming months, though there will be some uncertainty later in 2022 once the current levels of COVID policy support start to be withdrawn.
International Fixed Interest — Review
International bonds have had a difficult year. While an early-year rise in bond yields had reversed by August, leaving bond yields only modestly higher than where they started the year and reducing the scale of capital losses, more recently bond yields have headed back up again and are close to revisiting their earlier peaks. In the U.S., for example, the 10-year Treasury yield started off at 0.9%, peaked at 1.75% at the end of March, was back down to under 1.2% in early August, but has more recently risen all the way back up to its present 1.65%. There were similar, if smaller, cycles in other major bond markets. The upshot is that bond investors have lost ground, with capital losses outweighing very modest running yields. Year to date, the Bloomberg Global Aggregate Index in U.S. dollars has lost 4.3%, with government bonds losing 6.1% and corporate bonds 2.1%.
International Fixed Interest — Outlook
The outlook for bonds remains difficult, with the prospect of further increases in yields. One reason is that as the world economy continues to recover out of its 2020 COVID-19 slump, there is progressively less and less need for central banks to maintain their previously ultra-easy supportive monetary policies. And the second is that the global economy is currently going through a period of strong price pressures. It is still not clear how much of these pricing pressures will be transitory, linked to temporary collisions between unusually strong post-COVID demand and unusually constrained supply chains, and how much might be longer lasting, but either way higher inflation is the proverbial enemy of the fixed-coupon bondholder.
The latest (October) quarterly The Wall Street Journal survey of U.S. forecasters makes the points clear. At the end of next year, if the median forecast pans out, the U.S. economy will have had a year when gross domestic product will have grown by 3.6%, unemployment will be down to 3.9%, but inflation will be running at 2.5%. No central bank pursuing a conventional monetary policy will leave monetary policy on an ultra-supportive setting when an economy is effectively at full employment and inflation is well within its target range. It will move to normalise policy. The Fed has already said it is limbering up to buy fewer bonds (meaning it is less inclined to keep bond yields down), and in the Journal survey the forecasters expect that it will move further and actually start increasing interest rates before the end of next year. By the end of 2022 the 10-year yield is expected to have reached 2.15%. For similar reasons the markets expect the Bank of England to start tightening, too, with the latest futures pricing suggesting the first move could be as early as this December.
The probability is that bondholders will be looking at a period of further capital losses, and that is certainly the view of the global fund managers polled in the October BAML survey. They see higher inflation as the biggest risk ahead, and while a majority (58%) are inclined to think it is mostly transitory, they are taking no chances in case it is indeed permanent. Their allocation to bonds in October (a net 80% said they were underweight) was the lowest allocation in the 20-year history of the survey.
International Equities — Review
World share markets have regained confidence after their September sell-off. Prices bottomed out in early October, and since then the MSCI World Index in U.S. dollars has risen by over 5% and is nearly back to its all-time peak in early September. Year to date, the index is up by 17.0%. Performance remains significantly dependent on the U.S. market, where the S&P 500 is up 20.8% and the Nasdaq is up 17.3%, but even outside the U.S., equities have done well, and the MSCI World ex USA Index is up 10.4%. European shares have been strong, and the FTSE Eurofirst 300 Index is up 18.5% (in euros). Japan continues to be the main drag on developed market performance, with the Nikkei up by 6.6% in yen but down 3.7% in U.S. dollars.
Emerging markets however had made little progress. The MSCI Emerging Markets Index is up by a scant 0.8% year to date, and its core BRIC constituents (Brazil, Russia, India, China) are down by 2.9%, mainly owing to weak Brazilian shares (the MSCI Brazil Index is down 17.8%). Russia has done very well, buoyed by the strong oil price, and the MSCI Russia Index is up 35.9%, and India is also well ahead (the MSCI India Index is up 28.5%). How China went very much depends on which index you prefer: The Shanghai Composite is up by 5.6% in U.S. dollars, but the MSCI China is down by 11.4%. Either way, it took a back seat to the larger moves in the other BRIC markets.
International Equities — Outlook
The recovery in equity prices reflects growing evidence that the global economy is continuing to emerge from its COVID-19 setbacks. The September J.P. Morgan Global Composite Global Activity Index showed an ongoing and broad expansion across most economies, and the same data at a sector level, as the IHS Market global sector indexes also showed a broad-based recovery, with 18 of the 21 sectors increasing output during the month. The only major exception was car production, which has been particularly badly affected by supply chain interruptions.
The latest updates from the big international institutions have also been encouraging. The OECD, for example, in its latest (September) update to its economic outlook, estimates that the world economy contracted by 3.4% in 2020 but will bounce back by 5.7% this year and follow up with another good year of 4.5% in 2022. One qualification is that they expect some emerging economies to lag, largely because they are less well placed to handle COVID-19 challenges: "There are marked differences in the pace of vaccinations and the scope for policy support across countries, particularly in many emerging-market and developing economies." This (going by year-to-date share market patterns) is the same conclusion that equity investors have come to.
In terms of risks, the OECD said that "the distribution of risks is now better balanced than a year ago, but significant uncertainty remains." On the plus side, faster vaccination rollouts could produce an even better year ahead, but in those buoyant conditions, central banks would need to keep markets calm: “Clear guidance by the monetary authorities that the additional inflation pressures were only temporary would help to anchor inflation expectations and limit financial market repricing." The major downside risk to this otherwise positive outlook is some further mutation of the virus: “In such circumstances, stricter containment measures might need to be used again, confidence and private sector spending would be weaker than in the baseline, and some capital would be scrapped. In such a scenario, output would remain weaker than the precrisis path for an extended period. World GDP growth could drop to under 3% in 2022."
The International Monetary Fund, in the forecast update for its annual meeting in October, also sees ongoing global growth and has very similar numbers in mind: a drop of 3.1% last year, followed by a 5.9% rebound this year and a further 4.9% in 2022. The IMF also agreed with the OECD that, while the baseline scenario is positive, uncertainty remains high: "The balance of risks suggests that growth outcomes—over both the near and medium term—are more likely to disappoint than to register positive surprises." It pointed to much the same menu as the OECD: the emergence of more transmissible and deadlier virus variants and, if inflation remains high (because of supply chain issues or otherwise), the risk of "a faster-than-anticipated monetary normalization in advanced economies." In current market conditions, that would not go down well: "Compressed volatility and elevated equity price valuations point to the possibility of rapid repricing of financial assets in the event of a reassessment of the outlook."
By and large, the global fund managers in the October BAML survey also buy the ongoing growth story: a net 50% remain overweight to global equities. But they also feel that the peak period of GDP and profit growth is behind us, and they are particularly keen to be well positioned if inflation remains high, which is by far the biggest risk on their horizon (the top choice for 48%). The survey found that allocations to inflation-linked assets such as commodities, energy, and banks were at historically very high levels. The other main risks they mentioned were the ramifications of a slowdown in China (the knock-on impact of Evergrande may also have been in that basket, picked by 23%), the existence of asset bubbles (9%), and the impact of any Fed taper (less support for bond yields, also 9%). Oddly, given the thinking of the likes of the OECD and the IMF, the risk of COVID mutating was way down the list (picked by only 3%). It would be nice if the fund managers proved right.
Performance periods unless otherwise stated generally refer to periods ended Oct. 20, 2021.
See the Full MorningStar Economic update here.
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The most likely scenario is that the world economy will recover as the delta variant fades.
Morningstar Economic Update September 2021
Outlook for Investment Markets
Global equity markets have eased back in September reflecting the global surge in the delta variant of COVID-19. The most likely scenario is that the world economy will recover as the delta variant fades, but fund managers are no longer sure we will see a 2022 repeat of the sharp V-shaped recovery of 2020-21 we experienced in the wake of the first COVID-19 outbreak. At home, the economy had been very strong prior to the reappearance of COVID-19, and business and consumer surveys suggest there is a good prospect of solid business conditions resuming on the other side of the current lockdowns although, as with overseas markets, the rebound may not be as vigorous as it was in 2020. Asset valuations will have to factor in the impact of a likely string of interest rate increases by the Reserve Bank.
New Zealand Cash and Fixed Interest — Review
Short-term interest rates have been steady, with the 90-day bank bill yield at just over 0.5%. Bond yields have headed higher: the 10-year government bond yield went over 1.9% on Sept. 8, and is currently 1.87%, up almost 0.9% for the year. The New Zealand dollar is stronger, particularly since mid-August: at USD 71.1 cents it is up almost 3 cents over the past month. Year to date it is now 0.4% up in overall trade-weighted value.
New Zealand Cash and Fixed Interest — Outlook
Faced with the latest COVID-19 outbreak, the Reserve Bank of New Zealand bailed out of a planned increase in the Official Cash Rate, or OCR, on Aug. 18, but the fact that bank bills are at 0.5% implies that a rate rise at its next Monetary Policy Statement on Nov. 24 looks like a foregone conclusion to the financial markets (it might even move at its less formal "review" on Oct. 6). Forecasters, and the futures market, expect further increases, with a cumulative increase of around 1% over the coming year.
A central bank intent on moving monetary policy away from its previous highly supportive setting means that bond yields are also likely to increase. The RBNZ has already stopped its bond buying programme, which had kept bond yields lower than otherwise, and a mixture of domestic policy tightening and higher U.S. bond yields looks likely to send bond yields higher: the latest (September) consensus forecasts from the New Zealand Institute of Economic Research, or NZIER, see the 10-year yield averaging 2.3% in the year to March 2023, compared with an expected 1.8% for the current year to March 2022. Investors in New Zealand bonds are unlikely to see much respite from ongoing losses: year to date the S&P New Zealand Aggregate Bond index has lost 3.3%.
The actuality of interest rates rising ahead of the likely RBNZ moves, and the prospect of further local rate rises ahead of any moves by overseas central banks, explains much of the recent NZ dollar strength. On top of a helpful move in interest rate differentials, investors may also be looking at New Zealand’s so far successful COVID-19 containment strategy. While it has its own costs, it contrasts with the concerns investors currently have about the economic impact of the delta variant running wild elsewhere. The NZIER consensus currently sees a small (0.4%) kiwi dollar appreciation for the year to March 2023, but that could well underestimate the current attraction of the kiwi dollar to international investors.
New Zealand Property — Review
The S&P/NZX All Real Estate Index has made a small capital gain of 1.8% year to date, and has returned 4.4% including dividends (4.8% with imputation credits). The sector is scheduled to gain a new name this month, with Stride Property spinning off its office property subsidiary into a new listed entity, Fabric.
New Zealand Property — Outlook
As with the wider equity market, the most plausible take on the outlook is that there will be a relatively quick recovery from the current lockdowns: Collier’s latest (September) research report reflects the consensus view: “The reimposition of lockdown conditions and the uncertainty regarding exactly how long restrictions will be maintained in Auckland will clearly disrupt activity. However, the benefit of experience gained over the last year will help to mitigate many of the potential negative expectations that appeared from the previous lockdown. This, along with the fact that restrictions are already being eased across a majority of the country, is likely to see the slowdown in market activity being less pronounced this time than it was in 2020.”
One factor that has changed since last time, however, is the interest rate outlook. As noted earlier, the Reserve Bank is highly likely to start out on a path of interest rate increases, possibly as soon as next month. That might not matter much if there was a generous cushion between yields on the New Zealand REITs and yields on government bonds: share analysts differ on how they do the calculation, but the bottom line is that the yield on the sector (3.7% according to Standard & Poor’s) at best provides a normal pickup over bonds, or arguably is a bit less than usual. Either way it is not a helpful starting point if (as is probable) bond yields rise from current levels. While operational results are likely to support the sector as the economy comes out of lockdown, progressively more unattractive interest rate differentials are likely to be a strong headwind.
Australian & International Property — Review
The A-REITs have done well, and have matched the strong performance of the overall sharemarket. The S&P/ASX 200 A-REITs index is up 13.3% in capital value and has returned 16.2% including dividends. The sector saw the IPO on Sept. 6 of a substantial new name, the Healthco Healthcare and Wellness REIT, with some AUD 550 million of healthcare assets. The launch went well, and at AUD 2.34, it is currently trading at a 17% premium to its listing price.
Global listed property has also performed well, and year to date the FTSE EPRA/NAREIT Global Index in U.S. dollars is up by 14.7% in capital value and has delivered a total return of 17.5% including dividends. The result has been heavily influenced by the very strong U.S. market, which has returned 27.8%, and to a lesser degree by the U.K. market, which has returned 23.6% (also in dollars). The Asia-Pacific region (3.9% return) and the eurozone (3.5%) have been subdued, while emerging markets went backwards with a loss of 8.3%.
Australian & International Property — Outlook
Australian property had been doing well before the latest COVID lockdowns albeit with strong subsectoral cross currents. According to the Property Council of Australia/MSCI Property index, for the year to June, physical property returned 7.8% (income yield of 5.0%, capital gain of 2.0%). Industrial property was streets ahead of the other sectors with a 23.2% return, with tight supply meeting strong investment appeal as the infrastructure supporting e-commerce. At the other end was retail, with a total return of only 2.5% and, as at June, 11 straight quarters of capital loss. Not all retail is equal, however, with neighbourhood shopping centres, the most defensive end of retail during 2020 lockdowns, returning 7.5%.
The latest lockdowns have done quite a bit of short-term damage. One example, the Property Council’s monthly tracking of office occupancy relative to pre-COVID-19 levels showed that in August the office towers were effectively empty in the biggest markets (Sydney at 4% of normal, Melbourne at 7%). Looking ahead, the consensus outlook is for a relatively quick rebound as vaccinations increase and lockdowns are rolled back, and the improved operating performance is likely to support the sector in the near term, and push the longer-term structural issues that COVID caused, or accelerated, into the background for the time being. It helps that the Reserve Bank of Australia is likely to hold interest rates where they are for an extended period, which means that the dividend yield on the sector (3.6% according to Standard & Poor’s) will continue to have appeal.
Overseas, there is not the same degree of confidence as there is in Australia and New Zealand that progress with vaccination will see a relatively quick return to business as usual for commercial landlords: the dangerous delta variant has been a significant and ongoing disruption. In the U.S., for example, the office occupancy rate in August in New York was only 22.3%, and in San Francisco was only 19.7%. The delta outbreak has intensified the “work from home” trend. As the chief economist for Moody’s Analytics said in an article in the Wall Street Journal, “The pandemic has ignited an exit of workers from urban areas. They’ve been empowered to work wherever they like. Over three-quarters of a million more people have left big cities than have moved to them since the pandemic hit ... Some white-collar workers will give up the work-from-anywhere lifestyle when office buildings welcome back workers in earnest, but for most it is here to stay.”
In these circumstances it is not surprising that office landlords in particular are finding it tough going. Knights Frank runs a quarterly global "dashboard" which shows where the bargaining power lies between landlords and tenants. The June quarter dashboard shows there is not currently a single market in the developed world where the landlord is in the driving seat, and in Knight Frank’s view, the outlook for landlords in 2022 will be little better. While global REITs may eventually get support from improving economies on the far side of the delta variant, and industrial property in particular is likely to remain in strong demand, there are structural changes to the world of work and of shopping that are likely to limit further advances.
Global Infrastructure — Review
Global infrastructure has made reasonable progress: year to date the S&P Global Infrastructure Index in U.S. dollars has delivered a capital gain of 6.0% and has returned 7.9% including taxed dividends (9.7% hedged back into New Zealand dollars).
Global Infrastructure — Outlook
Investor sentiment has been swinging around in the sector. At one point the “reopening” trade was in fashion as cyclically patronage-dependent sub-sectors looked likely to recover from lockdowns, but the more recent eruption of the delta variant has made more defensive assets such as utilities look a safer option. There have been some exceptions to the overall trend: patronage-dependent Sydney Airport, for example, has seen the value of a takeover bid by a private equity consortium increase from an initial AUD 8.25 a share to the latest AUD 8.75; and the equally cyclical shipping industry (ex oil tankers, which face different conditions) has been making record profits due to a surge in pent-up demand for space and a shortage of both ships and containers.
As with other risk assets, the outlook from here is very much in the hands of the global evolution of COVID-19. If the delta variant gradually fades away through vaccination or otherwise, then the reopening trade may well re-emerge. For some investors, the typical regulatory arrangement around utility pricing also has value in a world where inflation might move higher, as utility prices tend to be allowed to reflect rising input costs. And just as industrial property has been heavily in demand as the logistical underpinning of a surge in e-commerce, there is an equivalent hot market for all the infrastructure (such as cell towers and data warehouses) needed to support the roll-out of 5G communication. On one estimate, global mobile data use will quadruple over the next five years with half of it on 5G. One challenge though is the currently low level of yield: income-oriented investors have generally had some infrastructure allocation on their radar, but a yield of 2.9% is not compelling, and will become less so if, as seems probable, global bond yields head higher over the coming year.
Australasian Equities — Review
Overall, New Zealand shares continue to show a poor outcome year to date, with the benchmark S&P/NZX50 index down 1.6% in capital value and returning a barely positive 0.1% total return including dividends. The overall result conceals some widely divergent subsectors. The top 10 have posted a 6.1% loss, with large falls for A2 Milk and Meridian outweighing large gains for Mainfreight and Fletcher Building. The Mid-Caps have done a lot better, with a 5.4% gain, while the Small Caps are well ahead, and are up 10.7%.
Australian shares have done well year to date, and the S&P/ASX 200 is up 12.9% in capital value and has returned 16.4% including dividends. Two prime beneficiaries of the faster than expected recovery from the 2020 COVID-19 outbreak have led the way, with the financials (ex the A-REITs) up 23.5% and consumer discretionary stocks, boosted by the release of the spending power that had been pent-up during the pandemic, up 21.3%.
Australasian Equities — Outlook
New Zealand went into the latest lockdown in strong shape. GDP grew in the June quarter by a very strong 2.8%, much faster than the 1.4% growth recorded in the March quarter and way above forecasters’ expectations of growth somewhere in the 1% to 1.5% area. The number has its oddities (normal seasonal patterns may not have applied in the unusual circumstances of the bounceback from 2020’s lockdowns) but qualitatively it feels right, and certainly aligns with the business surveys at the time, which were reporting robust business conditions. The reporting season for the year to June 2021 had also gone well, though again results were flattered by comparison with weaker COVID-constrained earlier periods.
The latest lockdowns have complicated things, and unsurprisingly the NZIER consensus poll found “a wider than usual range of forecasts for the growth outlook.” For the year to next March, GDP forecasts range from a low of 3.4% to a high of 5.9%, and for the year afterwards the range is also wide, from a low of 2.4% to a high of 5.1%. The average forecast is for 4.5% growth in both years, which would be a very strong performance by New Zealand standards and would, for example, take unemployment down below 4% in 2023. The latest business opinion surveys also suggest that the latest lockdown will be only a temporary interruption; early results from the ANZ Bank’s September survey “saw most forward-looking activity indicators hold up well ... Overall, the preliminary ANZ Business Outlook results suggest that firms can see light at the end of the tunnel, even in Auckland.”
This would make for a supportive environment for equities, though with two qualifications. One is that investors, having overestimated the downside impact of the 2020 lockdowns, may make the opposite mistake this time round, and underestimate the latest one. There will be businesses that could survive one lockdown, but not two, and there are still large question marks around the future of businesses linked to international tourism and education, especially now that the downside of a premature relaxation of travel with Australia has become apparent. Another is that top-line turnover growth may do well, but bottom-line profitability may be harder to book, given strong input cost pressures. And the last is that shares are seriously expensive—Standard & Poor’s estimates the market is trading on a forward P/E multiple of 35.6 times expected earnings—and the potential economic upside may already be well factored into current prices.
In Australia, the June reporting season also went well, though again benefiting from comparison with the temporarily COVID-depressed conditions in 2020. As CommSec’s earnings wrap-up said, “aggregate profits were up almost 76 per cent on a year ago (earnings per share doubled) ... Corporate Australia recorded strong financial results over the past year – although the year has effectively been a "rebound year – a period of recovery from the lockdowns that dominated over June quarter of 2020.”
Looking ahead, CommSec are surely right to say, “The answer to all questions is COVID-19,” but subject to that (major) uncertainty, the early take on the post-lockdown outlook is looking reasonably promising. Despite the latest outbreak being worse than initially hoped, both households and businesses appear to be taking it in their stride.
The September consumer confidence survey from Westpac and the Melbourne Institute, for example, found “The resilience of consumer sentiment in a period when Australia’s two major cities have been locked down and the economy has been contracting is truly remarkable. The Index is still comfortably above the reads seen over the five years prior to the pandemic and is only 0.9% below its June print just prior to Sydney’s move into lock-down.” On the business front, National Australia Bank’s latest (August) survey found that “business conditions are still elevated – and rebounded in both NSW and SA in the month – and remain well above average in all states ... The resilience of the survey during the current episode likely reflects the healthy momentum in the economy before the lockdowns, ongoing fiscal and monetary support as well as greater certainty that the lockdowns will end as vaccines roll out.”
Forecasters are consequently largely looking through the current setbacks: Commonwealth Bank, for example, expects GDP growth this year of 3.1% this year and 3.8% in 2022, and National Australia Bank has a similar projection, of 3.8% and 3.9%. That would be helpful for corporate performance, though again with the proviso that forecasters may be relying too much on the latest lockdown being a replay of the better-than-feared 2020 experience.
Valuations may also come into play. Standard & Poor’s calculate that the forward-looking P-E ratio is 17.1 times expected earnings, and CommSec said that “While earnings over the past year have partly validated higher share prices, valuations are still high, with the [backward-looking] price-earnings ratio at 19.61.” In CommSec’s view, that puts some upside limit on where prices can go. They picked a 7,500–7,700 range for the S&P/ASX 200 index by mid-2022, which would be only a modest pick-up on its 7,347 at time of writing.
International Fixed Interest — Review
The environment of a strong bounce in economic activity out of the first round of COVID-19, bringing various inflationary pressures with it, has not been congenial for bonds. Yields remain higher than where they started the year, and running yields have been too low to offset the capital losses. Year to date in U.S. dollars the Bloomberg Barclays Global Aggregate Bond Index is down by 2.1%: government bonds have lost 3.4%, while higher yields have helped protect the overall return from corporate bonds, which are down by 0.5%.
International Fixed Interest — Outlook
The likelihood is that monetary policy will, very gradually, move away from the highly supportive settings that had been appropriate in the period leading up to COVID: inflation had been lower, and unemployment higher, than central banks would have liked, and the easy money policies needed to get both moving to target levels got a further lease of life when COVID hit in 2020 and economies needed further support again. Now, however, there has been a strong initial rebound from COVID, and both inflation and growth prospects have improved (albeit with a considerable overhang of uncertainty): extremely stimulatory monetary policy no longer looks necessary.
In the first instance this is likely to manifest as a wind-back of "quantitative easing" programmes of bond buying, which had been targeted at keeping bond yields very low. In the U.S., for example, comments from various Fed officials suggest the current USD 120 billion a month pace of bond buying could well start to be wound back by the end of this year. One plausible scenario is that the Fed will start the process at its Nov. 2-3 meeting, with a "heads up" advance signal at its next meeting on Sept. 21-22. Similarly the European Central Bank said after its latest (September) meeting that it would ease back from the EUR 80 billion a month of bonds it had been buying under its "pandemic emergency purchase programme."
Any move to move beyond slower rates of bond buying, and to raise interest rates, is still a long way away, however. In the U.S., for example, the futures market thinks that the Fed’s first rate increase will not occur before 2023, and in Europe the ECB reiterated that interest rates will remain where they are until the bank “sees inflation reaching two per cent well ahead of the end of its projection horizon and durably for the rest of the projection horizon.” On the bank’s own projections, updated this month, core (ex food, ex energy) inflation will be 1.4% in 2022 and 1.5% in 2023, meaning interest rate increases in the eurozone are still a dim and distant prospect. But even so peak monetary policy support looks to be behind us, and markets are likely to start anticipating rate rises even before central banks finally press the hike button.
Bond market optimists argue that the current surge of COVID-related inflation will largely or completely die away, and took some heart from the latest inflation numbers in the U.S. In August both headline and "core" inflation rates eased back a little from July (annual core inflation dropped to 4.0% from 4.3%, for example), and they expect inflation to keep on dropping, reducing the likelihood that central banks will move towards tightening. While COVID-19 might yet lead central banks to hold off, entirely transitory inflation looks a somewhat unlikely scenario. In any event, even if inflation in the U.S. were to drop back to its pre-COVID 2% or so, and eurozone inflation drops back to the ECB’s expected 1.5%, bond holders are unlikely to tolerate current yields indefinitely. Holders of the benchmark 10-year U.S. Treasury bond earn 1.3%, and their German equivalents are paying the German government 0.3% a year. Both yields are well below likely inflation, even before tax. Whether though investor pushback, or ongoing monetary policy normalisation, market conditions look likely to remain difficult for bonds, absent any major setback to the global economy.
International Equities — Review
September has not been kind to world shares, with prices peaking early in the month and sliding since then. The recent weakness has been modest relative to the substantial gains earlier this year, however, so year to date the major share indices are still well ahead: the MSCI World index of developed markets in U.S. dollars is up by 15.8%. Performance has remained regionally diverse: the U.S. (S&P500 up 18.3%) and the eurozone (FTSE Eurofirst300 up 13.3% in U.S. dollars) have led the way, while Japan (Nikkei up 4.2% in dollars) has lagged. Emerging markets are barely ahead (MSCI Emerging Markets in U.S. dollars up 0.4%) and the key BRIC markets (Brazil, Russia, India, China) are down 4.8%.
International Equities — Outlook
The recent weakness has reflected several factors. A key one is that the pace of growth of the global economy, which had initially recovered much more strongly and quickly than expected from the initial 2020 COVID-19 outbreak, has eased back. The J. P. Morgan Global PMI Composite Output Index, which aggregates the latest business surveys across more than 40 countries, shows that the world economy is still growing, but in August it was growing at the slowest rate in seven months: “There was some evidence from companies that supply-chain disruptions (especially at manufacturers), COVID-19 issues and signs of labour and skill shortages all impacted on growth during the latest survey month.”
The mood of investors about the pace of growth was not improved by poor jobs numbers in the U.S. In August, there were an extra 235,000 jobs, hugely short of the 720,000 that forecasters had expected and way below the 962,000 extra jobs in June and the 1.1 million in July. One month could yet prove a blip, but it looks to be significant that the sectors most dependent on face-to-face interactions with customers were hit hardest: the leisure and hospitality trades, which had been booming in earlier months, created no new jobs in August, and retailers and restaurants shed staff, all of which is consistent with the delta variant posing a severe challenge to business activity. While the initial robust recovery from 2020’s COVID-19 had been very encouraging, investors have now had to reassess the realism of the impact of COVID-19 being largely behind us. As the New York Times noted in its latest coverage, “The virus continues to spread rapidly around the world, averaging about 550,000 new cases and almost 9,000 deaths per day. The most recent global wave peaked in late August, at more than 650,000 daily cases, but unlike previous peaks in January and April, the latest one has not been followed by a steep drop,” and countries are having to adopt new policies (such as booster shots) to try to manage the latest outbreak.
Investors may also have been lulled by the scale of the profit boom as the global economy surged out of the 2020 outbreak. In the U.S., for example, according to data company FactSet, profits in the June quarter were 91% up on a year earlier. While investors will have recognised, at some level, that profit growth of that order was an artefact of the COVID-19 bust and subsequent rebound, they may also not have adjusted expectations adequately for the more mundane profit outlook in 2022. FactSet’s polling of share analysts, for example, shows that they currently expect profit growth of 9.4%, which would be a satisfactory outcome, but the analysts also expect that this will underpin an 11.8% rise in an already expensive S&P500. Consumer discretionary stocks are now trading on a forward looking multiple of 30.3 times expected profits, which suggests that analysts are taking a remarkably upbeat view on the willingness of consumers to go on spending in a still COVID-bedevilled world.
Equity markets are also starting to face up to the prospect that central banks (as noted earlier) are starting, however cautiously and gradually, to edge away from their previous very supportive monetary policy settings. Equities will not be benefiting from the same degree of valuation support that they enjoyed in the period of peak liquidity and ultra-low interest rates.
In these circumstances, it is not surprising that global fund managers, polled in the latest (August) Bank of America Merrill Lynch survey, have turned markedly more cautious about the equity outlook. They are still pro-equities, and have not increased cash levels, but they are now taking a much less exuberant view. Back in March, in the middle of the strong V-shaped recovery from 2020, fund managers had been overwhelmingly upbeat: 91% expected the global economy to improve. Now, only 27% do. There was also a slump in the percentage of managers expecting global profits to improve, from 89% to 41%. The chances are that, as the managers expect, the global economy will continue to recover, but more slowly from now on, and further equity gains will be more difficult to bank.
Performance periods unless otherwise stated generally refer to periods ended September 14, 2021.
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