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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