In recent months we have highlighted how economies and markets seem at a crossroads. In June, there was further evidence of an upcoming moderation in domestic economic activity whilst cost pressures appear to be rising. Looking forward, this is a theme that remains near the top of our list of what to watch most closely on the horizon.
Looking back over June, while some macroeconomic data in Europe and Asia disappointed, economic activity in the US remained robust, with very solid non-farm payrolls numbers and manufacturing PMIs far into expansionary territory. This saw the US Federal Reserve stick to its plan of lifting the US Fed Funds Rate by 25 basis points to 1.75-2.00% and signalling more to come over the next couple of years.
While economic data remained resilient, growing trade tensions captured the imagination of markets. The US Administration has upped the rhetoric on trade tariffs, and Canada, China and Europe fired back counter threats. This saw a small flight to safety in markets into the end of June, with global equities ending slightly down, US Treasury yields lower and the USD stronger. Some emerging markets felt these tensions and USD strength more acutely, with the Chinese Renminbi weakening 3.3% - the worst single month decline since China established its foreign exchange market in 1994.
The NZ and Australian equity markets shrugged off the more cautious tone of global equity markets and ended the month stronger – the Australian equity market delivering its best quarterly return for 3 years. In New Zealand, the market was supported by a string of earnings upgrades. In Australia, a series of M&A deals highlighted underlying value. Higher oil prices also boosted returns from Australian energy stocks. Financials were generally weaker as the Royal Commission inquiry into misconduct in the banking, superannuation and financial services industry impacted on sentiment to the sector.
What to watch
For many years now, New Zealand has benefited from a robust background of solid and widespread economic growth, with very subdued inflation pressures. However, in recent months, there have been increasing signs of this dynamic changing, with economic growth moderating and becoming more dependent on fiscal stimulus, the strong terms of trade, and an export boost from a weakening NZ dollar; while at the same time pressures on costs appear to be rising from a low base.
Business confidence has remained at fairly subdued levels ever since the election. The initial fall was not surprising, given the habitual conservative leanings amongst the business community. This is consistent with previous times that Labour has come to power, especially as there is inevitably some policy uncertainty that arises when a change in leadership occurs. Historically, actual activity has not always followed the signals from confidence surveys. However, in June both the ANZ and NZIER business confidence surveys fell back to their recent lows, suggesting there is potentially more substance to the prospect of a moderation in economic activity. Supporting this view, the housing market has stalled in recent months, construction has eased back from what has been a very busy period and net migration appears to have peaked.
Looking forward, we are watching carefully for any signs of change in consumer confidence. So far, consumer confidence has remained relatively elevated, supported by low interest rates, strong job prospects, low unemployment, and a build-up of housing wealth. Currently, the combination of business and consumer confidence points to GDP growth moderating from 3.5-4.0% to closer to 2.0%. If consumer confidence were to also stall, perhaps due to a further slowdown in the housing market or a tightening in credit conditions, this would raise the chances of a more material economic slowdown.
Chart 1. NZ business and consumer confidence
The same surveys that are pointing to a fall in business confidence are also starting to point to rising costs and inflation pressures. Some of the factors driving this move may be relatively transitory, such as oil prices rising back towards US$80 and the NZ dollar falling on general US dollar strength. However, a lift in headline inflation towards 2% could help the process of lifting core inflation expectations to become more consistent with the target. Furthermore, the well-publicised industrial action of teachers and nurses is potentially highlighting a new wage-price dynamic in the current political environment. A turn in the net migration cycle could also put into reverse the plentiful labour supply that has helped keep wage inflation subdued in recent years.
Chart 2. NZ CPI inflation vs pricing intentions
At the moment, markets appear less concerned with domestic wage and inflation pressures and more focused on the moderation in economic activity. As such, most bank economists have shifted their picks for the first hike from the RBNZ from August 2019 to November 2019, and the Overnight Indexed Swaps (OIS) market is pricing in a small 10% chance of a cut by the end of 2018.
In fixed interest portfolios, we have been comfortable investing at the front end of the yield curve for some time now on the view that the OCR will remain on hold. However, we have reduced the size of that exposure given that yields have fallen so far, with the market pricing in the chance of a near-term cut. In our view, it is far too premature to expect the RBNZ to start a new cutting cycle. Indeed, we are mindful of rising inflation pressures over the medium term.
After falling recently on global trade tensions, we are expecting global bond yields rise in the medium term, as solid US economic activity and the US Fed withdrawing stimulus comes back into focus. As such, we are more defensively invested in long-term securities.
With early signs of domestic inflation pressures emerging, we believe that inflation-linked NZ government bonds currently provide better value than traditional nominal bonds, especially with implied inflation break-evens at just 1.30% - well below the 2.0% mid-point of the RBNZ’s inflation target. If the RBNZ is slow to identify rising inflation pressures, it will further support the attractiveness of these inflation-linked bonds.
The prospect of moderating economic activity and lifting cost pressures is a potentially challenging environment for equity markets. In our equity portfolios, we have taken profits on several strong-performing securities like Fisher & Paykel Healthcare and Xero. We like these businesses, but we are wary of the recent price strength. We have also exited our long-standing position in Oil Search, which has performed very strongly in recent months with the surge in the oil price. Our central view is that the globally-oriented companies should continue to provide better investment opportunities compared with companies challenged by a slowdown in New Zealand economic activity, disruption, higher bond yields or regulatory uncertainty.
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