Key market movements
- The MSCI All Country World Index (ACWI) started the year off with a 3.5% (1.3%) return in New Zealand dollar-unhedged (hedged) terms for the month. From a sector perspective performance was mixed, with information technology leading the way at 3.2%, followed by communication services at 2.9% and healthcare at 2.2%. On the other side of the ledger materials was the worst-performing sector at -5.4%, whilst utilities also lagged at -3.0%.
- Local market returns for the month were more muted, with the S&P/NZX 50 Gross Index (with imputation credits) adding 0.9%, and the S&P/ASX 200 Index returning 1.2% (0.8% in New Zealand dollar terms).
- Bond indices were mildly negative over the month. The Bloomberg NZBond Composite 0+ Yr Index fell -0.6%, whilst the Bloomberg Global Aggregate Bond Index (hedged to NZD) also lost -0.2% over the month. 10-year government bond yields in the US stayed relatively flat over the month, ending at 3.9%, whilst in New Zealand the 10-year yield rose to 4.6% from 4.3%.
One of the key themes of 2023 has continued in the first month of 2024 with the US economy cementing its place as the global outperformer. Q1 GDP growth is tracking at more than 4% on an annualised basis, after growing more than 3% on the same basis in Q4. Much of this economic strength comes from the consumer with retail sales and consumer confidence rising strongly in December and January, respectively. The January labour market reports also helps to explain consumer optimism with significant job gains, no change to unemployment and a pickup in wage growth. The US housing market is also responding positively to the 100bp fall in mortgage rates in Q4. Amazingly, inflation has been relatively well behaved. Core PCE inflation has been close to 2% (annualised) over the past nine months.
US economic strength carries inflation risks, however, and has caught the attention of the US Federal Reserve (Fed), with markets moderating easing expectations. The Fed’s January Statement noted it “does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent.” Fed Chair Powell also pushed back on the prospect of imminent easing in the press conference that followed. We started the year with the market pricing an almost 90% chance that the Fed would begin cutting rates at its March meeting, this is now just a 20% chance. The market, however, still prices a substantial amount of easing this year at almost 125bp.
In New Zealand, the Reserve Bank of New Zealand (RBNZ) doesn’t seem satisfied with recent economic data that suggests a substantial slowing in economic activity and lower inflation pressure. In a speech in late January, RBNZ Chief Economist, Paul Conway, was keen to bang the hawkish drum. While acknowledging the significant downside surprise to Q4 GDP, he noted that this may also provide information about lower productive capacity such that inflation pressure in the economy may not be all that different. Conway also seemed to discount the signal from the negative GDP revisions, citing that they were driven by lower government spending, and the more interest rate-sensitive components of consumption and investment were revised higher. On inflation, he wasn’t satisfied with the fall in headline and core inflation with non-tradable inflation coming in higher than RBNZ forecasts. This approach makes tactical sense from the RBNZ, particularly ahead of the MPS at the end of the month, but we expect building economic evidence to support rate cuts around the middle of this year.
What to watch
Despite historically high rates of net migration, December data suggest a stabilisation in housing market activity, rather than acceleration. After falling 16% between November 2021 and April 2023, New Zealand house prices have lifted just 2% in the past 7 months and sales have remained well below average. Most economists, however, expect migration to eventually support an increase in house prices over the coming year and more than offset the negative impact of rising unemployment. It’s also likely that the new National-led Government’s housing policies will encourage a recovery in house prices and activity.
The RBNZ, for example, forecasts a 5% increase in house prices this year and a 16% increase over the next three years. These numbers seem reasonable as they are broadly in line with the RBNZ’s forecast for average hourly earnings over the next three years, implying that houses don’t become more expensive on a house price-to-income basis.
Annual house price gains of more than 5% are harder to justify, however. The economy is stagnating, and unemployment is likely to rise meaningfully this year. Houses are extremely expensive for a new borrower, requiring c.60% of household disposable income to service an average mortgage. For existing borrowers, half of all outstanding mortgages will roll on to higher rates this year.
Market outlook and positioning
While expectations of interest rate cuts were tapered over January, we continue to see the balance of risk favouring lower interest rates, and the potential for interest rates to fall continues to provide support for equity market valuations. Lower interest rates will continue to see investors move capital up the risk curve, including into equity markets. Despite better-than-expected global economic activity, we continue to be mindful of earnings risk, particularly in cyclical stocks, and continue to favour quality growth investments that are likely to do better should economic growth deteriorate.
We expect capital market volatility to increase from current low levels. The reset of official interest rates from levels aimed at reducing economic activity may not happen in the time frame and by the magnitude current market consensus expects. A recalibration of investor expectations for low economic growth, inflation and interest rates to a higher inflation, higher nominal growth, lower interest rate cut environment is a risk to share market returns. The rapid move by investors from being underweight equities in late 2023 to being at least near neutral/benchmark against long-term asset allocation targets means valuations for parts of the equity market are stretched in the near term. We continue to see risks to earnings forecasts for more cyclical parts of the share market as the full impact of tighter monetary conditions over the last year flows through to slower economic activity. Elevated geopolitical risks also have the potential to destabilise markets.
After the recent rally, equity market pricing leaves limited room for earnings disappointments. We remain wary of the balance between interest rate cuts, recessions, and earnings. Historically, if official interest rates are cut when there is either a recession or clear-cut overvaluation, share markets have historically fallen. While the compensation for taking risk has declined in the near term, our medium-term view remains constructive for share market returns with interest rates having peaked for this economic cycle and the local earnings outlook providing a potential boost to returns. For share markets the destination in interest rates, and not the journey, is more important for medium-term returns, and the current destination is lower interest rates which supports valuations for parts of the share market. In our view it is better to be invested in assets that can withstand a bumpy journey.
Within equity growth portfolios our strategy remains to position for a range of scenarios and to be selective. The potential to return to a pre-COVID lower growth, lower inflation environment supports our continued favouring of investments with secular tailwinds that are less dependent on strong economic activity. Within the portfolio we are selectively overweight shares in the healthcare, information technology and financial services sectors that offer potential for compound growth.
While the healthcare sector may remain dynamic and face further disruption from innovative technology, the reset in investor expectations and valuation multiples provides us with the confidence to sustain a relatively large but share-specific investment in this proven compound growth sector. The information technology (IT) sector’s secular growth potential is underscored by the runway remaining in GenAI, improving IT budgets and expectations for improving margins. We also favour selected defensive shares, preferring non-cyclical growth channels and/or income streams that are tied to inflation and positive secular trends. We remain wary of cyclicals that are dependent on a recovery in consumer and corporate confidence. We continue to have a bias to quality, well-capitalised businesses that are well-positioned to fund value-adding growth opportunities.
We hold a positive outlook on New Zealand fixed income, given the perceived restrictive pricing of monetary policy across all maturities. Despite some lingering inflationary pressures, a weakening labour market and declining headline inflation are anticipated to eventually prompt a reduction in the OCR to levels below market expectations. The economic slowdown may require supportive cash rates at some point, aligning with a typical economic cycle post a significant 525 basis points increase and high debt levels. As such, we favour an overweight position in interest rates up to 7 years. Long-dated bonds face challenges due to substantial government bond supply both here and abroad. While our internal models suggest a market concession in the case of New Zealand, valuations aren't compelling for an overweight investment. We maintain a modest underweight position beyond 7 years, ready to seize attractive pricing levels during issuance events. Despite limited credit issuance year-to-date, a post-summer uptick is expected, influencing our cautiously optimistic stance on credit exposure, driven by selective stock selection. However, potential spread widening in specific retail-dominated sectors and new issuances poses risks.
The Active Growth Fund is defensively positioned being overweight bonds and underweight equities. After the recent rally in global share markets the current risk return proposition may not be compelling as it was, and we may see a period of consolidation in global equity markets. At a headline level, global equity markets (measured by the MSCI ACWI Index) are trading at their 91st percentile valuation when compared to the past 20 years, which is expensive in absolute terms. However, when we look at the forward-looking risk premium relative to bonds, we see an even more extreme outcome, trading at 97th percentile (i.e. expensive relative to history). These valuation levels have historically preceded below-average returns in the following 12 months, which makes us wary of holding a higher weight to equities.
The Income Fund has an overweight in short-dated New Zealand fixed income securities, driven by our assessment of monetary policy as persistently restrictive across all maturities. Over the month, we have strategically reduced our holding of global equities from 5% to 1% during a period of strong returns. Typically, global equities are not part of our benchmark allocation and are only held when we anticipate a positive market environment. While lower interest rates may bolster valuations in the medium term, current pricing indicates minimal tolerance for earnings disappointments. Consequently, we have adjusted our positions, trimming equities and reallocating to cash and short-term fixed interest securities. This strategic move positions us to take advantage of potential equity market pullbacks while maintaining a cautious stance amidst rising risks in the intermediate term.
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This publication is provided for general information purposes only. The information provided is not intended to be financial advice. The information provided is given in good faith and has been prepared from sources believed to be accurate and complete as at the date of issue, but such information may be subject to change. Past performance is not indicative of future results and no representation is made regarding future performance of the Funds. No person guarantees the performance of any funds managed by Harbour Asset Management Limited.
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