The Harbour Outlook summarises recent market developments, what we are monitoring closely, and our key views on the outlook for fixed interest, credit and equity markets.
A common theme which came through during May was economies and markets reaching crossroads. Globally, the US continued to generate solid economic data, while in Europe political tensions rose. Domestically, solid economic activity masked a growing divergence by type of activity. Equally, subdued near-term inflation pressures concealed the prospect of an uplift in some medium-term inflation drivers.
Bond yields fell over the month. Economic data in the US is continuing to print at very robust levels and markets are placing an 80% chance on the US Federal Reserve delivering another hike at their upcoming June meeting. However, this was more than offset during May by a flight to safety prompted by the failure of leading Italian political parties to form a government, heightened by the very high level of Italian Government debt and concerns that the Italians may wish to redefine aspects of their Eurozone membership. While Italian 2-year yields initially spiked as the market priced an additional risk premium, yields in other developed markets like the US, Australia and NZ fell given their relative safety.
Another factor supporting a fall in NZ Government bonds yields was domestic policy announcements. New Reserve Bank of New Zealand (RBNZ) Governor Adrian Orr reasserted the Bank’s view that the Official Cash Rate (OCR) will remain on hold for a considerable time. In addition, new Minister of Finance Grant Robertson delivered his first Budget, which retained the plan of reducing net NZ Government debt to below 20% of GDP – a sound footing by global standards.
Equity markets were firm in May despite ongoing discussions around trade disputes with the US and China, political disruption in Italy, and the on-again-off-again summit between the US and North Korea. Oil continued to push ahead despite a strong US dollar, primarily on concerns about global supply with US withdrawing from the Iran nuclear deal.
The New Zealand equity market returned 2.6% and the Australian equity market returned 1.1% over the month. The Australian Royal Commission continued its inquiry into the financial sector’s behaviour, focussing on small business lending, following earlier rounds of inquiry on consumer lending, financial advice and wealth management. This saw financials continue their recent underperformance.
What to watch
For many years now, New Zealand has benefited from a robust background on solid and widespread economic growth. However, looking ahead, there appears to be a growing divergence in this story by activity type.
On the strong side of the ledger, the Terms of Trade, which measures the net price of our exports relative to the price of imports, remains at record highs, providing solid revenue for our exporters. Furthermore, pricing is good across many products, rather than reliant on a single buoyant export market. The labour market is also strong, with the unemployment rate at 4.4%, which is the lowest level since 2008, which should support consumption. Finally, we know that the new Government is planning to front load fiscal stimulus in 2018 and 2019.
On the weaker side, business confidence has held 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. However, there are some other factors at play. Most notably, the housing market has stalled in recent months, construction has eased back from what has been a very busy period, and net migration has eased back from its peak.
Similarly, the domestic inflation outlook appears to be at a crossroads.
In the May Monetary Policy Statement, the RBNZ reiterated the view that inflation pressures remain modest at present and that the OCR would stay at 1.75% until late 2019. A key part of their assessment is that subdued wage and price setting behaviour has made it difficult to lift core Consumer Price Index (CPI) inflation sustainably back to the 2.0% target.
However, in coming months inflation may rise to 2.0% as higher oil prices and the fall in the New Zealand Dollar combine to lift headline CPI inflation. Historically, the RBNZ would look through currency and oil-driven changes, but a lift in inflation towards 2% may help the process of inflation expectations lifting to become more consistent with target, which the RBNZ would likely welcome. Furthermore, the well-publicised offer to increase nurses pay by 9-16% over 18 months is another area of focus. With other workers in the public sector, and potentially in the private sector as well, considering pay claims, there is another potential source of inflation for the Reserve Bank to contemplate.
While the message that the RBNZ is on hold for now is loud and clear, we are watching for when enough evidence has built to move away from this narrative.
In fixed interest portfolios, we have held with the view that the OCR will stay on hold for now, but have reduced the size of exposure to that view. We are expecting global bond yields to continue to rise, albeit moderately over time, so are more defensively invested in long-term securities. Portfolios are overweight credit. We have added exposure in the financial sector, where pricing has become more appealing, and retain a positive view for asset-backed securities, which are also well priced. We are underweight Local Authorities and cautious about corporate debt, which we believe is not attractively priced at present.
In equity portfolios, we still think that gradually rising interest rates will lead to some further caution about the pricing of some defensive stocks, despite a sequence of positive earnings results for REITs, and gathering merger and acquisition activity in the property sector.
We are relatively optimistic about the Australian corporate earnings momentum in the industrial sectors, mainly because economic data looks robust, and expectations for earnings are very subdued. Sentiment in the financial sector remains poor, and investor appetite for banks and some other shares has most likely been impacted by the ongoing Australian Royal Commission on conduct. Eventually we would expect that news flow to abate, potentially providing reasonable entry points at some stage. However, right now we are being patient given the uncertainty.
More generally, our equity portfolios are overweight versus the benchmark in selected quality growth companies in the financials, information technology, consumer staples and healthcare sectors, where the potential rate and sustainability of growth may not be fully reflected in share prices. Conversely, portfolios are typically underweight in the consumer discretionary sector where disruption risk remains high, and the utilities, real estate and telecommunications sectors, where valuations are high relative to their potential growth.
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