- The MSCI All Country World (global shares) Index fell -0.2% over the month in both NZD-hedged and -unhedged terms.
- The New Zealand equity market (S&P/NZX 50 Gross with imputation) finished the month down -4.8%, whilst the Australian equity market (S&P ASX 200) fell -2.6% in AUD terms (-1.9% in NZD terms).
- Bond yields tracked downwards through May with a partial re-tracing through the last week of the month. As a result, the Bloomberg NZ Bond Composite 0+Yr Index rose +0.4% over the month.
Global equity markets were volatile over the month. The investment narrative moved from inflation risk to concerns about slowing activity and growth. With inflation proving persistent, the debate over how quickly central banks will raise interest rates is triggering fears central bank rate hikes may tip the economy into a recession. Volatility was unprecedented – for example the US S&P 500 index plunged more than 3% three different times during the month and capped its longest streak of weekly losses since 2001 only to surge at the month’s end.
In New Zealand, weakness in Fletcher Building, Contact, Mainfreight, Auckland Airport and Air New Zealand dragged on market returns. A better-than-expected result lifted returns from Ryman, while merger and acquisition potential lifted returns from Pushpay. MSCI index rebalancing at month end saw very large volumes traded and outsized share price movements across the New Zealand market. In Australia, at a sector level, materials, utilities, industrials and energy were relatively strong, while real estate, technology, consumer staples and communications were weak.
Across both global and domestic bond markets, the focus shifted away from the question about how aggressively central banks would hike interest rates, to contemplating how much the projected rate hikes might hurt economic activity, perhaps even bringing recession. This started early in the month, with bond yields falling sharply as recession concerns were front of mind. However, the rally in bonds turned around when the Reserve Bank of New Zealand (RBNZ) argued that the economy was well positioned to cope with rate hikes and, as inflation expectations were at risk of rising sharply, the appropriate monetary policy decision was to hike quickly and assertively.
What to watch
Official Cash Rates: In New Zealand, a hawkish 0.5% OCR hike to 2.0% by the RBNZ in late May has seen short-term rates retrace all their May month-to-date declines. The RBNZ emphasised an urgency to get policy settings into restrictive territory to ensure high inflation doesn’t become embedded in inflation expectations. Another 0.5% increase in July seems likely, with little data between now and then to dissuade the central bank from this approach. The market, however, has extrapolated the hawkish tone and prices an OCR path that peaks around 4.1% in a year’s time, higher than the peak rate of 3.9% in the RBNZ’s forecasts. This expectation is at odds with the increasingly weak outlook for consumption, housing and broader economic activity. We believe the RBNZ will adopt a more balanced approach later this year in response to a deteriorating economic environment and the OCR is more likely to peak around 3.5%.
Market outlook and positioning
Equity markets have moved at warp speed to price in higher inflation, higher interest rates and, more recently, the risk of economic slowdown and recession. Equity markets have struggled with investors de-risking their portfolios in the face of the rapid rate of change. While markets are likely to remain volatile as they continue to transition due to the changing monetary policy, economic and geopolitical settings, the range of equity market return outcomes may be more balanced over the next 12 months with more conservative earnings expectations, lower valuation multiples and the self-correcting nature of equity markets providing a base for returns.
Aggressive removal of central bank liquidity (particularly by the RBNZ) increases the risk of a significant economic slowdown and, in some cases, recession. This risk has been quickly reflected in some stock prices. The stock prices for a wide range of cyclical companies have not gone up, or have even fallen, after announcing better profit results or profit updates. Consumer discretionary stocks have been particularly hard hit as pressure on household income and re-opening of economies for in-person services (particularly travel) is contributing to a reduction in purchases of durable goods. In the near term, markets are favouring stocks with a higher degree of earnings certainty. Some investors are starting to re-visit technology stocks with pricing power and strong cashflows now that valuations are more reasonable.
The pullback in markets to reflect lower liquidity and recession risk means market-wide price to earnings (P/E) valuation multiples are back to better levels, providing investors with an increasing degree of downside support. The 12-month forward market capitalisation weighted average P/E for the New Zealand market ended the month of May at 23x, 6% below its 5-year average multiple of 24.4x forward earnings. The median 12-month forward average P/E for the New Zealand market ended the month of May at 18.5x, 8% below its 5-year average multiple of 20.1x forward earnings, suggesting potential investment opportunities in the broader market. Investors may add to stock investments as the rate of inflation increase shows signs of peaking, central bank interest rate hike risk becomes more transparent, and the withdrawal of central bank liquidity nears its apex.
Within equity growth portfolios, we continue to focus on sectors that can do relatively well through the transition, particularly those with pricing power. Selected stocks in the healthcare sector may offer a good balance between relatively high, stable growth and reasonable valuation, driven by demand from aging demographics and technology change. Where supported by productivity enhancements, healthcare earnings may be relatively inflation protected. Resources companies may also have pricing power driven by supply-side disruptions. Increased Chinese government infrastructure spending, offsetting COVID lockdown weakness and positioning for future sustainability objectives, may also support accelerated demand for commodities.
Within fixed interest portfolios, we see a market that is pricing in an aggressive hiking path from the RBNZ, such that the OCR reaches 4.1% by July 2023. We do not expect rates to be hiked this far and accordingly are long duration in the 0 – 3-year sector that is exposed to the monetary policy outcomes. For longer maturities, we are more cautious, seeing scope for US 10-year bond yields to rise beyond 3.25%, which would most probably take longer rates in New Zealand higher. We retain a holding in inflation-indexed bonds and have edged towards a higher credit weighting as credit spreads have become more appealing.
Our research suggests that some markets, particularly New Zealand, may have over-priced the number of expected interest rate hikes. Within the Active Growth Fund, during May, we trimmed our underweight position to bonds. New Zealand bonds currently offer an attractive ~4% running yield with potential for price return should the RBNZ ultimately not hike rates as much as what is priced into interest rate markets; a scenario that we believe is more likely than not. We also used the weakness in global equity markets to add to our position over the month; we believe the market has unduly penalised some quality growth companies in this recent sell-off, so have used market volatility to add back at more attractive valuations.
Within the Income Fund, we have continued to have a broadly cautious approach with regards to equity weighting. However, we have added tactically to global growth equities, while making a small reduction to more conservative income equities. This is our first net addition to growth equities for several months. The fixed income investments are concentrated in the 0 – 5-year sector which captures our view that market pricing for RBNZ rate hikes will not get as far as 4.1%, as is currently priced. Within credit, we have made some reduction in domestic high yield credit.
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