Key points
- The MSCI All Country World Index (ACWI) bounced back from consecutive losses with a bumper return of 7.7% in NZD-hedged terms (2.9% in unhedged NZD terms). This ranked as the fifth highest monthly return in the last ten years for the hedged index. Returns were broad-based with all sectors positive, but information technology head and shoulders above the rest at 13.5%.
- Returns for the month were similarly strong in local markets, with the S&P/NZX 50 Gross Index (with imputation credits) advancing 5.4%, and the S&P/ASX 200 Index rising 5.0% (3.6% in New Zealand dollar terms).
- Bond indices were also positive over the month. The Bloomberg NZ Bond Composite 0+ Yr Index rose 3.2%, whilst the Bloomberg Global Aggregate Bond Index (hedged to NZD) also gained 3.3% over the month. This came as the US market saw 10-year government yields fall to 4.3%, considerably lower than the 5.0% highs seen in October.
Key developments
Global share markets delivered one of their strongest monthly returns as market expectations moved from a ‘higher for longer’ interest rate environment to a ‘soft-landing’ for the US economy. The fall in long term bond yields was driven by softer economic data, renewed signs of slowing inflation, and a lower-than-expected US Treasury funding requirement. The continued fall in inflation data allowed central bankers to deliver ‘hawkish pause’ (not lifting rates but ready to if inflation re-emerges) type comments during the month. This weak inflation data contributed to markets beginning to price in cuts to official interest rates over 2024. Given the rise in bond yields was the key headwind for equities in prior months, the fall in yields drove a sharp rally in equity markets.
Locally, the New Zealand share market was supported by the combination of the 10-year New Zealand government bond yield falling from 5.6% to 4.9% during the month, and a better-than-expected profit reporting season for the September period. For the New Zealand companies that reported results there were more beats than misses against earnings expectations. The beats were led by better-than-expected revenue growth offsetting lower profit margins. Dividend reductions were a disappointing stand out, although the reductions were well justified in most cases by companies’ need to preserve capital. Forward earnings forecasts saw more downgrades than upgrades mainly reflecting lower revenue forecasts. Dividend forecasts also saw more downgrades than upgrades.
The US economy is slowing, and further Fed tightening is unlikely. After growing nearly 5% on an annualised basis in Q3, real-time estimates of current quarter growth are 2% on the same basis, led by weakness in the manufacturing sector. Labour market pressures also appear to be easing with slower job growth pushing the unemployment rate higher and reducing the pace of wage gains. Weaker-than-expected inflation proved to be the final nail in the coffin for markets to remove the prospect of additional Fed tightening. While we agree that further Fed rate hikes are unlikely, market pricing of more than 100bp of rate cuts by the end of next year seems at odds with an economy that remains far from recession, with core inflation at 4% and an unemployment rate that is historically low.
The RBNZ shocked many with a hawkish hold at its November MPS meeting. The central bank lifted its OCR path to imply an 80% chance of a 25bp interest rate hike next year. They then also eliminated their prior forecast recession for H2 2023, dropped their unemployment rate forecast, and added to expectations of further house price gains. This is despite almost all the economic data in recent months suggesting monetary policy is working. What appears to have changed is i) the RBNZ is much more worried about high rates of migration being net inflationary (despite most evidence so far suggesting the opposite); ii) the RBNZ’s tolerance for inflation above the 1% to 3% band has reduced. They want to see more progress than in August; and iii) they are not impressed with the market’s anticipation of rate cuts next year.
What to watch
The market has become increasingly convinced of Fed rate cuts next year, now pricing 120bp of cuts in 2024, almost double that of six weeks ago. A combination of a slowing US economy and less-hawkish communication from Fed officials have been the two drivers. Activity indicators suggest the US economy is growing at a much slower annualised pace of 2% this quarter, versus almost 5% in Q3. Fed Governor, Christopher Waller, one of the more hawkish FOMC members, said recently that he was ‘increasingly confident that policy is currently well-positioned to slow the economy and get inflation back to 2%’. The question remains, however, whether this view is held by the wider Committee. We think perhaps not, and the Fed is likely to push back against the recent fall in rates at its upcoming December meeting.
Source: Bloomberg, Macrobond
Market outlook and positioning
Inflection points in inflation, interest rates and company earnings direction may provide the potential for a more constructive return environment for New Zealand and Australian share market returns. Economic activity is likely to continue to slow but recession may be avoided. Inflation has moved to disinflation, interest rates have stopped going up, and earnings expectations may be near their low. After one of the best months in equity market returns for some time, it would be easy to dismiss the change in tone in capital markets. But history suggests such a change in tone can represent a change in trend even if a change in trend does not deliver straight line outcomes. With geopolitical risk likely to remain elevated, investors should expect periods of higher market volatility.
The ‘Goldilocks’ scenario of economic slowdown without recession, which allows interest rates to fall without capital market disruption would be a historical rarity. But with central bank policy now well into restrictive territory (as per comments from US Federal Reserve Chair Powell) markets are anticipating that the Fed and other central banks could cut rates purely in response to longer-term disinflation. Economists are projecting 2024 real GDP growth in almost all key regions at a slower run rate than has transpired this year. Bond yields may be in the process of peaking - initially this move lower in interest rates is a positive for equity markets, but that might not be sustained as earnings forecasts move down with lower activity. Pricing power may be waning for more cyclical parts of the share market, with profit margins at risk from slowing revenue. Contracting money supply and tight monetary policy is likely to continue to put pressure on manufacturing and employment growth. The worst of the interest rate shock to growth may not be over. While central banks may be at the end of their interest rate hiking cycle they may choose to stay ‘higher for longer’ until the potential market or consumer weakness forces them to reconsider. Inverted yield curves (near-term rates higher than longer-term rates) have historically been an ominous sign for economic activity (with a lag of typically 12-18 months).
While monetary policy may move to being less restrictive over time, for now we have a gauge on what the new normal is for debt access and the normalised cost of debt. New Zealand and Australian businesses have moved to reset finances for restrictive conditions. Many companies have improved the focus on cashflow, gearing, interest coverage and interest rate hedging terms, often at the cost of near-term earnings growth. While there is potential for a further drag on earnings from a reset of financial structures, the bulk of the reduction in earnings may already be reflected in earnings forecasts. Earnings forecasts for the New Zealand and Australian share markets are showing signs of re-basing after two years of downgrades. We see potential for low earnings expectations to be beaten. The next phase of resetting for the new normal will include businesses revisiting projects that previously met return hurdles and no longer do, and disposing of non-core business activities. Historically these periods of increased focus on fundamentals have contributed to better returns for investors.
Within equity growth portfolios our strategy remains to position for a range of scenarios and to be selective. We continue to favour investments with structural tailwinds that are less dependent on strong economic activity. We continue to see technology disruption, de-carbonisation, and demographic changes as supporting company earnings. Within the portfolio we are selectively overweight growth at a reasonable price (GARP) shares in the healthcare, information technology and services sectors given they offer the potential for compound growth. 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 on cyclical stocks that are dependent on a recovery in consumer and corporate confidence. We favour businesses with productivity and efficiency ‘self-help’ programmes, particularly where business reengineering introduces technology that improves both revenue and cost structures. We continue to have a bias to quality, well-capitalised businesses that are less vulnerable to a tightening in financial conditions.
Within fixed interest portfolios we are balancing 3 key influences. Firstly, the slowing macroeconomic cycle that is enabling overall inflation to fall and encourages expectations that the RBNZ can cut the OCR next year. Secondly, and proving an offset to the first point, is that around 25% of the CPI basket that relates to immigration and housing (rents, rates, insurance, construction costs) is proving to be sticky. This complicates the decision-making for the RBNZ. Thirdly, global bond yields have fallen considerably over the last 4 weeks, with 10-year US Treasuries near 4%, while issuance of government debt is going to grow next year and test the market’s capacity to fund this. Bringing these together, the positive aspect of the softening macro cycle has some offsets that now suggest a more cautious risk position with regards to expecting bond yields to fall further for now. Accordingly, we have significantly reduced the long duration position that we established 4-6 weeks ago when yields were higher.
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 as 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 66th percentile valuation when compared to the past 20 years, by no means extreme on absolute terms. When we look at the forward-looking risk premium relative to bonds though, we see a more extreme outcome, trading at 89th percentile (i.e. expensive relative to history). However, when we dig below the surface, there appear to be interesting opportunities, particularly when we look at small companies, defensives, and non-US equity valuations. Over the past few years, we have seen a higher correlation between equities and bonds than history would suggest. However, we believe that equities and bonds are more likely to be highly correlated in high core inflation regimes. This informs our view that equities and bonds will reassert their negative correlation once the market narrative turns from one focussed on inflation, to one that recognises slowing growth. This being the case, and since the equity risk premium is hovering around historic lows, we continue to favour bonds over equities.
The Income Fund’s strategy reflects the view from fixed interest that a less aggressive duration position is now warranted. Equity allocation is currently just a little below neutral weight, reflecting the scope for valuations in the market to decline somewhat if the economy weakens more sharply than consensus. We are holding a short position to the New Zealand dollar, again to reflect the balance of global macro risks and New Zealand-specific challenges, such as the current account deficit and trade balance weakness.
IMPORTANT NOTICE AND DISCLAIMER
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.
Harbour Asset Management Limited (Harbour) is the issuer of the Harbour Investment Funds. A copy of the Product Disclosure Statement is available at https://www.harbourasset.co.nz/our-funds/investor-documents/. Harbour is also the issuer of Hunter Investment Funds (Hunter). A copy of the relevant Product Disclosure Statement is available at https://hunterinvestments.co.nz/resources/. Please find our quarterly Fund updates, which contain returns and total fees during the previous year on those Harbour and Hunter websites. Harbour also manages wholesale unit trusts. To invest as a wholesale investor, investors must fit the criteria as set out in the Financial Markets Conduct Act 2013.