In September we saw a continuation of the theme of low local interest rates in New Zealand, in a broader global environment where bond yields overseas have crept higher. This provided support for the local fixed interest and equity markets, while the NZ dollar remained at its recent low levels.
The tone in global markets has remained relatively cautious, with worries about trade tensions, pockets of strain in emerging markets and wobbles in the Italian banking sector and sovereign bond market.
However, despite these headlines, global macroeconomic data, particularly in the United States, continued to show a picture of solid actual economic activity running near economists’ expectations. This saw the US Federal Reserve deliver on its plans to raise the US Fed Funds rate by 25 basis points to 2.00% to 2.25% at its September meeting. This was the eighth increase since the Fed began normalising interest rates in December 2015. The FOMC’s published projections were little changed from last time, with one more hike projected for December, followed by 3 more hikes in 2019.
By contrast, the RBNZ left the OCR unchanged in September and stuck to its line that the OCR is expected to remain unchanged through 2019 and into 2020, with the next move in the OCR potentially up or down. As a result, while US 10-year treasury yields rose 20 basis points to 3.05%, local interest rates remained much more anchored with yields only a few basis points higher. In sticking to its dovish tone, the RBNZ looked through the release of a stronger than expected Q2 NZ GDP outturn (1.0% qoq vs 0.5% RBNZ expectations) and a small bounce in the ANZ business confidence survey off recent lows.
After very strong returns in August, the local equity market took a breather in August with more modest returns. Reversals in the previous month’s outperformers were a feature, particularly the MSCI index names. Within the market, there were also several sell downs by majority shareholders and equity raisings.
The release of the first report for discussion from the NZ Government’s electricity price review panel reduced the regulatory risk overhang for the electricity generator/retailers (“gentailers”) and contributed to the gentailers outperforming the broader NZ equity market over September. The panel found that gentailers are not earning excess returns, reducing potential regulation risk.
What to watch
On the global front, trade tensions remain at the top of the watch list.
Through September, trade tensions between China and the US escalated, with the US imposing duties on $200bn of Chinese imports and China retaliating with a new trade tariff on $60bn of US goods. The US tariffs started at 10% in September and are due to increase to 25% at the start of 2019 in the absence of an agreement between the two countries. After tough negotiations and strained relationships, towards the end of the month the US, Mexico and Canada finally signed a new trade deal to replace NAFTA.
When asked about the implications of increased trade tensions, US Federal Reserve Chairman, Jay Powell, noted that business contacts of the regional US Federal Reserve Banks were increasingly worried about the impact. The US Fed has yet to see any signs of effects from trade in the economic data but will continue to monitor signs of strains impacting financial markets and business confidence. In the short to medium term, there is an ongoing risk that brinkmanship in trade negotiations results in an incident that disrupts economies and markets.
On the domestic front, the interplay between moderating economic activity and lifting wage and cost pressures remains at the top of the watch list.
Since August, the RBNZ has come down squarely in favour of supporting economic activity, signalling a clear willingness to cut the OCR if required. By forming this judgement, the RBNZ has assumed that if domestic demand is lacking then wage and cost pressures are unlikely to be passed through to higher CPI inflation. Furthermore, with core inflation currently sitting below 2%, a rise towards the mid-point would be welcomed, as would spending some time in the top half of the 1-3% range.
Over the course of September, data on New Zealand activity has not been as bad as feared. Not only was NZ Q2 GDP stronger than expected, but there are signs that business confidence is stabilising after its recent falls, and economists are revising up their NZ Q3 GDP expectations to another solid quarterly outturn. At the same time, business surveys continue to show cost pressures and some expectations that these will be passed into pricing in the period ahead, through higher pricing intentions. Furthermore, the rise in oil prices to their highest levels since 2014 is translating into higher petrol prices feeding into headline CPI. As a result, some economists are now forecasting Q3 CPI inflation at a solid 0.7%, compared to the RBNZ’s forecast of 0.4%.
This all adds up to an environment where a near-term OCR cut looks less likely, with our central case that the RBNZ stays on hold for an extended period, supporting New Zealand fixed interest and equity markets, and giving inflation the best chance to rise above 2%.
Market outlook and positioning
In fixed interest portfolios, our strongest view is that inflation expectations will rise, either because business confidence continues to recover or the RBNZ is required to cut the OCR aggressively to lift inflation and employment growth. As such, we see New Zealand government inflation-indexed linked bonds at very attractive valuations, with these bonds providing very cheap protection against inflation rising back to the mid-point of the RBNZ’s inflation target.
In equity portfolios, the local earnings reporting season did not provide clear evidence of aggregate weakness or strength. However, our expectation is that domestically-oriented companies will have higher costs (wages and energy prices) and potentially face moderating demand. Disruption continues for some listed companies. In contrast, a lower NZ dollar and ongoing global growth appear to support the prospects for many globally-oriented companies and the trade wars today seem rather benign for most NZ exporters.
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