When establishing our core investment views for the near- and medium-term, we are conscious that markets often skew towards tail risks, and also towards factors that are already observable but uncertain.
When our research team considers technology disruption in sectors and the macro-environment, we have to be aware that the range of outcomes may provide investment opportunities as markets can react both slowly to news and rapidly to noise.
The delineation between news and noise, combined with an awareness that risks bring opportunities, is why our team spends time debating issues that might surprise markets. We hope you find sharing our discussion of some of these perspectives both interesting and useful for your financial considerations.
Little did we know when we released our Top 10 Risks and Opportunities article at the end of 2022, we did so just days after one of the most influential driving forces of 2023. Yes, it is hard to believe that Open AI’s Chat GPT was only released on 30 November 2022 and the “Magnificent Seven” did not enter the vernacular until months later. These “Magnificent Seven”, which are comprised of Apple, Amazon, Alphabet, Meta, Microsoft, Nvidia and Tesla have accounted for nearly 50% of the return of the c.3000 MSCI ACWI Index.
GLP-1 (the diabetes drugs with off-label use for weight loss) was another not to feature in our risks for 2023, but had a profound impact on the healthcare and consumer sectors. This was both via the direct winners, being Novo Nordisk (up 48% this year) and Eli Lilly (up 62% this year), but also indirectly felt by companies across multiple sectors. The consumer staples sector was negatively impacted by guesses that America’s calorific intake may reduce by low single digit percentage points. The share prices of companies in the healthcare sector, from kidney dialysis providers to CPAP machine producers, sold off due to fears they may see reduced demand resulting from healthier patients due to GLP-1 treatments.
What we did allude to in 2022’s Top 10 Risks and Opportunities article was just how downbeat the consensus was heading into 2023, which, in hindsight, created a low bar for upside surprises. Many Wall Street strategists had negative return expectations for the S&P 500, investors were underweight technology stocks, and the US was widely picked to fall into recession by H2 2023.
Reality was quite different. AI contributed towards a boon year for technology stocks, the much-feared recession failed to eventuate, and investor sentiment improved as a result, causing earnings multiples to expand. As we have said in the past, the greatest risks and opportunities in markets arise from consensus views, which ultimately prove incorrect and spur repricing - 2023 was certainly proof of that.
Today, the consensus paints a less bearish view. Scanning external research and fund manager surveys tells us that:
- Year-end price targets for US equity indices are pointing to high single-digit returns for equities.
- Investors are generally overweight “big tech” stocks.
- Investor positioning is bearish towards China.
- The base case for the US economy is for a soft landing (i.e. inflation comes down without central banks having to inflict severe economic damage).
- Investors expect bonds to outperform equities in 2024.
- Yield curves for most developed markets point to rate cuts in 2024, but with policy remaining above current estimates of neutral.
1. A much better backdrop for bond returns (redux)
If this headline looks familiar, then it should. It featured in last year’s piece. Back then we had the view that 2023 should be a better year for bond returns owing to higher running yields, inflation moderating and demand softening. While bonds have delivered positive returns this year, with the Bloomberg NZBond Composite 0 year+ Index up almost 5% and the Bloomberg Global Aggregate NZD Hedged Index up around 3% to the end of November, we think the story has much further to run in 2024, particularly in New Zealand where we are seeing signs of monetary policy working and ample room for further pricing in of rate cuts. Globally the driver could be a move away from the consensus “soft landing” narrative that is currently persisting. One thing we believe is the attractiveness of running yields of 5.1% for the Bloomberg NZBond Composite 0 year+ Index and 5.2% for the Bloomberg Global Aggregate NZD Hedged Index. Importantly, bonds are at yield levels where they have plenty of room to rally if a non-inflationary macroeconomic shock were to occur.
The large pipeline of bond issuance, however, may cause some volatility. In New Zealand, the Government needs to raise almost NZ$40bn in 2024 via the bond market, more than four times the pre-COVID annual average. In the US, the independent US Congressional Budget Office forecasts the US Government to run increasingly large fiscal deficits for the next decade, taking debt to 120% of GDP, from 100% currently. Increasing net interest outlays are a key contributor, along with larger-than-sustainable primary deficits. The worrying thing for markets is that this outlook for US fiscal deterioration sits in the context of below-average term premia and quantitative tightening from global central banks. As such, many analysts don’t think these challenging dynamics are fully reflected in current yields.
2. Company earnings struggle to meet their lofty expectations
As pointed out by one of our global research providers, there is an inconsistency in the US fixed income market anticipating at least four 0.25% interest rate cuts in 2024, while at the same time the consensus of equity analyst forecasts has S&P 500 profits rising 10%. At face value, it seems unlikely that both market expectations could be right. Rarely would sharp cuts in the Federal Reserve’s Fed Funds rate of 1% or more be correlated with a double digit rise in corporate earnings.
Which of these market expectations is more likely? Typically, once the Federal Reserve starts easing policy, it is unlikely that they cut only once or twice. They generally cut because the economy enters a recession, or because something breaks (often a bank or two). On the other hand, if economic growth and earnings do deliver, and, like recent quarters, beat expectations, it would be hard to see a decent reason for the Fed to cut rates, especially four or five times.
Is there a middle road? Perhaps, with a stretch of imagination, some combination of productivity gains from generative AI and the positive workforce implications of GLP-1 drugs like Ozempic will provide both a leap in corporate earnings and a disinflationary force for good.
3. Trump returns, hold your breath... do markets react?
Political polls suggest that Donald Trump is more likely than not to get a second term as US President. Recent polls show that Trump is the favoured Republican candidate by a large margin and is preferred to current President, Joe Biden. The return of Trump as President may change the nature of the US involvement in key areas of geopolitical risk - Ukraine, Israel, and Taiwan. Trump’s willingness to tolerate Vladimir Putin’s aggression, for example, may result in less support for Ukraine. Trump’s return could also raise concerns about an erosion of US institutional strength and democratic process. Overall, the fiscal stance is likely to be more contractionary under the Republicans. There have already been indications that the Inflation Reduction Act may be repealed as part of a broader set of policies that will unwind many climate change and energy initiatives put in place by the Democrats.
The impact on equity markets from a Trump presidency is harder to anticipate. While Trump was largely feared by markets prior to being elected in 2017, his presidency was far from a death knell for markets. In fact, it was quite the opposite. Trump’s tax package boosted net-of-tax earnings for companies, though later in his presidency this good news gave way to increased trade tensions with China. Perhaps the best observation for equity markets is that Trump usually brings with him an air of unpredictability and an additional risk premium.
4. Can the global economy stick to the soft-landing?
This time last year, deeply inverted yield curves and high levels of market volatility had convinced investors that many economies were destined for recession in 2023, including the US and Europe. The global economy, however, has been surprisingly resilient in the face of higher interest rates, a banking crisis, and geopolitical events. A soft-landing for 2024, where inflation continues to decline, economic growth slows and central bank easing cycles can begin in H2, is now consensus.
A lot needs to go right for economies to stick to the soft-landing. Our global bond manager, PIMCO, for example, finds that since the 1960’s, central bank tightening of more than 400bps is almost always followed by recession. Labour markets remain too tight and are generating wage growth that is keeping services inflation too high for comfort. Forward labour market indicators suggest wage pressures should continue to ease, but if they don’t, central banks may have to resume tightening cycles or keep rates higher for longer than markets currently assume. Ongoing consumption growth is another risk to the soft-landing narrative, particularly in the US, and may require central banks to further tighten financial conditions to reduce demand. High rates of US consumption growth have been supported by a reduction of household’s excess savings that were accumulated during 2020 and 2021. While we estimate that most of these excess savings have been spent, it is possible that consumption has also been supported by other factors that will persist in to 2024. The prevalence of 30-year mortgage rates, for example, will continue to limit the negative income effect of higher policy rates, as these will only reset to market rates if people refinance or move house. Household balance sheets also remain in good shape, limiting the ability for a negative wealth effect to slow consumption growth.
5. AI adoption continues to create disruption (but some of that could be priced)
It took Netflix more than three years, Facebook ten months and Spotify five months, but for ChatGPT the path to 1 million users took just five days. And this was just the start. NVIDIA announced year-on-year earnings growth of over 1200% in Q3 (yes that is 13x) with AI being a key driver. The share prices of many others benefitted, from the “magnificent seven” to data centres. Is AI a flash in the pan or could the growth continue into 2024? One thing that is likely to be a key driver is the roll out of Microsoft’s Copilot. While a version of Copilot was released in November 2023, it is said that many advanced capabilities will not be rolled out until 2024. Further, the roll-out has been restricted to companies that can purchase a minimum of 300 seats, limiting its adoption to larger businesses that can afford the minimum US$108,000 per annum commitment. The release of this into a slowing economy could have large productivity and employment implications.
While the more widespread adoption of AI could go ahead in leaps and bounds, the implication for AI-exposed stocks could be more muted in 2024. Why? Earnings growth expectations have been significantly upgraded for 2024 and beyond, creating a higher bar for upside surprises. But despite this, we expect AI to be an enduring theme in markets.
6. Will New Zealand be the first developed economy to cut interest rates?
We were first to lift rates, will we be first to cut? There is a large degree of consistency in what markets price for most developed economy central banks in 2024 – a small chance of rate cuts in H1 and meaningful easing in H2 (Japan and Australia are notable exceptions). New Zealand is one of them, but we can see reasons for New Zealand to lead the developed economy easing cycle. The RBNZ was the first to end its Quantitative Easing (QE) programme in the middle of 2021 and lift its policy rate in October of the same year. Quantitative Tightening (QT) has been happening since the middle of 2022. The Official Cash Rate (OCR) has been lifted 525bp and pushed retail interest rates to post-GFC highs.
Tight monetary policy is clearly working in New Zealand. Indicators of economic activity, inflation and the labour market all suggest that the RBNZ can begin an easing cycle around the middle of 2024. This is much less clear for other developed economies, particularly the US, where demand appears more robust and labour markets in better health which may require a longer period of tight policy.
However, there is a caveat to this scenario. A significant slice of the inflation basket could experience persistently high inflation, notably areas that are not meaningfully influenced by monetary policy. The surge in immigration could push rents higher, council rates are exploding higher due to ongoing spending and infrastructure investment, construction cost inflation is expected to be around 4% to 5%, and insurance premiums are expected to be sharply higher. Overall housing costs and inflation make up 30% of the inflation basket, requiring inflation for all other items to fall to 1.5% in order for CPI to get back inside the target band.
7. New Zealand’s new Government tightens the purse strings
Under our new National-ACT-NZ First coalition Government, spending may be less supportive of economic growth in the coming years. While we are yet to have the new Government’s policies formally costed and assessed by Treasury, announced policies suggest a greater degree of fiscal prudence. The abandonment of allowing foreigners to buy houses above NZ$2mn and taxing them 15%, for example, represents a loss of revenue (c.NZ$700mn/year) that is likely to require spending cuts. There also appears to be a clear intention to reduce employment in the public sector.
This sits in the context of a set of fiscal projections that were already challenged by some very optimistic growth assumptions. Aside from policy implications, the new Government will likely need to incorporate a less rosy outlook for the economy which would have a negative impact on tax revenue and place more pressure on bond issuance to fill the gap. The RBNZ expects the economy to contract 0.2% over the next three quarters, while Treasury at the time of the September Pre-election Economic and Fiscal Update (PREFU) expected it to expand 1.3%.
8. Can China manage a cyclical bounce within a structural downtrend?
Most don’t expect a re-acceleration in Chinese economic growth in 2024. While public sector spending is expected to continue, weak consumption, slowing exports and low rates of private sector investment are seen as providing ongoing challenges to growth. These sit in the context of structural headwinds such as a debt-burdened property sector and a highly challenged demography with plunging birth-rates and a fast-ageing population.
With expectations so low, China may well surprise to the upside. There seems to be more appetite for policy support – both fiscal and monetary. In October, for example, the Chinese Government expanded the 2023 budget deficit to 3.8% of GDP, from 3.0%.
President Xi Jinping is also making direct efforts to boost FDI (foreign direct investment) after recent regulatory changes have spooked foreign investors, notably in financial technology, and the West has restricted the supply of technology, e.g. chip-making equipment. Turning the repatriation of profits by multi-national companies into inbound investments will require tweaks to policy settings, creating an environment where confidence in the underlying economy and that of capital flows improves.
Our view is that the direction of stimulus will be positive – a requirement given the state of the economy. Whether it will be large enough to drive improved consumer confidence and private sector sentiment is a key risk to the 2024 outlook. The property sector has been under siege from excess debt and falling prices for several years now and is a critical circuit breaker for economy-wide sentiment. Stemming the risks of more developer defaults will be a welcome change to the outlook for this important sector.
Finally, China plays a significant role in geopolitical stability globally and in our region. With both Ukraine and Taiwan having potential to escalate, recent bilateral meetings between Xi and Biden have reduced perceived risks of accelerated tension. Investors ought to follow political developments and monitor statements from senior politicians to gauge changes in direction.
9. Will New Zealand migration remain net disinflationary?
High rates of migration continue to pose an upside inflation risk. For now, the record 120,000 people that have entered New Zealand over the past year have been most helpful in alleviating supply pressure in the labour market, with the impact on demand less obvious. One area where migrant demand is showing up, however, is in housing. New rent prices are up more than 6% over the past year and house prices have lifted 2% in the past six months. With the prospect of mortgage rate declines in the coming months and the new Government’s pro-housing policies, the housing market may heat up over the summer. The associated positive impact on residential investment and consumption (via increased demand for furnishings and whiteware, along with the wealth effect) may create unwanted inflation pressure for the RBNZ.
10. Will New Zealand’s sovereign credit rating be downgraded in 2024?
New Zealand’s reliance on the rest of the world is growing and may culminate in a ratings downgrade in 2024. Our current account deficit has reduced from the almost 9% of GDP at the end of 2022 to 7.5%, but this is still too large. The most important metric for ratings agencies is New Zealand's funding need as a proportion of its foreign revenue. Specifically, this is the current account deficit as a proportion of current account receipts. This is currently 24%, where anything larger than 20% is seen as downgrade territory. Most economists expect growing tourism revenue and reduced import demand to see a further reduction in the current account deficit over the coming years. With a global economy in slowdown and Chinese tourist numbers currently a fraction of their pre-COVID levels, the question is whether this adjustment happens sufficiently quickly for ratings agencies to leave our AAA credit rating unchanged.
A higher reliance on the rest of the world may place further pressure on New Zealand to provide greater appeal to the marginal foreign investor. A weaker currency is the most common release valve in these situations but weakness in underlying assets, e.g. higher bond yields, is also possible.
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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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