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Market Commentary (May 2024)

“People often say there’s lots of uncertainty, but when was there ever certainty in the markets, the economy, or the future? I am just trying to understand the present” –  Bill Miller, Fund Manager at Legg Mason Capital.

Inflation is now surprising to the upside.

Inflation expectations have significantly shifted over the past three months, with inflation now starting to surprise to the upside. The US Federal Reserve's (The Fed) favoured measure of inflation is the Personal Consumption Expenditure (PCE) index. In the first quarter of 2024, the core PCE index rose 3.7% over the last 12-months, above the Fed's 3.4% expectation. The headline rate (including food and energy) rose 3.4% in Q1, up from 1.8% in Q4 of 2023.

It is not only in the US inflation that is surprising to the upside. As shown below, several countries have seen this change - including New Zealand, where non-tradable (local) inflation remains higher than was forecast.

The market expectations for the future path of the Federal Fund's cash rate have shifted significantly again in recent months, reflecting the improved economic outlook, inflation still being outside the US Fed’s target range, and a continuing tight US labour market. The market is now pricing a 0.37% cumulative reduction in the policy rate by the end of 2024, down from the incredible 1.75% worth of rate cuts priced in for January, only four months earlier.

The massive shift in market pricing in November 2023 was driven by Jerome Powell’s Monetary Policy Statement, where he confirmed the US cash rate was unlikely to rise further. Interestingly, he also stated the central bank had not even begun considering rate cuts and wouldn’t until inflation was under control. Clearly, the markets doubted his conviction in these views.

Reserve Bank of New Zealand is still on hold.

In the RBNZ’s latest Monetary Policy Statement (MPS), Adrian Orr confirmed that the RBNZ was less likely to raise the Official Cash Rate (OCR) beyond the current 5.50%. They provided guidance on the OCR over the coming years, suggesting the chance of a further rate rise has reduced from the previous 75% to a 40% chance as of February 2024.

The RBNZ Committee agreed that interest rates need to remain at restrictive levels for “a sustained period of time.” What does a sustained period look like? That will be data-dependent, with the RBNZ focusing on the non-tradable (or local) inflation pressures, which have proven more challenging to get back within the 1% - 3% target band. The RBNZ's latest guidance for the OCR suggests that NZ headline inflation will return to 2% in 2025. 

The higher for longer indication from the RBNZ will not be well received by those with large mortgages but will be well received by savers with money on term deposits. As stated above, markets remain highly uncertain about the timing of rate cuts. Any forecast is only as good as the data they consider on the day.

In early April, the RBNZ confirmed that New Zealand inflation had fallen from an annualised 4.7% to 4.0%. Unfortunately, non-tradable inflation eased only marginally, from 5.9% to 5.8% year-on-year, well above the RBNZ’s forecast of 5.3%. Within non-tradable inflation, services inflation actually re-accelerated, up from 4.7% to 5.3% year-on-year.

This was the fourth upward surprise in domestic inflation in New Zealand since the RBNZ went on hold in May 2023. It may be that there is a longer than usual lag between raising the local cash rate and inflation slowing, or it may be that the RBNZ needs to hold rates higher for longer. Possibly even one more rate rise to stamp out local (non-tradable) inflation pressures.

NZ property

Sustained inflationary pressures are leading to markets, economists, and the RBNZ reviewing their forecasts for the first rate cut. Previously, everyone was forecasting the first cash rate cut to be in early 2024 before being revised to late 2024, and now some economists are predicting the first cut to occur in the first quarter of 2025. This is not good news for New Zealand mortgage holders.

In March, NZ house prices fell 0.50% month-on-month, with sales continuing to fall, down 4.1% month-on-month. In early 2024, Barefoot and Thompson auction clearance rates increased to almost 60%, as purchasers anticipated that the New Zealand Official Cash Rate was at its peak for this economic cycle. House prices should stabilise and start to rise again. This view has now clearly changed, with clearance rates reducing to under 30% and continuing to decline.

New Zealand's house price inflation is closely correlated with expectations on interest rates. ANZ economists have reduced their 2024 annual house price inflation forecast from almost 8% to 3%. If inflation continues to prove stubborn through 2024, we may even see local economists forecast a further leg lower in house prices.

NZ Economy

No matter who you talk to, all agree that 2024 will be another challenging year. Already, we have seen negative third (-0.30%) and fourth-quarter (-0.10%) GDP. This confirms New Zealand is in a mild recession, with two negative quarters. We have now seen NZ’s GDP contract in four of the past five quarters. When allowing for the record level of immigration into New Zealand over the last year, New Zealand’s GDP is now down a more meaningful -3.9% peak to trough on a GDP per capita basis ending Q4 of 2023. To put this result in context, the GDP per capita drawdown in the 2008 Global Financial Crisis was 4.2% per capita.

If inflation continues to fall, we will likely see some much needed relief in the form of falling interest rates. The data to date, however is less than convincing.

Nvidia – the poster child of the rise of Generative AI.

Unless you have been living under a rock, you will have heard that Nvidia’s share price has rocketed to a new record price on the back of a massive increase in computer chip, server and data centre demand, on the back of the rise in Generative Artificial Intelligence (GenAI). Examples of Gen AI are Chat GPT, Copilot (Microsoft), and Bard (Google), to name a few. Nvidia dominates this sector with a market share of the AI chip market of nearly 80%.

Over the last three years, Nvidia’s share price has increased 517% (ending 22^nd of March 2024 This has occurred because of staggering earnings growth, with still more to come. Nvidia's revenue has grown 180% annually and 584% over the last twelve months. Revenue is forecast to grow a further 60% over the next 12-months.

At the time of writing, Nvidia's share price has dropped 12% from the 22^nd of March peak. It was not the only stock to fall from the previous peak, with the so-called Magnificent Seven (Nvidia, Meta, Amazon, Tesla, Microsoft, Google, & Apple) all down. In the week ending 19^th of April, the Magnificent Seven’s market cap (value of the seven companies) declined by an incredible US$950 billion. Nvidia’s capital value dropped $258 billion. This loss is larger than the total market cap of its rival, Advanced Micro Devices.

Why have we seen such a rapid rise in Nivida earnings and share price? Because the world is moving into a new technological paradigm, which demands greater computing power (more powerful chips). We are, of course, referring to the rise of Artificial Generative Intelligence.

Nvidia’s CEO, Jensen Huang, has suggested the rise of Gen AI will occur in four distinct waves:

• Wave One – (where we are now) The initial training and infrastructure build-out.
• Wave Two – Widespread Gen AI adoption within global businesses, driven by the rise of “AI agents”.
• Wave Three – Gen AI adoption in heavy industry (manufacturing, energy, etc).
• Wave Four – Gen AI adoption at a sovereign level, where every government relies on AI to function.

AI Agents are systems that can learn and act independently, such as Chat GPT. We understand that “computers” that can learn and act on their own sounds like something from the Terminator series, but AI agents will change the world for the better in many ways. One example is Deepmind, which created an AI agent called AlphaFold that, in 2020 mapped all the proteins expressed by the human genome, which would have taken humans millions of years. AlphaFold did it in just eighteen months. This has already led to massive advances in combating malaria, antibiotic resistance, and plastic waste.

Summary.

We expect 2024 to be another year of volatility and uncertainty. This view is best epitomised when we consider this year; we have the largest number of people ever in history going to the polls to vote in elections.

Economies have slowed, but we see economic surprises to the upside and consumer sentiment improving in most countries. This is not good news for central banks, who want to continue slowing down economies.

China is now exporting disinflation (an annualised decrease in the inflation rate) to all its trading partners as the cost of goods shipped worldwide declines. The only question is by how much. We now wait to see if the Central Banks can manifest a soft landing (no recession).

As shown below, NZ house price inflation will either be flat, with no growth over the next two years, or up 13% if you subscribe to the ASB and BNZ’s forecasts.

One thing is for sure: markets don’t like uncertainty, which is directly reflected in the heightened levels of market volatility we continue to experience in bond markets. In times like these, our focus is to carefully position portfolios to protect capital value and seek attractive investment options where we can. 

‍All information in this post is a guide only and not personal advice, PWA is not responsible for any decisions you make after reading this. Call us to discuss your personal circumstances.

This video is approximately 50 minutes in length and includes questions and answers sent in by guests.

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“As is often the case, we are navigating by the stars under cloudy skies” Jerome Powell, Chairman US Federal Reserve, August 2023

New Zealand is officially in recession

In the most recent survey, we have seen a small rally in NZ business sentiment from its recent lows, with the NZ “Business Own Activity” sneaking back into positive territory in June for the first time in 14 months.

According to the ANZ research team, the improvement across the NZ economy was broad, with the largest turnaround being in the service sector. This large shift in sentiment is likely related to the Reserve Bank of New Zealand recently indicating that NZ was now at the top of this tightening cycle.

Even though the NZ business community feels less pessimistic, the Consumer Confidence Index shows that consumers remain close to their most pessimistic on record. This has led some local economists to forecast that New Zealand may emerge from recession in the current quarter, only to quickly stumble back into another slowdown into late 2023 and early 2024.

ANZ’s tables below show that they forecast an annual net NZ migration number of 75,000 through 2023, declining to under 50,000 in 2024. This spike in net migration into New Zealand is the main reason we may muddle through 2024 with only a mild recession.

It is interesting to note that the GDP per capita (person) in New Zealand is forecast to decline rapidly in 2024. This is due to production in NZ not increasing in line with the net migration number. Another way of putting this is that we may only have a minor technical recession in 2024, but it could feel like a more severe recession to the average NZ citizen.

One thing is sure; there is a high degree of uncertainty around how deep or long this recessionary cycle may be, both locally and globally.

NZ property

Higher mortgage rates remain a significant headwind to NZ’s future GDP growth. While the average one-year rate may be c.7.25% in New Zealand, the average effective mortgage rate (average fixed rate of all mortgages) is still only c.5.0% (according to the Westpac Economics team) due to borrowers only now rolling off the lower rates.

As borrowers continue rolling off their low fixed-term rates over the coming 12 months, the effective rate is forecast to increase. The percentage of disposable income going to pay for mortgages in NZ has risen from its low of 5% in 2021 to 9% as of July 2023. This rate is forecast to peak at 10.5% in 2024. This is an average, with some who stretched to afford their home having to bear more of the burden. This will again impact the consumer’s discretionary income and add to the recessionary feeling.

According to REINZ data complied by Opes Partners, NZ average property prices have declined 18% from their peak in February 2022 to May 2023. Wellington is still leading the drop with a 25.4% decline, followed closely by Auckland, down 21.6% from their respective peaks. Despite this substantial price fall, Auckland is still 13% above the value last seen in January 2020, pre-Covid.

At the end of July, we have had three months of positive house price inflation, and auction clearance rates continue improving. Add to this the increase in immigration leading to higher rent inflation and interest rates possibly peaking, and it is beginning to look like the property correction may be at or just past the bottom of this cycle. Indeed, many economists are now calling the bottom and forecasting growth to start being positive y.o.y late in 2023.

ANZ forecasts that NZ house prices will rise 3% over the second half of 2023 before slowing into 2024 as we see rising unemployment, sustained high borrowing costs, and stretched affordability slowing the price inflation.

This may be correct if inflation continues to come down, and any recession in 2023 or 2024 is minor. However, the inflation dragon is far from tamed. The RBNZ will have minimal tolerance for increasing house prices because of a genuine fear that may add to inflationary pressures.

Is it deflation, inflation, or stagflation?

You can’t pick up a paper at present without finding a discussion about inflation in one form or another. In New Zealand, inflation is currently sitting at 6% after peaking at 7.3% in June 2022.

The US headline inflation peaked at 9.1% in June 2022 before rapidly declining to 3.0% as of June 2023. This rapid decline in headline inflation has come from reduced food and energy price inflation, while core inflation has proven more stubborn to get under control.

Wage inflation in the US is now higher than headline inflation. This suggests that there will be continued pressure on US inflation, pushing back to the 1 – 3% range that the US Federal Reserve wants to see before cutting rates.

We can expect US YOY headline inflation to increase over the next two months as the July and August 2022 rollout of the annual numbers. In July 2022, US monthly inflation was 0.0%; in August, it was 0.2%. According to Economist Steven Anastasiou, this will likely leave the US inflation range bound between 3% and 3.6% into the end of 2023. 

Economist Steve Anastasiou produced the US M2 and CPI table below. We have not seen the US M2 money supply decline by this level since the 1930s Great Depression. Ignoring that ominous observation, the table also highlights that we have also seen deflation in all instances where the US M2 money supply has declined. This supports the argument that we may see US inflation back within their 1-3% range sooner than most (including us) forecast and maybe even see deflation in late 2024.

It is fair to observe that most market commentators have no idea how this inflationary period will play out in 2024. Still, as we will discuss over the page, the bond markets are having difficulty pricing all the changing views.

Bond market uncertainty

At the start of 2023, we knew interest rates had risen rapidly, inflation was a problem, and expected share markets would struggle to produce positive returns in the following twelve months.

One of those three assumptions has proven untrue, with US share markets testing new highs as investors ignore all the dark clouds and invest with an eye on the hopefully sunny horizon.

In the bond market, there was less conviction on where the peak in interest rates might be or when global inflation would hopefully be tamed. This uncertainty has led to history's most volatile period in the US two-year government bond pricing. The chart below shows the weekly change in the US two-year government bond yield. What is most interesting about this is that two-year bonds should have less volatility, as markets should be able to forecast that far in advance, with only a small margin for error. An example showing how unprecedented this level of volatility is can be seen when comparing the last twelve months' variance in yield to the period in 2008, the Global Financial Crisis.

Most economists forecast that the US Federal Reserve will keep the cash rate high into the middle of 2024, with some suggesting the Fed will be able to start cutting rates as soon as the end of 2023.

Since 2008, the global central banks have been pushing interest rates lower to support growth via sustained Quantitative Easing (QE). The QE led to interest rates dropping below zero per cent for the first time in history. It should be unsurprising then to note that since 2021, when the Fed started raising rates to combat inflation, we have had one of the worst performance periods in the US ten-year government bond in history.

Given this historically high level of uncertainty in the ordinarily calm bond markets, it does cause us some concern that the US share market appears priced for perfection. The chance of an unpleasant surprise continues to be high when considering the change in the bond markets over the past three years.

US share market – some valuations are eye-watering.

The Price-to-earnings (P/E) ratio of the S&P500 is currently 19.8 times (X). This is historically on the expensive side. If we remove the so-called “enormous eight”, the PE ratio drops to 17.2 times. It is still expensive but closer to the long-run average S&P500 PE ratio of 14.9X.

Considering the eight largest stocks in the S&P 500, we can easily see that most of these are trading well above the long-run average. Tesla is “winning” the prize for most overvalued with a share price that is 59X forward 12-month forecast earnings, followed closely by Amazon (53X) and Nvidia (45X).

Another way of measuring whether a share is expensive or not is the Price of the Share divided by the firm's Annual Sales (P/S ratio). The average P/S ratio for the S&P500 is 2.5X. Nvidia is trading a truly incredible 43X P/S. The last time Nvidia was this expensive was just before the 2000 Tech Wreck.

We are certainly not forecasting a 2000 kind of correction, as companies have more substantial balance sheets and a more defensible revenue stream than in 2000. Still, there is no denying some of these tech stocks are now priced for perfection (and then some).

One last way to measure the value of the S&P500 is to compare the yields you get from the shares versus the yields you might get from a safer US 10-year government bond. As of the time of writing, the S&P500 is offering investors a yield of 1.54%, and the 10-year US Government Bond is yielding 4.05%. The last time the risk premium was this negative was in 2007, before the Global Financial Crisis.

China is slowing

China’s economy was expected to bounce back strongly after their Covid restrictions ended due to the “re-opening trade” we had seen worldwide. This recovery is yet to eventuate, with China’s economy slowing due to the global slowdown, increasing restrictions from the US, and China’s government restricting capital to critical sectors of their economy (mainly the property development sector). China is New Zealand’s biggest trading partner, followed closely by Australia (whose biggest trading partner is also China). Given this, it is fair to say that what happens in China will likely impact New Zealand’s economy.

China’s youth unemployment is over 21% and is expected to rise further over the coming quarters, highlighting the lack of growth in China’s economy. The high unemployment is very uncomfortable for the government. Given this, the government devised a novel way to fix the youth unemployment data. They simply stopped reporting it in August. Problem solved….?

At the start of 2021, the China High Yield (Junk Bond) index offered brave investors a yield of 7.37%. This appeared favourable compared to the 3.8% offered on US-domiciled junk bonds. Unfortunately, most investors were unaware of the risk associated with the Chinese debt, which was mainly made up of property developers.

Fast forward to today, and many Chinese property developers are now bankrupt after the government attempted to slow the growth of this sector via tightening lending standards. This has led to a drop of over 51% in the value of the Chinese high-yield (HY) index, which is now offering yields of over 25% to those brave enough to call a potential bottom.

China’s share market has returned 6.30% p.a. over the last decade. This is a reasonable return, but when we allow for a very high level of volatility over that same period, the “risk-adjusted” return looks unattractive. We can expect this volatility to continue as the central government continues to manipulate markets with regulation and stimulus.

China’s growth pulled the world’s economies out of recession after the 2008 Global Financial Crisis. They achieved this via internal infrastructure projects and the global Belt and Road initiatives. This development was largely funded via debt and has led to China’s debt-to-GDP ratio exceeding the US and Eurozone.

As noted in Salt Fund Management’s latest Insight report, China is not a free-market economy like the rest of the developed world. Both state controls and market forces instead characterise China’s economy. Most commentators expect the Chinese government to provide stimulus at the appropriate time to support a recovery in specific sectors of their economy. This is a realistic assumption, as they have done this consistently in the past. However, this also means that the most significant risk to China’s growth is likely a policy misstep by the government.

Summary

It is now clear that the world economies are slowing, with some already in contraction. Inflation appears to have peaked globally and is now slowing. Most economists forecast inflation to continue declining through 2024 until it is back within the central bank's targeted bands.

China is now exporting dis-inflation (a decrease in the inflation rate) to all its trading partners and is suffering from deflation (a year-on-year decline in the general pricing levels). This observation supports the view that inflation has peaked and is declining, suggesting interest rates may be close to peaking globally.

Will the Central Banks’ pause in rate rises be sufficient to stop a global recessionary environment? NZ and the Eurozone have already had a technical recession with two negative quarters of GDP. The rest of the world is still slowing. Hence, we may see most of the developed world slide into recession in late 2023 or early 2024. This is a probability in our view. The possibility is that we see other parts of the market, such as China or USA stimulate to levels that allow the rest of the world to have a soft landing.

At PWA, we monitor these markets closely while maintaining a patient and disciplined approach to managing portfolios. Given this level of uncertainty, we continue to proceed with caution as we wait for clear indications about where inflation is heading, when the US Fed will be able to stop tightening, and confirmation as to whether we might see a global recession. 

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All information in this post is a guide only and not personal advice, PWA is not responsible for any decisions you make after reading this. Call us to discuss your personal circumstances.

PWA supports the I Am Hope and the Gumboot Foundations by donating a percentage of our profits to these worthy charities each year. These two charitable foundations work at the very frontline of youth mental health in New Zealand, the Gumboot Foundation using 100% of their funding to provide access to free mental health care for those in need.

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We recently received a copy of their latest impact report, which discusses the current state of youth mental health in New Zealand as well as outlining the impact that the Gumboot Foundation has had on helping those in need. 

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Click here to download the report.

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Market Commentary (August 2023)

“The individual investor should act consistently as an investor and not as a speculator." 

Source: Benjamin Graham

The markets in a snapshot

US share markets have rallied since reaching a low in October 2022, with the S&P500 up almost 18% year to date (YTD) and the NASDAQ reaching its previous record high, up a staggering 44.5%. This rally in US share markets is on the back of the US Federal Reserve continuing to increase interest rates and the collapse of several US and Europe banks. This rally style is best described as “climbing a wall of worry.”

Below is a table showing the performance of different indices for the period ending 31^st July. The five-year performance in the bond market is now looking very poor after the 2022 drop in capital values caused by rapidly rising interest rates.

The US Aggregate Bond Index has declined 13% over the last 3-years. This has been the longest drawdown in the US bond market's history. This capital decline wiped out most of the small gains investors made when holding bonds with negative yields over the past five years.

The NZX All Real Estate index has declined almost 25% from its September 2021 high, as the listed property markets priced in the rising interest rates and a possible reduction in rental income due to more businesses now allowing staff to work from home. We have yet to see a similar decline in the unlisted commercial property sector.  As yields on the direct unlisted property are only now rising, reflecting the higher cash/borrowing rates.

Some other interesting year-on-year changes in USD are below. It is fair to say that Bitcoin has given the highest return since 2011, with a return of just over nine and a half million per cent (not a typo!).

New Zealand is officially in recession

In the quarter ending December 2022, New Zealand’s economy contracted by 0.70%. The first quarter of 2023, ending March 2023, was also slightly negative at 0.10%. While this is only a tiny contraction, the two-quarters of negative growth is the technical definition of a recession.

In the most recent survey, we have seen a small rally in NZ business sentiment from its recent lows, with the NZ Business Own Activity sneaking back into positive territory in June, for the first time in 14 months.

According to the ANZ research team, the improvement across the NZ economy was broad, with the largest turnaround being in the service sector. This large shift in sentiment is likely related to the Reserve Bank of New Zealand recently indicating that NZ was now at the top of this tightening cycle.

Even though the NZ business community feels less pessimistic, the NZ Consumer Confidence index shows that consumers remain close to the most pessimistic on record. This has led some local economists to forecast that New Zealand may emerge from recession in the current quarter, only to quickly stumble back into another slowdown into late 2023 and early 2024.

ANZ’s tables below show that they forecast an annual net NZ migration number of 75,000 over 2023, declining to under 50,000 in 2024. This spike in net migration into New Zealand is the main reason we may muddle through 2024 with only a mild recession.

It is interesting to note that the GDP per capita (person) in New Zealand is forecast to decline rapidly in 2024. This is due to production in NZ not increasing in line with the net migration number. Another way of putting this is that we may only have a minor technical recession in 2024, but it could feel like a more severe recession to the average NZ citizen.

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NZ property

Higher mortgage rates remain a significant headwind to NZ’s future GDP growth. While the average one-year rate may be c.7.30% in New Zealand, the average effective mortgage rate (average fixed rate of all mortgages) is still only 4.90%, according to the Westpac Economics team, due to borrower only now rolling off the lower rates.

As borrowers continue rolling off their low fixed-term rates over the coming 12 months, the effective rate is forecast to increase. As shown below, the percentage of disposable income going to pay for mortgages in NZ has risen from its low of 5% in 2021 to 9% as of July 2023. This rate is forecast to peak at 10.5% in 2024. This is an average, with some who stretched to afford their home having to bear more of the burden. This will again impact the consumer’s discretionary income and add to the recessionary feeling.

According to Core Logic data, NZ average property prices have declined -12.7% from their peak in February 2022 to June 2023. Wellington is still leading the drop with a -21.3% decline, followed closely by Auckland, down -16.8% from their respective peaks. Despite this substantial price fall, Auckland is still 13% above the value last seen in January 2020, pre-Covid.

Auction clearance rates have started to improve. Add to this the increase in immigration leading to higher rent inflation and interest rates possibly peaking, and it is beginning to look like the property correction may be at or just past the bottom of this cycle. Indeed, many economists are now calling the bottom and forecasting growth to start being positive y.o.y late in 2023.

ANZ forecasts that NZ house prices will rise 3% over the second half of 2023 before slowing into 2024 as we see rising unemployment, sustained high borrowing costs and stretched affordability.

NZ House Price Forecast

This may be correct if inflation continues to come down, and any recession in 2023 or 2024 is minor. But, the inflation dragon is far from tamed. The RBNZ will have minimal tolerance for increasing house prices because of a genuine fear that may add to inflationary pressures.

Is it deflation, inflation, or stagflation?

You can’t pick up a paper at present without finding a discussion about inflation in one form or another. In New Zealand, inflation is currently sitting at 6% after peaking at 7.3% in June 2022.

The US headline inflation peaked at 9.1% in June 2022 before rapidly declining to 3.0% as of June 2023. This rapid decline in headline inflation has come from reduced food and energy price inflation, while core inflation has proven more stubborn to get under control.

Wage inflation in the US is now higher than headline inflation. This suggests that there will be continued pressure on US inflation, pushing back to the 1 – 3% range that the US Federal Reserve wants to see before cutting rates.

We can expect US YOY headline inflation to increase over the next two months as the July and August 2022 rollout of the annual numbers. In July 2022, US monthly inflation was 0.0%; in August, it was 0.2%. According to Economist Steven Anastasiou, this will likely leave the US inflation range bound between 3% and 3.6% into the end of 2023.  

Economist Steve Anastasiou produced the US M2 and CPI table below. We have not seen the US M2 money supply decline by this level since the 1920s Great Depression. Ignoring that ominous observation, the table also highlights that we have also seen deflation in all of the six-years instances since 1913, where the US M2 money supply has declined. This supports the argument that we may see US inflation back within their 1-3% range sooner than most (including us) forecast.

It is fair to observe that most market commentators have no idea how this inflationary period will play out in 2024. Still, as we will discuss over the page, the bond markets are having difficulty pricing all the changing views.

Bond market uncertainty

At the start of 2023, we knew interest rates had risen rapidly, inflation was a problem, and the share market would struggle to produce positive returns in the following twelve months.

One of those three assumptions has proven untrue, with US share markets testing new highs as investors ignore all the dark clouds and invest with an eye on the hopefully sunny horizon.

In the bond market, there was less conviction on where the peak in interest rates might be or when global inflation would hopefully be tamed. This uncertainty has led to history's most volatile period in the US two-year government bond pricing. The chart below shows the weekly change in the US two-year government bond yield. What is most interesting about this is that two-year bonds should have less volatility, as markets should be able to forecast that far in advance, with only a small margin for error. An example showing how unprecedented this level of volatility is can be seen when comparing the last twelve months' variance in yield to the period in 2008, the Global Financial Crisis.

Most economists forecast that the US Federal Reserve will keep the cash rate high into the middle of 2024, but some suggest the Fed will be able to start cutting rates as soon as the end of 2023.

US Cash rates, as shown below in the three-month Treasury Bills (T-bills) T-bills, are now back at levels not seen in the last twenty years. The three-month T-bills are not pricing in any fall in interest rates into the end of this year. The yield on these T-bills has instead been rising consistently through 2023.

Given this historically high level of uncertainty in the ordinarily calm bond markets, it does cause us some concern that the US share market appears priced for perfection. The chance of an unpleasant surprise in the share market continues to be high when considering the change in the bond markets over the past three years.

US share market – some valuations are eye-watering

The Price to Earnings (P/E) ratio of the S&P500 is currently 19.8 times(X). This is historically on the expensive side. If we remove the so-called “enormous eight”, the PE ratio drops to 17.2 times. Still expensive but closer to the long-run average S&P500 PE ratio of 14.9X.

Considering the eight largest stocks in the S&P 500, we can easily see that most of these are trading well above the long-run average. Tesla is “winning” the prize for most overvalued with a share price that is 59X forward 12-month forecast earnings, followed closely by Amazon (53X) and Nvidia (45X).

Another way of measuring whether a share is expensive or not is the Price of the Share divided by the firm's Annual Sales (P/S ratio). The average P/S ratio for the S&P500 is 2.5X. Nvidia is trading a truly incredible 43X P/S. The last time Nvidia was this expensive was just before the 2000 Tech Wreck.

We are certainly not forecasting a significant correction, like in 2000, as the companies have more substantial balance sheets and a more defensible revenue stream than in 2000. Still, there is no denying some of these tech stocks are now priced for perfection (and then some).

One last way to measure the value of the S&P500 is to compare the yields you get from the shares versus the yields you might get from a safer US 10-year government bond. As of the time of writing this, the S&P500 is offering investors a yield of 1.54%, and the 10-year US Government Bond is yielding 4.05%. The last time the risk premium was this negative was in 2007, before the Global Financial Crisis.

Summary

As interest rates have risen and economies have slowed, share analysts have made multiple earnings downgrades anticipating a slowing in growth and companies missing their earnings guidance.

Several leading indicators suggest global corporate earnings can fall further. Below is a chart going back to the 1990s, showing the correlation between global earnings per share (EPS) and Taiwanese exports (pushed six months forward).

The chart is from May 2023, but Taiwanese exports have continued to fall, with a decline of 10.4% YOY for the period ending July, the eleventh Y.O.Y decline. If this long-term correlation holds, we can expect earnings to decline over the coming six to twelve months.

Most share markets do not have this level of earnings contraction reflected in their share prices; hence, they may struggle to hold their current high valuations.

Will the Central Banks’ pause in rate rises be sufficient to stop a global recessionary environment? NZ and the Eurozone have already had a technical recession with two negative quarters of GDP contraction. The rest of the world is still slowing. Hence, we may see most of the developed world slide into recession in late 2023 or early 2024. This is a probability in our view. The possibility is that we see other parts of the market, such as China or USA stimulate to a level that allows the rest of the world to have a soft landing.

At PWA, we monitor these markets closely while maintaining a patient and disciplined approach to managing portfolios. Given this level of uncertainty, we continue to proceed with caution as we wait for clear indications about where inflation is heading, when the US Fed will be able to stop tightening, and confirmation as to whether we might see a global recession. 

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“Volatility is a symptom that shows people have no clue of the underlying value.” –Jeremy Grantham -GMO

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The US is tightening – right up until they are not

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So much happened in March that we find it difficult to know where to start with this month’s commentary. March has proven to be where the US Federal Reserve’s (the Fed) increase in their cash rate got to a point where the US banking system broke. You will have heard of the collapse of Silicon Valley Bank (SVB), Signature bank, and Credit Suisse.

This outcome is not unusual when the Central Banks increase their cash rates. The rapid rise in cash rates leads to an increase in lending rates, which leads to the companies (and people) that have borrowed too much money, or planned on lower rates for longer failing.

As shown below, most periods in history where the US Fed has increased rates now have a historical name. Some periods that most of you will remember are the 1987 stock market crash, the tech wreck of 2000, and the Global Financial Crisis of 2008.

Fed tightening constantly breaks something

Will the 2023 banking crisis earn a historical name? Time will tell. But at this stage, the Fed and other larger investment banks have supported the banking sector by providing liquidity to meet the run on capital as investors pulled their cash out of uninsured banks.

In 2022, the US Fed stopped its quantitive easing (QE) due to inflation concerns and started quantitive tightening (QT). QT is where it pulls the QE back out of the financial system. Since QE peaked in April 2022, the Fed has been tightening for 11 months. Over this time, they had withdrawn US$626 billion.

The Fed pumped US$392 billion into the banking sector in only two weeks when the banks started collapsing last month. This means that over 60% of all the QT during the previous eleven months was undone in only two weeks.

US Fed – Balance sheet

US economy tightening

Post the run on Silicon Valley Bank (SVB) and Signature Bank, the US Fed Discount Window has seen a record level of demand as US banks move to shore up their balance sheets. US banks have drawn down almost US$170 billion over the two weeks since the banking crisis commenced. As shown below, this discount window usage level easily exceeds the 2008 Global Financial Crisis and the 2020 Covid lockdowns.

US emergency borrowing may lead to tighter lending standards

Post previous banking crises, we have seen US banks tighten the rules around lending to businesses. We have already seen lending conditions tighten this time, with expectations of further tightening to follow. As shown below, this increases the risk of a US recession.

Tighter lending conditions increase the risk of a US recession

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Bond markets pricing in a high chance of interest rate reductions

After the failure of SVB (and the corresponding bail-out), bond markets around the world repriced dramatically. As shown below, the NZ bond market anticipated the OCR would peak at just over 5.50% at the end of 2023. After the banking failure, market expectations were repriced to just over 5%.

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NZ OCR Market pricing – Friday 10^th March

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NZ OCR March Pricing – Friday 17th March

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This rapid change in the market pricing of future rate hikes occurred due to bond investors’ pricing in a higher chance of a recession and hence a rapid decline in central banks’ cash rates as they try to re-stimulate shrinking economies.

Bond markets have good reason to believe the US Federal Reserve will commence cutting rates if that economy moves into a recession, as they have done so regularly in previous recessions.

US Fed – cash rate changes during previous recessions

The Fed may not be able to meet the expectation of the bond investors by reducing the cash rate anytime soon, regardless of a recession. Inflation in the US does appear to have peaked (and now declining) as it has in the wider developed world, but it is still proving stubborn to get under control.

Below is the Personal Consumption Expenditure (PCE) inflation index. The PCE index is the Fed’s preferred measure of US inflation pressures. The circles show when the US Fed has previously changed the direction of their cash rate movements based on their 2% average inflation target.

From 1995 – 2020 inflation was very benign. Hence the Fed needed to only make small changes to the cash rate as the inflation rate traded around 2%. Post the Covid lockdown, the stimulus put into the consumer’s hands rapidly increased PCE inflation, which peaked at c.5.50% in mid-2022. PCE headline inflation has now dropped to 4.71% and is forecast to drop further as Covid price pressures abate. As shown, PCE inflation has a long way to fall before the US Fed feels comfortable the inflation outbreak is under control.

Core US PCE inflation (YoY % - with Fed 2% target & pivots (circles)

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Are US share analysts too optimistic?

The left table below shows US share analyst’s consensus forecast (purple bars). The S&P500 earnings per share (EPS) are forecast to grow 15% into the end of 2023. The table on the right shows the consensus forecast for YoY GDP growth in the US. As shown, analysts forecasting growing EPS are also predicting a slowing US economy. We would agree if you think these two forecasts are at odds with each other.

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Below is a table showing the same S&P500 forward earnings per share (dark blue line), which has slowed since it peaked in late-2021. The light blue line is a forward indicator for S&P500 earnings. This indicator comprises a survey of US credit managers and the ISM Manufacturing PMI index.

If the correlation between these two lines holds, it suggests the S&P500 EPS will decline by c.5% into the end of 2023. Quite a difference from the analyst’s forecasts of 15% growth.

S&P500 EPS vs. leading indicators

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Even among share analysts, the dispersion of earnings growth into the end of this year is at historically high levels. This indicates the heightened uncertainty around whether the US economy will suffer a recession (two negative quarters) in 2023. Most indicators suggest a recession, but the tailwind for US growth is improving with China’s re-opening from the Covid lockdown.

The year-to-date S&P500 rally has been driven by Price to Earnings ratio expansion in anticipation of rising EPS. This suggests that the market may reprice lower if the analysts forecast EPS growth proves too optimistic.

NZ property market continues to decline

New Zealand house prices continue to fall as the sharpest increase in interest rates in four decades decreases the affordability of properties. Before this sell-off, New Zealand had one of the world's most overpriced housing markets. Given this, it is unsurprising that we are now having one of the worst declines in house prices in the developed world. To date, NZ prices are down 16.2% from the November 2021 peak, with Wellington dropping the most, down -22.9%, with Auckland a close second, down -21.6%.

NZ mortgage rates & quarterly house price inflation

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Property Investors have been well rewarded over the past 20-years. According to data from REINZ, as interest rates in New Zealand have declined over this period, Auckland house prices have risen at 6.8% per annum or 372% over the last 20-years! Considering that most property investors borrow to purchase (or leverage), their returns on the capital they committed will be well in excess of 372%. No wonder property investors cannot understand why 100% property is not the best investment.

New Zealanders have benefited from a very positive “wealth effect” from rapidly increasing capital prices. The wealth effect occurs as people feel richer (even if it's only a paper gain) they will spend more. The exact opposite is now happening. As house prices drop, people feel poorer. Given this, it is unsurprising that New Zealand's consumer and business confidence index has fallen so dramatically.

ANZ NZ Consumer Confidence Index ( March 2023)

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ANZ Business Confidence Survey  (March 2023)

With prices falling in most areas, the average house price-to-income ratio has also reduced from 8.8 to 7.8 times. This ratio is still expensive and well above the long-term average of 6.0 times.

As wage inflation continues to drag incomes higher and house prices continue to decline, we can expect to see house prices bottom, maybe as soon as the end of 2023. If we see a rapid decline in interest rates on the back of a recession, we could potentially see prices increase again. As to when this occurs is anyone's guess. As discussed above, the uncertainty around inflation and interest rates remains high.

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Summary

We have seen a historically high level of support for the US banking sector on the back of the collapse of Silicon Vally Bank (SVB) and Signature bank. The increased uncertainty in this sector has led to massive swings in the US interest rate market. Below is a chart showing the US short-dated interest rate market movement. At the start of 2023, the market was pricing a cash rate of 4.4% by Feb 2024. This had reduced a bit by the beginning of Feb 2023 to c4.2%. Inflation then started to surprise too the upside, and we saw a massive move in pricing from 4.2% to 5.6% over just five weeks.

US Yield Curve has been volatile from 1^st January – 17^th March 2023

Whilst this increase in interest rates was massive,  it was nothing compared to the 1.8% drop that occurred over just ten days post the collapse of SVB. This collapse led to one of history's most significant moves in the US 2-year government bond rate.

At PWA, we continue to monitor these markets closely while maintaining a patient and disciplined approach to managing portfolios. Given this level of uncertainty, we continue to proceed with a high level of caution as we wait for clearing indications about where inflation is heading, when the US Fed will be able to stop tightening, and confirmation as to if we will see a global recession. 

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Private Wealth Advisers believes the information in this publication is correct, and it has reasonable grounds for any opinion or recommendation found within this publication on the date of this publication. However, no liability is accepted for any loss or damage incurred by any person because of any error in any information, opinion, or recommendation in this publication. Nothing in this publication is, or should be taken as, an offer, invitation, or recommendation to buy, sell or retain any investment in or make any deposit with any person. The information contained in this publication is general in nature. It may not be relevant to individual circumstances. Before making any investment, insurance, or other financial decisions, you should consult a professional financial adviser. This publication is for the use of persons in New Zealand only. Copyright in this publication is owned by Private Wealth Advisers. You must not reproduce or distribute content from this publication or any part of it without prior permission.

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"Don't give me a low rate. Give me a true rate, and then I shall know how to keep my house in order." — Hjalmar Schacht, Reichsbank president, 1927

US inflation surprised to the upside…….again

At the June 2022 Federal Open Market Committee (FOMC) meeting, US inflation surprised to the upside (again) with a year-on-year (YoY) increase of 8.58%. It is now forecast to peak at 9% later in 2022.

The chart below shows that this upside surprise was due to food and energy inflation. Other parts of the US economy have been slowing, so even though Inflation surprised to the upside, core inflation (inflation excl. food and energy) has continued to decline.

US inflation and forecast – July 2022

The last time US inflation was at 8.58% was in December 1981. Back then, the US Federal Reserve (the Fed) cash rate was at 13% vs today's cash rate of only 1.58%. Is the Fed "behind the curve" and needing to accelerate their interest rate increases? Yes, they now forecast much higher cash rates into the end of 2022 and 2023, as discussed over the page.

US Cash rate & Inflation (1954 – 2022)

As US inflation continues to surprise to the upside, the Fed’s indicative cash rate forecasts have also climbed. As shown below, in September 2021, the Fed forecasted the US cash rates would be 0.25% by the end of 2022 and 1.00% by the end of 2023. Fast forward to their June 2022 FOMC meeting, and they are now forecasting the cash rate to peak at 3.40% in 2022 and 3.75% in 2023. This is an increase of 1,260% in the 2022 forecast cash rate in only eight months!!

US Fed June 2022 Dot Charts

The Fed dot chart above is also forecasting interest rates dropping into 2024. This assumes that Inflation has declined and the increasing chance that the US economy will go into recession in 2023.

Share markets are now pricing in higher interest rates

At the end of June, the markets have dropped -21% (S&P500), -30% (Nasdaq100), -13% (ASX200), -19% (NZX50) from their respective 2021 peaks. Below is a chart showing the worst US share market drawdowns since 1928. The current bear market is the bold blue line, and as shown, there is potential for further downside from these levels.

Worst US equity drawdowns (1928 – 2022)

Share analyst forecast – slow to price a recession

When considering what might be a suitable entry-level to buy into falling share markets, one of the indicators we consider is the Price to Earnings (P/E) ratio. This indicates the multiple that the share price is above the 12-month forecast earnings. The average P/E ratio for the S&P500 over the last 20 years is 15 times earnings. After the recent drop in share prices, the market is now trading at this level. This suggests that it may be a reasonable entry point. Not cheap but also not expensive.

If we used this as the only indicator, we might recommend the deployment of funds; however, the ratio has two parts to it. One is the price of shares, which is simply what the current share prices are trading at. The second part is the 12-month forward earnings. This is the less simple part of the ratio as it is determined by share analysts' forecasts for the company's earnings over the next 12 months.

The chart below shows that historically analysts have not been very accurate at forecasting a drop in earnings caused by a recession. During such times, analysts' forward earnings estimates have proven to be too optimistic. This is to be expected as recessions are inherently challenging to forecast.

Equity analyst earning downgrades usually miss recessions

Currently, there is an increasing risk of a recession globally; hence the earnings forecast for the coming 12 months may be too optimistic. The chart below highlights that global Purchasing Managers Indices (PMIs) are declining, suggesting the global economy is slowing. The chart suggests we may see a drop in earnings per share (EPS). If we factor in falling earnings (below the analysts’ forecasts), then the P/E multiple might be closer to 18 times, which is not cheap.

S&P500 earnings expected to drop

No diversification benefits

When designing investment portfolios, the standard practice is to invest in some shares and bonds. This is to reduce the risk of the portfolio's assets all dropping simultaneously.

Unprecedented levels of quantitative easing (QE) had pushed global interest rates/yields to historically low levels (record high bond prices) and shares to record high levels. When the QE ceased, interest rates started to revert to more normal levels, and as you would expect, both bond and share prices also normalised.

Since peak prices in November 2021, share and bond performance has become correlated for the first time since early 2000. The first quarter of 2022 shows a combined loss (shares + bonds) of almost 25%. This is the worst quarterly performance in modern history. During this correlated period, cash and short-dated bonds are kings.

Global Stocks and Bonds just had their worst quarter ever

The rise & fall of retail investors

In past corrections, the decline in share values has been exacerbated by retail investors capitulating and selling shares into a falling market. This behaviour has led to periods where shares traded at historically cheap valuations, such as in 2000 (the “Tech Wreck”) and 2008 (the Global Financial Crisis (GFC)). In the current decline, retail investors have held their positions and have continued to "buy the dip."

As shown in the chart below, retail investor sentiment is at levels last seen in the GFC, yet their portfolio allocation to shares remains historically high. This correction is unusual from others, given retail investors now have access to quality market information via Google, YouTube, and trading platforms like Robinhood in the US or Sharesies & Hatch closer to home.

We hope this will change retail investors' behaviour, but the psychological pain felt from losses will still be high at present. Retail investors have not capitulated to date, but there is already some serious blood on the street within their portfolios. We continue to watch the retail investors closely.

US Retail investors still holding shares

Average retail investment now in loss

Summary

We expect continued volatility into the end of 2022 and a possible global recession in 2023. However, we anticipate that interest rates are potentially already at or near their peak levels for this cycle.

Bond and share markets are now trading at more reasonable valuations versus history, though there are still some headwinds that we need to be mindful of. Share markets may be reasonably priced, but that does not mean they can't get cheaper.

No one rings the bell at the bottom of a bear market, but at PWA, we monitor these markets closely as we attempt to identify a time to start increasing the exposure to shares and bonds.

PDF with images available for download

We don't have to be smarter than the rest. We have to be more disciplined. – Warren Buffett

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A volatile start to the year

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Most developed world share markets remain in negative territory year to date, with the NASDAQ 100 and Shenzhen CSI 300 vying for the worst performance, with both down over 18% year to date.

The NASDAQ 100 declined -13.37% in April 2022, the worst monthly decline since October 2008, and is now down -22% from its December 2021 peak. The Dow Jones has lost -13.3% YTD, which is the worst start to a year since 1939.

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Global share market indexes - YTD

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Share market declines are mainly due to inflation pressures continuing to surprise to the upside. This increases pressure on Central Banks to continue raising rates as they try to tame the inflation monster.

As shown in the table below, bond markets are pricing in between 1.25% and 2.60%  increases to official cash rates, with the U.S. Fed forecast to increase by the most over the next 12-months. The table also shows the N.Z. bond market is expecting the RBNZ to tighten a further 2.00%, which is lower than the U.S. Fed, but the RBNZ has already raised the N.Z. Official Cash Rate (OCR) four times (since October 2021) for a total increase of 1.50%. If we add this to the forecast rate rises, this totals an increase of 3.50% to the N.Z. OCR. The N.Z. OCR was 0.25% at the end of September 2021.

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G10 Central Banks Monetary Policy

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The global bond market is also declining

As inflation expectations have risen, the yields demanded by investors have also risen. An increase in yields leads to a drop in the capital value of the bonds. The longer the term to the maturity of the bond, the greater the capital impact from a change in interest rate pricing.

As shown below, the U.S. Aggregate Bond Index has now declined over 11% since its peak in price in late 2021. This is the biggest drawdown of this index in history. If we focus on longer-dated bonds, the U.S. 20-year+ Government Bond Index capital value has dropped by c.30% since the peak. U.S. government bonds are supposed to be some of the safest bonds globally, but the recent quantitative easing from the U.S. Fed during the Covid lockdown in 2020 had pushed the price of bonds to unsustainable levels.

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Barclays U.S. Aggregate Bond Index (USD) – Drawdowns (%)

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Inflation continues to exceed expectations

The Ukraine war's impact on commodity prices is only part of the inflation pressure we see in 2022. In 2020, as I am sure we all remember, the world was introduced to a pandemic and placed into rolling lockdowns. These lockdowns had a devastating effect on the production and supply of goods.

At the same time, governments worldwide provided record-high levels of stimulus. This led to an equally significant increase on the demand side. This increase has led to suppliers being unable to meet demand.

As shown below, economists worldwide continuously upgrade their peak inflation number for 2022. The continual increase in the forecast can also be seen closer to home, with N.Z. economists and the RBNZ predicting in February 2021 that inflation would peak at about 2.5%.

Fast forward to February 2022, and N.Z. economists are now forecasting inflation to peak at over 7%, with ASB Economists now forecasting N.Z. inflation to stay above 5% for the rest of 2022 and not fall back to 3% until 2024 at the earliest.

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Latest inflation forecast for 2022 – higher for longer

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The forecast peak for inflation has constantly increased, as has the expected duration Still, the one thing that has not changed is the almost universal belief that high inflation will be transitory. It is simply a matter of how long "transitory" is.

As shown in the table below, a significant part of the increase in U.S. inflation has come from energy and food inflation. This pricing pressure is forecast to peak and reduce over 2022, with U.S. inflation forecast to be just under 4% by the end of 2022. As another example of the speed of changing predictions, most U.S. economists were forecasting that U.S. inflation would be close to 2% by the end of 2022, as recently as early-2021.

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U.S. – CPI Inflation contributions

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The more concerning observation is that core inflation (excluding food and energy prices) has been climbing and is expected to increase over 2022. This is concerning as core inflation is stickier and is more difficult for the U.S. Fed to get under control with their rate rises. U.S. Core inflation is forecast to remain above 2% into 2024.

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Interest rate expectations rise rapidly

So, what does all this inflation talk mean for the markets? In March, the U.S. Fed commenced raising the U.S. cash rate to a range of 0.25% to 0.50%. This was its first hike since 2018.

As inflation pressures rise, the bond market is pricing in more significant and faster increases in U.S. cash rates. In January, the bond markets were pricing in only a 38% chance of a 0.25% increase in the U.S. cash rate in May and only three rate hikes in total in 2022. The most recent reading shows the market is now pricing in a 13% chance of a 0.75% increase in the U.S. cash rate in May and eleven rate hikes in 2022. There are not eleven more Fed meetings this year, which means that the bond market has gone from expecting a few 0.25% rate rises to multiple 0.50% cash rate increases this year.

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Market pricing of 0.25% rate rise in U.S. in May

Market pricing of0.25% rate rise in U.S. in June

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The U.S. bond market is now forecasting this tightening cycle (increasing interest rates) to be one of the most rapid in the last 25-years. This aggressive future pricing of rate hikes does leave some room for the Fed to change its mind and indicate a slower than forecast increasing cycle.

If inflation proves to be transitory and economic growth continues to slow, we can expect the U.S. Fed to consider walking back a few of their forecast rate rises. Given the uncertainty around inflationary pressures, we would not want to be taking any high conviction positions around where the U.S. cash rate will peak this cycle.

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Current pricing for rate rises vs previous tightening cycles

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The "Bears" are coming out

In the investment world, there are "Bulls" (investors that think markets will go higher) and “Bears” (investors that think markets will go lower). The Bears have got a lot louder in the last month, with the AAII Bull Spread index now back in Bear territory to levels last seen in 2009.

This phenomenon is not just appearing in the retail sector but also within the institutional sector, with almost 80% of fund managers polled now expecting a slowing economy. This is the worst reading on record. In March, a fund manager's biggest fear was understandably the invasion of Ukraine by Russia, but in April, their biggest concern has changed to the fear of a global recession.

As of the end of April 2022, the U.S. GDP for the first quarter of 2022 was confirmed at -1.4%. This was a very large miss from the +1.0% growth expected by most economists. Delving into the data from this result, it is quickly apparent that the major detractor was net exports. This is due to the U.S. having the biggest trade monthly deficit ever, of -$125 billion in March 2022.

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Global Growth optimism at all time low

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Fund managers biggest "tail risk" fears

This may sound very dramatic and negative; however, it is arguable that share markets have already priced much of this risk in their declines year-to-date. Historically, this level of negativity has proven to be a good time to consider buying into the markets as others sell. To quote Warren Buffett, "Be greedy when others are fearful". We may now be getting closer to the "capitulation" of retail investors.

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NASDAQ 100 – now in a bear market

As discussed above, the Nasdaq has fallen -22% since its peak in 2021. With a drop of over 20%, the NASDAQ 100 is now officially in a "bear market". The decline from the peak may sound significant, but it hides a much higher level of losses within this index. Over 45% of all the companies listed on the NASDAQ 100 have declined by over 50% from their peaks. A further 20% dropped more than 70%, with 4% dropping by a terrifying 90% from their peaks.

So, why is the index only down 20% when c.70% of the companies in the index have declined by more than 50%? The top 10 companies make up over 52% of the Nasdaq's market cap. These are the giant firms such as Apple, Microsoft, Amazon, Meta, etc. Why does this matter? Because it could be argued that we may have already had a "Global Financial Crisis" level correction in the Nasdaq.

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Nasdaq 100 – percentage decline from company's previous peak

Summary

It has certainly been an eventful beginning to 2022. Global inflationary pressures remain the primary concern in the medium term. As we get a more precise reading of inflation's transitory (or not) nature, we will get a better feel for where interest rate rises may end. At present, any forecasts around this come with a sizeable margin of error.

Lastly, when the U.S. Federal Reserve started increasing cash rates, this did not mean that it was the end of the share market rally. As shown below, when reviewing fifteen different tightening cycles in the U.S.,   global share markets usually moved higher over 12 to 24-months. This is generally because it takes several rate rises before the economy slows and the risk of a recession starts to drag share markets lower.

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S&P500 performance 12-mths before & 24-mths after the first rate hike

As discussed at the start, we have come into 2022 with concerns around possible volatility in the global investment markets, which has played out. How financial markets continue to move over the rest of 2022 remains uncertain, with many possible outcomes.

At PWA, we monitor these historical events and portfolios closely while remaining conservatively positioned within portfolios and maintaining a disciplined approach.

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“…people who are comfortable with their investments will, on average, achieve better results than those who are motivated by ever-changing headlines, chatter, and promises.” – Warren Buffet – 2021

A volatile start to the year

Global stock and bond markets were already declining as we entered 2022. The decline over the last couple of months was due to several strong headwinds. Data suggested a slowing global economy,  Central Banks had signaled an end to easy money (Quantitative Easing), and persistent inflation led to rapidly rising interest rates.

We now have further headwinds with Russia’s tragic invasion of Ukraine. Russia and Ukraine supply a surprisingly large percentage of commodities to the world. Russia’s key exports are crude oil, gas, and coal briquettes. Ukraine was the second-largest exporter of grains to the EU and a large food supplier to Asian and African countries.

This disruption to supply has led to a rapid rise in commodity prices at levels we have not seen in the last 100-years. These rapid rises in commodity prices have pushed peak inflation expectations even higher globally, in turn driving bond yields higher.

CRB Commodity Index – y.o.y % change

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Given Europe’s geographic proximity to the conflict and its heavy reliance on Russia for energy, their share markets have declined post the invasion. The STOXX Europe 600 index fell -15.30% from the start of the year before staging a recovery to finish down only -6.31% year to date (as of the 31^st March).

The majority of the developed economy share markets are in negative territory year-to-date. Still, more interestingly, bond markets are also tumbling as yields on bonds rise on the back of increasing inflation pressures.

The Barclay Global Aggregate Bond Index (the Agg) is a selection of more than 10,000 government and corporate bonds and mortgage-backed securities. The Agg has declined by c.-7.3% over the last 12-months and has fallen from its previous high by more than -11%. Both of these drops are the largest negative performance numbers in the history of the Agg, and we are only three months into the year!

Barclays Global Aggregate Bond Index (USD) – ending 24t March 2022

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Inflation continues to exceed expectations

The Ukraine war’s impact on commodity prices is only part of the inflation pressure we see in 2022. In 2020, as I am sure we all remember, the world was introduced to a pandemic and placed into rolling lockdowns. These lockdowns had a devastating effect on the production and supply of goods. At the same time, governments worldwide provided record-high levels of stimulus to their citizens. These payments led to an equally significant increase in the demand side. This increase in demand has led to suppliers being unable to meet demand.

As shown below, economists worldwide continuously upgrade their peak inflation number for 2022. The continual increase in the forecast can also be seen closer to home, with NZ economists and the RBNZ predicting in February 2021 that inflation would peak at about 2.5%. Fast forward to February 2022, and they are now forecasting inflation to peak at just over 7%.

Latest inflation forecast for 2022 – higher for longer

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The forecast peak for inflation has constantly increased, as has the expected duration for which we will be experiencing higher inflation. Still, the one thing that has not changed is an almost universal belief that high inflation will be transitory. It is simply a matter of how long “transitory” is.

As shown in the table below, a significant part of the increase in U.S. inflation has come from energy and food. This pricing pressure is forecast to peak and reduce over 2022, with U.S. inflation forecast to be just under 4% by the end of 2022.

U.S. – CPI Inflation contributions

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The more concerning observation from this is that core inflation (excluding food and energy prices) has been climbing and is expected to move higher in 2022. This is more concerning as core inflation is stickier and is more difficult for the U.S. Fed to get under control with their rate rises. We can also note that core inflation is forecast to remain above 2% into 2024.

Interest rate expectations rise rapidly

So what does all this inflation talk mean for the markets? In March, the U.S. Fed commenced raising the U.S. cash rate to a range of 0.25% and 0.50%. This was its first hike since 2018. Since the start of 2022, the expectation around the number and speed of further rate hikes in 2022 has increased dramatically.

As inflation pressures rise, the bond market is pricing in larger and faster increases in the U.S. cash rates. In January, the bond markets were pricing in only a 38% chance of a 0.25% increase in the U.S. cash rate in May and only three rate hikes in total in 2022. The most recent reading shows the market is now pricing in a 72% chance of a 0.50% increase in the U.S. cash rate and almost ten rate hikes. There are not nine more Fed meetings this year, which means that the market has gone from expecting a few 0.25% rate rises to three 0.50% cash rate increases this year.

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Market pricing of 0.25% rate rise in the U.S. in May

No. of rate rises expected in the U.S. in 2022

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The U.S. bond market is now forecasting this tightening cycle (increasing interest rates) to be one of the most rapid tightening periods in the last 25 years. This aggressive future pricing or rate hikes does leave some room for the Fed to indicate a slower than forecast increasing cycle.

If inflation proves to be transitory and economic growth continues to slow, we can expect the U.S. Fed to consider walking back a few of their forecast rate rises. Given the uncertainty around inflationary pressures, though, we would not want to be taking any high conviction around where the U.S. cash rate will peak this cycle.

Current pricing for rate rises vs previous tightening cycles

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Stagflation becomes a larger risk

According to the Oxford Dictionary, Stagflation is defined as “persistent high inflation, combined with high unemployment, and stagnant demand in the country’s economy”. According to Google, the number of users searching “stagflation” has recently spiked to the highest level in Google history (Google started 24 years ago).

Google searches for the word “Stagflation”

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We already have one of the requirements mentioned above for Stagflation with persistently high inflation. Concerning the other two measures, unemployment remains at record low levels in the developed world, and according to Fitch’s latest forecasts, global GDP growth will be 3.5% and will slow to 2.8% in 2023.

Probability of U.S. recession in 1-yr & 3-yrs

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We may see these other two measures worsen as higher energy and food prices and rising interest rates start to impact disposable income around the world. For example, U.S. job openings remain at near-record highs, with five million more job openings than unemployed people. Still, U.S. small businesses’ hiring plans have recently started to decline from a record level.

Regarding food, the global average food price increase has been +40% since the start of the pandemic. The increasing cost of food and energy, coupled with rising interest rates globally, can drop global consumption. As shown above, the probability of a U.S. recession (negative GDP growth) remains low over the next 12-months, but there is now a 60% chance of a U.S. recession in the next three years.

Summary

It has certainly been an eventful beginning to 2022. Global inflationary pressures remain the primary concern in the medium term. As we get a more precise reading of the transitory (or not) nature of inflation, we will get a better feel for where interest rate rises may end. At present, any forecasts around this come with a sizeable margin of error.

We continue to expect to see heightened volatility in the short term. However, this is not always bad and can present excellent opportunities to purchase quality companies/investments at discounted prices.

Lastly, when the U.S. Federal Reserve started increasing cash rates, this did not mean that it was the end of the share market rally. As shown below, when reviewing fifteen different tightening cycles in the U.S.,  the global share markets usually moved higher over 12 to 24-months. This is generally because it takes several rate rises before the economy slows and the risk of a recession starts to drag share markets lower.

S&P500 performance 12-mths before & 24-mths after the first rate hike

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As discussed at the start, we have come into 2022 with concerns around possible volatility in the global investment markets, which has played out. How financial markets continue to move over the rest of 2022 remains uncertain, with a wide variety of possible outcomes.

At PWA, we monitor these historical events and portfolios closely while remaining conservatively positioned within portfolios and maintaining a disciplined approach.

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Private Wealth Advisers believes the information in this publication is correct, and it has reasonable grounds for any opinion or recommendation found within this publication on the date of this publication. However, no liability is accepted for any loss or damage incurred by any person because of any error in any information, opinion, or recommendation in this publication. Nothing in this publication is, or should be taken as, an offer, invitation, or recommendation to buy, sell or retain any investment in or make any deposit with any person. The information contained in this publication is general in nature. It may not be relevant to individual circumstances. Before making any investment, insurance, or other financial decisions, you should consult a professional financial adviser. This publication is for the use of persons in New Zealand only. Copyright in this publication is owned by Private Wealth Advisers. You must not reproduce or distribute content from this publication or any part of it without prior permission.

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Sharon Zollner, ANZ's chief economist provides a market update to Private Wealth Advisers.

Slides available for download, click here

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What to expect in 2022

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"Forecasting" is a polite synonym for "guessing." The better ones are informed guesses but still inherently uncertain. With this in mind, here are some forecasts:

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1. The US Federal Reserve will wind down their money-printing program faster than expected and commence raising cash rates maybe as soon as the first quarter of 2022.

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2. The Reserve Bank of Australia will reverse course on Quantitative Easing (OE) and admit that inflation is an issue they need to address with rising rates.

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3. The Reserve Bank of New Zealand (RBNZ) will continue to raise rates as forecast. At this time, ANZ is forecasting that the Official Cash Rate will go no higher than 2%, but the RBNZ is forecasting the cash rate will peak at 2.6%.

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Click here to continue to read the full market commentary

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A world of uncertainty

Over the last quarter, there have been some sensational headlines that have led to rising investor uncertainty; however, the US share market continues to defy gravity with the S&P500 reaching a record new high valuation.

Greater than forecast inflation, rapidly rising energy prices, a slowing Chinese economy and the US Federal Reserve commencing tapering (ending Quantitative Easing (QE)) are currently the largest “tail risk” concerns. Tail risk means the chance of a large loss occurring due to a rare event. An example would be Lehman’s Brothers collapse leading to the Global Financial Crisis.

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Click here to view the latest commentary

PWA invited Tony Alexander to present a market update to our clients, here is what he had to say.

You can sign up to Tony's newsletter here: http://www.tonyalexander.nz/

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Market Commentary (September 2021)

NZ back in Level 4 lockdown – what does this mean for our economy?

On the 17th of August, New Zealanders ability to move freely around our country was once again curtailed as we were placed back into the dreaded Level 4 lockdown. As you well know, this was due to the more infectious and harmful Covid-19 Delta variant being found within our community.

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We have seen much debate in the media around why this was required and how slow the vaccination programme is progressing. We will not be debating this. Rather, what we will look at is how this lockdown is forecast to impact the New Zealand economy. All the discussion below is based on a belief that we will manage to get the community spread of Covid Delta under control by the end of September, and the economy starts to reopen. 

NZ economy forecast to bounce

ANZ’s excellent research team has recently produced a report covering the expected impact of this lockdown on the strong recovery we have been experiencing since March 2020. They note that in the current environment it is impossible to forecast with any level of confidence. If we instead continue to slide in and out of level 3 & 4 lockdowns, then the economic data discussed below will get worse, and interest rates will stay lower for longer. 

ANZ is forecasting that this time we will see GDP drop by 6% in the September 2021 quarter but recover in a timely fashion due to the fiscal stimulus provided by the government during this period. As we saw in March 2020, we can again expect GDP to be boosted by pent up demand on reopening.

NZ’s unemployment rate is forecast to hold at 4% for reasons stated above, as well as businesses now being better positioned to retain staff that were proving difficult to secure pre-lockdown. 

Official Cash Rate increases – still coming

Sustainably low NZ unemployment (an RBNZ target) has been achieved, with the figure currently sitting at 4%. This demonstrates that New Zealand has very little spare capacity within its economy, which is likely to lead to domestic non-tradable inflation pressures. 

We are also seeing global inflation pressures being passed onto New Zealand consumers from our trading partners. This is due to the rising cost of goods and the difficulty in getting the goods shipped to New Zealand. ANZ are forecasting headline inflation will peak around 4% y.o.y. This is above the RBNZ’s second target to keep inflation between 1% and 3% over the medium term. 

Lastly, we are seeing unsustainable growth in the NZ property market. Driven by record low interest rates, and the RBNZ’s fiscal stimulus. 

The Reserve Bank of New Zealand (RBNZ) held their quarterly Monetary Policy Statement (MPS) meeting on the 18th of August, only a day after NZ went into Level 4 lockdown. They have now exceeded all their official targets. This means that we can expect the RBNZ to reduce stimulus measures, and start raising rates over the coming year, with the first rate rise maybe coming as soon as October (assuming NZ has Delta infection rates under control). 

At the meeting, the RBNZ made it very clear that even though they were on hold as they awaited more data on the impact of the current lockdown, they did not expect this to slow their forecast rate rises. Markets agree and continue to forecast the OCR moving from its current 0.25% to 1.75% over the next 2-years.

RBNZ expected to lead the developed world on rate rises

As discussed, markets are pricing in a much faster increase in short-term interest rates in New Zealand than we see in most OECD economies. As shown in the chart below, markets are now pricing in the first 0.25% increase in the Official Cash Rate (OCR) by November 2021, with a combined total rate increase of 1.00% (increase the OCR to 1.25%) by November 2022. 

When comparing this to Australia, the US or Europe (which suggest the first rate rise may be as far away as 2023), we can see that New Zealand’s forecast rate rises are well ahead of our trading partners. The reasons for this variance are that we are likely to have less transitory inflation due to price pressures from our global trading partners, house price inflation is again at excessive levels, and local inflation pressures are rising, i.e., wage inflation. 

Across most of the developed world, inflation is now above each country’s Central Bank target, with Turkey having the highest annual inflation rate of 18.95%. There are several exceptions, such as Japan which continues to fight against deflationary pressures. 

The inflationary pressures seen across the developed world are driven by demand exceeding supply, as countries ease up on lockdowns and consumers spend their saved funds. These surplus funds are an outcome of the unprecedented level of fiscal stimulus that was pumped into the system to allow economies to weather the Covid lockdowns. As an example of the inconceivable nature of the levels of stimulus, 40% of all the money the US has ever printed was produced in 2020. 

As vaccination rates increase and more economies open up, we can expect these inflationary pressures to persist for at least another 6-months. Some economists are already highlighting that inflation is exceeding most forecasts and may be proving to be much more difficult to get under control. Once again of course, this is all Delta dependant (or some new strain of Covid). 

NZ mortgage rate forecasts

As the expectation of OCR increases has become more certain, we have now seen term deposit and mortgage rates start to increase in New Zealand. Mortgage rates are now expected to increase, with most fixed term rates forecast to rise almost 2% over the next 2-years. 

NZ Mortgage Rates Climbing

These may all sound like large interest rate movements, but it is important that we put them in perspective. At present, interest rates in New Zealand are at historically record low levels. An increase of 2% will simply take them back to the low levels they were at the start of 2020 (pre-Covid). 

This will still be a stimulatory level for the NZ economy, and while these mortgage rate increases may lead to some buyers (who have stretched to maximum lending level in the last year) struggling, most borrowers will be able to afford the higher rates. 

These potential increases are therefore unlikely to cause house prices to drop in New Zealand, but they are likely to provide a headwind to further property price rises. Inflation would have to move much higher, forcing the OCR to move beyond these forecast levels for us to see forecasts for property prices declining. 

Transitory Inflation?

Most central banks views remain that the spike in inflation is driven by a shortfall of supply as demand increased around the world post the end of Covid lockdowns, with supply expected to meet and exceed demand in the next 12-months. We have seen this cycle before in the last decade.

Given this view, Central Banks around the world are looking through this short-term spike in inflation and are all using the word “transitory” to describe their view. As shown in the chart below, the high inflation readings are mainly due to the cost of energy (oil prices rising), transport services (flight fares) and transport costs (used cars) which have all spiked due to the US economy reopening - and hence are likely to be transitory. Meanwhile, food and shelter costs, which make up a much higher weighting in the inflation basket, have remained at or around the 1.50% - 2% mark. 

Housing Price Inflation – less transitory

When calculating US inflation numbers, “shelter” costs make up around 33% of the inflation calculations weighting. As shown in the table below, shelter costs are now starting to move a lot higher, with single home rents up over 12.50%. Add to this US wage inflation which has increased by 4.30% over the last 12-months, and the transitory inflation discussion starts to look questionable. 

The wage inflation, and house price inflation in the US is a direct result of the fiscal (not monetary) stimulus that was pumped into the system in 2020. The fiscal stimulus led to a strange anomaly where unemployment benefits exceeded the minimum wage in US. This in turn led to minimum wage workers not wanting to return to work, where they would earn less than they were by staying at home. 

If these inflation pressures do prove to be less transitory than most economists forecast, then we may see interest rates in the US rise faster than expected. To date, the US Federal Reserve has started public discussions around how and when they might start to exit their most recent fiscal and monetary programmes. We can expect interest rates to push a bit higher in the US as they start their tapering. 

The next move to control inflation pressures will be the raising of the cash rate. As discussed above, New Zealand is forecast to commence raising cash rates as soon as October. The US is not forecast to raise rates until the start of 2023. 

Summary – share markets defy gravity

The world share markets continue to defy gravity and test new highs. We have seen a record level of US$676 billion in funds flowing into global share markets so far this year. This is an amount more than the previous 15-years of funds flows combined. This is mainly due to TINA (There is No Alternative) meaning that investors are coming to share markets to get yields that are higher than those they can get on bonds. 

This fund flow has seen Facebook, Amazon, Netflix, Google, Microsoft, Apple & Nvidia (FANGMAN) move to a total market capital value of US$10.35 trillion, or 25% of the total S&P500. The top three are Apple, Microsoft and Amazon. Apple remains the largest company in the S&P500, with a market cap of US$2.75 trillion, or 6.27% of the total S&P500 index, followed closely by Microsoft (US$2.20 trillion), and Amazon (US$1.76 trillion). 

These are all unprecedented valuations, as are many other measures in global markets. The valuations are also closely correlated to the level of quantitative easing we have seen globally. We now see markets respond positively to bad economic news, and negatively to good economic news. This is due to good economic news equalling a faster end of Quantitative Easing and higher interest rates. 

There is a high level of uncertainty in the markets at present around how sustainable the current rise in inflation will be. Research we have seen to date still supports the theory that inflation will be transient, but as discussed there are some components of this calculation that need close monitoring. 

There is still much debate about how long we will be in this tightening cycle with several commentators now starting to discuss a possible second recession in early 2024 – 2025 as the global economy progresses through the large stimulus we saw in 2020/2021 and back into a higher ‘more normal’ interest rate environment. 

One thing we can be reasonably sure of is that financial markets will continue to be volatile as investors position for either rapidly rising interest rates, or lower growth and lower interest rates for longer. 

Crypto-Calamity

May 2021 was a tumultuous month for ‘investors and traders of cryptocurrencies, as Chinese authorities cracked down on Bitcoin trading (and mining) which sent prices of all crypto tumbling.

Bitcoin was one of the better performing cryptocurrencies, but still fell 17% on a single day in the month and at the time of writing was down 50% from its all-time high.

Bloomberg Crypto index

The Chinese announcement banned Chinese financial institutions and payment companies from providing services relating to crypto transactions – although it stopped short of barring individuals from actually holding crypto. The announcement led to several of the largest crypto mining operators suspending their Chinese operations. This is a big deal for crypto coins as China accounts for up to 70% of the worlds crypto mining.

Adding to the woes of the sector, the US Federal Reserve Chair Jerome Powell also stated that cryptocurrencies pose risks to financial stability and indicated that increased regulation might be required. If you are wondering why authorities are looking to crack down on crypto this chart might help explain.

Cryptocurrency payments by type of recipient

What could possibly go wrong from a market that is favoured by criminals, and has variants such as ‘Dogecoin’ invented out of thin air one day as a joke and worth ‘billions’ the next?

NZ doing well?

Our domestic economy appears to be faring well at present, and one of the reasons is that we suffered a very small dip in GDP last year. In fact, our largest trading partner (China) managed to grow their economy over 6%, whilst our 2nd largest (Australia) fared similar to ourselves.

The following chart highlights how fortunate we were on the economic front in 2020.

GDP Growth by country - % for calendar year 2020

However, there are a couple of things we in New Zealand need to keep an eye on. Firstly, according to the chart below, which shows the percentage households around the world are saving of their net current incomes, we appear to be among the worst savers in the developed world.

At least we aren’t in negative territory (as we were through the first part of this century), however this is not the type of measure we want to be last in. The chart below indicates we may not have much capacity to tolerate a sustained shock or recession.

Global Net Household Saving Rates Percentage

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We have discussed inflation extensively in our recent commentaries however, it remains one of the key factors that is likely to shape markets going forward, with continued uncertainty around if the forecast spike in inflation later this year will be transitory or sustained higher inflation.

The latest inflation indicators from ANZ (based on the correlation with their Business Outlook pricing intentions survey) look sobering. There is a clear indication that companies are now likely to start passing on the inflationary pressures they are seeing in the manufacturing and shipping of goods both globally and locally.

NZ Business Pricing Intentions

When interest rates do begin to experience a meaningful rise, it will be interesting to see the impact on those who have become accustomed to the lowest mortgage rates we have ever seen in this country. As shown below house prices have historically been reasonably well correlated with interest rates.

As shown below, over 60% of all mortgage holders are currently choosing to be fixed for 12-months or less, meaning any change in interest rates will be felt by most borrowers almost immediately after they start to rise. We have also recently seen the NZ 5-year mortgage rates start to move higher, which is potentially a concerning indicator of things to come.

NZ Residential Mortgage Rates

NZ Mortgage fixed terms

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NZ Mortgage rates vs. NZ House price index

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Global Markets

It was a rather ‘topsy-turvy’ performance from financial markets through May. There was little overall change in US Equities, however they did experience a mid-month sell-off as a higher-than-expected annualised inflation figure of +4.2% was announced. This was largely shrugged off through the 2nd half of May, and US Equities edged their way higher.

The key question of when the US Federal Reserve might start ‘tapering’ back its Quantitative Easing (keeping the risk-free rate of return lower) continues to be debated. Below is a chart showing that the market expectation of when the US fed will start tapering was pulled forward with the majority of those polled suggesting we could see this as soon as the first half of 2022.

When will the Fed raise rates?

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This is important because Quantitative Easing comprises approximately half of the US$12 trillion stimulus injected into the US economy since early 2020. This stimulus has been the key driver for supercharged returns from shares and property as interest rates have fallen around the world.

Fiscal & Monetary Stimulus Feb 2020 – March 2021

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The impact to growth from Covid lockdowns

On the Covid front, we are seeing some significant 2nd and 3rd waves across parts of world, with Asia (ex-China) being amongst the worst affected. India has been receiving the most news, however even those countries that had previously done very well containing Covid (i.e., Taiwan) are now experiencing strict lockdowns as they struggle to keep a lid on the latest waves.

However, for financial markets these Covid outbreaks have been offset by the successful vaccination rollouts in major western nations. The United States has led the way, and as such Westpac has recently upgraded its growth forecasts for the largest economy in the world for an expected 6.5% growth in Gross Domestic Product (GDP) for 2021 and 4.1% growth in 2022. In 2023 and beyond economists are forecasting the US to return to slow and low growth meaning the high growth that we are seeing in 2021 and 2022 are simply an outcome of record stimulus, and an economy reopening after a year of rolling Covid-19 lockdowns.

Global GDP Growth Forecasts

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As we should all be aware the US has demonstrated strong political disparity between Democrats and Republicans over the past few years. This has played out in views expressed around wearing a mask, and getting the Covid-19 vaccine, with Republicans demonstrating a high lack of trust in government and scientific recommendations.

As at the time of writing this commentary 164 million Americans, or 50% of the population has had at least one Covid vaccination shot. We are now seeing the number of US citizens turning out to get their first shot declining and the US government resorting to different approach to try and encourage people to come and get vaccinated.

One interesting strategy that a number of US States are undertaking are ‘vaccination lotteries. A 22-year-old from Ohio made headlines when she won that State’s US$1 million lottery that is open to all people who have had at least one shot of a coronavirus vaccine.

Not to be outdone, California has announced they would fund a US$116.5 million vaccine incentive programme intended to motivate their population to get a jab. Of this funding, US$100m is in the form of $50 prepaid cards for the next 2 million people who get vaccinated and $16.5m will be given out in cash prizes to some of those vaccinated Californians!

US Vaccination Cash Splurge

Summary

Global share markets had a reasonably volatile month through May, ending up around where they started the month. This was due to investors starting to focus on when the US Federal Reserve may start discussing tapering their Quantitative Easing Programme.

Investors in cryptocurrencies had a rude awakening, as regulators began to turn up the heat which has sent prices nosediving. We continue to watch this with a high level of interest (and scepticism) to see if this new investment vehicle proves to be a stable long-term investment. To date it appears to be one of the more volatile ways to invest.

Most importantly, the fear of sustained inflation, and consequences resulting from this scenario (chiefly higher interest rates/bond yields) continue to be the primary concern and focus of the markets. Global economies continue to forge ahead and produce strong GDP growth numbers – particularly those economies leading the charge on vaccinations. This is likely to result in strong earnings figures over the coming months – the key question for markets might be how much of this is already baked into prices?

We certainly continue to live in historically significant times. The investment markets both bonds and shares continue to trade in a tight range. Only time will tell how they receive any news about the end of the US QE programme. As has become common over the past 24-months we continue to recommend clients proceed with caution and have a solid understanding of what they are invested in and the potential upside and downside risk/return payoffs.

Private Wealth Advisers believes the information in this publication is correct, and it has reasonable grounds for any opinion or recommendation found within this publication on the date of this publication. However, no liability is accepted for any loss or damage incurred by any person as a result of any error in any information, opinion or recommendation in this publication. Nothing in this publication is, or should be taken as, an offer, invitation or recommendation to buy, sell or retain any investment in or make any deposit with any person. The information contained in this publication is general in nature. It may not be relevant to individual circumstances. Before making any investment, insurance or other financial decisions, you should consult a professional financial adviser. This publication is for the use of persons in New Zealand only.

Why investors should be concerned about a dam bursting in Brazil?

The Responsible Investment Association of Australia state “Responsible investors all understand that companies or assets won’t thrive whilst ignoring environmental issues (pollution, climate change, water and other resources scarcity), social issues (local communities, employees, health and safety), corporate governance issues (prudent management, business ethics, strong boards, appropriate executive pay) or ethical issues.”

On November 5th, 2015 a dam co-owned by BHP burst, killing 13, injuring hundreds and impacting thousands. Brazil’s government has subsequently filed a law suit against BHP and Vale for $5.2b USD to compensate those affected. Investing ethically is no longer about being a ‘green, tree-hugging hippie’, it is about understanding that companies who cause catastrophic disasters will be hit where it hurts, usually in the form of billions of dollars, which in turn, hurts the shareholder.

BHP price post 5th November 2015

HOW SUSTAINABILITY CAN DRIVE FINANCIAL OUTPERFORMANCE

The University of Oxford and Arabesque Asset Management have undertaken a study which analyses the links between “responsibility and profitability”. There is a drive for transparency for the stockholder. Here are some examples:

• Vehicles have CO2 emissions listed as a standard (Volkswagen anyone?) – Now France have introduced mandatory carbon reporting on financial institutions. Imagine when you are considering a managed fund, say a KiwiSaver fund, comparing fees, performance, investment style and carbon emissions!
• Screening of industries, historical ‘black listed’ stocks have been tobacco, fossil fuels, gambling, alcohol, human rights abuses, pornography, weapons and now… sugar.
• Some of the largest sovereign wealth funds are ‘divesting’ their portfolios of various industries, such as the Norwegian Government Pension Fund dumping 122 coal company stocks.

Report Highlights

Responsible Investment Returns

Source: Responsibleinvestment.org

If it looks like a bubble...

It is very likely that US share markets are now in “bubble” territory. Bubble means shares are trading at historically expensive valuations. At present, many longer-term valuation measures show that S&P500 shares are trading at valuations higher than levels reached in 2000. The record high valuations in 2000 were the precursor to the “Tech Wreck” which saw the S&P500 fall by 44.70% over the next 2.1 years.

S&P500 valuations stretched

It is easy to point to the markets and conclude we are in a bubble. The next question is: how big will this bubble get, and will it pop? As the famous economist John Maynard Keynes once said, “the market can remain irrational longer than you can remain solvent.”

We are anticipating increased volatility in the US sharemarket in 2021, but are also cognisant of several possible reasons the markets will push higher:

There is No Alternative (TINA).

The bond and cash markets are offering investors negative returns. As shown below, there is now almost US$20 trillion worth of global bonds trading at interest rates below 0%.

US$19 trill in negative yielding bonds

Cash is flowing into share markets at record levels.

At the end of 2020, we saw the largest 2-month inflow of cash into global shares in history. There is also still a large percentage of cash and bonds held in institutional portfolios. We can also expect some of this to make its way into shares as the managers hunt higher yielding investments.

US$200 bill flowed into global shares over 2-mth Large sum still held in cash (MM) and bonds

Purchasing Manager Index (PMI) moving higher.

The global PMI is set to test record highs, with consumers hopefully coming out of lockdowns as vaccinations continue into late-2021. Historically, fund flows into shares are closely correlated with global PMI.

Global PMI vs. Global share flows US Fed Dot-chart

Central Banks expected to leave short term interest rates low.

The US Federal Reserve has given strong indications to the market that their primary focus is reducing the unemployment rate in the US, and that they will look through short term spikes in inflation to ensure they keep the economy growing.

One of the committee members has also suggested that if inflation were to move above 3% p.a. that they would want to see it remain at this level for a period of 12-months before they would consider moving interest rates to slow the inflation down. They could also act to devalue the US currency which would have a similar impact in slowing growth without increasing borrowing costs.

Lastly, the Fed “dot chart”, which is a chart showing where each Federal Reserve Committee member is forecasting future interest rates, suggests that we will not see short term interest rates move higher until 2023 at the earliest.

Only a fool would try to forecast when a share market bubble will pop, but as valuations climb higher, the chance of further upside gains declines, and the chance of higher downside losses increases.

The rise of the empowered retail investor

Over the past year, we have seen a large increase in the number of retail traders. Trading platforms such as Robinhood have allowed micro investors into a market previously only accessible to larger investors, and previously only via brokerage and account fees. Robinhood offers access to global share markets to retail investors for free. The platform’s success is apparent in the growth of its accounts, which numbered 340,000 when it first opened in 2014. The number of accounts has since grown to over 13 million as at the end of 2020.

This rise in retail investors, who are meeting in global chat rooms to discuss the next best investment idea, has led to a massive increase in their influence in the markets. As at mid-January, “small traders” (10 or less contracts) were in excess of 12 million, versus “large traders” at 5 million. According to data from a recent Bloomberg study, “small traders” now make up over 9% of all contracts on the New York Stock Exchange, up from just under 1% in 2016.

No. of options US share market – millions US share account margin trading

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Alongside this rise in retail investors, we have seen a large increase in traders using margin trading accounts which allows investors to buy shares with borrowed funds. US margin debt has increased from around $475 million in March 2020 to just under US$800 billion at the start of 2021. So not only are retail investors pouring their own funds into the share market, but they are also borrowing heavily to do it.

On the 7th of Jan 2021, Elon Musk tweeted “use Signal“. He was referring to a messaging app called Signal. The retail chat rooms lit up with some investors finally deciding Elon must be referring to Signal Advance, a company that sells signal detection units. As shown below, as retail investors flooded into this stock, the share price went vertical rising 1,100% before investors finally figured out it was the wrong company. As they started selling, the poor investors that had bought at the top would have lost 84% of their capital, and if they used a margin account likely lost 100%+ of their capital. Retail investors continue to take these somewhat questionable risks using the battle cry YOLO (you only live once) in chat rooms to justify their behaviour. You may only live once, but debt stays with you forever.

The risks of trading on a “tip”

Global debt across all sectors (public and private) increased by just under US$20 trillion in 2020, with global Debt to GDP ratio rising from 330% in Jan 2020 to over 365% at the end of 2020. As an interesting side note, Australia was one of very few countries that saw a reduction in their household debt through 2020, reducing by about 4%.

Change in Debt to GDP (end of Q4 2019 – end of Q3 2020)

As shown in the table above, Canada had the largest increase across all measures with the level of debt in that country moving higher by 80% over the first three quarters of 2020. New Zealand’s total debt increased by c.30% over the same period, with NZ having the second largest increase in household debt of c.15%.

While the Debt to GDP increase in NZ is large as a percentage, the actual sum of government bonds being purchased by the Reserve Bank of New Zealand (c.$35 billion) equates to only a small blip when compared in dollars to the sum being held by other central banks.

G10 Central Bank government bond holdings

2021 global growth forecast

As we move into 2021, governments and central banks of the world continue to support the recovery with both quantitative easing (QE) and fiscal stimulus (benefits and infrastructure spending). The level of support is at unprecedented levels. The combined stimulus that has been pumped into the US economy over the last 8-months is greater than the total stimulus given in the last 5 US recessions combined.

Another example is from 2008 (when the US Federal Reserve first started QE) to 2014, when the US Fed placed a total of $3.66 trillion into the markets. In the first half of 2020, the Fed pumped in an incredible $4.9 trillion in only 6-months.

It is fair to say that global economies are getting unprecedented levels of support. How this plays out over the coming 5-years is going to be interesting. However, with this level of support and the option to extend or continue it, we can certainly expect economies to recover.

The International Monetary Fund (IMF) has produced a GDP forecast for 2021, which supports the market view that we are unlikely to see a double dip recession from the US or China. Indeed, Chinese GDP is forecast to grow at an impressive 10.70% in the 2021 calendar year.

IMF country GDP forecast – ending 2021

The main risk to this recovery is likely to be central banks’ ability to continue to provide stimulus if inflation does surprise to the upside in 2021. At this time, most economists are forecasting a spike in inflation as economies open, but this is expected to be a short-term blip and is forecast to decline again into the start of 2022.

Given the asset bubble across shares, bonds, commercial property and yes even residential property has been wholly driven by the central banks’ stimulus, an unexpected end to this due to out-of-control inflation would likely be very bad for most asset prices across the world.

NZ Property

You cannot go to a BBQ or catch up over a beer/wine without property prices coming into the discussion. There is a strong belief in New Zealand that investing into houses is…..well “safe as houses”! Given the fanatical belief that New Zealanders have in this sector, it is unsurprising to see anecdotal evidence of cash moving into this sector due to the banks record low interest rates.

There are several reasons stated for property prices to be where they are today. Some of these are:

• A shortage in housing vs. the higher demand.
  
• Ex-pat Kiwis returning home with profits from their offshore work.
  
• Favourable tax treatment for property investors who borrow (leverage) large sums to purchase residential property.
  
• Falling interest rates (lower mortgage rates).
  

All these reasons have in some way driven house prices higher, but one can be shown to have had the greatest impact, and this is falling interest rates.

Below is a chart from Westpac’s economists showing house price and rent inflation over the past 19-years. This shows that house prices are up over 3.6 times (c.7% p.a.) over this period whereas rents have only increased by about 1.8 times (c.3% p.a.).

This supports the argument that current house price increases are NOT being driven by a shortage in available properties, as if this were the case then we could also expect rents to be increasing by a similar sum. Rents inability to keep pace with house prices has also led to residential rental yields being at record low levels with central Auckland’s properties averaging 3.8% gross p.a. as of October 2020, according to data from REINZ.

NZ House price & rent inflation NZ mortgage rates and house price inflation

The main driver for house prices in NZ, and indeed around the world, has been the rapid decline in interest rates providing an ability to borrow greater and greater sums.

The chart above from Westpac’s economics team shows the direct correlation between average mortgage rates (average of 2 yr. and 5 yr. mortgage rates) and house price inflation. As shown, any drop in interest rates has a corresponding spike in house prices in the following quarter. The drop in borrowing costs in NZ has been the major driver of property markets over the past 20-years.

Given the recent continued fall in interest rates in NZ on the back of unprecedented quantitative easing from the RBNZ, economists are now forecasting low double digit increases in house prices in 2021. Assuming interest rates stay at these levels, we can also expect further increase in house prices in 2022. Westpac is currently forecasting house prices finally flattening in 2024, on the assumption that interest rates should be rising by then.

NZ House price forecast

Summary

Warren Buffet famously said, “Be fearful when others are greedy and greedy when others are fearful.” We are certainly in a “greed” period in markets with asset prices in the US testing new high valuations, but as discussed above, bubbles can last a lot longer than a sensible investor would think possible, so we continue to proceed with caution.

Share markets have started off the year positively, and are looking through short-term noise, focusing on a successful roll out of the vaccine and continued stimulus from governments and central banks. Share markets have already priced in an economic recovery, so any news to the downside could see markets reprice lower in 2021.

While it could be argued the sharemarket is ‘expensive’, low interest rates are leading to TINA (There Is No Alternative) supporting continued funds flowing into shares in a hunt for yield. This could well push share markets higher in 2021.

There are still some clouds on the horizon, especially in longer dated bonds as yield curves steepen in anticipation of rising inflation over the next 3-5 years.

There are currently several known unknowns in the market, and obviously some unknown unknowns that will no doubt eventuate, but we start this year more positive around economic recoveries and the sharemarket than we were middle of 2020.

The progression of vaccinations will likely be directly correlated to each country’s economic growth in 2021. Barring some unforeseen issue, we expect the world to start to return to some level of normalcy into the end of the year and early 2022. However, we will keep one eye on the inflation numbers as central banks continued support is key to asset prices and the speed of this “V-shaped recovery”.

NZ Property Update

House price inflation is rampant in NZ with +22% y.o.y. for the period ending February 2021. This sort of growth increases the risk of a major disruption to the wider NZ economy when the $1.5 trillion property bubble finally bursts. How could we address this rising risk? Enter Prime Minister Jacinda Ardern!

The biggest news in the past month for NZ investors has to be the changes to property investing announced as part of Labour’s Housing Package by PM Ardern on the 23rd of March. The major changes were:

1. THE EXTENSION OF THE BRIGHT-LINE TEST TO 10-YEARS

Previously, if you purchased an investment property after October 2015 and sold it within 2-years, you may have to pay income tax on the change in property value. This was then increased to 5-years in March 2018 and has now been extended to 10-years from the 27th of March.

Bright-Line Test evolution

To keep things complicated (and accountants employed):

• The bright-line test will remain at 5-years for “new builds” acquired after the 29th of March. This is designed to encourage support of new property builds.
• If you purchased a residential owner-occupied property before the 29th of March and occupied it for more than 50% of the bright-line period, it was exempt from capital gains tax.
• Under the new rules, owner-occupied properties that are purchased after the 29th of March, then sold prior to the 10-year bright-line period will have their capital gains taxed for the percentage of time that the property may have been a rental property; i.e. a property that was owner-occupied for 60% of the time and a rental property for 40% of the time will have to pay personal income tax on 40% of the gains in the property value if sold within 10-years of the purchase date.

These changes by themselves would be unlikely to dissuade individuals to invest into residential property in NZ. The change in the bright-line term to 10-years would simply mean that investors would now aim to hold properties longer than this period.

2. THE CESSATION OF INTEREST COSTS BEING DEDUCTIBLE

For residential investment properties purchased after the 29th of March, the interest on the mortgage used for the purchase will no longer be deductible against the property’s rental income from the 1st of October.

Investment Property Tax Deductible table

For residential investment properties purchased before 29th of March, interest deductibility will remain but will reduce over the next four-years. From the 1st of October, 75% of interest costs will be deductible. For the tax year ending 2024, this reduces to 50% and then 25% for the tax year ending 2025. All interest deductions will be completely removed from 1st April 2025.

This will have a meaningful impact on property investors that relied heavily on borrowings to fund their property purchases. According to early forecasting by ANZ, these changes may lead to investors offering 5% – 15% less for properties to maintain their previously expected yields. Another option that has been widely publicised is for landlords to pass on this increased cost (from loss of tax credit) to tenants by putting their rents up. It is most likely that it will be a mixture of both.

3. THE NEW KAINGA ORA FUND & HOMES AND COMMUNITIES LAND FUND

The government will now offer $3.9 billion to councils to fund infrastructure costs that will allow for faster growth in subdivisions. This is designed to help purchasers by increasing the supply of residential properties and deal with the supply shortfall in NZ.

According to latest government figures, there are more than 22,000 people on the housing waitlist. This is 7,000 more than prior to the pandemic. The government has offered $2 billion to be used for the purchase of land for social housing needs. This is designed to help reduce the level of homelessness in NZ.

According to economist Shamubeel Eaqub, these two initiatives have the potential to produce 80,000 serviced sections over the next decade. This will go some way to address the shortfall of 60,000 – 90,000 properties that Shamubeel estimates exists today.

4. APPRENTICESHIP FUNDING

The government has extended the Apprenticeship Boost payment until 2022. The payments are $1,000 per month for first year apprentices, and $500 per month for second year apprentices. This is designed to support trade companies grow their apprenticeship programs and to ensure that NZ has a larger number of qualified trades people to meet the construction demands.

It was never going to be possible to please 100% of New Zealanders with these changes, but some of these initiatives have received wide support. Unsurprisingly, the removal of interest costs being deductible has met with much criticism from property investors and some commentators in the wider market.

ANZ has produced the below table to show their forecasted impact from all the Housing Package initiatives. As shown, they are forecasting a minimal impact to NZ house price inflation, with the heat taken out of the current cycle slightly earlier than previously forecast.

The message received by the market from these changes is that the government no longer wishes to support people who pursue a property investment business. Property investors make up c.30% of all property purchases.

It is expected that those most affected by these changes will unfortunately be the tenants who will see their rents increase. This in turn may impact the poorest in the community who can now only just afford rent. Potentially, one of the negative outcomes of these changes could be a rise in homelessness.

House price forecast – post Housing Package changes

GLOBAL MARKET VIEWS

Below we have included a table showing the current views of a pool of fund managers around where different parts of the US economy are currently at.

The question around the US economic cycle produced the most division, with 25% of respondents stating we were at the start of an economic recovery, followed closely by 22% of respondents who felt we were at the start of a decline.

Across the remainder of the questions, most respondents believe share markets are approaching the current peak of this cycle, debt markets are starting to decline, and commodity markets are now in a rising market.

Fund managers’ view on where we are in current cycles

POST LOCKDOWN INFLATION

The Bank of America recently completed a survey of global fund managers’ views. Managers were asked what they thought the biggest risks for a major “tail-end” share market correction were. Thirty-six percent of respondents put higher than expected inflation as the largest risk. Within the survey, over 70% of respondents were expecting higher global inflation. The last time inflation expectations were this high was May 2004.

What are the biggest global risks facing investors?

The high expectation of rising inflation is mainly due to economies starting to come out of lockdown as they vaccinate their citizens. This is leading to an increase in demand for goods as consumers look to spend some of their savings. The lower level of supply to meet this demand is the main reason most economists are forecasting a spike in inflation in late 2021.

SO, WHAT IS HAPPENING WITH INFLATION EXPECTATIONS?

In the RBNZ February Monetary Policy Statement (MPS), they provided updated guidance on their forecast for expected inflation over the coming years. They, like all developed economy central banks, are forecasting a rise in inflation in 2021 to a possible high of 2.50%.

NZ Consumer Price Inflation (CPI) forecasts

Again, like most central banks, they are forecasting that this spike will be a temporary anomaly with inflation reducing back down to 1.50% in 2022. This means the RBNZ will not feel pressure to increase interest rates until they are certain that our economy has achieved ‘escape velocity’ to confirm any economic recovery is sustainable.

THE RISE OF LONG DATED BOND YIELDS

As the risk of higher inflation increases, global bond investors have started demanding a higher return on their longer dated bond investments. As shown below, when bond yields rise, the capital value reduces. The US 10-year bond yield has risen by just over 1% since its low in mid-2020. This has led to the resale value of the 10-year bonds purchased mid-2020 to drop by over 10% in value.

US Government 10-year bond yield

Investors had been expecting a rise in interest rates due to rising inflationary pressures, but it is the speed of the rise that has caught most investors unawares. This has led to the MOVE index (bond volatility) increasing vs. the VIX indices (share volatility) which remains low. Remember, bonds are supposed to be the safe part of a diversified portfolio!

The US 10-year bond rate is used as the “risk free rate” for investments with an expected duration of 10-years or more. Investors then demand extra interest above the risk-free rate to compensate them for the perceived higher risk of other investments. As an example, if we were trying to determine the yield we needed from a share, we would start with the risk-free rate (1.66%) and may require an extra 3% (spread) to justify the higher risk of the share. This would equate to a required yield of 4.66%.

Both the risk-free rate and the spread can move, hence the yield required can change. If the risk-free rate increases, then the required yield from the share investment would increase as well. The share yield can increase either from a higher dividend being paid, or the capital value of the share declining.

WHY DO RISING INTEREST RATES MATTER?

We have seen share markets around the world dip on the back of the rise in longer dated interest rates. This is due to the increase in the risk-free rate causing a squeeze in the share/bond yield spread, which is the percentage difference between the yield being offered by shares vs. that being offered on the risk-free rate (government debt).

Historically, each time we have seen a meaningful rise in the US 10-year bond rate share markets decline. The difference that we may see this time if interest rates continue to rise is not only a falling share market but falling bond prices as well.

Share capital values are not likely to drop by the same level as bond values should yield increases continue because most companies are producing earnings and announcing profit upgrades. Therefore, the yield is supported by a higher dividend which means the share price does not have to drop as much to retain the historical spread.

US 10-year yield – 1985 to 2021

Over the page is a table showing a survey of global fund managers and economists. They were asked to predict what level the US 10-year government bond rate would have to rise by to trigger a 10% or more decline in the US share markets. As shown in the table, the majority felt 2.00% on the US 10-year government bond could be the trigger level. This is only 0.34% above the current US 10-year bond yield.

What level on the US 10-yr. will cause +10% market correction?

Will the US 10-year reach the dreaded 2.00%? Will this be the trigger for a wider share market sell-off? All this is unknown, but what we do know with a higher level of certainty is that the US Fed is not planning to raise interest rates anytime soon.

The US Federal Reserve can also act to drive the longer dated interest rates/bond yields lower as well. They can easily do this by moving their quantitative easing (QE) programme from short-dated bonds to longer dated bonds. If they did this the yields curve would flatten, and markets would likely rally due to a stronger belief in lower interest rates.

WHEN WILL THIS PERIOD OF LOW INTEREST RATES END?

The question on all investors’ minds right now should be, “when will interest rates normalise?” To qualify what normalise means, there is “normalise” back to pre-Covid-19 stimulus levels, and “normalise” back to before Central Banks pumped QE into the markets.

As shown below, the current yield for the US 10-year government bond is now 1.66% and the pre-Covid-19 “normal” yields for the US 10-year bond were about 2% p.a., so interest rates only need to move a bit higher to reach these levels. If we look back to the start of 2008 for “Pre-Quantitative Easing” levels, the interest rate then was 3.60%, which is 1.20% higher (or over double) than the current US 10-year yield.

We do not see any end to the QE from central banks in the next 2-years. Indeed, governments cannot afford for interest rates to move higher as this would end up costing them more in interest than they could maybe afford, due to the record high levels of debt most central banks carry. So, when might this stimulus end?

US Debt to GDP & Interest Costs to GDP

The US Federal Reserve has confirmed that they do not plan to raise rates in the next 12-24 months and are primarily focused on ensuring their unemployment rate comes down. In the latest reading in mid-February, the number of Americans filing for unemployment benefits unexpectedly increased.

US Fed Dot-chart – Feb 2021

While it could be argued sharemarkets are ‘expensive’, low interest rates are leading to ‘TINA’ (There Is No Alternative) and supporting continued funds into shares in a hunt for yield. Fund flow into US shares is now at record levels of just under US$75 billion per month. This supports share markets at current levels and could well push share markets higher in 2021.

The only question is when will this reverse? To answer that we need to first know when interest rates will move higher, and to answer that we need to know what inflation is going to do. These are all unknown factors currently. We (and all investors) will be watching these indicators with great interest, and we can expect that as the picture becomes clearer markets will move quickly to price in new information, both positive and negative.

US share monthly fund flow at record levels

WHAT DOES “DOWNSIDE RISK” MEAN?

If you are talking to any investment adviser, at some point during your conversation the term “downside risk” will be used. What does this actually mean to you and how big is the risk? The answer is (as always) it depends. If you are new to investing and have only been invested for the past 5-years, then downside risk likely means between a 20% – 30% fall in share markets, with full recovery of capital in the next 2-3 months. As shown below, the Covid-19 crash and recovery only shows as a small blip on the table. So small in fact that they must expand the section out to highlight the correction.

US share market crash timeline – $1 invested in US stock market – Real Peak values

Looking further back in history, the more likely drawdowns are 50%+, and it can take as long as 10-years to recover your capital value from any drawdown. Most investors, and even some investment advisers, are not aware of the mental fortitude required to navigate through such periods.

Drawdowns have a meaningful impact of longer-term compounding returns and are more difficult to recover from than most investors are aware. As an example, if you had $100 invested and this dropped by 50% to $50, you would now need to secure a return of 100% just to get the capital value back to break-even.

For investors that do not draw income from their investment portfolios, major share market corrections are difficult to navigate, but for those that draw income in retirement, it is much more unbearable and any major fall can have a meaningful impact on an individual’s ability to fund their retirement.

Why are we telling you this? Because we want our investors to be informed around what real downside risk looks and feels like as this will better prepare you for the difficult decisions that need to be made during such times.

Are we forecasting a major market correction? As shown in the table above, a major market correction is inevitable according to history. The only issue is we have no idea when it will occur, or what might be the catalyst for the end of the current share market rally. The best we can do is plan for the worst and hope for the best.

SUMMARY

We have seen differing outcomes with vaccination programs globally. The US has managed to secure an exceptionally high number of vaccine shots, and equally have had a solid vaccination program operating since President Biden took office. The progression of vaccinations around the rest of the world is less successful, but as more vaccination shots are made available, we can expect this to accelerate.

This can be expected to lead to a rapid rise in consumerism, which could see the forecast spike in inflation. What happens from there is still anyone’s guess, but at present, most economists are forecasting only a temporary spike in inflation meaning there will be little pressure on central banks to raise rates.

No. of vaccinations administered per 100 people

Warren Buffet famously said, “Be fearful when others are greedy and greedy when others are fearful.” We are certainly in a “greed” period in most markets with asset prices in the US testing new highs. However, as discussed above, bubbles can last a lot longer than a sensible investor would think possible, so we continue to proceed with caution.

Private Wealth Advisers believes the information in this publication is correct, and it has reasonable grounds for any opinion or recommendation found within this publication on the date of this publication. However, no liability is accepted for any loss or damage incurred by any person as a result of any error in any information, opinion or recommendation in this publication. Nothing in this publication is, or should be taken as, an offer, invitation or recommendation to buy, sell or retain any investment in or make any deposit with any person. The information contained in this publication is general in nature. It may not be relevant to individual circumstances. Before making any investment, insurance or other financial decisions, you should consult a professional financial adviser. This publication is for the use of persons in New Zealand only.