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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