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.