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.