September Market Update

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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.