Tricky transition favours stock picking

The Harbour Investment Outlook summarises recent market developments, what we are monitoring closely and our key views on the outlook for fixed income and equity markets.

Saturday, January 22nd 2022, 8:00AM

by Harbour Asset Management

Key points

The MSCI All Country World (global shares) Index rose 4.0% in USD in December, taking the three-month return to 6.7%. The same Index rose 3.1% in NZD terms over the month, and with the New Zealand dollar weakening in the past quarter, the three-month return in NZD was stronger at 7.5%.
The New Zealand 10-year bond yield dropped to 2.39% from 2.49% during December, while the US 10 year bond yield rose from 1.44% to 1.51%. The move in New Zealand yields contributed to positive performance across domestic bond indices, whilst global indices fell.
Interest rate yield curves flattened over December as central banks globally (the Reserve Bank of Australia being the laggard) acknowledged inflation may be more than transitory and began lifting official rates. At the same time, ongoing shortages and maturing of the economic recovery contributed to the global equity market earnings revision upgrade ratio slowing, to be only slightly positive. This lift in rates and slowing earnings revisions is likely to contribute to a lift in equity market volatility.

Key developments
Global equity markets rose over the month and quarter. In a volatile month, investors looked through several negative factors including disruptions in China’s property market, a rise in bond yields as the US Federal Reserve (Fed) reduces stimulus, the impact of shortages (supply chain disruptions and energy) and ongoing Covid-19 disruption.

Higher global bond yields triggered a rotation from growth and information technology to cyclical stocks. Omicron hit re-opening stocks, particularly travel stocks. Chinese policy easing supported commodity prices and materials stocks.

The December month saw a rally in equity market returns to offset what was, overall, a weak quarter and year for the New Zealand market. Financials and materials were the strongest Australasian sectors over the month and quarter.

Consumer staples and industrials (travel) were the weakest New Zealand sectors over the month, while information technology and consumer staples were weakest over the quarter.

In Australia, utilities and materials were the best-performing sectors over the month and quarter. Information technology and healthcare were the weakest sectors over the month, while energy and information technology were the worst performers over the quarter.

Changes in New Zealand bond yields were relatively modest during December, with better performance from the 10 year Government stock enabling the domestic market to finish a dismal year on a better note. With 2 and 10-year interest rate swap rates rising 1.9% and 1.6% respectively over the year, annual market returns were the worst in over three decades.

The domestic fixed income market was relatively stable in December, as investors largely held with the view that the Reserve Bank of New Zealand (RBNZ) would steadily hike the official cash rate (OCR) in 25 basis point moves until August 2022, before continuing with hikes at a slower rate.

The possibility of a sharply slower housing market, combined with Omicron potentially leading to ongoing restrictions and reduced confidence did drive a modest decline in cash rate expectations. Global bond yields held down towards the lower end of recent trading ranges.

New Zealand’s economic outlook remains positive, but some cracks have started to appear. An extremely tight labour market is providing strong job security and Q3 GDP data released in December showed that lockdowns didn’t damage economic activity as much as feared.

Covid-19 continues to create additional uncertainty, but our high vaccination rate and boosters are likely to help in the case of an outbreak.

Additionally, there is growing evidence that the Omicron variant may result in lower numbers of severe cases requiring hospitalisation. Consumer and business confidence, however, deteriorated further in December.

For households, high inflation is eroding purchasing power. People are also increasingly aware of higher interest rates and the growing challenges to the housing market. For businesses, labour shortages, cost pressures and supply chain disruptions are weighing on confidence.

In New Zealand, markets expect a particularly aggressive tightening cycle that doesn’t appear to allow for downside risks.

Markets currently price the OCR to reach 2.2% and 2.7% by the end of 2022 and 2023, respectively. The economic outlook, however, remains highly uncertain.

Mortgage rates have increased significantly, for example, and a larger-than-anticipated decline in house prices is a key downside risk for 2022. Growth in building consents continues to outstrip population growth and the outcome of the Government’s review of migration settings holds important implications for this balance.

These influences collectively lead us to believe New Zealand interest rate rises may not be as aggressive in 2022 as currently expected.

Concerns about the Omicron Covid-19 variant have eased in recent weeks – increasing investor confidence about the economic recovery and monetary policy tightening.

Evidence to date suggests Omicron is a more contagious Covid-19 variant but less harmful, allowing authorities in most countries to leave mobility restrictions largely unchanged. The continued advancement of Covid-19 treatments may provide further comfort to authorities and help in the process of considering Covid-19 as an endemic disease in 2022.

What to watch

Will central banks commit to raising rates in 2022? Global central banks reaffirmed their hawkish tone last month by placing greater weight on high inflation than on economic growth uncertainty. While Omicron represented an additional source of uncertainty at the time, core inflation in most countries is well above central bank targets and at risk of becoming unanchored.

In the US, for example, it is almost 5% y/y. At its December meeting, the US Federal Reserve (the ‘Fed’) announced it would double the pace of asset purchase tapering, partly in response to recent inflation developments. It also pointed to the recent strengthening in indicators of economic activity and employment.

The most hawkish change, however, was that the Committee expected to hike the Fed Funds rate three times in 2022, versus just once previously and market pricing at the time of two hikes this year. Elsewhere in December, the European Central Bank reduced the pace of its bond buying by more than many anticipated and the Bank of England unexpectedly increased its policy rate.

Market outlook and positioning
The transition to less easy monetary policy settings is already well underway. Interest rate yield curves flattened over December as central banks globally (the Reserve Bank of Australia being the laggard) acknowledged inflation may be more than transitory and begun lifting official rates.

At the same time ongoing shortages and maturing in the economic recovery contributed to the global equity market earnings revision upgrade ratio slowing, to be only slightly positive. This lift in rates and slowing earnings revisions is likely to contribute to a lift in equity market volatility.

Given supply chains are catching up, it is possible that increases in inflation may begin to slow by mid-year and inflation expectations may continue to stabilise (at levels that are likely to be above the last decade), taking pressure off central banks to increase official interest rates. In fact, inflation rates could fall below wage growth ensuring real incomes rise, supporting consumer stocks.

Or, more importantly, limit the need for a shock acceleration in the pace of central bank official interest rate hikes that would test equity markets.

With nominal GDP growth above government bond yields, equities should be able to outperform. Nominal tightening in monetary policy is unlikely to send real yields positive meaning equities will continue to have yield-based investor support.

But equity markets are sensitive to changes in direction in central bank money creation - even if inflation turns to disinflation (lower pace of inflation) central banks are likely to continue reversing pandemic stimulus, lowering liquidity, which is likely to contribute to higher equity market volatility. Tighter financial conditions, including a more circumspect credit market, may limit returns for more early stage and challenging business models.

Within equity growth portfolios we are not focusing on any one macro-economic influence. Rather we continue to focus on the ability of stocks to increase their return on capital employed relative to their cost of capital.

This in turn is influenced by structural growth trends including digitisation, demographics and decarbonisation and company-specific characteristics including barriers to entry, competitive advantage and pricing power (with many companies currently experiencing healthy profit margins).

We continue to favour stocks which benefit from structural growth tail winds. Ultimately our focus remains on stocks that can continue to grow their earnings and dividends faster than the market expects.

Within fixed interest portfolios, our strategy is overweight bonds in the 0 – 3-year maturity range, as we see scope for the RBNZ to possibly hike less quickly than is priced into markets, while we are underweight select longer-dated bonds which not only look expensive in our valuation models, but are also vulnerable to the rise in global bonds yields that we expect to see.

In the corporate bond sector, we expect to see a solid issuance environment unfold, including from the big 4 trading banks. The banks have been light issuers over the last year, but a return may prompt some re-pricing across the market, towards wider spreads. High-grade credit has already started to widen, to levels we describe as less expensive. We are looking to add exposure in the event we see more attractive margins.

Within the Active Growth Fund, we have bought into the weakness in equity markets, mostly through closing our underweight to the New Zealand share market.

We think the New Zealand share market will fare better in 2022 after being impacted by a multitude of largely one-off factors in 2021, such as the KiwiSaver default rebalancing, large gentailer stocks being impacted by global clean energy index changes and New Zealand interest rate expectations changing ahead of the rest of the developed world.

Further, we’ve allocated to a US Financials ETF which we believe will benefit from higher interest rate expectations and to Asian shares which are trading at extremely low relative valuations.

Within the Income Fund, our strategy continues to reflect the themes of ongoing inflation risks and the reduction of liquidity we expect to see in the financial system as central banks move steadily towards tighter monetary policy. This has led us to be cautious about longer-dated fixed interest securities and highly geared borrowers. We are neutrally positioned in equities, with an emphasis on defensive stocks that are less sensitive to rising bond yields.

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