Can conditions get better for NZ equities?

In the short term the New Zealand equity market might take a breather. There are signs that the market is ‘losing breadth’, although we doubt that is a robust measure to judge the outlook. Typically equity markets follow GDP growth trends, and New Zealand GDP growth remains robust. Over the medium term New Zealand equity returns have been nicely tied to GDP growth because company revenue prospects, margins and corporate profits are closely related to how well the economy is performing.

Figure 1:  The equity market eventually follows economic growth

Source: Harbour, Bloomberg

With NZ economic growth set to improve further, the equity market has continued to ride high. However the equity market is also affected by the outlook for inflation, interest rates and expectations of profits. We need to ask what is ‘baked-in’?
The key factor that generally stops an equity bull market is unanticipated inflation – when a Central Bank has no choice but to unexpectedly place the brakes on. Unexpected inflation is negative because real interest rates need to rise more sharply, companies often find unexpected price rise hit margins, and economies tend to slow sharply as a combination of a rise in household savings, falling investment and a negative inventory cycle all come together in a hurry. Investors often also pull funds out of both fixed income and equity markets, and equity valuations fall.

Rising inflation expectations generally provide a warning shot for investors.