Returns dip as central banks indicate interest rates will stay higher for longer
Commentary on the September quarter by Russell Investments, UniSaver’s investment manager and consultant
Global share markets fell in the September quarter, with the MSCI ACWI Index ‒ Net returning -1.5% in unhedged New Zealand dollar (NZD) terms. Contributing to the decline were expectations global interest rates will stay higher for longer in the face of stubbornly high inflation. In the US, the Federal Reserve (Fed) hit the pause button in September but surprised the market when it flagged one more rate increase this year and fewer rate cuts next year. The Fed is now projecting just two interest rate cuts in 2024, which is down on the four rate cuts the Bank forecast back in June. The new projections followed the release of the latest inflation figures, which showed headline inflation rose 3.7% in the 12 months to 31 August. This was up on the 3.2% gain we saw in July and slightly more than the 3.6% outcome the market had anticipated. At the same time, economic growth and the country’s labour market have proven remarkably resilient amid sharply higher interest rates. Speaking to the media following the Fed’s latest meeting, chairman Jerome Powell said the Bank intends to hold rates at a restrictive level until it’s confident inflation is moving down sustainably toward its (2.0%) objective. We saw a similar theme in Europe and the UK, with both the European Central Bank and the Bank of England nearing the end of their rate tightening cycles and indicating that rates will likely remain higher for some time. The increasingly hawkish central bank rhetoric we saw throughout the period also contributed to a sharp rise in government bond yields, which put further pressure on stocks. Higher bond yields make stocks less attractive. Share markets were also impacted by Chinese growth concerns and ongoing geopolitical uncertainty.
In the US, the benchmark S&P 500 index (-3.6%), the Dow Jones Industrial Average (-2.6%) and the tech-heavy NASDAQ (-4.1%) were all weaker for the quarter. Stocks also fell in Europe (-5.1% ) and China (-4.0% ) but rose in Japan (1.5% ) and the UK (1.0% ).
Global bonds fell over the period, returning -1.8% in hedged NZD terms. Longer-term government bond yields rose (prices fell), driven largely by the ‘higher for longer’ interest rate theme that dominated financial markets throughout the quarter. Credit markets were mixed. Spreads on US and European investment-grade debt narrowed over the period, as did spreads on European high-yield debt. However, spreads on US high-yield debt were wider; though only slightly. Both hard and local currency emerging markets debt underperformed.
New Zealand shares
The New Zealand share market was also weaker in the third quarter, returning -4.8% . Like their global counterparts, the local market was impacted by expectations central bank interest rates will remain higher for longer and a subsequent jump in government bond yields. Stocks were also impacted by concerns over the deteriorating economic outlook in China; the world’s second-biggest economy and our largest trading partner. The optimism that had accompanied China’s emergence from its strict COVID-19-related lockdown earlier in the year has since faded amid a slump in the country’s property market and a string of disappointing economic data. Whilst Beijing has responded with various stimulus measures, including cuts to key lending rates, such measures have so far fallen short of the type of large-scale policy support that most economists believe is needed to help spur growth. In contrast, the market benefited from good gains across the broader commodities complex and better-than-expected second-quarter growth, with gross domestic product for the three months to 30 June coming in at 0.9%. This was up on the zero growth we saw in the first quarter and easily beat analysts’ expectations of a 0.5% expansion. On an annual basis, the economy grew 1.8%, which was down on the 2.2% growth we saw in the previous quarter. Meanwhile, the Reserve Bank of New Zealand (RBNZ) maintained the official cash rate at 5.50% throughout the period. The Bank hit the pause button in July following a cumulative increase in interest rates of 5.25% since October 2021.
New Zealand fixed income
The New Zealand bond market weakened over the quarter, returning -1.6% . Similar to their global peers, domestic long-term government bond yields rose amid expectations central bank interest rates will stay higher for longer. In contrast, bonds benefited from their traditionally defensive characteristics in the face of China’s deteriorating economic outlook. The yield on New Zealand 10-year government debt closed the quarter 68 basis points higher at 5.3050%. Local credit markets were positive, with spreads narrowing over the period.
How did markets affect UniSaver’s investment options?
With both equities and bonds falling, all of the diversifed member options delivered negative returns to members over the last quarter. However returns over the last 12 months remain strong with gains of 2.1%, 4.4% and 6.4% from Conservative, Balanced and Growth respectively. The Cash option delivered a 3.6% return over the same period.
Over the last ten years the Conservative, Balanced and Growth options have returned 3.3%, 5.3% and 6.7% per annum respectively, after the deduction of fees and tax.
Markets are betting that a soft landing is likely for the US economy, rather than a deep recession. Industry consensus expectations are for a rebound in corporate earnings next year and interest-rate markets are pricing only modest central bank easing.
We think a mild recession before the end of 2024 is the most likely outcome, but the complexities caused by the pandemic make forecasting difficult. The lockdowns and reopening disrupted supply chains, caused inflation to surge and sent the cycles for goods and services out of sync. Goods demand was brought forward during the pandemic and services consumption rebounded during the reopening. Households emerged from the lockdowns with record cash balances from government support payments and businesses built up large cash buffers during the post-pandemic profits surge.
This is the first significant Fed tightening when neither households or businesses are overstretched in terms of debt or interest payments. For that reason, we shouldn’t be surprised that the lag between Fed rate hikes and the economic impact is taking longer than usual. It is possible that we get a soft landing where the economy cools by enough to allow the Fed to start lowering rates and prevent recession. The economy could also get a temporary second wind if receding inflation boosts consumer purchasing power, or manufacturing has a mini recovery as inventories are rebuilt. This no-landing scenario is the most worrying for investors as it would see the Fed contemplate further tightening and risk an eventual deeper recession..
It is hard to be optimistic about New Zealand’s economy given the very restrictive stance of the Reserve Bank of New Zealand. The labour market has started to weaken and the number of applications per job posting has surpassed the pandemic’s peak, indicating that the deterioration is likely to continue. The upcoming general election in October is unlikely to change the economic outlook, with neither party indicating a change in the fiscal stance. New Zealand equities screen as slightly expensive relative to global equities, while New Zealand government bonds look attractive given the cyclical backdrop of heightened recession risk.