In our latest market update for clients, independent Investment Committee members George Boubouras and Tim Macready provided valuable insights into the global economic landscape from expectations for interest rates, to considerations for investors in the year ahead.
What is the current state of the global economy? With economies slowing, where are we in the cycle and what does this mean for interest rates?
In terms of the global economy, what stands out is the divergence in performance between developed and emerging markets. There is a distinct unevenness across economic activity by region. The need to slow the economy and tame inflation has resulted in developed markets engineering ‘demand destruction’ within their economies by increasing interest rates at a rapid rate and delivering quantitative tightening (QT) in an effort to address persistent core inflation. The US economy has continued with stimulatory fiscal policy well into 2022 which has created additional complexities for central banks to navigate. This has led to a higher for longer Fed Funds rate expectation from markets.
Global growth has proven resilient, and the key developed economies have generally held up well, to the surprise of many. Earnings in the US, for example, are still expanding (although at a slower rate) and the most recent US quarterly earnings (EPS) have risen +3% year-on-year. Given this has been one of the most rapid increases in policy rates for a generation, this is impressive and supports a softer landing scenario. The surprise is not only the resilience of economic conditions following the higher rates but also the ability for many companies to pass on higher costs. The ability for this to continue will be more challenging.
There has been some good progress on slowing inflation in key economies, however whilst the direction is promising, there are some concerns. Despite inflation globally falling from recent highs following the aggressive monetary policy, the resilience in the economy has made it difficult for central banks to get inflation within its target bands of 2%-3%. Central banks will therefore need to continue to balance their actions between slowing economic growth and continuing to rein in inflation. Lower government spending would assist in helping the central bank policy decision makers in slowing the economy to a level whereby inflation gets towards the lower end of the band. Stability in prices is critical to ensure economies are better positioned for future productivity gains which are supportive for futures earnings and investor returns.
China
Unlike the tightening experienced within developed market economies, the second largest economy China, for example, has been cutting interest rates for the past two years and attempting to stimulate their economy. The key challenge for China is how to deal with the consequences of the very sharp and depressed property construction sector. The impact on other key partial economic indicators has also been severe, evident in the weak consumer and business sentiment and the flight of capital. The high debt levels within the property sector are also notable headwinds and a challenge for Beijing as they look to deliver another stimulus package to help drive domestic demand.
The positive news is that China has maintained accommodative monetary policy and their official rates remain low. Unlike the bulk of the developed world which has the opposite higher and restrictive interest rate settings, the central bank in China (PBoC) continues to stimulate. Combined with some additional targeted stimulus the aim is to try and improve confidence. Also, despite the very high property debt levels, the government has the ability to lend more to assist the long repair within the property sector. Investors in China’s property sector will continue to face difficult conditions.
In another attempt to address the many headwinds, Beijing continues to reach out to expand their alignment with the BRIC economies and increasingly, the west. This has been very public in recent months with the rotation of many EU member countries visiting China on official visits, followed by the US, Australia and other countries in the South-Pacific.
More broadly, global growth looks to be around 3% for 2023 (following 3.5% for 2022) and 2.9% for 2024. The forecast for next year assumes there is no hard landing in the US.
It’s important for investors to be thinking about the next stage of the economic cycle. The low rates that have marked the post-GFC period from 2008-2022 should no longer be the norm. Instead, investors should anticipate that higher cash rates within developed markets will remain for the foreseeable future. When rates are lowered by central banks, they will not go to levels we have been accustomed to. Price stability will be important for New Zealand, with expectations of future rate cuts taking the interest rate to circa 3%-3.5% by 2025. The RBNZ has clearly delivered more aggressive monetary policy tightening compared to other economies. If NZ core inflation continues to fall the expectation will be for rate cuts.
Is it advisable to continue holding cash or invest in a diversified portfolio, considering the current economic environment, interest rates and inflation?
It’s crucial for investors to keep real returns in mind, as even a seemingly attractive cash rate may not keep pace with inflation. While an overweight to cash may be acceptable as a natural hedge to risk in other parts of your portfolio, deploying it into a diversified portfolio is ultimately most effective for generating long-term growth and protection against inflation.
Basic portfolio theory suggests that a balanced portfolio across multiple asset classes is the key to generate sustainable ‘real’ (after inflation) returns over time reflecting the various business cycles and the volatility events that are part of the cycle. Different asset classes should exhibit different correlations and that is why equities (the most volatile asset class) have the lowest correlation to fixed income over time.
The appropriate portfolio mix of asset classes aims to look at investor expected return and their risk tolerance. Just like an endowment fund e.g. Harvard, Yale or sovereign wealth fund, investors are always looking at the appropriate long term optimised portfolio that generates the lowest risk possible to achieve their expected return target. Limiting the size of large drawdowns in times of excess volatility protects the portfolio on the downside while benefiting from the upside.
The optimal portfolio is what we refer to as the efficient frontier. Alternatively, the optimal asset allocation for an individual investor reflects their risk tolerance and expected return target, or put simply, they can sleep at night.
Given recent volatility in bond portfolios, what are the expectations for long-term bond yields, and how does this impact investment portfolios?
The volatility in bonds has been driven by changes in expectations and interest rates. As rates have gone up, the value of existing bonds has fallen. While we expect more volatility to persist, this will likely be less so than the volatility experienced over the past two years. Yields for longer term bonds will decline as interest rates and interest rate expectations fall.
The bond market volatility this year has been excessive impacting market sentiment. Just like predicting future earnings vary on expectations of future conditions, bond markets are very much leading indicators of future credit conditions. The volatility is reflecting the rapid changes to expectations, including the yield curve.
The range in the US 10-year yield from 3.31% in April to 5% in October is a very rare market event. The sharp rise in US treasury yields through to October has clearly done some of the Federal Reserve’s tightening for them. The higher long bond rates delivered headwinds for risk assets, however, the recent slowdown reflected in the data continues to suggest lower long bond yields and therefore a softer landing scenario.
Is there a window of opportunity to move from cash to fixed interest, especially considering potentially higher yields in New Zealand?
For clients with a longer-term outlook, it could be reasonable to move from overweight cash to some fixed income, provided you are able to remain invested through periods of volatility. Exposure to fixed income provides defensive characteristics in a portfolio given their low correlation to equities. The best way to invest is through specialist bond fund managers to maximise the defensive characteristics as bond portfolios tend to have many different exposures, which assists in achieving greater diversification and reduces the impact of defaults.
What are the prospects for equities, considering recent volatility and potential future developments?
Even for professional investors, the ability to consistently forecast whether shares will rise or fall over short-term timeframes is challenging. However, staying invested over the long term is a proven way to generate value. The new year will not be without its challenges, as geopolitical events continue, recession remains a possibility for many countries and central banks have further work to do to successfully quell inflation. However, the prospect of central banks cutting interest rates, or signaling their intention to do so, is a very powerful driver of equity valuations and returns.
The most appropriate approach is to stay invested and remain thoughtful and prudent when making investment decisions. It’s important to continue to invest, as part of a well-diversified portfolio, into growth-oriented assets that can deliver returns throughout a high inflation environment.
Some commentary on the recent earnings reporting period. The third quarter US earnings season has delivered once again vs the expectation of the ongoing slowdown in earnings. The EPS growth outlook is circa +3% year-on-year for the US and nearly -8% year-on-year for the EU. The US earnings profile continues to look reasonable vs expectations, particularly given the amount of restrictive monetary policy (including ongoing QT). The guidance from companies however has been disappointing.
Can you elaborate on the situation in Japan?
Japan has benefited from their well-established technology sector, including cloud technology and AI, similar to North America, which has been a core driver of the expansion in the sector. The higher barriers to entry in key technologies has been supportive for the Nikkei this year.
The weakness of the Yen has been a concern as markets look at how the Bank of Japan (BoJ) will deal with their ongoing yield curve management (YCC) policy or begin to roll out some tighter monetary policy given the acceleration in 2023 GDP and marginally higher inflation, following many decades of deflation. The weaker Yen will be a challenge for the industrial sector in Japan, but it will also attract additional capital.
Additionally, with many investors exiting from China since the trade wars, this has led to capital flowing into Japan instead (as well as a number of other Southeast Asian countries).
Views on currency
Currency volatility has been high this year as markets adjust to the changing central bank rate decision expectations. The USD has traded in a very large band, weaker in the March quarter then appreciating from July through to late October as US bond yields were rising. It has since reversed that appreciation in recent weeks. The volatility in USD will continue for emerging economies that have USD liabilities. Further, geopolitical uncertainty influences short-term markets as well as the currency’s status as a safe haven.
Heading into year-end what is the USD outlook for 2024?
Expectations are for the USD to broadly stay strong in 2024 (USD Index DXY) supported by the expectation of higher for longer “relative” US bond yields combined with softer growth (i.e. soft landing) vs 2023.
There are many moving parts to any forecasts and currencies are volatile given they are trying to be predictive of future conditions. Changing expectations for central bank policy rates, leading economic indicators, long bond yields, fiscal policy changes are just a few examples. Also, let’s not forget the US Elections in November 2024.
