Key market movements
- The MSCI All Country World Index (ACWI) finished the year on a high with a 4.0% (2.2%) return in New Zealand dollar-hedged (unhedged) terms for the month. This left the gauge at 21.4% and 22.1% for the year respectively for hedged and unhedged indices, the fourth highest annual return this century.
- Returns for the month were similarly strong in local markets, with the S&P/NZX 50 Gross Index (with imputation credits) advancing 4.0%, and the S&P/ASX 200 Index rising 7.3% (7.8% in New Zealand dollar terms). Despite a strong finish to the year, the NZX 50 only advanced 3.5% for the year, whilst the ASX 200 added 12.4% (13.0% in New Zealand dollar terms).
- Bond indices were also positive over the month. The Bloomberg NZBond Composite 0+ Yr Index rose 2.8%, whilst the Bloomberg Global Aggregate Bond Index (hedged to NZD) also gained 3.1% over the month. This came as the US market saw 10-year government yields continue to fall, closing out the year at 3.9%. The New Zealand 10-year government yield has also had a precipitous fall over the past quarter, from 5.6% at the end of October to 4.3% at the end of the year.
Key developments
The US Federal Reserve performed an unexpected dovish pivot at its December meeting and markets now anticipate a "soft landing" where inflation returns to 2% without the Fed having to inflict severe economic damage, opening the gates for a flood of cash into equity markets. The so-called ‘Fed pivot’ saw capital markets quickly focus on when and by how much the Fed and other central banks would cut interest rates. After a lower-than-expected core inflation reading capital markets fully priced a Fed Funds rate cut in March and 150bps of rate cuts over 2024, which would see the Fed Funds rate sit at circa 3.75% versus the 5.25-5.5% range at the end of 2023. Institutional and retail investor money came off the sidelines from money-market funds into equity markets on expectations that the currently high yields offered in money market funds would fall early in the first quarter of 2024. This flood of capital contributed to a broadening in sector performance with all ACWI sectors apart from energy positive for the month.
Locally, the New Zealand share market delivered a solid return over the December month supported by the fall in government bond yields over the month. The market saw the negative impact of earnings downgrades during the period from consumer cyclical companies (including Air New Zealand, Heartland Group, Kathmandu and Sky City) offset by lower bond yields and a flurry of merger and acquisition (M&A) proposals (including Arvida) that highlighted valuation anomalies. The best performing New Zealand sectors for the month were information technology (+16.5%), consumer staples (+8.2%), and real estate (+7.3%). The worst performing sector over the month was energy (-2.5%), driven by a block sell-down of Channel Infrastructure shares at a discount.
The "soft landing" view is not unique to the US with economists expecting a version of that to occur for much of the world next year. A lot needs to go right for economies to stick the soft landing. Since the 1960's, for example, central bank tightening of more than 400bps is almost always followed by recession, though the starting point for policy rates this time was particularly low. Tight labour markets are generating wage growth that is keeping services inflation too high for comfort. Forward labour market indicators suggest wage pressures should continue to ease, but if they don't, central banks may have to resume tightening cycles or keep rates higher for longer than markets currently assume. Ongoing consumption growth is another risk to the soft-landing narrative, particularly in the US, and may require central banks to further tighten financial conditions to reduce demand.
The New Zealand economy is in much worse shape than previously thought and tight monetary policy appears to be working. Q3 GDP data showed the economy unexpectedly contracted 0.3% in the quarter and negative historical revisions meant the economy is 1.8% smaller than the Reserve Bank of New Zealand (RBNZ) had assumed in its most recent November MPS. The big signal here is that monetary policy is working better than previously assumed and, despite the large influx of migrants, activity is not holding up particularly well. On a per capita basis, it's awful, with GDP down more than 3% over the past year. All else equal, these data should lower the RBNZ's OCR forecast when we see it next. However, we still have inflation and labour market data before the RBNZ meets next at the end of February.
What to watch
Source: Bloomberg, Deutsche Bank
Bond and equity markets have been trading in a highly correlated fashion over the last several months in both directions, and, on some metrics, they’ve been around their most correlated in decades. The chart above shows the S&P 500 and 10yr US Treasury yield since the beginning of August, where the start of this tight relationship began. It was seemingly triggered by the surprise ‘bearish’ US quarterly refinancing announcement (QRA) and the implications for yields and risk. One quarter later and a more optimistic QRA (amongst other things) turned both around and again they moved in lockstep. Anyone who has looked at the history of these two markets will know this tight relationship probably won’t last forever as such correlations are typically unstable and can flip very quickly. Keep your eyes peeled for when this happens!
Market outlook and positioning
Over the past two years, investor interest has been focussed on how to navigate a hawkish, rate increase biased, central bank policy. A more balanced monetary policy setting with official rates not being increased rapidly, and earnings expectations finding a base locally provides a more constructive framework for local share market returns. The local New Zealand and Australian share markets are starting to offer a useful alternative for income-focussed investors after the sharp drop in long-term government bond yields over the last few months.
Our economic base case remains for an orderly slowing in global economic activity (resilient but including potential technical recessions), rather than deep recession. If the next step lower in inflation proves stickier and inflation rates remain above central bank targets, then the move in bond yields may have overshot near term. In contrast, recession risks may be being underappreciated by equity investors. We would not be surprised to see bond yields oscillate around current levels reflecting economic data points and expect equity market volatility will increase as bond markets land on how far and how fast interest rates need to fall – just as the ride up in interest rates was volatile for share markets so too will be the ride down in interest rates. We still think more RBNZ rate cuts can be priced for this year, and the market-implied trough for the OCR is too high at 3.5%, but the recent decline in interest rates has delivered market pricing that better reflects the balance of risks, in our view.
Within equity growth portfolios our strategy remains to position for a range of scenarios and to be selective. The potential to return to a pre-COVID lower growth, lower inflation environment supports our continued favouring of investments with secular tailwinds that are less dependent on strong economic activity. Within the portfolio we are selectively overweight shares in the healthcare, information technology and financial services sectors that offer potential for compound growth. While the healthcare sector may remain dynamic and face further disruption from innovative technology the reset in investor expectations and valuation multiples, provides us with the confidence to sustain a relatively large but share specific investment in this proven compound growth sector. The information technology (IT) sector’s secular growth potential is underscored by the runway remaining in GenAI, improving IT budgets and expectations for improving margins. We also favour selected defensive shares, preferring non-cyclical growth channels and/or income streams that are tied to inflation and positive secular trends. We remain wary on cyclicals that are dependent on a recovery in consumer and corporate confidence. We continue to have a bias to quality, well-capitalised businesses that are well positioned to fund value-adding growth opportunities.
Within fixed interest portfolios we now have a more balanced outlook for the market. Much of that comes from the fact that yields have declined quite sharply. The RBNZ's concerns are also significant. The other notable aspect is that the Government is scheduled to issue a large amount of bonds for the remainder of the fiscal year (to June 2024). This coincides with similar treasury bond issuance in the United States. The market may seek a premium to find a clearing price for this issuance. This pressure is likely to continue over the years ahead, as the increased debt position of governments has become a structural issue. Over the year we expect the yield curve to steepen, with 2-year rates declining below 10-year rates. This reflects the contrasting influences of expected cuts in the official cash rate, while longer-term bonds are somewhat constrained by issuance challenges. Our portfolios are positioned accordingly, with a bias for duration overweight exposure to be held in the 1-3-year maturity range.
The Active Growth Fund is defensively positioned, being overweight bonds and underweight equities. After the recent rally in global share markets the current risk return proposition may not be compelling as it was, and we may see a period of consolidation in global equity markets. At a headline level, global equity markets (measured by the MSCI ACWI Index) are trading at their 88th-percentile valuation when compared to the past 20 years, which is expensive in absolute terms. When we look at the forward-looking risk premium relative to bonds, we see a more extreme outcome, trading at 93rd percentile (i.e. expensive relative to history). However, when we dig below the surface, there appear to be interesting opportunities, particularly when we look at small company, defensives, and non-US equity valuations. New Zealand share market valuations are also more reasonable. Over the past few years, we have seen a higher correlation between equities and bonds than history would suggest. However, we believe that equities and bonds are more likely to be highly correlated in high core inflation regimes. This informs our view that equities and bonds will reassert their negative correlation once the market narrative turns from one focussed on inflation, to one that recognises slowing growth. This being the case, and since the equity risk premium is hovering around historic lows, we continue to favour bonds over equities.
The Income Fund’s strategy over the course of 2023 shifted from a defensive one of focusing on the downside economic and earnings risks that arose as central banks continued to hike interest rates towards a more positive view on markets, particularly fixed interest, as inflation began to decline and the rates hiking cycle looked to be complete. In recent months we have lifted equity allocation from as low as 24% to 30% and added duration in the fixed interest sector. Core holdings have been retained in inflation-indexed bonds, private credit and high-yield credit. The recent strong performance across both fixed interest and equity markets now begs the question of whether we can expect more of this, or have markets already overshot. Our core view is that bond and equity markets will perform reasonably well in 2024, but that we will experience phases of shifting optimism and pessimism, which could induce a moderate degree of volatility. Therefore, our strategy is to be patient and build up equity and fixed interest positions in periods of weakness and to exercise some patience in committing to significant additions.
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This publication is provided for general information purposes only. The information provided is not intended to be financial advice. The information provided is given in good faith and has been prepared from sources believed to be accurate and complete as at the date of issue, but such information may be subject to change. Past performance is not indicative of future results and no representation is made regarding future performance of the Funds. No person guarantees the performance of any funds managed by Harbour Asset Management Limited.
Harbour Asset Management Limited (Harbour) is the issuer of the Harbour Investment Funds. A copy of the Product Disclosure Statement is available at https://www.harbourasset.co.nz/our-funds/investor-documents/. Harbour is also the issuer of Hunter Investment Funds (Hunter). A copy of the relevant Product Disclosure Statement is available at https://hunterinvestments.co.nz/resources/. Please find our quarterly Fund updates, which contain returns and total fees during the previous year on those Harbour and Hunter websites. Harbour also manages wholesale unit trusts. To invest as a wholesale investor, investors must fit the criteria as set out in the Financial Markets Conduct Act 2013.