The Harbour Investment Outlook summarises recent market developments, what we are monitoring closely and our key views on the outlook for fixed interest, credit and equity markets.
- Both nominal and real bond yields increased sharply over the month. This saw interest rate sensitive stocks, such as the gentailers in New Zealand and long duration growth stocks give back some performance. Cyclical stocks that would benefit from stronger growth outperformed.
- US earnings season was strong, with 77% of companies either in-line or beating earnings expectations. Our observation, both domestically and offshore, is that the earnings outlook is cautious, reflecting COVID-19 uncertainty, and wary as to the impact of declining government support packages and the on /off impact of lockdowns. In our view, this leaves room for earnings upside.
- The US economy is likely to grow by as much as 7% this year, assisted by a larger-than-expected US$1.9 trn (9% of GDP) stimulus package.
- New Zealand’s economic strength, coupled with a stronger global economic picture, has led to a marked change in interest rate expectations. Market pricing now expects an OCR hike in the middle of 2022. This is a far cry from the negative rates that were priced into markets late last year.
Equity markets priced in a reflationary environment as better COVID-19 vaccination evidence and extended monetary and fiscal stimulus lifted potential economic growth and inflation. Longer term government bond yields increased sharply across most market. For example the New Zealand Government 10-year bond yield rose from 1.1% to 1.9% over the month. Globally, investors moved capital into more cyclical sectors, including banks and materials, which may perform better in a strong economic growth environment. Bond yield sensitive defensives underperformed as did higher growth technology stocks.
Against this backdrop, the New Zealand equity market (S&P/NZX 50 Gross with imputation) finished the month down -6.9%, underperforming most other developed economies as our index’s high weighting to stocks sensitive to bond yields weighed on the index over the month. The comparatively more cyclical Australian market rose 1.5% for the month. The MSCI All Country World index rose 2.2% over the month; notably the “value” stocks within this index rose 4.3%, while the “growth” stocks rose 0.1%. While this outperformance seems a large number, the value index is still 26% behind over the past 12 months.
The global COVID-19 vaccine rollout is likely to allow large, developed economies to begin reopening in the coming quarters. The associated unleashing of consumers that have accumulated large amounts of liquid savings over the past year is likely to see advanced economies grow 4% in 2021, versus an average of 2.4% y/y between 1980 and 2019. The US economy is likely to grow by as much as 7% this year. The US has administered 23 vaccines per 100 people and will likely have enough vaccines available to cover its entire population by mid-year. Europe should have enough by year-end. Most developed economies should reach herd immunity (or population immunity), defined as vaccination coverage of 63% (assuming an R0 of 2.7), by the end of Q2 or Q3 2021.
Central banks are likely to look through the impending transitory increase in inflation and keep monetary policy stimulus in place. The combination of goods supply disruption, higher commodity prices and base effects will increase annual inflation rates above central bank targets in Q2. In the case where this inflation becomes more persistent, still-high unemployment rates through the second half of 2021 will augur for ongoing central bank support – largely via signalling that cash rates will stay low for some time.
What to watch
Earnings: The local profit reporting season for the December half produced results that were generally consistent with expectations. Globally and in the US especially, the earnings season was particularly robust, with 77% of companies either in line or beating consensus expectations. The scale of the earnings surprises has been especially strong.
Both domestically and globally, company management remained wary of providing formal profit guidance – and where they did it was cautious reflecting COVID-19 uncertainty, wariness as to the impact of declining government support packages and the on /off impact of lockdowns on costs, revenues and morale. While companies were cautious on guidance, a number announced higher dividends than expected perhaps reflecting that, so far, COVID-19 has had a lower impact on profitability and financial strength than previously expected. In our view, there remains upside to earnings and dividends as companies get better comfort on the impact of COVID-19.
Market outlook and positioning
The combination of the sharp increase in long term government bond yields and a very busy profit reporting season created a volatile month for equity market returns. The increase in bond yields reflects a range of factors including:
- expectations of mobility improving with a faster pace of vaccination globally and higher vaccine efficacy
- supply side constraints resulting in some price increases,
- US fiscal stimulus ($1400 cheque in the mail for individuals), and
- central banks, including US Federal Reserve and the Reserve Bank of New Zealand (RBNZ) maintaining ultra easy monetary stimulus in a ‘path of least regret’ strategy.
For equity markets, higher bond yields mean investors don’t need to own as many income yield-producing shares to hit overall portfolio income targets. Higher bond yields and increased cyclical growth rates also reduce the relative near-term attraction of higher growth stocks. The reflation trade has seen investors switch out of growth and bond proxy stocks into more cyclical stocks including banks and resources that are likely to benefit more from the higher economic activity, price increases and higher interest rates which are the key ingredients behind reflation.
At economic turning points, like the environment we may currently be facing, research highlights that diversified portfolios tend to produce better returns. Within equities, our growth portfolios have been repositioned over the second half of 2020, increasing exposure to selected cyclical growth stocks in the financial and materials sectors that may benefit from the near-term recovery in activity. Our portfolios remain anchored by selected structural growth stocks in the healthcare, information technology and consumer staples sectors, which will grow returns over the medium term. In our view, a barbell of selected stocks from the structural growth and cyclical growth sectors should support returns in the near term, providing a balanced solution to the uncertainty of what the near term new normal may look like.
Within fixed interest portfolios, we started the month with a short duration position, anticipating a further rise in long term bond yields. The New Zealand 10-year bond started February at a yield of 1.1% and early in the month we set a strategy of 1.60% as a level where we would reinvest and adopt a neutral position. In the last week of February this target was met and exceeded. We held off our purchases until the very end of the month, buying when the 10-year yield was 1.9%. Yields have subsequently eased a little lower.
It is a challenge to select levels at which to invest in the face of high volatility, however our current assessment is that, as the RBNZ is unlikely to hike the Official Cash Rate (OCR) until late 2022 at the earliest, 10-year yields above 1.75% may offer some appeal for the time being. Over the longer term, if the global economy continues to re-open at a rapid rate and if inflation rises, we would expect yields to continue to rise. Looking beyond yield curve positioning, we see scope for inflation expectations to continue to climb, however any meaningful rise may require clear signals from the data, which may take some time.
Within the Active Growth Fund, we have continued add to more cyclical exposures with the ballast of the portfolio remaining in stocks that will benefit from long-term structural trends. Overall, the Fund is underweight share markets, though the scale of this underweight has been reduced as markets have provided attractive re-entry points.
The Income Fund’s strategy has continued with its underweight equities position and has only a modest exposure to interest rate risk. In mid-February we hedged 3.6% of our global equity exposure, taking the effective equity allocation to 26%, which is 6% below our neutral weight. Similarly, the Fund’s sensitivity to interest rate rises is lower than benchmark. As yields rose, we were prepared to make some investments, however the duration of these securities is 2.4 years on average, compared to the benchmark duration of 3.7 years. The attractive running yield on inflation-indexed bonds will support their performance over the next 6 months, so we are in no rush to exit this position.
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Harbour Asset Management Limited is the issuer and manager of the Harbour Investment Funds. Investors must receive and should read carefully the Product Disclosure Statement, available at www.harbourasset.co.nz. We are required to publish quarterly Fund updates showing returns and total fees during the previous year, also available at www.harbourasset.co.nz. Harbour Asset Management Limited 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. This publication is provided in good faith for general information purposes only. Information has been prepared from sources believed to be reliable and accurate at the time of publication, but this is not guaranteed. Information, analysis or views contained herein reflect a judgement at the date of publication and are subject to change without notice. This is not intended to constitute advice to any person. To the extent that any such information, analysis, opinions or views constitutes advice, it does not consider any person’s particular financial situation or goals and, accordingly, does not constitute personalised advice under the Financial Advisers Act 2008. This does not constitute advice of a legal, accounting, tax or other nature to any persons. You should consult your tax adviser in order to understand the impact of investment decisions on your tax position. The price, value and income derived from investments may fluctuate and investors may get back less than originally invested. Where an investment is denominated in a foreign currency, changes in rates of exchange may have an adverse effect on the value, price or income of the investment. Actual performance will be affected by fund charges as well as the timing of an investor’s cash flows into or out of the Fund. Past performance is not indicative of future results, and no representation or warranty, express or implied, is made regarding future performance. Neither Harbour Asset Management Limited nor any other person guarantees repayment of any capital or any returns on capital invested in the investments. To the maximum extent permitted by law, no liability or responsibility is accepted for any loss or damage, direct or consequential, arising from or in connection with this or its contents.