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Economic Update 2019

 

 

Investment markets equity prices have had a good start to the year, though the price gains have yet to recover all the ground lost in the global sell-off late last year. The more defensive, income-oriented sectors have done especially well as investors have worried less about the valuation threat from potential bond yield rises, and have viewed less cyclical equities as a useful hedge against global growth shocks. Looking ahead, the central scenario is ongoing global growth at a modestly slower rate, though with significant potential for trade disruptions (US-China, Brexit) and for the policy errors or other accidents that can derail already mature business cycles. Cash and bond yields look likely to remain very low by historical standards.

In New Zealand, the economic outlook is still positive, though the economy appears to be hitting some capacity constraints. The key issue is whether ongoing growth will translate into stronger business profits: companies’ profit margins appear to be squeezed between rising costs and an inability to raise selling prices. The opening months of this year have generally been kind to the more income-oriented, defensive classes of equity, and New Zealand property has been no exception. The S&P/NZX All Real Estate index has provided a capital gain of 6.26% for the year to date (12.03.2019).

The economy is continuing to grow, even if capacity constraints are affecting its rate of growth, and drivers of underlying property performance are solid. In the industrial sector, for example, the latest Bank of New Zealand/

Business NZ performance of manufacturing index showed that “the manufacturing sector continues to add to its now six-year expansion,” and in the office sector, business surveys show ongoing strong demand for staff.

Colliers’ February research report showed operating conditions are strong, particularly in the Auckland and Wellington office and industrial sectors. In the office markets, the Auckland CBD vacancy rate is at an all-time low of 5.2%, and Wellington’s is at a 10-year low of 6.2%, with prime office space almost unavailable (1.2% vacancy). Industrial space is also very tight with vacancy rates on Colliers’ latest estimates of only 1.5% in Wellington and 1.7% in Auckland. Listed global infrastructure has had a good start to the year.

Infrastructure had been a disappointment up to the final quarter of last year, mainly because of investors’ negative reaction to the failure of the Trump administration to deliver on its promised boost to American infrastructure spending. However, investor sentiment appears to have changed for the better in recent months. The resilience of relatively defensive assets like infrastructure through the December quarter global equity sell-off has been a plus. So has the current outlook for bond yields: like other interest rate-sensitive asset classes, infrastructure is benefiting from the likelihood that bonds now look likely to rise more slowly, and less than investors previously expected.

The central outlook for the world economy— ongoing growth but at a slower rate—suits sectors like infrastructure which are not as dependent as “growth” stocks on booming demand. Infrastructure may not continue to match its recent level pegging with the broader equity markets, but is looking a better option than in 2017 and most of 2018, with the bonus it may again offer a relatively safe refuge if any of the larger risks to the global economy materialise. The economic outlook remains reasonably positive, although headwinds do exist. As the RBNZ said in its latest policy statement, “firms report that they have been unable to maintain their margins by increasing prices. Businesses have identified competition (both local and international) and long-term fixed-price contracts as factors restricting their ability to raise prices.” Firms are having to absorb rising input costs, with higher wages, in particular, in the cost pipeline.

Valuations also remain reasonably expensive. Standard & Poor’s estimate the forward-looking P/E ratio for the New Zealand market is 20.9 times expected earnings, well above, for example, the latest 15.8 times earnings multiple for the S&P500 in the US. Investors may not mind too much—the relatively defensive nature of the market and the dividend yields have their own attractions when international uncertainties are high and cash and bond yields are low—but it could become an issue if the profit outlook were to weaken from already quite modest expectations.

In Australia, the economy has been alternating for some time between periods of acceleration and deceleration, with no definitive move towards consistently faster growth. The most recent readings on the business outlook continue the pattern, and are pointing to a modest deceleration.

It would be nice to be able to say the interlinked worries that triggered the big sell-off in equities late last year had all been resolved, but sadly the outlook remains up in the air for some of the key moving parts. The outlook for the global economy, for some of its key players, and for the outcome of the various threats to world trade (US-China and Brexit, in particular) are all still in play. On the upside, the potential threat from monetary policy

mistakenly being tightened too much now looks much less of an issue, and share valuations being too expensive, particularly in the US, are also less troubling. Higher US corporate profits and lower equity prices have brought the prospective P/E ratio on the S&P500 down to a more reasonable 15.8 times expected earnings (on data company FactSet’s estimate). They have been helpful developments, but other large uncertainties remain. On the global business cycle, the likelihood is that the world economy will continue to “muddle through” at a slightly slower rate of growth than previously. That is still the central view of both the IMF and the World Bank, but everyone agrees that the risks are loaded to the downside. There are, in sum, a variety of economic cross-currents which hopefully will resolve into ongoing, if slower, growth in global business activity, which would be supportive of

further equity market recovery. But the reality is what would be a fair-to-middling business outlook is still hostage to a major imponderable: the political threat to global trade and supply chains from trade. Markets in recent weeks have been vacillating from optimism to pessimism about the US-China trade negotiations in particular, but nobody has a clear idea of what the endgame will be. For many investors, the best approach will combine diversification across asset classes, for example, downside insurance via bonds, and placing some emphasis within equities on less cyclically- exposed sectors. The long post-GFC investment cycle has survived a series of shocks that seemed highly troubling at the time, and these latest trade tensions may also pass without lasting damage. When intransigent politicians have taken the helm, it will likely pay to be prepared for trade policy mistakes.

 

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