Many asset classes, both at home and overseas, ran into heavy weather over the past month, principally because markets started to confront the reality rather than the distant prospect of more-normal monetary policy in the United States. Many asset valuations had made sense only when interest rates looked likely to remain very low, and thus were vulnerable when the tide started to turn. There are likely to be further episodes of valuation reassessment in coming months as investors continue to rethink asset prices against a background of only modest global economic growth. New Zealand assets, in contrast, have fared relatively well and may continue to do so, given the strength of the current business cycle.
The RBNZ continues to face a serious dilemma. On the one hand, the economy is growing quite strongly, and house prices, particularly in Auckland but more widely of late, are rising at a very rapid pace. In normal circumstances, there would be no case for any further easing of monetary policy. But these are not normal circumstances. A strong economy is, thus far, having little effect on the bank’s primary objective: the inflation rate. In the June quarter, the annual inflation rate was only 0.4%, well below the 2% centre of the bank’s 1%-3% target range.
Returns on the likes of bank deposits are likely to drop to even lower levels. Local investors are better off than many investors elsewhere in the developed world, whereshort-term rates have been zero (or even negative), but even so, the year-to- date return of the S&P/NZX Bank Bills 90-Day Index has been only 1.80%.
NEW ZEALAND & AUSTRALIAN EQUITIES REVIEW
The New Zealand share market has benefited from a post-Brexit recovery of global equity investor confidence and evidence of ongoing domestic economic growth. The S&P/NZX 50 Index year to date has recorded a capital gain of 14.0% and a total return of 16.4% (17.1% including the value of imputation credits).
With the economy in ongoing robust shape, and all the main drivers (retail sales, employment, industrial production) of property operating performance firing up, it is not surprising the latest batch of result reports from the listed property companies have been strong across the board with Precinct (offices), Property for Industry (industrial), Summerset (retirement villages) and Vital (healthcare properties) all delivering good outcomes.
Australian equities shared in the initial post-Brexit recovery, but have essentially gone sideways since, with the S&P/ASX 200 Index little changed from its end-July level. Year to date the index is up by 4.4% in capital value and by 7.0% in terms of total return. New Zealand investors’ returns were almost exactly the same, with the New Zealand dollar only marginally lower (down 0.2%) to the end of August.
While there is still underlying support for New Zealand equities from the length and strength of the current business cycle, and companies are more optimistic than usual about their profit prospects, profit-related measures of valuation are now outright expensive. The effect of the extended bull run is that the historic P/E ratio is now 20.9 times historic earnings and 21.5 times one-year forward projected earnings.
Like many other equity markets, these valuations are sustainable only against a background of equally expensive cash and bonds. For now, there is very little probability that cash or bond yields are likely to improve, and the local business cycle provides stronger support for valuations than in many other developed countries that are currently growing more slowly. The market remains vulnerable to any unexpected setback to the business and to any earnings disappointments.
In Australia, the long period of slower than usual economic growth shows little immediate sign of accelerating into a stronger recovery that would make a sizeable difference to the outlook for corporate profitability. That’s not to say that current conditions are difficult. All three of the sectoral indices manufacturing, services and construction are showing business expansion. Actual business conditions have been holding up reasonably well, but businesses have not yet kicked on into a higher gear.
One key issue is non-mining investment has not grown fast enough to fill the hole left when the big mining projects were completed. Forecasters expect total business investment will still be falling over the next two years and will not turn positive until 2018. At the same time, however, one of the current up-lifters for business conditions, the strong housing construction sector, is expected to start dropping away (there is looming oversupply in some areas). The net effect is the cross- currents are keeping overall economic growth in Australia slower than normal and for the bulk of the market, modest single-digit increases in profits look on the cards.
INTERNATIONAL EQUITIES — OUTLOOK
Equity investors have not liked the look of the global economy growing quite slowly (and arguably slowing down a bit further in recent months) set against high equity valuations and the prospect that the precarious equilibrium of both expensive bonds and expensive equities will break down if bond yields start to rise. The potential for further setbacks along September’s lines remains quite high. In general, fund managers think equities are very expensive (the most expensive since 2000); they are particularly worried about the impact of further rises in U.S. bond yields and are concerned about too many investors, all trying to avoid unusually low bond yields, have crowded into the same bets (such as emerging markets); and they are holding historically high levels of cash because of their unease.
The world economy will however push through the current spot of cyclical weakness. Forecasters (as surveyed in The Economist’s September international poll) are still predicting that the developed economies will post some growth next year. However, the anticipated growth rates are modest: 2.0% in the U.S., 1.2% in the euro zone, and even less in Japan (0.8%) and post-Brexit Britain (0.5%). Overall, it is likely to be a picture of slower-than-usual growth in world business activity, with the potential for flurries of concern over growth prospects. In these circumstances, particularly when it becomes clear that U.S. interest rates are definitively increasing, we are likely to see repeats of September’s rethink of the expensive value on offer from global equities.