Analysis: Investors are hoping to focus less on the pain of the current downturn and are more looking through to the eventual economic, and profits, recovery.
What a difference a few words can make. On July 10th the Reserve Bank of New Zealand (RBNZ) Monetary Policy Committee (MPC) delivered a surprisingly ‘dovish’ and welcome surprise to the markets. These comments sent wholesale interest rates down with the 2year swap dropping -18bp and the NZ Dollar lower against the US Dollar by -0.69%. It also saw a small resurgence in the recently poor performing New Zealand equity market, with the NZX50 bouncing +0.80% on the news.
Equity market leaders shifted considerably, in what was one of the larger sector rotations we have seen in the New Zealand equity market for some time. This macro shift, intensified by softening inflation data in the US, suggests scope for earlier cuts in US rates as well. So will we see new positions with a different mix of asset classes and equities deliver portfolio outperformance in the coming quarters? Time to stick or twist.
The RBNZ Pivot: What did the central bank actually say?
At the May meeting, only 6 weeks prior to the July Monetary Policy Review (MPR) the RBNZ delivered an extremely ‘hawkish’ Monetary Policy Statement (MPS). The central bank’s forecasts suggested no cuts to the Official Cash Rate (OCR) till August 2025 and implied a greater than 50% probability of an additional 25bp hike to come. Citing high ‘non-tradeable’ inflation, often termed ‘domestic’ inflation, which is heavily influenced by local wage costs. In response to the May MPS we saw economists either noting upside risks or revising their interest rate forecasts to reflect a later start date for OCR cuts, with most expecting a first 25bp reduction to come in February 2025.
In the lead up to July’s MPR the economist and forecasting community had picked it to be, essentially, a non-event. There was a universal expectation among major bank economists that the RBNZ would leave the OCR ‘on hold’ at the current level of 5.5% and maintain their hawkish bias.
Especially so, given the July meeting is a lighter touch ‘review’ and does not include publishing of a fresh set of RBNZ forecasts nor is there any major press conference. The published output from the RBNZ is limited to a news release with a few paragraphs and a summary record of the meeting which notes the various points discussed by the Monetary Policy Committee. The words in this record are carefully analysed by the market for any change in tone.
So, what were the key changes in tone from the MPC and why was it interpreted as a pivot?
- Members agreed there was increased evidence of ‘excess capacity emerging’ in the economy – which is economist speak for idle resources, including labour
- Members are now ‘confident’ inflation returns to within its target range in the second half of 2024 (read Q3 of this year). Previous comments had been for inflation to being within target range by ‘the end of 2024’ – suggesting inflation is falling faster than their last published forecast
- Members discussed the risk that domestic monetary policy is feeding through to domestic demand more strongly than expected – higher frequency data suggesting downside risks to activity levels
- And finally, at the previous meeting the committee discussed the possibility of increasing the OCR, this time, it was not mentioned at all. Rather, members agreed that monetary policy needed to ‘remain restrictive’, but importantly added the comment that ‘the extent of this restraint will be tempered over time consistent with the expected decline in inflation pressures’.
The last comment was the key and signaled the committee opening the door to rate cuts. The market moved quickly to price in an earlier start to easing, with OCR cuts of -25bp in October and November now fully priced in to rates markets.
The impact of tight monetary policy are obvious for all to see with the current state of the NZ economy. Some worthy data-points;
- Consumer spending has collapsed, with retail sales volumes down by 8.7% since the end of 2021, despite strong population growth
- The unemployment rate has risen from 3.2% to 4.3% and job losses appear to be accelerating, with government cuts and corporate restructures starting to flow through;
- Economic growth (as measured by GDP) has been net negative over the last 18 months. With more timely activity indicators in free-fall, the Performance of Manufacturing Index is sitting at GFC levels, and the Performance of Services Index is currently at its lowest level, outside of COVID lockdowns, since the survey began;
- Horrific business and consumer confidence, and rising receiverships with a ‘double dip’ decline in house prices now playing out; and finally
- Various updates from companies, particularly economic bellwethers, suggesting demand conditions have cratered to GFC levels. Many will need to right-size their cost base for today’s lower revenue environment.
With tighter fiscal policy on the horizon and mounting job losses, the near-term outlook for NZ’s economy is challenging to say the least. We expect a few rate cuts, likely starting in November this year, will do little to boost the real economy over the next 12 months given the long and variable lags inherent in monetary policy. The high share of fixed rate loans in NZ means that changes to the OCR are only very slowly captured by borrowers, on the way up as we’ve seen, but also on the way down.
So what does it mean for your portfolio?
We and many others have painted a fairly grim picture of the NZ economy so far, but there is a good news story here which is two-fold. First, the cost of living crises is nearing an end with the CPI moving to be in the target range this year (the astronomical rise in council rates and insurance aside).
Secondly, investors and asset markets will start to look through the expected pain and weaker earnings outcomes over the next 12 months to better economic prospects beginning some time later in 2025 as lower rates flow through.
So what do we see as the key portfolio implications of a lower rates outlook in NZ;
- NZ Fixed Interest - falling rates should deliver meaningful capital gains from bond portfolios with greater gains realised by portfolios with longer duration
- NZ Cash funds or shorter duration investments - limited capital appreciation from falling rates and reinvestment yields will fall as declining short rates flow through
- NZ equities to outperform global equities - NZ is a highly rate sensitive market due to its sector mix, this is a key driver of its significant underperformance in recent years as Central Banks have hiked rates. We could see this trend reverse as rates fall; and finally
- After an awful run, we expect the property sector should outperform. Most of the NZ Real Estate sector are trading at relatively steep discounts to their externally assessed tangible asset backing. As bond yields fall the dividend yields offered by these stocks become more attractive.
Within the local equity market, we've already seen a shift in sector leadership.
With enthusiastic bidding up of many cyclicals, housing sensitive names and the more highly leveraged property companies. We’ve also seen companies exposed to the NZ consumer participate in the post-pivot rally, though we believe that most will see limited impacts on their revenue and earnings for at least the next 12 months.
A favoured trade in this context is the aged care sector, where despite the recent rally, valuations remain relatively low. These companies should see the benefits of falling rates accrue quite rapidly via lower interest costs on unhedged borrowings and a release in working capital (unsold resale and new sales inventory) as lower rates return liquidity to the housing market.
Last week’s change in tone by the RBNZ has arguably ushered in a new phase for the market. One where people focus less on the pain of the current downturn, to one where they look through to the eventual economic, and profits, recovery.
We are living, and investing, in interesting times.
Tobias Newton is an Equity Analyst at Octagon Asset Management