The cost of living, inflation and interest rates were the key drivers for a gloomy quarter in financial markets. The latest July data shows inflation at 7.3 percent, the highest in 32 years.
New Zealand house prices seem to have peaked, with housing market indicators suggesting prices could be easing in many regions. While the house prices cool, mortgage rates are heating up, which will only serve to curb spending further.
Consumers and businesses have shown remarkable resilience over the last few years. But the economic environment continues to be challenging, and the pathway toward a sustainable economic recovery is unlikely to be smooth.
When investors feel happy and confident, they are often more comfortable allocating to higher-risk investments. However, they are less inclined to take higher risks when they lack confidence. Market commentators have a specific phrase for this general investor attitude. They refer to it as ‘investor sentiment’, either positive or negative.
Recently, investor sentiment has been negative due to the struggles of global share markets over recent months.
One of the elements that will shape the speed of any recovery will be inflation.
The current surge in global inflation can be traced back to the start of the Covid-19 pandemic when an imbalance between the supply and demand of goods emerged. The global economy tightened in the first half of 2020 as lockdowns were imposed. A highly unusual recession followed, and households were protected from economic pain. This was due, in part, to many being able to work from home on full pay and businesses being able to have their balance sheets supported by government payments and employment subsidies. Consumers were flush with cash as spending was limited—this increased demand in the goods sector and, in New Zealand’s case, the housing market. Demand for goods was amplified by Covid lockdowns and disruption to the global supply chain. Shortages of goods caused supplier delivery times to lengthen, and a deteriorating imbalance between supply and demand flowed through to consumers in the form of higher prices.
More recently, geopolitical events, such as the war in Ukraine, have exacerbated inflation trends, as commodity prices have soared, lifting inflation further.
High oil prices were hurting consumers at the pump, with the cost per barrel around US$50 in February 2020 to nearly US$120 per barrel by early June 2022. The price has dropped to around US$100 per barrel in the last few weeks. Price declines have been seen through other industrial commodities such as copper used in building construction and electronic product manufacturing. The copper price has eased by over 20 percent since doubling in price in March 2020.
These recent price trends are indicators that inflation may begin to ease for the remainder of 2022.
There has been robust economic activity as consumers absorb higher prices. The tight labour market and pick-up in wage growth have also helped. These factors should remain supportive for a time, but cracks have begun to emerge on the demand side of the global economy.
With inflation exceeding wage growth in most countries, a squeeze on household income has started to erode consumer confidence. Some measures in the US and UK have fallen to levels not seen since the global financial crisis, and trust is declining in Europe. In New Zealand, the high cost of living is the number one issue facing households. This suggests that consumers may soon be less willing or able to tolerate higher prices. There is even a risk of outright declines in demand. This adjustment may already be underway in the case of recent oil, copper, and other commodity price declines.
Meanwhile, central banks continue to use interest rates to reduce inflation and global bond markets to price additional rate hikes. There are also signs that tighter financial conditions are starting to impact.
In the US, 30-year mortgage rates climbed to 5.7 percent in mid-June, the highest level since 2008. This has coincided with a deterioration in the US housing market. The New Zealand housing market is also showing clear signs of cooling from the FOMO (fear of missing out) days of late 2021/early 2022. The Reserve Bank of New Zealand (RBNZ) was among the first global central banks to begin raising interest rates late last year. With floating mortgage rates now nudging 5.5 percent, we are seeing more regular commentary suggesting a slowdown in house sales.
All of this makes for a challenging environment for policymakers. Faced with widespread pricing pressures, central banks have determined that tackling inflation is their highest priority. Higher interest rates are the primary tool at their disposal to achieve it. As long as inflation remains a concern, central banks will likely continue raising interest rates.
This too will pass
Currently, there are elevated levels of uncertainty, but this has already been priced into markets. While this has been a significant factor in the poor share market returns year to date, it doesn’t tell us anything about the returns we should expect for the remainder of this year.
Markets are relentlessly forward-looking. They calibrate the information known today, along with every market participant’s fears, hopes and expectations. Investor sentiment has been very negative, which has weighed heavily on market prices. We know that sentiment and markets can turn very quickly.
Given the current low market starting point, if the sentiment was to begin to improve in the coming weeks and months around any one or more of the current uncertainties (inflation, central bank policy, economic growth, Covid or the war in Ukraine), then share markets, at these lower prices, might suddenly look a lot more appealing.
As always, in periods like this where the market has been challenging, it is best not to ‘time’ your exposure. It might be tempting to think you could just sit out and wait for the current storm to blow over. The forward-looking markets will always go up, and sometimes strongly, well before the economic clouds have cleared. Given the speed that markets can react, being on the side-lines and missing the recovery can often be far more detrimental to a long-term plan than absorbing the current lower valuations and higher volatility of returns.
The most reliable advice is always to maintain the risk exposure you set and consider it appropriate when the skies are clearer. Investing more when prices are lower is usually an even better option, but that may not be an option that is available to everybody. If it isn’t, just batten down the hatches and wait this one out. The skies always clear, and the markets always recover. We just don’t ever quite know the timing.
26 July 2022
Article provided by Consilium.
Disclaimer: Information as at 22 July 2022. This article is general information and does not consider your financial situation or goals and does not constitute personalised advice. Please contact your financial adviser for advice specific to your situation. There are no warranties, expressed or implied, regarding the accuracy or completeness of any information included as part of this article.