Economic Commentary Spring 2023

Spring Trees Flowers

In some welcome news, the world economy is showing signs of resilience this year despite lingering inflation and a sluggish recovery in China. The International Monetary Fund (IMF) released its latest World Economic Outlook in July, noting that this resilience increases the odds that a global recession may be avoided.

These signs of optimism may also give global policymakers additional confidence that their efforts to contain inflation without causing more severe economic harm may be working. However, global growth remains weak by historical standards, and IMF economists warned that significant risks still exist, as the recovery from the pandemic and Russia’s invasion of Ukraine has been very slow. The succinct appraisal from IMF Chief Economist Pierre-Olivier Gourinchas is that the global economy is “not yet out of the woods”.

Although the economic environment requires careful navigation by policymakers, the IMF raised its forecast for global growth this year to 3% (up from 2.8% in April). It also predicted that global inflation would continue to ease from 8.7% in 2022 to 6.8% this year and 5.2% in 2024 as the effects of higher interest rates filter worldwide.

The outlook was largely rosier because financial markets – shaken by the collapse of several large banks in the United States and Europe earlier in the year – have largely stabilised.

Sadly, as we go to print, Palestinian militant groups led by Hamas launched a large-scale invasion against Israel from the Gaza Strip, triggering a swift response from the Israeli military. While geopolitical conflict tends not to impact markets directly, all independent observers will hope for a speedy resolution.

Key commodity prices weaken

Weakening trading partner demand, driven by the slowing Chinese economy, has resulted in a significant decline in New Zealand’s commodity export prices in recent months, none more so than in the dairy sector.

In early August, Fonterra reduced its 2023/24 season milk price forecast by one dollar to a mid-point of $7 per kg of milk solids. The sheer volume of milk solids that Fonterra collects yearly equates to 0.4% of New Zealand’s gross domestic product (GDP) before any indirect economic effects are considered. Some economists suggest the total economic impact could be as much as 4 to 5 times the direct effect.

The forecasted price of $7 per kg of milk solids is 15% lower than last season’s price and below most breakeven rate estimates. This is noteworthy because dairy is our largest export, making up almost a third of New Zealand’s total goods exports.

Other key export prices for lambs and logs have also been under pressure from slowing demand. Unfortunately, while prices have weakened, farm costs have been moving in the other direction, increasing the pressure on our agricultural sector.

These price declines challenge New Zealand’s broader economy as lower export revenues will likely hurt overall economic activity.

Housing decline over?

On the flip side, the local housing market has finally shown some positive signs of stabilising.

Figure 1: New Zealand’s average property value since June 2018

Source: Property value data derived from the OneRoof-Valocity House Value Index on September 20, 2023.

From August 2020 to February 2022, with our international borders still closed, and as the New Zealand economy reoriented itself after the national Covid lockdown, the average value of the local housing market increased by just over 40% in 18 months.

This turned around over the following 16 months to June 2023 as New Zealanders finally got their boarding passes again, mortgage interest rates rose quickly, and inward migration flows remained frustratingly weak.

Today, with inward migration numbers much higher again (adding further weight to housing demand) and interest rates stabilising, housing values have slowly begun to pick up again. For many who have their total net worth closely linked to the value of their home, this has been a ray of sunshine in an otherwise challenging economic environment.

Interest rates stabilised

The Reserve Bank of New Zealand (RBNZ) believes it has done enough to get inflation back under control. Across the 12 July, 16 August and 4 October Monetary Policy decisions, the RBNZ left the Official Cash Rate (OCR) unchanged at 5.50% and made only minimal changes to its forward-looking OCR forecast. This demonstrates confidence within the RBNZ that it remains on track to achieving its inflation target even with current inflation still elevated.

The RBNZ believe the current level of interest rates is limiting spending and reducing inflation pressures, and headline inflation is tracking downward.

This has been primarily driven by a helpful fall in ‘tradables’ inflation, which measures the price changes for goods and services more exposed to international competition. Unfortunately, inflation on the goods and services we use daily, such as construction, rent, restaurant meals, ready-to-eat food, etc., is reducing much more slowly.

Inflation in this area (non-tradables) is proving to be a bit ‘stickier’ than the RBNZ initially hoped; however, there is an emerging consensus that overall inflation is at least heading in the right direction. Several commentators suggest this could lead to reductions in the OCR from early next year, even though the RBNZ’s forecasts suggest this might not happen until 2025.

Diversification remains valuable

Since the emergence of Covid-19 back in early 2020, global asset markets have generally experienced some degree of upheaval. At the pandemic’s beginning, global share markets capitulated over the first few weeks of March 2020 before embarking on a searing rally. In the case of the New Zealand NZX 50 Index, this rally was so strong that by September 2020, it had recovered all its lost ground from earlier in the year.

So, what has happened in the three years since then?

As the table below shows, it’s been a relatively underwhelming period for New Zealand shares, with the local index (including dividends) having ground out a slight annualised loss. With the benefit of hindsight, that’s not a shocking discovery. The small New Zealand economy was slower to reopen to the rest of the world and has since been on the back foot trying to compete for much-needed skilled labour in what has suddenly appeared to be a global labour market shortage.

That wouldn’t have been a great result for investors with all their growth assets in New Zealand, but for diversified global investors, the story has probably been more positive.

The neighbouring Australian share market (ASX 200) and the globally significant US share market (S&P 500) delivered excellent returns over the same three-year period, rewarding investors who were mindful not to have all their growth exposures in New Zealand.

Outside of global shares, several other asset classes also struggled.

Bond markets in New Zealand (A-Grade Corporate Bond index) and internationally (Bloomberg Global Aggregate Bond index) all laboured as global interest rates generally rose. Global listed property produced a weak positive return, while gold – often touted as a haven in times of market trouble – could only deliver a small negative return.

While Bitcoin did very well (initially), its highly speculative properties make it an unsuitable holding for most investors, something which its price decline of -60% since October 2021 probably confirms.

If in doubt, stick to the plan

With international inflation pressures slowly receding and the outlook for global growth looking slightly brighter, investors can take a bit of heart.

The last few years have been unlike any we’ve experienced, with the global economy effectively shutting down for some time and no rule book on how to get it successfully restarted. Perhaps not surprisingly, the economic transition from the depths of the pandemic has been far from painless.

Over the last three years, we’ve witnessed rampant house prices (followed by rapidly falling house prices), galloping inflation, a cost-of-living crisis and extreme labour shortages in New Zealand alone. We have, however, endured. And well-diversified investment portfolios have endured, particularly those containing at least a scattering of traditional international growth exposures.

To the layperson, investing through the ‘good times’ is often considered easy – when just having your money somewhere will give you a good return. However, a robust strategy and good investor behaviour usually pay the most significant dividends when navigating the’ difficult times’. That doesn’t necessarily mean earning higher returns, but it almost always means helping investors avoid the pitfalls of succumbing to short-term (emotionally driven) thinking and impaired decision-making. Doing the wrong thing at the wrong time is the surest way we know to undermine even the most innovative strategy.

The challenge is that no matter how obvious everything seems in hindsight (once events have happened and their consequences are known), it’s usually impossible to know which period – good or bad – lies immediately ahead. All we have is the certainty that both will appear at different times and, on average, there will be more good than bad.

That’s why building a sound long-term investment strategy is so important. One that allows someone to stay invested when the going gets tough – so they are in the best position to benefit from the inevitable recovery.

24 October 2023

Article provided by Consilium.

Disclaimer: Information as of 24 October 2023. This article is general information, does not consider your financial situation or goals, and does not constitute personalised advice. Please get in touch with 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 in this article.

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