Economic Commentary Winter 2023

cosy fire and couch with teaset

As the grey clouds gather for winter, it’s pleasing to report that the sun still shines on portfolios.

Global share markets advanced again during the quarter, with the gains led by developed markets and, most notably, large US technology companies.

Global investor sentiment remained generally positive with moderating US inflation and signs that the American economy had displayed resilience despite higher interest rates.

There was some caution surrounding the US debt ceiling negotiations reported at the beginning of the quarter. However, in early June, Congress approved legislation that suspended the debt ceiling in a deal expected to have minimal impact on economic growth.

The Chinese share market bucked the generally positive trend as the economic rebound following their post-Covid reopening quickly began to cool.

After declining over the first quarter, global interest rates were generally on the rise again, with most major central banks continuing to raise rates over the quarter. However, in a positive move signifying that inflation (at least in the US) may now retreat, the US Federal Reserve was the first central bank to pause their rate hiking program in June.

Artificial Intelligence: The rise of the machines

Notably, the returns from only seven companies (Apple, Microsoft, Nvidia, Amazon, Meta Platforms, Alphabet and Tesla) account for almost three-quarters of the total US share market return so far this year.

The first six on this list are technology companies which have benefited from the growing hype and excitement surrounding artificial intelligence (AI) – specifically natural language processing tools such as ChatGPT.

All of the pictures in this article have been generated using AI technology with a single touch of a button. It is a small example of the efficiency that AI will be able to provide businesses.

Despite stubborn inflation and rising interest rates that typically hamper the performance of growth-focused technology companies, the prices of AI-linked businesses that might benefit from the future implementation of this technology have been driven significantly higher.

The question for this technology is – where to from here?

Wall Street and the news media have been quick to promote the hype around AI technology, with some labelling it the start of a fourth industrial revolution that will help transform life on Earth. Others say the sudden enthusiasm for AI has the same hallmarks as the meteoric rise of cryptocurrencies and meme stocks during the Covid pandemic or the mania surrounding the internet companies of the dot-com era during the early 2000s.

The challenge for investors is that even if AI is to become a utility in our daily lives, it doesn’t mean every AI company is automatically worth buying, especially at their current (much higher) valuations.

In that regard, the dotcom bubble may hold valuable lessons. The hype about the internet drove up the technology-heavy Nasdaq Composite index by 400% between 1995 and 2000. When the dotcom bubble finally burst, the Nasdaq fell nearly 77% between March 2000 and October 2002, with many of the once high-flying internet companies falling to zero.

Looking back, excitement about the long-term benefits of the internet was well-founded, but that didn’t stop investors from eventually losing a lot of money chasing the hype.

Do recessions matter?

New Zealand’s economy is wrestling with rising interest rates, a cost-of-living crisis and a general shortage of skilled workers. Based on recent growth data, we are also in a technical recession. What’s not quite so clear is whether we should be concerned about it.

A recession is defined as two consecutive quarters of contraction in economic activity, or in simple terms, it happens when the economy shrinks. Economic output (measured by changes in gross domestic product (GDP)) tends to shrink during a recession because there’s generally higher unemployment, less consumer demand and reduced production of goods and services. Housing prices are also prone to weakening during recessions.

Although New Zealand’s economic output has declined (partly due to the destructive effects of cyclone Gabrielle) and our housing market is currently weaker, unemployment has been surprisingly slow to rise, and consumer spending continues to hold up remarkably well.

That combination of factors currently makes this recession less concerning. Yes, it’s a small mathematical decline, but it’s not a meaningful contraction across a broader range of categories where employment, consumer spending, retail sales and production are all struggling. That would be more concerning.

Recessions can generally last anywhere from a few months to several years, but most recessions in New Zealand have been less than a year, based on historical data from several decades. On that basis, we may already be closer to the end of this recession than the beginning. Unless conditions were to take a significant turn for the worse suddenly, the fact that we may be in a technical recession today shouldn’t, on its own, be concerning.

Investing during a recession

Although economic activity shrinks during a recession, it doesn’t mean investment returns will also shrink. While recessions can undoubtedly lead to weaker markets, the findings are interesting when we look at the average performance of share markets during recessions.

For example, the main share market index in the US (the S&P 500) has increased by an average of around 1% during all recession periods since 1945. In part, that’s because share markets usually peak before the start of a recession and bottom out before their conclusion. In other words, the worst is generally over for shares before it’s over for the rest of the economy.

It’s also why share markets are widely acknowledged as being forward-looking. When a share market is declining, it can be a sign that investors might believe the economy could be headed towards recession.

If an economy eventually moves into a recession, share prices are typically lower by then. However, when share prices are lower, the expected future return from owning shares generally increases, making share ownership more attractive! And, given the average short duration of most recessions, it’s not unreasonable for the confirmation of a recession to be viewed as a long-term buy signal.

To reinforce the point that a recession doesn’t guarantee a poor investment outcome, we only have to look at the performance of our share market from September 2022 to 31 March 2023, when the New Zealand economy is now acknowledged to have been in a technical recession. The local S&P/NZX 50 Index (gross with imputation) went up 3.79% between September and December 2022, followed by a further increase of 3.89% between January and March 2023.

These returns are welcome in any economic environment.

What next for interest rates?

We need to continue taking our cues from the Reserve Bank because they are responsible for setting short-term interest rates in New Zealand. These short-term rates are set when they adjust the official cash rate (OCR). Longer-term interest rates, including mortgage rates, are determined by market forces, but all are related in some way to the prevailing level of the OCR.

In November 2022, the Reserve Bank projected a peak in the OCR of 5.50%, and after another 0.25% increase at their May 2023 meeting, the OCR now sits at 5.50%. The wider market is not yet convinced this will be the end of New Zealand’s rate-rising cycle, but through the quarter, the market consensus was that the Reserve Bank would pause at this level, at least for a while.

Pausing here will allow time for the lagged effects of the previous rate rises to gradually slow the economy down and bring inflation back towards their long-term target band of 1-3%.

Having moved the OCR up quickly since October 2021, and with New Zealand already in a technical recession, the Reserve Bank will tread very lightly now. While intent on dampening inflation, they don’t want to risk turning a mild recession into a deeper and more prolonged downturn. They also know that with over 50% of outstanding mortgages due to be refixed at higher interest rates over the coming year, this will act as a further handbrake on discretionary consumer spending over the coming months.

On the positive side, enough early evidence suggests that monetary policy is beginning to work. Economic growth is already contracting. Inflation, on a quarterly basis, is slowly dropping and taking inflation expectations with it. And the labour market has moved from being extremely tight to now showing a very slight increase in the unemployment rate.

If these trends continue, there is plenty of scope for short-term interest rates to begin falling again in New Zealand in 2024.

Stay focused

Following the significant Covid interruptions of early 2020, central banks worldwide are still trying to navigate the best route for their economies to achieve greater stability and prosperity.

It hasn’t been straightforward. The economic reboot from a near-global shutdown has thrown up many unexpected challenges – supply chain issues, production shortages, cost pressures, labour shortages, galloping inflation and, recently, rapidly rising global interest rates.

However, one by one, these challenges are being met.

That economic growth has come under pressure in the meantime is entirely understandable. Policymakers eventually winning this battle is equally inevitable.

As individual investors, we should focus on what we can control – following our strategic plan, staying diversified and maintaining discipline.

Challenges, fads, speculation and uncertainty will always be part of why markets will deliver positive long-term returns. It’s the reward paid to investors for taking investment risk.

And the best way to manage those risks is to acknowledge their existence, develop strategies to manage or mitigate them, and then relentlessly implement those strategies – something all good advisers are ideally placed to help with.

18 July 2023

Article provided by Consilium.

Disclaimer: Information in this article was accurate on 18 July 2023. 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.

Share This Post

This website requires cookies

For more information, please click the ‘Read More’ button. To accept cookies from this site, please click the ‘Agree’ button.