Economic Commentary Winter 2022

winter flowers blooming

The global economy has been hit with multiple challenges in 2022.

Amidst sharply increasing inflation, tight labour markets, rapidly rising interest rates, ongoing uncertainties surrounding the continued war in Ukraine and the lingering pandemic, the global economy has puttered its way through the year.

Food and energy prices are eroding real incomes, triggering a global cost-of-living crisis. Economic growth in the world’s three largest economies – the United States, China, and the European Union – is weakening, with spillover to other countries.

Interest rates

Fixed-interest markets continue to be highly focused on inflation, monetary policy signals from central banks and the state of the economy.

Considerations about the economy are largely centred on two competing themes:

  1. supply-based constraints leading to higher labour and goods prices; and
  2. forward-looking concerns about potential recession risks.

In New Zealand, escalating recession fears in July, linked to the idea of potentially fewer interest rate hikes, drove New Zealand’s 10-year government bond yields down to their lowest levels since April. By late August, however, the focus had shifted almost entirely to the policy comments made by central banks. In synchronicity with other major central banks, the Reserve Bank of New Zealand (RBNZ) reaffirmed its absolute focus on getting inflation back down towards its target range, resulting in the New Zealand 10-year government bond yield moving back to its June highs.

It was a very similar pattern in the USA. The US 10-year treasury bond yield reached an intra-year high of 3.5% in the middle of June before steadily declining over the next six weeks as market concerns about recession risks took centre stage. However, it became clear that the Federal Reserve was steadfast in its commitment to subduing inflation. Yields quickly rose from early August, back beyond the prior peak, and briefly touched 4% near the end of September, a yield not seen on the US 10-year treasury bond since 2010.

With interest rates rising everywhere, tightening will ultimately depend on local conditions. In New Zealand, the RBNZ’s latest projections are for the Overnight Cash rate to rise to just over 4% in 2023. With the RBNZ having recently adjusted this benchmark rate to 3.50% on 5 October, it implies we are getting closer to the end of the current round of rate rises. That is certainly what many homeowners with mortgages will be hoping for.

Farewell to Queen Elizabeth II

The UK hit the headlines for a very different reason during the quarter – on 8 September, the world was met with the sad news that Queen Elizabeth II, the UK’s longest-serving monarch, had died at Balmoral aged 96, after reigning for 70 years.

The Queen ascended to the throne in 1952 and witnessed enormous social change during her reign. She also worked with 15 prime ministers, from Winston Churchill in 1952 to Liz Truss, who took office on 6 September, just two days before Queen Elizabeth’s death.

Goodbye to modern monetary theory

With the UK barely out of its official mourning period, Liz Truss, alongside Chancellor Kwasi Kwarteng, announced its most significant tax package in 50 years. The package aimed to boost UK growth by cutting taxes and regulations and was to be funded by vast amounts of new government borrowing.

Unfortunately, the announcement met with almost universal opposition.

The International Monetary Fund openly criticised the plan, warning that the proposed measures were “likely to fuel the cost-of-living crisis.” The financial market reaction was equally severe, sending a powerful signal that modern monetary theory, which was fashionable during the pandemic, is now completely discredited.

Modern monetary theory assumes that monetarily sovereign countries (like the UK, USA and New Zealand) do not need to rely on taxes or borrowing to support their spending objectives. Since they are the monopoly issuers of their currency, they can print and spend as much as they need. However, the seismic market fallout that erupted following the UK’s late September tax proposals strongly suggests otherwise.

The proposed plan triggered an immediate crisis of investor confidence in the UK government – jolting global financial markets to such an extent that the Bank of England had to intervene with a pledge to purchase 65 billion pounds of UK government bonds to stem a potential market rout.

This led to the UK government quickly back-tracking and scrapping some of the tax plans they had unveiled to much fanfare only a few days earlier. As of 17 October 2022, Britain’s new chancellor of the Exchequer, Jeremy Hunt, reversed virtually all of Truss’s planned tax cuts.

What next for investment portfolios?

Portfolio valuations have been volatile in 2022, reflecting the uncertainties surrounding complex real-world issues. Share markets have been buffeted as investor confidence has waned, and bond markets have suffered due to rapidly changing interest rate expectations.

One source of comfort is that investor sentiment is currently very negative. That may sound counterintuitive, but when investor sentiment is strongly negative, it means the markets have likely factored in (and priced in) all of the existing bad news.

That’s why investors at the end of September could buy a 10-year New Zealand Government bond yielding 4.3% when at the start of the year, it was paying just 2.4%. It is also why the price-to-earnings ratio of the USA’s globally significant S&P 500 Index was at 19.8, down from 26.3 at the start of the year and 37.3 at the end of 2020. Unlike in our real-world supermarkets, almost everything is now cheaper in the investment world.

In many ways, the investment discounts available today versus what investors were paying only months ago should be enough to see buyers queuing around the street. For the moment, the queues are relatively short. But as greater clarity emerges about global inflation, interest rates and economic growth rates, the prices available in financial markets might begin to look appealing. Forward-looking markets can respond (and respond quickly) to the prospect of better times ahead.

While investor patience has been tested this year, it is always important to remind ourselves that:

  1. investment returns often come in spurts – making it essential to stick to the long-term strategy
  2. markets are volatile – meaning they can go down as well as up, so down periods should always be expected
  3. critical to achieving sound long-term investment outcomes is good ‘investor behaviour’ – which means holding on to quality assets that have become temporarily cheaper rather than being tempted to sell at a discount.

21 October 2022

Article provided by Consilium.

Disclaimer: Information as at 21 October 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.

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.