August Market Update

While we thought the end of the COVID-19 pandemic might have been in sight, the rise of the Delta variant continues to cause alarm around the globe. Since the initial approval in December 2020, approximately 3.5 billion doses of COVID-19 vaccines have been administered in the first half of 2021. The vaccine rollout has always been identified as a key driver in a return to ‘normal’, but as economies start to open, the impacts of COVID-19 and central bank responses to it linger.

Many central banks have taken the approach of doing too much rather than too little. In particular, the US Federal Reserve has indicated that it will do whatever is necessary to support the economy. This has contributed to record highs in US stock markets and record low yields in bonds. Domestic financial markets have been impacted in a similar way with the Reserve Bank of New Zealand (RBNZ) also taking an extremely accommodative monetary policy stance (low Official Cash Rate); however, change is on the horizon.

Central banks begin to reassess monetary policy

The threat of inflation rising too much appears to be dominating the headlines recently. In June, the US Consumer Price Index (CPI) was higher than expected, rising 0.9% over the previous month. This brought core inflation to 4.5%, the highest annual rate since November 1991. In New Zealand, inflation concerns are also emerging with June CPI reported at a 3.3% year-on-year increase, significantly above market expectations. This period of higher inflation could be transitory, but it’s likely to lead to several impacts.

Inflation usually leads to higher interest rates. Of course, this will increase the amount we have to pay on home loans, but it also will have an effect on financial markets.

For share markets, the higher interest rates that often come with increased inflation may negatively impact ‘growth’ companies, such as those in the technology sector. This is because companies are commonly valued using future cashflow and ‘growth’ companies have significant increases to projected cashflow further in the future. The further in the future that these cashflows are, the more sensitive the valuation of the company is to interest rate changes. On the other hand, the valuations of ‘value’ companies, such as those in the energy sector which tend to be more mature companies with stable cashflows, are less sensitive to interest rate changes. This has led to the out-performance of ‘value’ versus ‘growth’ companies in the first half of 2021 as interest rates have begun to rise.

Bonds are also impacted by rising inflation. Given the inverse relationship between bond prices and interest rates, as interest rates increase with rising inflation, bond prices go down. This has a more negative impact on the price of longer dated bonds. Therefore, some investors may position themselves toward shorter dated bonds in order to mitigate the impact of rising interest rates.

Central banks are already starting to respond to the accommodative monetary policy implemented to combat the economic effects of COVID-19. The US Federal Reserve brought forward expectations of a rate hike from 2024 to 2023. In New Zealand, the RBNZ is responding to economic data by bringing a halt to its Large-Scale Asset Purchase (LSAP) programme. This, combined with higher-than-expected inflation, lead many economists to predict that the Official Cash Rate (OCR) may start rising later in the year. However, this thinking may be put on-hold with the latest developments surrounding the new COVID cases in NZ, leading the Reserve Bank to hold the OCR at 0.25% at the 18 August announcement.

What’s next?

Time will tell whether the inflation experienced in recent months is, as central banks suggest, transitory. Either way, inflation concerns will continue to be front of mind for financial market participants over the coming months.

The vaccination roll-out will be another key factor that will influence financial markets over the next 6-12 months. There is concern of new variants being immune to vaccinations. As economies, such as the UK, remove restrictions, the spread of the virus may worsen and increase the risk of even more dangerous variants. While we remain cautiously optimistic in the fight against COVID-19, the risk the virus poses will continue to impact the global economy. Investors should take comfort in having a well-diversified portfolio that should withstand the uncertainties that remain.

Any views expressed in this article are the personal views of the author and do not necessarily represent the views of BNZ, or its related entities.

This article is solely for information purposes and is not intended to be financial advice. If you need help, please contact BNZ or your financial adviser. Neither BNZ nor any person involved in this article accepts any liability for any loss or damage whatsoever which may directly or indirectly result from any advice, opinion, information, representation, or omission, whether negligent or otherwise, contained in this article.