This year has been and continues to be a challenging one for investors. As central banks try to tackle surging inflation, the ultra-low emergency-level interest rates that were set in response to the COVID-19 pandemic have ended. The transition to a higher interest rate environment has not been smooth sailing for markets. Additionally, other global factors such as the Russian invasion of Ukraine and lockdowns in China continue to plague financial markets. This has resulted in substantial declines in the value of fixed interest and equity investments. The simultaneous and significant decline in both asset classes has been particularly painful for investors. However, while the future remains highly uncertain, some factors may be starting to show signs of improvement.
Valuations have improved
The developments mentioned above took markets by surprise, and they adjusted downwards quickly. However, these events are now well understood by the market. As a result, they better reflect the current uncertain economic conditions, and equities and bonds are now more attractive from a valuation perspective. Higher interest rates mean that fixed interest is now more likely to deliver positive returns in the future. Similarly, equity markets began the year on quite a buoyant note but looked expensive. Since then some of the froth has come out of the market, especially in the tech sector. As the year continues to progress valuations are now starting to look more reasonable.
Inflation could be near an inflection point
Central banks around the world initially thought that rising rates of inflation were only a transitionary phenomenon. If this held true, central banks could continue to stimulate the economy by keeping interest rates at historically low levels and continue their quantitative easing (bond buying) programs. But instead, rising inflation rates have been more persistent, and this has caught the central bankers off guard. To counter this, they have been aggressively raising interest rates to bring inflation under control. However, this is a very difficult balancing act to maintain because raising interest rates too far too fast might ultimately push economies into recession.
While recent inflation data in the United States and New Zealand came in higher than the expectations, there are signs that we may be nearing peak levels. The US inflation rate accelerated to 9.1% for the year to June, which is the highest rate of inflation since November 1981. In New Zealand inflation data showed that the inflation rate increased to 7.3%, which is substantially above the 1 – 3% target over the medium term. It is quite possible that inflation rates could start to ease over the next few months, as the crude oil price, a major economic input, remains well below the peak it set in June. Additionally, companies such as Tesla have indicated that they see supply chain issues easing. Higher mortgage rates will start to flow through to higher payments as fixed rates expire, leaving consumers with less to spend on discretionary items and resulting in weaker consumer spending. In turn this will make it harder for businesses to continue to raise prices.
However, recession looks more likely
In the balancing act central banks are trying to perform between putting a lid on inflation while avoiding a recession, investors are leaning towards the view that economies could be losing their balance and tottering towards a recession. This is most visible in the US fixed interest markets, with the 2-year yield of US Treasury bonds moving above the 10-year yield. This has historically been a reliable recession indicator and suggests that interest rates are higher than the economy can sustain. The fixed interest market is anticipating that both the Reserve Bank of New Zealand and the Federal Reserve to start cutting rates next year, as the recent rates hikes slow economic growth and start gaining traction in bringing the rate of inflation down.
A recession could be negative for equities due to falling company earnings and increased uncertainty, but it could be effective at bringing inflation down. This would likely be positive for fixed interest returns.
Maintain Your Approach
As Nobel laureate Niels Bohr said, “Prediction is very difficult, especially if it’s about the future!”. With the economic and market outlook remaining highly uncertain this especially applies now. Whichever way the market unfolds, BNZ will continue to focus on investing in high quality, liquid assets, diversified across a wide range of countries, sectors, asset classes, styles of investment, and securities. This puts BNZ investment portfolios in a solid position to navigate a wide range of market conditions.
Any views expressed in this article are the personal views 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 Bank of New Zealand nor any person involved in this article accepts any liability for any loss or damage whatsoever which may directly or indirectly result from any, information, representation or omission, whether negligent or otherwise, contained in this article.