INSIGHTS
INTEREST RATE HEADWINDS TO PERSIST
Mark Lister, Investment Director
Markets have remained volatile for investors in recent months. After a weak first half of the year, we saw a very strong rebound through July and into early August, although the optimism faded and global shares fell sharply late in the third quarter.
September lived up to its name as the weakest month for US shares. The S&P 500 fell 9.3%, the worst monthly performance since March 2020 (when it fell 12.5%), and before that February 2009 (when it was down 11.0%). That saw US shares fall below June levels, with the S&P 500 ending September 25.2% below its peak.
The domestic NZX 50 has been much more resilient, rising slightly during the three months to the end of September and finishing the quarter down more modestly in 2002 compared to other markets.
A much weaker NZ dollar has provided an important shock absorber for local investors, improving the returns from many international markets. The currency is down 7.4% in 2022 on a trade weighted basis, while it is 18.0% lower against the resurgent US dollar.
This has offset the weakness in US shares, and it means the 2022 return from the S&P 500 falls from 24.8% to just 8.3%, when currency moves are accounted for.
For those with balanced portfolios, fixed income returns have continued to be impacted by rises in interest rates. The domestic five-year wholesale swap rate finished September at 4.48%, close to an eight-year high.
Fixed income prices move inversely to yields, so higher interest rates negatively impact the market price of existing securities. This has seen the NZX Corporate Bond index fall 5.2% in 2022, a better performance than most sharemarkets, but still the first decline in many years.
The Official Cash rate is currently sitting at 3.50%, which is where it got to in 2014 at the peak of the post-GFC tightening cycle. The last time it was this high was back in 2009.
Financial markets see the OCR increasing to 4.00% by the end of this year, and then pushing to a peak of between 4.50% and 5.00% during 2023. One silver lining of these higher interest rates is that the future return prospects for fixed income look more attractive than they have for some time. This provides an excellent opportunity for conservative or balanced investors to add to holdings.
Looking ahead, we expect the global economy to slow in the coming months. The US remains more robust than others, while the UK and Europe are grappling with rising energy prices that are exacerbating the fight against inflation.
Australia and New Zealand are well positioned with low unemployment, modest government debt levels, robust commodity prices and lower currencies providing support. However, we are not immune to a global slowdown and the full impact of a rising mortgage rates is yet to be felt.
On a brighter note, there are early signs of inflation peaking, with commodity prices down from their highs, demand softening and indications of supply bottlenecks easing. However, inflation is not falling as quick as hoped, and central banks are likely to keep tightening monetary policy in response, which will mean headwinds remain.
While the worst of the volatility could be behind us, it is still a time for caution and investors should ensure portfolios are defensively positioned. Ensure asset allocations match long-term objectives and that portfolios are well-diversified across regions and sectors. Favour high quality businesses and those with structural growth tailwinds, but apply a defensive tilt and anchor portfolios with stable, dividend-paying companies.
At the same time, many asset classes look better value than they have for some time. New investors should view this as an opportunity and use further weakness in quality assets to build positions.
While there are challenges ahead, seasonality is on our side over the balance of the year. November and December are traditionally the strongest months of the year, while the December quarter is typically the most buoyant quarter by a wide margin.
Since 1950, the S&P 500 has increased by an average of 4.1% during the December quarter, and it has been up on 79% of occasions. With some of the heat having come out of the market in recent months, this will hopefully make for a more stable finish to the calendar year.