Market update – quarter ended 30 September 2022

Commentary on the September quarter by Russell Investments, New Zealand Fire Service Superannuation Scheme’s investment consultant

Global markets

Global share markets fell in local currency terms in the September quarter but a weakening New Zealand dollar (NZD) meant that they rose in NZD terms, with the MSCI ACWI Index - Net returning 2.4%.

Much of the decline was driven by further, aggressive central bank activity globally and growing recession fears. In the US, the Federal Reserve (Fed) raised interest rates twice over the period after inflation climbed to 8.3% in the 12 months to 31 August. The Fed lifted rates by 0.75% at each of its two scheduled meetings during the quarter, taking its benchmark fed funds rate to a range of between 3.00% and 3.25% – its highest level since 2008. Speaking at the Fed’s press conference following its most recent rate hike, chairman Jerome Powell reaffirmed his determination to rein in inflation and made clear that interest rates will continue to rise until price stability is restored; even if it means tipping the world’s largest economy into recession. Elsewhere, rising consumer prices in the euro-zone saw the European Central Bank (ECB) deliver its first rate hike in 11 years in July; the Bank lifting its main refinancing rate by 0.50%. The ECB followed this up with a further, unprecedented 0.75% increase in early September.

Meanwhile, the Bank of England raised rates twice over the period and warned of steeper rate hikes ahead after UK inflation hit double figures in July. Stocks were also impacted by ongoing geopolitical risks and disappointing Chinese growth. Limiting the decline was a series of encouraging US and European earnings updates, which is to say that results were not as bad as many first feared, and further merger and acquisition activity.

At the country level, all three major US indices – the benchmark S&P 500 Index (-5.3%), the Dow Jones Industrial Average (-6.6%) and the tech-heavy NASDAQ (-4.1%) – fell over the quarter. Stocks were also lower in China (-15.2%), Europe (-4.0%), the UK (-3.8%) and Japan (-1.9%).

Global bonds also fell in the third quarter, returning -3.7%  in hedged NZD terms. Longer-term government bond yields rose (prices fell) as central banks continued to raise interest rates in the face of persistently high inflation. Credit markets were mixed. Spreads on US and European investment-grade debt widened amid heightened economic and geopolitical uncertainty, while spreads on their high-yield counterparts narrowed, albeit modestly. Emerging markets debt underperformed.

New Zealand shares

The New Zealand share market made relatively good gains in the second quarter, returning 2.2%. Stocks performed very well through the early part of the period amid hopes that inflation may be peaking and a series of better-than-expected domestic earnings updates. Stocks also benefited from a strong rebound in domestic growth, with the local economy expanding 1.7% in the June quarter. The outcome, which follows the 0.2% contraction we saw in the March quarter, easily beat analysts’ expectations of 1.0% growth. Limiting the advance were a further two rate hikes from the Reserve Bank of New Zealand (RBNZ) and a sharp selloff in global share markets toward the end of the quarter. At the sector level, consumer staples was the best performer, followed by communication services and utilities. Industrials also performed well, while information technology and consumer discretionary recorded sizable declines.

New Zealand fixed income

The New Zealand bond market also fell over the quarter, returning -1.4%. Domestic long-term government bond yields rose (prices fell) as the RBNZ continued to lift interest rates in response to rising inflation. Bonds were also impacted by rising interest rates globally and a series of encouraging company updates. The yield on New Zealand 10-year government bonds closed the quarter 0.44% higher at 4.30%. Meanwhile, domestic credit markets were positive, with spreads narrowing over the period.

How did markets affect NZFSSS investment options?

The continuing sell-off in both shares and bonds meant that all of the NZFSSS investment options, except for Cash, delivered negative returns over the September quarter. This is the third consecutive quarter of negative returns which means that members in options with a large exposure to growth assets, such as shares, will have seen significant declines in their balances over the last 12 months.

Longer term returns remain positive, with the Conservative, Balanced and Growth options returning 1.7%, 3.3% and 4.5% per annum over the last five years and 3.4%, 6.2% and 7.9% per annum over ten years, after the deduction of fees and tax.

Looking ahead

It’s hard to find much good news, but one source of comfort is that investor sentiment is very negative, providing some reassurance that markets have already accounted for the bad news.

It’s too early to predict that a recession is the most likely outcome for the U.S. economy during 2023, but the probability is rising. Recession, however, seems unavoidable for the Eurozone and UK, where surging prices for natural gas are hitting hard. China’s economy remains weak, but stimulus is happening, albeit gradually. The end of China’s resurgent COVID-19 lockdowns, hopefully by early next year, should allow growth to recover.

We expect inflation to trend lower over coming months, which along with signs of softer growth, should allow the Fed to pause once the target rate is around 4.0-4.5%. Fed tightening phases, however, are usually anxious times for markets. Investors are likely to worry about excessive monetary tightening and the risk of a more severe recession. It’s possible that the mid-June lows for equity markets will be retested, and markets are likely to remain volatile until inflation is clearly trending lower.

Housing markets are the key source of concern in the Australian and New Zealand economies. House prices rose rapidly during the pandemic and both countries have high levels of housing debt. In Australia, household debt as a share of disposable income is close to 200%.

Already, there are signs that housing activity is slowing in both countries and house prices have begun to decline. Both economies are poised to slow over the next year, but we expect that recession will be avoided. The Reserve Bank of Australia has demonstrated in the past that it will pull back from aggressive action if the housing market weakens sharply. We are more cautious on the New Zealand outlook since core and headline inflation are notably higher than in Australia.