Market update – quarter ended 31 December 2023

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

Global markets

Global share markets made good gains in the December quarter, with the MSCI ACWI Index ‒ Net returning 5.4% in unhedged New Zealand dollar (NZD) terms. Much of the gains were driven by expectations that the world’s major central banks will cut interest rates sooner and faster than anticipated. In the US, easing inflation saw the Federal Reserve (Fed) maintain its benchmark fed funds rate at a target range of between 5.25% and 5.50% throughout the period; though the Bank shifted to a slightly more dovish stance on monetary policy in December, saying it now expects to lower interest rates by 0.75% in 2024. That’s more than the 0.50% it forecast in September. Put another way, the Fed said it now expects to cut interest rates three times instead of twice, assuming 0.25% increments. However, Fed chair Jerome Powell did warn that the Bank will continue to proceed carefully in terms of its monetary policy as inflation is still too high. Investors, though, were unfazed by his comments. In fact, the market immediately moved to price in a far more aggressive rate-cut path, betting that the Fed will lower interest rates six times, or 1.50%, over the next 12 months; the first of which is expected as early as March. We saw a similar theme in Europe and the UK where, despite officials’ attempts to downplay rate cut expectations, the market bet the European Central Bank (ECB) and the Bank of England (BoE) will both cut interest rates six times in 2024. The ECB is expected to move first in either March or April, with the BoE seen following in May. Rate cut expectations also contributed to a sharp decline in government bond yields, providing further support for stocks.

At the country level, the benchmark US S&P 500 Index (11.2%), the tech-heavy NASDAQ Composite (13.6%) and the Dow Jones Industrial Average (12.5%) all posted very strong gains for the quarter. Stocks were also higher in Europe (8.3% ), Japan (1.9% ) and the UK (1.6% ) but fell in China (-7.0% ).

Global bonds were positive for the quarter, returning 5.7%  in hedged NZD terms. Longer-term government bond yields fell (prices rose) over the period, driven mainly by global rate cut expectations. Bonds also benefited from their traditionally defensive characteristics in the face of fresh tensions in the Middle East. Credit markets were also stronger, with spreads on US and European investment-grade and high-yield debt all narrowing amid the ‘risk on’ tone that permeated financial markets throughout much of the quarter. Emerging markets debt also performed well.

New Zealand shares

The New Zealand share market also performed well in the fourth quarter, returning 4.3% . Like their global counterparts, the local market’s gains were driven by expectations that easing inflation will see the world’s major central banks cut interest rates more aggressively in 2024 and a subsequent decline in government bond yields. Limiting the advance was weakness across the broader commodities complex and softer-than-expected third quarter growth, with the economy contracting 0.3% in the three months to 30 September. This was down on the revised 0.5% growth we saw in the second quarter and less than the 0.2% expansion the market had anticipated. On an annual basis, the economy shrank 0.6%, which was well down on the revised 1.5% growth we saw in the previous quarter. In terms of inflation, headline prices eased from 6.0% to 5.6% in the third quarter. Whilst the outcome marked the lowest figure since the third quarter of 2021, inflation remains well above the Reserve Bank of New Zealand (RBNZ)’s 1-3% target range. Meanwhile, the RBNZ maintained the official cash rate at 5.50% throughout the period; though the Bank surprised the market following its latest (November) gathering with a more hawkish view of recent economic developments. Underpinning this shift were two factors; namely higher-than-expected migration rates and inflation that remains too high for the Bank’s liking. At the sector level, real estate and communication services recorded the biggest gains, while consumer discretionary and energy were both weaker.

New Zealand fixed income

The New Zealand bond market also performed well over the period, returning 6.0% . Similar to their global peers, domestic long-term government bond yields fell amid expectations global central banks will cut interest rates more aggressively in 2024 and the asset class’s traditionally defensive qualities in the face of heightened geopolitical uncertainty. The yield on New Zealand 10-year government debt closed the quarter 56 basis points lower at 4.32%. Local credit markets were weaker, with spreads slightly wider over the period.

How did markets affect NZFSSS investment options?

With gains from both equities and bonds, all of the diversifed member options delivered good returns to members over the last quarter: 7.1% for Growth, 6.2% for Balanced and 4.0% for Conservative.  Returns over the last 12 months remain strong with gains of 6.7%, 10.0% and 13.0% from Conservative, Balanced and Growth respectively. The Cash option delivered a 3.8% return over the same period.

Over the last ten years the Conservative, Balanced and Growth options have returned 3.4%, 5.8% and 7.4% per annum respectively, after the deduction of fees and tax.

Looking ahead

Global markets have exceeded expectations in 2023, thanks in large part to the mega-cap technology stocks known as the Magnificent Seven. Investor sentiment has shifted from “a recession is coming” to “a soft landing is around the corner.” Our market psychology index indicates high investor optimism, even though market gains have been concentrated. Too much optimism can make the markets more vulnerable to overcorrections. Our outlook for 2024 is more cautious due to restrictive monetary policy, slowing growth, and geopolitical tensions.

The U.S. Federal Reserve’s “higher for longer” approach will likely strain finances in the year ahead, impacting borrowers and refinancers. Meanwhile, we expect Europe and the UK to continue contending with weak demand, high inflation, manufacturing slumps, and Brexit. Lastly, China although stabilising will continue to grapple with long-term issues like debt and property markets and demographics.

Despite all this, markets are pricing closer to a smooth landing in 2024. We aren’t as confident about that, but we still see opportunities in a total portfolio context. Government bonds look valuable as yields exceed inflation and could become more appealing as a hedge against stock market volatility. We prefer quality equities for their relative value and defensive characteristics. Real estate investment trusts and global listed infrastructure are also attractive to us and should benefit from longer demographic and technology trends.

The New Zealand outlook is mixed. Monetary policy is tight and is likely to remain that way for some time. However, aggregate demand should be supported through 2024 by a notable pickup in population growth. The recent change in government from October election results will likely see fiscal policy become less supportive over the second half of 2024, but there is still uncertainty given the National/ACT coalition of political parties did not get a majority. New Zealand bonds look slightly cheap.