Market update – quarter ended 31 December 2022

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 local currency terms in the December quarter but fell in unhedged New Zealand dollar (NZD) terms, with the MSCI ACWI Index - Net returning -1.8%. Much of the gains were driven by expectations the world’s major central banks would soon pivot to smaller rate hikes amid increasing evidence inflation may have peaked. The US Federal Reserve, the European Central Bank and the Bank of England all raised their benchmark rates by smaller (0.50%) increments in December; though the banks did warn that further rate hikes were needed to tame inflation.

Stocks also benefited from a series of mostly encouraging US and European earnings updates and Beijing’s decision to begin relaxing its strict COVID-19-related restrictions despite an alarming number of new cases sweeping the country. Limiting the advance were renewed recession fears, ongoing geopolitical risks and the Bank of Japan’s surprise decision to widen the band it allows the country’s 10-year government bond yield to trade within; the move effectively setting the stage for a shift away from the Bank’s current, ultra-easy monetary policy.

At the country level, both the benchmark US S&P 500 Index (7.1%) and the Dow Jones Industrial Average (15.4%) performed well over the period, while the tech-heavy NASDAQ (-1.0%) fell, albeit modestly. Stocks were also higher in Europe (14.3%), the UK (8.1%), Japan (3.0%) and China (1.8%).

Global bonds made modest gains in the fourth quarter, returning 0.8% in hedged NZD terms. Longer-term government bond yields rose (prices fell) as central banks continued to raise interest rates in the face of high inflation. Credit markets were stronger for the quarter, with spreads on US and European high-yield and investment-grade debt narrowing amid the general ‘risk on’ tone that permeated financial markets throughout much of the period. Emerging markets debt also performed well.

New Zealand shares

The New Zealand share market made good gains in the fourth quarter, returning 3.8%. Stocks benefited in part from news the local economy expanded 2.0% in the three months to 30 September. The outcome, which follows the upwardly revised 1.9% expansion we saw in the second quarter, easily beat market expectations of 0.9% growth. Stocks also benefited from a modest easing in the latest inflation figures and a positive lead from major overseas markets. Limiting the advance were a further two rate hikes from the Reserve Bank of New Zealand (RBNZ), which took the official cash rate to 4.25%; its highest level since January 2009. The RBNZ raised interest rates a total of seven times throughout 2022 – a cumulative increase of 3.50%. At the sector level, consumer staples was the best performer, followed by communication services and healthcare. Financials and industrials also performed well, while consumer discretionary recorded a sizable decline.

New Zealand fixed income

The New Zealand bond market edged slightly higher over the period, returning 0.1%. Domestic long-term government bond yields rose (prices fell) as the RBNZ continued to raise interest rates in response to still-high inflation. Bonds were also impacted by further rate hikes globally. The yield on New Zealand 10-year government bonds closed the quarter 17 basis points higher at 4.47%. Meanwhile, local credit markets were positive, with spreads narrowing over the period.

How did markets affect NZFSSS investment options?

After three consecutive quarters of negative returns, the final quarter of 2022 saw some relief for members with the Conservative, Balanced and Growth options returning 0.8%, 1.5% and 2.0%  respectively. Recent increases in the Official Cash Rate meant that the Cash option return of 0.7% was its best quarterly return since June 2015.

Longer term returns remain positive, with the Conservative, Balanced and Growth options returning 1.4%, 2.8% and 3.7% per annum over the last five years and 3.3%, 6.0% and 7.7% per annum over ten years, after the deduction of fees and tax. 

Looking ahead

It’s been a hellish year for investors with almost every major listed asset class posting negative returns. The rebound over the past couple of months has provided investors with some relief, but it’s too early to be confident that we have seen the worst.

The economic news is likely to deteriorate. Europe and the UK are probably in recession, and a mild recession at least seems likely for the United States given the extent of monetary tightening. It’s unclear when China can fully escape zero-tolerance Covid-19 lockdowns and the property-market implosion. The exception as always is Japan, which hasn’t had monetary tightening and where the inflation spike offers the opportunity to break nearly three decades of deflationary psychology. 

Markets, of course, are forward looking and usually price in bad economic outcomes ahead of time. It’s possible that we’ve already seen the worst declines in equity markets. This may be the case if the U.S. has only a mild recession in 2023. On the other hand, markets may transition from the current ‘bad news is good’ narrative that sees soft economic data as heralding a U.S. Federal Reserve (Fed) pivot, to a ‘bad news is bad’ scenario wherein fears of significant contraction in profits and jobs lead to further market downturns.

The main issue for 2023 is whether inflation pressures ease sufficiently to allow central banks to step away from rate hikes and potentially begin easing. We expect inflation will be on a downward trend as global demand slows. This should allow central banks to eventually change direction and may set the scene for the next economic upswing. Markets and economies move in cycles. There is no certainty that we have passed the worst of market conditions, but the contours of the next upswing are visible on the horizon. The beaten-down investors of 2022 in Churchill’s words need to keep going into 2023.

The outlook for New Zealand is more precarious than for Australia, given the aggressive rate hikes from the Reserve Bank of New Zealand (RBNZ). Housing has already suffered a significant decline, and this is likely to continue through the first half of 2023. The market expects the RBNZ cash rate to peak near 5.5%, which means over another 100 basis points of tightening.