Today we released the July issue of Quarterly Strategic Outlook. The commentary below is the Executive Summary. To view the full publication click here.
Investors were rewarded for diversity in the June quarter. Among the more defensive assets, domestic cash and bonds produced positive returns for the quarter. In contrast, global bond returns were negative as Eurozone deflation risk was priced out of the market and the US Federal Reserve (the Fed) reaffirmed it is still on course to raise rates this year. An earlier than expected rate cut from the Reserve Bank of New Zealand (RBNZ) meant domestic bond yields didn’t follow offshore yields higher.
Returns were also negative in the main equity asset classes with Greece concerns and higher bond yields playing a key role in a number of markets. New Zealand shares have come under pressure on various fronts recently. GDP growth has slowed and earnings growth has hit the pause button. It also appears the weak New Zealand dollar (NZD) is leading some foreign investors to sell local shares to limit currency losses.
A shift to a neutral stance from the Reserve Bank of Australia (RBA) and a surge in long term bond yields, weighed heavily on the Australian share market over the quarter, particularly the high dividend paying financial sector. In contrast, solid returns from China, Brazil and Russia held up emerging market shares over the quarter.
Among real assets, property and infrastructure returns were also under pressure from rising bond yields. However, commodity prices recovered some of their recent losses as oil and global agriculture prices rallied on declining inventories. The rate cut from the RBNZ together with further weakness in dairy prices and softer GDP growth contributed to a 10% decline in the NZD over the quarter, lifting returns on unhedged offshore assets.
Growth in economic activity has underwhelmed in the first half of the year, a theme we have become well used to since the Great Recession. The weakness was all the more relevant because it centred on the world’s two largest economies: the United States and China. But it hasn’t all been bad news with the Eurozone looking stronger as the year has progressed, despite the ongoing debt saga in Greece.
We are expecting a stronger second half of the year, led predominantly by the US as it recovers from the disruptions from the start of the year, along with further improvement in Europe. At the same time, we are seeing early signs of macroeconomic stabilisation in China with the recent decline in its share market representing a necessary correction rather than signalling any new signs of weakness in the economy.
We have lowered our New Zealand GDP forecasts on the back of further declines in dairy prices and a softening in business confidence. This will allow further reductions in the Official Cash Rate.
As we move into the second half of the year, the key focus will be on the Fed and the next steps towards monetary policy normalisation, the broader global ramifications of higher US interest rates, economic and financial stability in China, and Greece.
With the situation with Greece changing on a daily basis, it is easy to get caught up in the ongoing drama and lose sight of the fundamentals. Valuations are the key determinant of asset returns over the medium term and our view is bonds are still expensive, developed market and New Zealand shares are fully valued, whereas commodities and emerging markets remain inexpensive relative to longer term trends. We also think the NZD is close to fair value at current levels.
Over a shorter term horizon, asset returns are more influenced by macro fundamentals such as global growth. Given our central view that growth will pick up over the coming year, we expect bond yields and equities to also rise but there will likely be some setbacks along the way. Finally, we think the NZD/USD ‘correction’ is over, and any further falls against the US dollar (USD) would take it into currency ‘overshoot’ territory.