Investment Insight | Monthly Review | November 2021
Investment performance update
During the financial market rebound, NZ Funds acquired several positions which we expected to benefit from the world returning to normal.
As the market rebounded these paid off and generated above index returns for the year ended 31 December 2020.
Gains continued into 2021 with one of the strongest starts to the year NZ Funds has seen.
However, from 1 April onwards positions became more volatile. This volatility led to most Portfolios giving up their gains from earlier in the year.
While we have retained the capital gain over the index for 2020, to align the Portfolios more closely to their benchmark for the remainder of 2021, and for 2022, we have substantially reduced risk, acknowledging the current uncertainty around interest rates and Omicron.
We remain strongly of the view that a well-diversified portfolio, which contains assets which profit from rising inflation and interest rates, will be more resilient through the business cycle.
Market review
In this longer than usual Investment Insight we step through the key contributors and detractors for performance over the past few months. We then go on to discuss Omicron and our protocols should this lead to further increased market volatility.
Fixed Income – a period of transition
November has been a decidedly difficult period for the Income Portfolios. This is primarily a reflection of unsettled international fixed income markets. Over the last month, we have seen plenty of evidence that reinforces our view around inflation and the necessary path upwards for United States interest rates.
Sadly, this news was not sufficient to sustainably lift yields higher. Over the last six weeks we have seen the benchmark United States 10-year interest rate decline by 30bps from its October highs. It then regained all this decline over the middle part of the November only to decline again by 30bps with the emergence of Omicron, a total cumulative range of almost 1% over six weeks.
Despite this very challenging period, we begin December with news of a significant pivot from the United States central bank – the Federal Reserve (the Fed). As the United States economy continues to pick up pace, the Fed has acknowledged that they need to begin to tighten financial conditions.
We are clearly now in the transition period from the ultra-low interest rates of the last two years to one where interest rates are more normal, say in the 2 - 3% range. Despite this imminent action by the Fed, United States interest rates remain trapped at or near their lowest levels since early September thanks to the occurrence of the Omicron variant.
In the past three major interest rate tightening cycles (1994, 2004-2006 and 2016-2018), factors such as the Fed policy rate expectations, timing to the next hike, and medium-term growth and inflation expectations have been key drivers of interest rates.
If these relationships are still true, then current pricing suggest the market expects a low growth outlook for 2022. While there is an Omicron scenario where this could eventuate, our central case is for robust growth and inflation in the United States next year. To us this says that United States interest rates increasing from their current low levels offers a compelling opportunity over the months ahead.
Here in New Zealand, we are ahead of many parts of the world in that we have mostly completed the interest rate transition back to the levels that prevailed pre-Covid. The Reserve Bank has lifted the official cash rate twice and is now well into their hiking cycle. As a result, we see the yields available in New Zealand as generally attractive and we are happy to own them for the first time in a while.
Share markets
Global and local shares markets were down in November and have continued to selloff in December. While we have materially reduced our share exposure over the last two months, the general market weakness has had a negative impact on our Portfolios.
Energy commodities
Energy commodities were the largest component of our losses in November with both natural gas and heating oil having significant pullbacks.
United States natural gas declined by 17% throughout November. The fall in the natural gas price was driven by warmer weather in the United States which has led to easing of the lower than normal gas storage levels.
While United States gas storage levels remain below normal levels for this time of the year, the warmer weather has eased concerns of a significant gas crisis. However, the European situation remains very tight and gas prices there have remained elevated, which will continue to encourage exports of United States gas to Europe.
As the Northern Hemisphere enters winter, the most important period for natural gas. There remains a potential for a polar vortex-driven cold winter which we set out in Investment Insight | 29 October 2021 | Polar vortex is coming. We have significantly reduced risk but retain significant upside potential through natural gas options.
Our heating oil position also experienced a material -13% one day selloff at the end of the month, from fears that Omicron would cause further global lockdowns.
Given our risk management processes, we were able to reduce much of our heating oil exposure before this occurred, but still experienced some negative returns. Like natural gas, we retain our heating oil exposure through options.
Clean energy
The uranium price increased from US$41 to US$45 over the month of November reflecting the continued tightening in the supply and demand situation in the uranium market. However, our uranium exposure is held through uranium miner shares whose prices declined throughout the month. This was caused by the global risk-off move triggered by the Omicron variant.
Even though the fundamentals for Uranium remain extremely positive, the share prices of commodity exposed shares will selloff in a global risk-off environment such as is occurring right now. We have not reduced exposure to these positions as the fundamentals remain compelling and we believe share prices will reach new highs once the wider market stabilises.
Digital assets
Cryptocurrencies have been relatively resilient to the global risk-off movement. Since the Omicron news broke, Bitcoin has fallen by 3% while Ethereum has risen by approximately 3% (at the time of writing). Cryptocurrencies initially sold off over 10% when the Omicron news hit but have recovered as investors potentially look to invest in alternative asset classes.
Throughout the month of November Bitcoin fell 6%, but it had hit a new high of US$68,000 earlier in the month. Ethereum increased 8.5% in November after hitting a new high of $4,800 earlier in the month.
While we remain positive on the medium and long-term outlook for digital assets, we are cautious right now in the current risk-off environment which could still translate into negative price action for cryptocurrencies. We have therefore reduced some Bitcoin exposure and have booked a profit for this trade.
Omicron – impacting the global investment landscape
The Omicron variant of the Covid-19 virus made global headlines on 25 November and quickly triggered a selloff in most investment asset markets globally. This included share markets, commodity markets and cryptocurrency assets. Investors raced to reduce risk and bought safe haven assets such as United States treasury bonds.
As of the time of writing, the movement in some key markets has now totalled:
• United States shares -4%
• United States small cap shares -8%
• Crude Oil -16%
• United States 10-year interest rates to 1.41%
Omicron together with a more hawkish Fed (see Fixed Income – a period of transition, above) have increased market volatility. It is still too early to know the severity of the Omicron variant and therefore to understand the potential economic and investment market implications.
As more data comes out over the coming weeks, the investment market reaction to the new variant will focus on three key areas.
Virus transmissibility: How contagious is this variant and therefore how fast will it spread? Early indications suggest Omicron is more contagious than Delta and therefore has the potential to spread at an alarmingly fast speed and become the dominant global variant.
Virus severity: How bad are the symptoms from the variant? This will impact hospitalisation rates. High hospitalisation rates result in lockdowns and therefore slowing of economic activity.
Vaccine effectiveness: Will existing vaccines have high efficacy levels against this variant? An effectiveness >90% is generally considered an important level. If modified vaccines are required, it will take at least 100 days to begin rolling them out.
Although we are yet to have conclusive information on Omicron’s transmissibility, most experts agree it looks more transmissible than Delta. If the new variant proves to be more severe and vaccines have low effectiveness, this will be negative for share markets and many commodity markets.
However, there is a possibility the variant may be positive for markets. If the variant has low severity and does not lead to high hospitalisation rates, we may then have a dominant strain that spreads globally without causing lockdowns. This could act like a ‘natural vaccine’ and immunise populations.
In the share market downturns in 2000, 2009 and 2020, NZ Funds developed a strategy with a set of rules and protocols which we would follow in the next major market downturn. While it is still too early to know the effects of Omicron on investment markets, we remain well placed with the tools required should we need to act. In the meantime, we have significantly cut risk to manage our exposures and believe it will be at least a few weeks before we get more certainty.
During the financial market rebound, NZ Funds acquired several positions which we expected to benefit from the world returning to normal.
As the market rebounded these paid off and generated above index returns for the year ended 31 December 2020.
Gains continued into 2021 with one of the strongest starts to the year NZ Funds has seen.
However, from 1 April onwards positions became more volatile. This volatility led to most Portfolios giving up their gains from earlier in the year.
While we have retained the capital gain over the index for 2020, to align the Portfolios more closely to their benchmark for the remainder of 2021, and for 2022, we have substantially reduced risk, acknowledging the current uncertainty around interest rates and Omicron.
We remain strongly of the view that a well-diversified portfolio, which contains assets which profit from rising inflation and interest rates, will be more resilient through the business cycle.
Market review
In this longer than usual Investment Insight we step through the key contributors and detractors for performance over the past few months. We then go on to discuss Omicron and our protocols should this lead to further increased market volatility.
Fixed Income – a period of transition
November has been a decidedly difficult period for the Income Portfolios. This is primarily a reflection of unsettled international fixed income markets. Over the last month, we have seen plenty of evidence that reinforces our view around inflation and the necessary path upwards for United States interest rates.
Sadly, this news was not sufficient to sustainably lift yields higher. Over the last six weeks we have seen the benchmark United States 10-year interest rate decline by 30bps from its October highs. It then regained all this decline over the middle part of the November only to decline again by 30bps with the emergence of Omicron, a total cumulative range of almost 1% over six weeks.
Despite this very challenging period, we begin December with news of a significant pivot from the United States central bank – the Federal Reserve (the Fed). As the United States economy continues to pick up pace, the Fed has acknowledged that they need to begin to tighten financial conditions.
We are clearly now in the transition period from the ultra-low interest rates of the last two years to one where interest rates are more normal, say in the 2 - 3% range. Despite this imminent action by the Fed, United States interest rates remain trapped at or near their lowest levels since early September thanks to the occurrence of the Omicron variant.
In the past three major interest rate tightening cycles (1994, 2004-2006 and 2016-2018), factors such as the Fed policy rate expectations, timing to the next hike, and medium-term growth and inflation expectations have been key drivers of interest rates.
Source: Bloomberg.
If these relationships are still true, then current pricing suggest the market expects a low growth outlook for 2022. While there is an Omicron scenario where this could eventuate, our central case is for robust growth and inflation in the United States next year. To us this says that United States interest rates increasing from their current low levels offers a compelling opportunity over the months ahead.
Here in New Zealand, we are ahead of many parts of the world in that we have mostly completed the interest rate transition back to the levels that prevailed pre-Covid. The Reserve Bank has lifted the official cash rate twice and is now well into their hiking cycle. As a result, we see the yields available in New Zealand as generally attractive and we are happy to own them for the first time in a while.
Share markets
Global and local shares markets were down in November and have continued to selloff in December. While we have materially reduced our share exposure over the last two months, the general market weakness has had a negative impact on our Portfolios.
Energy commodities
Energy commodities were the largest component of our losses in November with both natural gas and heating oil having significant pullbacks.
United States natural gas declined by 17% throughout November. The fall in the natural gas price was driven by warmer weather in the United States which has led to easing of the lower than normal gas storage levels.
While United States gas storage levels remain below normal levels for this time of the year, the warmer weather has eased concerns of a significant gas crisis. However, the European situation remains very tight and gas prices there have remained elevated, which will continue to encourage exports of United States gas to Europe.
As the Northern Hemisphere enters winter, the most important period for natural gas. There remains a potential for a polar vortex-driven cold winter which we set out in Investment Insight | 29 October 2021 | Polar vortex is coming. We have significantly reduced risk but retain significant upside potential through natural gas options.
Our heating oil position also experienced a material -13% one day selloff at the end of the month, from fears that Omicron would cause further global lockdowns.
Given our risk management processes, we were able to reduce much of our heating oil exposure before this occurred, but still experienced some negative returns. Like natural gas, we retain our heating oil exposure through options.
Clean energy
The uranium price increased from US$41 to US$45 over the month of November reflecting the continued tightening in the supply and demand situation in the uranium market. However, our uranium exposure is held through uranium miner shares whose prices declined throughout the month. This was caused by the global risk-off move triggered by the Omicron variant.
Even though the fundamentals for Uranium remain extremely positive, the share prices of commodity exposed shares will selloff in a global risk-off environment such as is occurring right now. We have not reduced exposure to these positions as the fundamentals remain compelling and we believe share prices will reach new highs once the wider market stabilises.
Digital assets
Cryptocurrencies have been relatively resilient to the global risk-off movement. Since the Omicron news broke, Bitcoin has fallen by 3% while Ethereum has risen by approximately 3% (at the time of writing). Cryptocurrencies initially sold off over 10% when the Omicron news hit but have recovered as investors potentially look to invest in alternative asset classes.
Throughout the month of November Bitcoin fell 6%, but it had hit a new high of US$68,000 earlier in the month. Ethereum increased 8.5% in November after hitting a new high of $4,800 earlier in the month.
While we remain positive on the medium and long-term outlook for digital assets, we are cautious right now in the current risk-off environment which could still translate into negative price action for cryptocurrencies. We have therefore reduced some Bitcoin exposure and have booked a profit for this trade.
Omicron – impacting the global investment landscape
The Omicron variant of the Covid-19 virus made global headlines on 25 November and quickly triggered a selloff in most investment asset markets globally. This included share markets, commodity markets and cryptocurrency assets. Investors raced to reduce risk and bought safe haven assets such as United States treasury bonds.
As of the time of writing, the movement in some key markets has now totalled:
• United States shares -4%
• United States small cap shares -8%
• Crude Oil -16%
• United States 10-year interest rates to 1.41%
Omicron together with a more hawkish Fed (see Fixed Income – a period of transition, above) have increased market volatility. It is still too early to know the severity of the Omicron variant and therefore to understand the potential economic and investment market implications.
As more data comes out over the coming weeks, the investment market reaction to the new variant will focus on three key areas.
Virus transmissibility: How contagious is this variant and therefore how fast will it spread? Early indications suggest Omicron is more contagious than Delta and therefore has the potential to spread at an alarmingly fast speed and become the dominant global variant.
Virus severity: How bad are the symptoms from the variant? This will impact hospitalisation rates. High hospitalisation rates result in lockdowns and therefore slowing of economic activity.
Vaccine effectiveness: Will existing vaccines have high efficacy levels against this variant? An effectiveness >90% is generally considered an important level. If modified vaccines are required, it will take at least 100 days to begin rolling them out.
Although we are yet to have conclusive information on Omicron’s transmissibility, most experts agree it looks more transmissible than Delta. If the new variant proves to be more severe and vaccines have low effectiveness, this will be negative for share markets and many commodity markets.
However, there is a possibility the variant may be positive for markets. If the variant has low severity and does not lead to high hospitalisation rates, we may then have a dominant strain that spreads globally without causing lockdowns. This could act like a ‘natural vaccine’ and immunise populations.
In the share market downturns in 2000, 2009 and 2020, NZ Funds developed a strategy with a set of rules and protocols which we would follow in the next major market downturn. While it is still too early to know the effects of Omicron on investment markets, we remain well placed with the tools required should we need to act. In the meantime, we have significantly cut risk to manage our exposures and believe it will be at least a few weeks before we get more certainty.
This document has been provided for information purposes only. The content of this document is not intended as a substitute for specific professional advice on investments, financial planning or any other matter.
While the information provided in this document is stated accurately to the best of our knowledge and belief, New Zealand Funds Management Limited, its directors, employees and related parties accept no liability or responsibility for any loss, damage, claim or expense suffered or incurred by any party as a result of reliance on the information provided and opinions expressed except as required by law.
While the information provided in this document is stated accurately to the best of our knowledge and belief, New Zealand Funds Management Limited, its directors, employees and related parties accept no liability or responsibility for any loss, damage, claim or expense suffered or incurred by any party as a result of reliance on the information provided and opinions expressed except as required by law.
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James Grigor is Chief Investment Officer for New Zealand Funds Management Limited (NZ Funds) and a member of the NZ Funds KiwiSaver Scheme. James' comments are of a general nature, and he is not responsible for any loss that any reader may suffer from following it.
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