Investment Insight | Monthly Review | The October effect
In the first Investment Insight of each month, we will look back at the key themes and trends for the previous month; and forward, setting out our views on what will affect client performance in the months to come.
Persistent supply chain constraints are weighing on the path of the recovery and feeding fears of longer lasting inflationary pressures. However, the growth outlook remains firmly underpinned by huge levels of pent-up demand, solid corporate balance sheets and robust investment intentions.
Meanwhile, income assets and property are under pressure from rising interest rates. Those who cannot manage duration risk are already suffering large negative returns in their income assets.
October was a tale of two halves, but we retain our conviction as we fast approach the end of 2021.
Interest Rates
October proved to be an eventful four weeks for interest rates. Markets have been wary of the spectre of rising inflation for some time. However, a run of strong inflation results - New Zealand 4.9% for the year, the United States 5.4% and to a lesser extent Australia at 3.0% - generated a rapid, and in some markets, a brutal reassessment of when central banks will need to increase cash rates to dampen rising prices.
This generated strong performance in the first half of October for Income portfolios, but this fell back in the second half in response to the speed of the moves in short interest rates.
This saw short-term interest rates (1 year, 2 year and 3 year maturities) rise across a wide number of markets including the United Kingdom, Canada, United States and Australia. Not to be left behind, the New Zealand market led the charge in this move with the wholesale 2-year interest rate rising by 83bps over the month to end at 2.26%. This was the largest monthly increase since the early 1990s.
Two reasons why a rising 2-year wholesale interest rate is important
First, it signals that the Reserve Bank of New Zealand's (RBNZ) decision to increase the official cash rate (OCR) in October from 0.25% to 0.50% will not be the end of it. Current market pricing implies that the RBNZ will increase the OCR at every six-weekly meeting between now and the end of 2022.
The second reason is that this rise has had a dramatic impact on mortgage rates. The spread between wholesale rates and the retail mortgage rates is typically around 2%. With wholesale rates above 2% the days of mortgage rates starting with a 2 or a 3 are long gone.
For a borrower with a $1m mortgage, something that may not be that unusual in Auckland, a 2% increase in interest rates means a repayment increase of around $20,000p.a. when they come off their existing fixed rates. This will reduce the money available for other spending and, coming on the back of a long lockdown, suggests that the outlook for 2022 is becoming more clouded.
NZ Funds' position: Clients' portfolios continue to be positioned for persistent inflation pushing longer term interest rates higher. Over the last month this positioning resulted in negative performance as long-term interest rates initially moved higher and then fell back in response to the speed of the moves in short-term interest rates.
Locally, we do think that the RBNZ will increase the OCR but not as aggressively as implied by market pricing. Reflecting this we have begun to add long positions in 1- and 2-year interest rates.
Share markets
While the New Zealand market fell by -1%, global share markets posted a strong October and recovered much of the losses from September. The MSCI World index added 5% and the United States market posted a 7% return.
The October strength in global markets largely reflected the easing of concerns in Chinese property company defaults, as well as a return of the ‘risk on' sentiment after initial negative reactions to inflation concerns were absorbed.
Also helping the strong global share market performance was the beginning of the Third Quarter earnings season which started very well, particularly in the United States, with many companies beating market financial result expectations.
NZ Funds' position: We are neutral global shares with a slight overweight to Australasian shares across the Growth portfolios.
Technology shares
The United States mega cap technology companies reported a relatively mixed set of earnings, resulting in some divergent share price performance.
Facebook's share price fell on results due to weak advertising revenues and datapoints, whereas Google and Microsoft had strong results and positive share price performance reflecting strength in their underlying performance.
Amazon continued to see pressure on earnings as the world reopens and people spend less money on online orders. Apple had a mixed result with supply issues on chips for its iPhones suppressing numbers.
NZ Funds' position: We had meaningfully reduced our mega cap exposure over September therefore these results have not had a significant impact on client returns.
Commodities
Commodities form an important part of the Growth and Inflation portfolios given where we are in the economic cycle and the persistent threats of inflation. The commodities cycle is long-term, and clients' portfolios look to benefit from this.
Looking at our key commodity exposures, energy commodities and uranium had a month of two halves.
Natural Gas
Natural gas finished October broadly at the same level that it started. However, the movement in between these two points was choppy with a strong upward trend until a sell-off coming into month-end. Clients looking at intra-month returns would have witnessed this strong up and down.
We are in a 'shoulder season' for natural gas where the Northern Hemisphere is determining if we are going to experience a colder than normal winter, or not. See Investment Insight | 29 October 2021 | Polar vortex is coming.
From a fundamental standpoint, our investment case which we described in Investment Insight | 17 September 2021 | The natural gas price squeeze remains intact, particularly around the lack of natural gas making its way into Europe from Russia.
Uranium
The uranium spot price also finished October at a similar level to the beginning of the month, but with a large up and down during that period. Most of our exposure comes through listed uranium mining shares which performed well throughout the month, even as uranium prices ended the month flat.
China have revealed that they are planning to add at least 150 new nuclear reactors in the next 15 years, while France and the United Kingdom continue to make positive comments regarding their desire to use nuclear as a key energy source to meet their 2030 and 2050 decarbonisations goals.
NZ Funds' position: The Growth and Inflation portfolios remain invested across the commodities space given our view on the commodities cycle. While this causes performance to differentiate from the market, we believe it will add significant value over the long term.
Cryptocurrency
Bitcoin's recent bull run has differed from those in past years. One key distinction has been decreased volatility. Cryptocurrency volatility (or price swings) did not spike when Bitcoin's price hit record highs in October, indicating that Bitcoin may be evolving into a more mature investment asset.
Meanwhile, Ethereum could surge circa 80% to US$8,000 in the next two months according to Goldman Sachs, given Ethereum closely tracks inflation expectations - which have recently jumped. Goldman Sachs believe Ethereum's token, which hit record highs in October, could be reaching the 'starting point of an accelerating rally'.
NZ Funds' position: The Growth and Inflation portfolios remain invested in a diversified basket of cryptocurrencies which have similar attributes to commodities in an inflationary environment.
Outlook
We believe the environment remains supportive for share markets, especially following the dovish comments from central banks. However, we monitor this closely as we move towards the end of the year.
While volatility is increasing and is likely to remain elevated, we believe any drawdowns should be viewed as buying opportunities, given our investments across several different asset classes which provide multiple drivers for clients' portfolios to increase over the next six to 12 months.
Persistent supply chain constraints are weighing on the path of the recovery and feeding fears of longer lasting inflationary pressures. However, the growth outlook remains firmly underpinned by huge levels of pent-up demand, solid corporate balance sheets and robust investment intentions.
Meanwhile, income assets and property are under pressure from rising interest rates. Those who cannot manage duration risk are already suffering large negative returns in their income assets.
October was a tale of two halves, but we retain our conviction as we fast approach the end of 2021.
Interest Rates
October proved to be an eventful four weeks for interest rates. Markets have been wary of the spectre of rising inflation for some time. However, a run of strong inflation results - New Zealand 4.9% for the year, the United States 5.4% and to a lesser extent Australia at 3.0% - generated a rapid, and in some markets, a brutal reassessment of when central banks will need to increase cash rates to dampen rising prices.
This generated strong performance in the first half of October for Income portfolios, but this fell back in the second half in response to the speed of the moves in short interest rates.
This saw short-term interest rates (1 year, 2 year and 3 year maturities) rise across a wide number of markets including the United Kingdom, Canada, United States and Australia. Not to be left behind, the New Zealand market led the charge in this move with the wholesale 2-year interest rate rising by 83bps over the month to end at 2.26%. This was the largest monthly increase since the early 1990s.
Two reasons why a rising 2-year wholesale interest rate is important
First, it signals that the Reserve Bank of New Zealand's (RBNZ) decision to increase the official cash rate (OCR) in October from 0.25% to 0.50% will not be the end of it. Current market pricing implies that the RBNZ will increase the OCR at every six-weekly meeting between now and the end of 2022.
The second reason is that this rise has had a dramatic impact on mortgage rates. The spread between wholesale rates and the retail mortgage rates is typically around 2%. With wholesale rates above 2% the days of mortgage rates starting with a 2 or a 3 are long gone.
Source: Bloomberg.
For a borrower with a $1m mortgage, something that may not be that unusual in Auckland, a 2% increase in interest rates means a repayment increase of around $20,000p.a. when they come off their existing fixed rates. This will reduce the money available for other spending and, coming on the back of a long lockdown, suggests that the outlook for 2022 is becoming more clouded.
NZ Funds' position: Clients' portfolios continue to be positioned for persistent inflation pushing longer term interest rates higher. Over the last month this positioning resulted in negative performance as long-term interest rates initially moved higher and then fell back in response to the speed of the moves in short-term interest rates.
Locally, we do think that the RBNZ will increase the OCR but not as aggressively as implied by market pricing. Reflecting this we have begun to add long positions in 1- and 2-year interest rates.
Share markets
While the New Zealand market fell by -1%, global share markets posted a strong October and recovered much of the losses from September. The MSCI World index added 5% and the United States market posted a 7% return.
The October strength in global markets largely reflected the easing of concerns in Chinese property company defaults, as well as a return of the ‘risk on' sentiment after initial negative reactions to inflation concerns were absorbed.
Also helping the strong global share market performance was the beginning of the Third Quarter earnings season which started very well, particularly in the United States, with many companies beating market financial result expectations.
NZ Funds' position: We are neutral global shares with a slight overweight to Australasian shares across the Growth portfolios.
Technology shares
The United States mega cap technology companies reported a relatively mixed set of earnings, resulting in some divergent share price performance.
Facebook's share price fell on results due to weak advertising revenues and datapoints, whereas Google and Microsoft had strong results and positive share price performance reflecting strength in their underlying performance.
Amazon continued to see pressure on earnings as the world reopens and people spend less money on online orders. Apple had a mixed result with supply issues on chips for its iPhones suppressing numbers.
NZ Funds' position: We had meaningfully reduced our mega cap exposure over September therefore these results have not had a significant impact on client returns.
Commodities
Commodities form an important part of the Growth and Inflation portfolios given where we are in the economic cycle and the persistent threats of inflation. The commodities cycle is long-term, and clients' portfolios look to benefit from this.
Looking at our key commodity exposures, energy commodities and uranium had a month of two halves.
Natural Gas
Natural gas finished October broadly at the same level that it started. However, the movement in between these two points was choppy with a strong upward trend until a sell-off coming into month-end. Clients looking at intra-month returns would have witnessed this strong up and down.
Source: Bloomberg.
We are in a 'shoulder season' for natural gas where the Northern Hemisphere is determining if we are going to experience a colder than normal winter, or not. See Investment Insight | 29 October 2021 | Polar vortex is coming.
From a fundamental standpoint, our investment case which we described in Investment Insight | 17 September 2021 | The natural gas price squeeze remains intact, particularly around the lack of natural gas making its way into Europe from Russia.
Uranium
The uranium spot price also finished October at a similar level to the beginning of the month, but with a large up and down during that period. Most of our exposure comes through listed uranium mining shares which performed well throughout the month, even as uranium prices ended the month flat.
Source: Bloomberg.
China have revealed that they are planning to add at least 150 new nuclear reactors in the next 15 years, while France and the United Kingdom continue to make positive comments regarding their desire to use nuclear as a key energy source to meet their 2030 and 2050 decarbonisations goals.
NZ Funds' position: The Growth and Inflation portfolios remain invested across the commodities space given our view on the commodities cycle. While this causes performance to differentiate from the market, we believe it will add significant value over the long term.
Cryptocurrency
Bitcoin's recent bull run has differed from those in past years. One key distinction has been decreased volatility. Cryptocurrency volatility (or price swings) did not spike when Bitcoin's price hit record highs in October, indicating that Bitcoin may be evolving into a more mature investment asset.
Source: Bloomberg.
Meanwhile, Ethereum could surge circa 80% to US$8,000 in the next two months according to Goldman Sachs, given Ethereum closely tracks inflation expectations - which have recently jumped. Goldman Sachs believe Ethereum's token, which hit record highs in October, could be reaching the 'starting point of an accelerating rally'.
NZ Funds' position: The Growth and Inflation portfolios remain invested in a diversified basket of cryptocurrencies which have similar attributes to commodities in an inflationary environment.
Outlook
We believe the environment remains supportive for share markets, especially following the dovish comments from central banks. However, we monitor this closely as we move towards the end of the year.
While volatility is increasing and is likely to remain elevated, we believe any drawdowns should be viewed as buying opportunities, given our investments across several different asset classes which provide multiple drivers for clients' portfolios to increase over the next six to 12 months.
For more information please contact NZ Funds.
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.
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.
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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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