In 1994 The Lesson Was… Know It Now
Monthly Market and Economic Update – February 2021
Peter Flannery CFP AFA
“If you have one economist on your team,
it’s likely that you have one more than you’ll need.”
The chart on the left shows the US share market (the Dow Jones) over the last six months. The
chart on the right shows the US share market (the Dow Jones) over the last year. The US markets, as measured by the Dow Jones continues to rise to new all-time highs and the Nasdaq representing the tech sector even faster still.
- When (not if) interest rates rise, what does it mean for investors?
- What about homeowners?
- Are interest rates rising now?
- What should we do about rising interest rates?
The inverse relationship between interest rates and asset prices
Interest rates when they rise can cause asset prices to decline. That’s what the above story in 1994 is suggesting. But what’s it all about?
The start of it is when a Central Bank notices inflation ahead and considers what to do in order to slow it down.
One of the tools they use is simply to raise interest rates. That’s what went on in 1994 and is outlined above ( I clearly remember it). Indeed one of my clients at the time remarked “Peter, I notice the portfolio cash up value declined over the last month and it seems to keep on going down whenever I look at it. I really am starting to wonder if it is going to go all the way down to zero!”
Indeed he watched his portfolio cash up value decline for several months before it turned around and changed direction. The difference between 1994 and the drop in the markets as a result of the Coronavirus over 2020 was that the decline last year was sharp, sudden and significant and then gradually recovered. In 1994 it went the other way and was insidiously slow, week in, month out steadily declining, declining, declining….
As you can imagine at WISEplanning we took advantage of lower prices and building on our positions. We continued to buy as prices declined. In hindsight that turned out to be a really good idea!
I simply raise this issue about upcoming inflation because there are signs of it in some parts of the world, particularly the US where the US Federal Reserve (as I recently signalled) has suggested that they will let inflation run a bit hotter in the future in order to help get things moving in the US economy to offset the impact of the Coronavirus.
In New Zealand too, we are starting to see some signs of inflation in the future. You will have noticed the narrative around negative interest rates here in NZ has all but disappeared and there is now talk of interest rates increasing. Just take a look at those longer dated bond yields and those longer dated interest rates and you’ll see what I mean.
So what should we do if interest rates are rising?
If you were one for playing the markets you might be inclined to “rebalance your portfolio” by increasing levels of cash and fixed interest and reducing exposure to growth investments. It sounds like a great idea but is such only in theory. The practicalities are that this type of manoeuvre requires getting the timing right. It sounds easy when we say it. It’s just difficult to execute successfully, again and again.
“When markets are rising, any cash in the portfolio is too much. When markets are declining any cash in the portfolio is not enough.”
Although it remains to be seen, my view is that we are heading into a period of so-called “grumpy growth” whereby the Coronavirus will gradually be contained and the world will focus on other items.
Markets never rise in a straight line. It’s always a bumpy ride but that’s great. That gives us the opportunity to take advantage of those lower prices from time to time. Indeed from around 2009 through 2020, although there were spots from time to time where prices were a bit cheaper, overall it was a steady grind in an upward direction making passive index funds look like heroes and anyone trying to find bargains look decidedly flat-footed.
The upcoming environment is better for us because it will be volatile, however at this stage it’s difficult to see any black swans (significant economic events) swimming close by. China is one to watch and we’ll talk more about that in a future update. But otherwise, rising interest rates might be the next item on our agenda and certainly one that markets will be faced with navigating in due course.
The above diagram shows a projected timeline for the rollout of the Coronavirus vaccine.
As we can see from the chart above which offers one estimate of the rollout of the Coronavirus vaccine, it is somewhat uneven. The point is that we live in a global economy, even with Coronavirus and so it will be important, particularly for those emerging economies, to get sufficient supply of the vaccine in order to help contain it so that they’re able to continue to trade with the rest of the world.
In the end, it appears though that no matter what we do, we’re not going to be able to eliminate it (you never know I could be proved wrong about that). But certainly containment is a big step in the right direction in terms of global economic stability and growth. It’s not a bad idea either that we save people’s lives.
The Global Economy
The above table provides a number of economic indicators for various economies around the world. Green is good, red not so much.
Whilst markets to a large extent are looking through the Coronavirus at other economic indicators, the global economy being a lagging indicator, is still right in it. The Coronavirus continues to spread however the rate of spread appears to be declining in some areas.
Although the above table does paint a bit of a mixed picture, overall it shows that the global economy with the support of Central Banks around the world has been resilient. Notwithstanding that some sectors are significantly affected, overall the wheels of the global economy continue to turn.
The above graph shows historical and projected inflation rates for those countries outlined on the graph above.
There are many economic indicators that we could discuss. To me, inflation is an important one because it can be an indicator of rising interest rates. The estimate of inflation in the graph above does not indicate rampant inflation but enough nonetheless to suggest that interest rates can move higher. Indeed some longer term interest rates already have, over the last 6 months or so. I will be keeping an eye out for projected inflation estimates, particularly from the US and here in New Zealand as well.
The United States of America
So, America has a new President. Here are some snippets of Joe Biden’s ideas for USA.
- Coronavirus: He’s looking to provide free testing for everyone and hire approximately 100,000 people to set up a national contact tracing program.
- Jobs and money: He has stated that he will look to raise the minimum wage and invest in green energy. Among those initiatives, he’ll also extend loans to small businesses and increase direct payments of cash to American families. He also intends to repeal the Donald Trump tax cuts and the $10,000 student loan forgiveness for Federal loans. He likes the idea of raising the Federal minimum wage to $15 per hour. He’s also looking to invest two trillion dollars into green energy. He believes that a boost in green manufacturing helps working class union workers who do most of those jobs anyway. Although he criticised Donald Trump’s initiatives around “buy American” he intends to support this initiative.
- Race: In light of the significant race protests and riots that gripped America last year, he has stated that racism does exist in the US and needs to be dealt with through a broad range of economic and social programs to support minorities. Once a proponent of “tough on crime” he has now changed direction and is proposing policies to reduce incarceration, gender and income based disparities in the justice system with a focus on rehabilitating released prisoners. He has rejected calls to stop funding the Police suggesting that instead, maintaining standards is what is required.
- Climate change: Re-join the global climate accord.
- Foreign policy: He intends to focus on national issues first. He stated his intention to repair any damaged relationships with US allies, particularly with regard to the NATO alliance. His approach to China is not necessarily to remove all tariffs but to adopt a broader approach including other economies in the hope that China has no option but to pay attention to new initiatives because it still relies on the rest of the world.
- Healthcare: He intends to expand Obamacare and implement the plan to insure an estimated 97% of Americans. That said, he has stopped short of an overarching universal health insurance proposal that would be much more expensive and more left wing as some of his party members would prefer.
- Immigration: Undo Trump’s policies.
- Education: In a decisive move to the left, he appears to be endorsing a number of large education policies that have been popular within the party. His thinking is to fund this area of expenditure from the money gained from withdrawing the Trump era tax cuts. It will be interesting to see what impact those tax cuts have on American business and the American economy.
The above graph shows economic growth in America including the fourth quarter of 2020.
Real Gross Domestic Product (GDP) increased at an annual rate of 4.0% in the fourth quarter of 2020 by some estimates. By comparison the third quarter increase in real GDP was 33.4% which of course followed the sharp contraction in the second quarter of 2020 caused by the Coronavirus.
Thanks to the support of the US Federal Reserve, low interest rates and other stimulus measures, the American economy is getting back on track. The US economy can be resilient when things get tough although this time around it was that US Fed support that helped keep things going. Still, the US economy is broad and significant. America inc. have a history of innovation too.
The above graph shows the inflation rate in America.
I include inflation in this month’s commentary because, as I’ve mentioned elsewhere, it can be an indicator of rising interest rates. We can see that the annual rate of inflation in America increased to 1.4% in December of 2020 from 1.2% in November which was slightly higher than the market forecast of 1.3%. Although subtle, this above market expectation result is somewhat of a trend.
The above chart shows the rise in the 10-year treasury rate, particularly over the last month or so.
Although I don’t see interest rates spiking up in the near future, nonetheless with the inflation rate in America subtly climbing and the 10-year Treasury rate even higher as well, these indicators are worth watching.
Coronavirus spread starting to head in the right direction
The top graph tracks daily hospitalisations in America.
The bottom graph tracks the daily change in Intensive Care patients in America.
Of course, the Coronavirus is a tricky little virus and it’s far too early for us to think that things are under control. Far from it, particularly in the likes of Europe, the UK and the US. However as the above graphs show, infections and hospitalisations are trending in the right direction (finally!).
The above graph tracks economic growth in China.
China led the world into the Coronavirus pandemic and the resulting economic shrinkage of the economy, and out. China’s economy grew by 2.3% over 2020, the slowest pace of growth in more than four decades. However, China is likely one of the few economies to avoid economic contraction over that period. This looks like a sizeable achievement given the population of over 1.3 billion people.
The above two graphs track China’s industrial production and China’s retail sales value.
China’s economy continues to get back on track and progress, as can be seen by the above graphs that highlight China’s industrial product growth as well as the recovery in retail sales. Obviously, with Chinese people banned from leaving home, retail sales dropped significantly as the chart above shows but gradually, as the virus was contained and lockdowns diminished, Chinese people (just like people in Western countries) were able to go outside, go to malls and shops and spend money. China as you know is morphing from an industrial exporting nation to one that is less reliant on outside economic exports to one of internal consumption.
On another note, my information suggests that China has decided it is a world power and will behave more like one in the future. We may see China exerting pressure on other economies as it becomes more assertive on the world stage, with little regard for what others think.
The above diagram shows current and projected economic growth, inflation and interest rates along with the unemployment rate.
The above table shows estimates for economic growth and other economic indicators over 2021 and 2022.
Britain remains in the grip of the Coronavirus, not helped by the new more infectious strain that has recently emerged. In my view, this will force the UK government to take much tougher measures to contain the virus which ultimately will help with the management and proper containment of the virus at some point hopefully over 2021.
With the rollout of vaccines across the UK, there is the possibility that vulnerable groups may receive the vaccine by around April/May this year, which would lead to an easing of lockdowns and possibly a return to some sort of normal life in the UK.
This in turn could see economic growth return reaching around 4% over 2021 potentially. By some estimates economic growth will be in the range of between 2.2% and 5.6% over 2021. Better than a deflationary outcome where the economy shrinks, that’s for sure.
The above table shows three main scenarios based on certain assumptions around the roll out of the vaccine.
As outlined in the table above, the main scenario suggests a gradual easing of restrictions and falling infection rates over the next few months. This of course is dependent on no new variant mutating in the meantime.
On the downside, if new versions of the Coronavirus emerge, this will obviously slow down the easing of lockdowns and ultimately economic growth. Also if the current vaccines become less effective due to Coronavirus resistance or mutation this also slows things down.
The UK government will want to be very certain about the effectiveness of any vaccine along with the ability to roll it out and to reach, first of all, those vulnerable members of the population and also have more confidence that another mutation is not hiding away, ready to pounce just when they think it’s all safe.
School children returning to school does help the economy to get back on track because parents can then get back to work although this does unfortunately, in some cases lead to an increase in the infection rate. The government will be looking for a balance of returning children to school and keeping that spread of the infection rate under control.
The above graph tracks inflation estimates in Britain looking at three specific scenarios.
Most indications suggest low inflation throughout 2021 as the economy struggles to get back on track. The headline rate of inflation will likely stay below the Bank of England’s target of 2%. A number of estimates suggest that inflation will likely remain around 1.7% from the middle of 2021 into 2022. Not a bad outcome although higher levels of inflation will be beneficial in order to help the economy to grow sustainably.
The bottom line for the UK is that the Central Bank of England will need to remain supportive until further notice.
The above table provides a variety of economic indicators for Australia.
Australia continues to battle the Coronavirus but overall has made good progress, despite the recent outbreaks. This is obviously important because New Zealand and Australia are strong trading partners. China is Australia’s number one trading partner which is the same for us here in New Zealand too. China and Australia have not been getting on well of late.
Economic growth Australia
The above graph tracks economic growth in Australia.
As the above graph shows, the Coronavirus had a significant impact on the Australian economy causing economic contraction in the second and third quarters of 2020. Like many others, the Reserve Bank of Australia stepped up with support. Also like pretty much every other country, that support has been a better option than the alternative.
Interest rates Australia
The above chart tracks interest rates in Australia from prior to 2000 to date.
Interest rates reflect a deflationary environment in Australia, hence they sit at all-time lows. That will likely be the case, at least in the short-term. The Reserve Bank of Australia left its cash rate unchanged at a record low of 0.1% during its February meeting. This was widely expected. Interestingly, the Reserve Bank of Australia suggested that they will maintain rates on hold at least until 2024. Time will tell…..
The above graph tracks the inflation rate in Australia.
Like many other economies around the world, inflation remains stubbornly low. The annual inflation rate in Australia was at 0.9% in the fourth quarter of 2020 compared with a market consensus in the prior quarters figure of 0.7%. That said, this was the highest reading in three quarters. Rising inflation is a good thing in terms of signalling the economy is possibly expanding. Too much inflation of course in the future, is not the idea.
Australia versus China
China and Australia have been at odds now for around 6 months or more. The Chinese may have been very unhappy with Australia going along with Donald Trump and his idea that an investigation by the World Health Organisation should be carried out into the origins of COVID-19, along with some criticism of China’s actions in Hong Kong over the last 12 months or so. China last year asserted that Australia is unfairly dumping many of its exports and have imposed tariffs on, for example wine (up to 200%) and barley (up to 80%).
Lobster for example has been blocked by more stringent hygiene requirements. Other products such as timber shipments have been held up with accusations around pest infections, meat supply lines have been disrupted by concerns over labelling and health certification.
Interestingly, iron ore is the only Australian export that has so far not been targeted. Australia of course dominates the international market and China needs lots of it.
Australia has taken its concerns to the World Trade Organisation (WTO). This could be a lengthy process and we need to wait and see how it works out.
Like Australia, New Zealand has a free trade agreement with China which of course has been growing strongly since around 2015.
China makes up a significant 30% of Australia’s top export markets. China is Australia’s number one trading partner (like New Zealand).
Australia recently handed an olive branch to China. China immediately threw it straight back at them – not interested. China will no doubt take a strategic view (as it always does) and apply real pressure to Australia but I’m sure they have not forgotten the fact that they rely on Australia for iron ore. This will be interesting to watch.
The above charts track the change in milk fat prices with the bottom chart showing a longer term view.
It’s difficult to talk about the economy in New Zealand without mentioning the impact of Covid-19.
Right now though we have the makings of a trend with the price of milk fat rising although in an up and down fashion since November last year. Nothing surprising about that up and down movement because milk powder etc is a commodity and indeed, the dairy industry is based on supply and demand for its product.
The demand side of things has been strong of late. Dairy prices lifted 6.6% in January and now we have dairy prices higher than prior to the pandemic. We can see whole milk powder prices are up by over 5% with a greater increase recorded for both butter and skim milk powder. It will be interesting to see if there are any delays in delivery (e.g. shipping).
Global and New Zealand dollar based global prices
The above graphs track the movement in commodity prices (the chart on the right reflecting $NZ prices)
On the back of ever reducing interest rates and New Zealand Reserve Bank stimulus, residential property prices are booming. This is interesting when you consider that immigration has slowed, apart from New Zealand expats returning home of course. Not only has low interest rates helped fuel rising residential property prices, also the shortage of stock has ramped up demand which again is fanning the flames of rising residential property prices.
The above chart shows the increase in the medium property price across all regions around New Zealand.
Thinking about the Tiwai aluminium smelter which inevitably will be closing (at the moment there is a reprieve), the price of aluminium did decline 1.1% over the month of January which is a significant decline but has nonetheless rallied 12% over 2020. China of course may well ramp up its production of aluminium which does impact on the global price of this commodity. Rio Tinto by the way has indicated that the end of 2024 is when they’re looking to finalise the closure of the Tiwai aluminium smelter.
GDP – New Zealand
The above graph tracks economic growth in New Zealand
Unsurprisingly the New Zealand economy took a significant hit as a result of the spread of the Coronavirus. The above graph says it all. The challenge too is that catching up on lost ground is not easy and takes time.
As is often the case too, with these types of events, the impact is indiscriminate. Some people actually benefit from this type of event whereas others at the other end of the scale, are severely compromised (e.g. hospitality, tourism, etc). Then of course there are all of those in the middle who are impacted to some degree, to a greater or lesser extent.
Interesting how property continues to boom even though the underlying economy has suffered the biggest hit in history. Of course that’s because the market sets the price (the fundamentals have little to do with it, at least in the short-term). Longer term though the fundamentals (sometimes called the weighing machine) becomes the real driver of property prices (not the voting machine).
It is interesting to see the banks proactively announcing tougher lending measures for borrowers, without being compelled by the Reserve Bank of New Zealand first. The reason is because there are new rules that will be coming in this year that places much greater onus on large institutions like banks to adhere to a stricter code of conduct.
One thing is for sure, the regulatory grip is becoming ever tighter in the finance and banking sector in NZ. In contrast the government is now trying to unwind the resource management act because it has become too restrictive. One outcome is considered to be a lack of housing in NZ.
Anyway, the New Zealand economy continues to progress. Thanks to the support by the government and the Reserve Bank of New Zealand, we appear to be easing our way through the cloudy world of ongoing Coronavirus spread. The outlook for New Zealand is like the rest of the world; an improving economic outlook over 2021 and early 2022 as containment measures begin to take hold. Still, there remains the real possibility community cases suddenly turning up and the risk of community spread here in NZ.
Interest rates New Zealand
The above graph tracks the official cash rate in New Zealand
As you will likely know, interest rates have been declining for decades and the New Zealand official cash rate is at a record low of 0.25%.
The Governor of the New Zealand Reserve Bank kept this low rate in September last year as widely expected. In short, like other Central Banks around the world, the New Zealand Reserve Bank is wanting to ensure that New Zealand economy has sufficient liquidity to be able to function freely in order to ease its way out of the current challenging economic environment.
That said, there is increasing indications on the prospect of interest rates rising with the talk of negative interest rates all but gone. Let’s watch this space.
All things considered the New Zealand economy is performing quite well when we take into account that we are a tiny economy in a sea of Coronavirus, the impact of which has been huge. It could have been a lot worse for everyday kiwis.
To Summarise …
I know that we’re all bored with hearing about Covid-19 however it still features strongly from an economic perspective. Community cases are NOT over here in NZ.
There have been infection spikes in different parts of Europe, Perth and we’ve even had a couple of community cases here in New Zealand recently, confirming how tricky this virus can be. Further, those mutations that generated the UK and South African version of the virus are still playing out, but look to be potentially under control – thankfully. The longer term outlook would appear to be that humans will just need to live with COVID-19 and that it will possibly be contained towards the end of 2021 and into 2022.
There has certainly been a renewed effort in America where hospitalisation and infection spread rates have finally begun to decline. Until recently, the leadership in America was borderline destructive and partially responsible for the spread of the virus across the US and potentially an unnecessary loss of life. That’s democracy for you!
Economically, Europe continues to struggle but is holding its own thanks to the European Central Bank support. Britain is dealing with Brexit and the Coronavirus. Whilst it’s early days yet, that outbreak a couple of months ago I believe will force the UK government to take stronger measures that will lead to eventual containment and control of COVID-19.
China’s economy is getting back to where it was prior to the outbreak of the Coronavirus. They did have a small outbreak recently however that appears to be contained. The Chinese government doesn’t muck about!
I would expect to see interesting times ahead for the global economy as a result of China asserting its influence and power as a major global player. I suspect it may cause markets to become unsettled at some point in the future.
In general terms though, the global economy is slowly but surely getting back on track and once the roll out of vaccines (agree with it or not) begins to have its effect, the global economy will respond by gradually returning to more sustainable growth, with less need for Central Bank support.
I have mentioned it previously and whilst I may be somewhat early, nonetheless, long term interest rates look to be increasing. Short term rates have declined, however the longer term rates are rising in some countries. Let’s watch this space.
Although there will always be events and there will always be volatility and uncertainty from time to time, my view at this stage is that (until the next major event) the global economy is on track for slow but steady growth.