This monthly commentary has been one of the most difficult to write in a long time. The reason for this, is that global markets are changing so fast with monumental shifts happening on a regular basis. I have attempted to capture some of the larger changes below, but no doubt by the time you are reading this it will seem like old news due to some other monumental shift.
RBNZ cuts 0.50%
We will start with the Reserve Bank of New Zealand (RBNZ) surprising the markets with a 0.50% cut to the official cash rate (OCR) versus the widely expected 0.25%. While this may seem a trivial difference, the only times in recent history that there has been a 0.50% cut in the OCR has been the following the 9/11 terror attacks, during the GFC, and post the Christchurch earthquake. This is meaningful.
This reduced the OCR to 1.00% and caused the bond valuations to move higher (yields lower). The NZ 10-year government bond rate has now fallen by an incredible 1.21% to a new record low of 1.08% gross p.a. since the start of 2019.
We also saw the New Zealand and Australian dollars continue to weaken post the rate cut with the NZD now down 3 cents to 0.65 cents against the USD and a drop of almost two-cents against the AUD. This is good news for an exporting nation like ours, given a weaker currency means higher profits for NZ exporters.
RBNZ Governor Adrian Orr stated that this committee felt this was required to meet the RBNZ employment and inflation targets. Global demand has continued to shrink and as our trading partners slow so does New Zealand, hence the need to provide stimulus via a rate cut.
The most disturbing part of the announcement was when Governor Orr discussed that the RBNZ committee was engaging with local and international experts around if negative interest rates, and/or quantitative easing would be best for NZ if the economy continues to slow.
NZ bank interest rates
The fall in interest rates is also impacting the mortgage rates with some banks such as ANZ and BNZ quick to respond with a two-year mortgage rate of only 3.75% p.a. To date we have not seen any reduction in the banks term deposit rates. Why is this?
NZ registered banks were previously required to hold equity capital equal to at least 8.5% of their risk-weighted assets (debt). The RBNZ has proposed to increase the required minimum to 16%. This will be staged in over the next five-years. These rules are designed to improve the level of capital the banks must carry against their loan books.
As shown in the chart below the growth in term deposits held in within the NZ banks has been slowing since mid-2018 as interest rates reduced and investors moved into higher yielding investments. We have also seen an increase in the demand for debt in New Zealand again on the back of falling interest rates. This funding gap is being funded from offshore sources which is not a favoured approach by the RBNZ as this opens NZ banks up to offshore shocks. It is for this reason that we do not believe mortgage and term deposits rates will move too much if the RBNZ continues to tighten.
NZ Bank Deposit and Loan Growth
One and Done
As expected by the market the US Federal Reserve cut interest rates for the first time since the start of the Global Financial Crisis in 2007. This has occurred on the back of slowing global growth, increased political risk and a rising risk of the US moving into recession in the next 12 – 24 months.
US Cash rate & recessions
When announcing the rate cut in late July Jerome Powell stated this was a “midcycle adjustment” which investors took to mean this was “one and done”. President Trump was predictably not happy with this and tweeted that “Powell let us down” by not cutting the US cash rate by more.
US China Trade war escalates
President Trump later tweeted that the US was now planning to slap a 10% tariff on $300 billion more worth of China imports from the 1st September. Some have seen this as potentially Trump trying to force Jerome Powell’s hand to cut more rates, and as shown in the table below the chance of a second rate cut went from 62% to 100% on the back of Trumps Tweet.
Probability of a rate cut in September 2019
As expected, China retaliated and has since halted and asked its state-owned enterprises to suspend purchases of US Agricultural goods and fired the first shot in what may escalate into a full-blown currency war as they unpegged their currency, letting the CNY rate jump past 7 Renminbi versus the USD.
The US has now labelled China as a currency manipulator but the International Monetary Fund (IMF) does not agree. China re-pegging their currency above 7 Renminbi is not currency manipulation as if they had floated their rate (i.e. not pegged it) a fairer value for it to be trading at would be c.7.30 or higher. Could President Trump have pushed to far this time, and lost the ability to reel in an angry China? We will find out as this month progresses.
The UK now has a new Prime Minister with Boris Johnson stepping into the role. Boris has clearly indicated that he plans to take the UK out of the EU via a “hard Brexit” on or before October 31st. Unfortunately for Boris he is now only ruling with a majority of one in parliament after the Conservative party lost one of their seats in a special election that was held due to the Conservative member being convicted and fined for expenses fraud.
Boris may now need to call a new election in the UK to allow him to firm up his support to proceed with the Hard Brexit, or he could be simply playing hard-ball with the European Union on the hopes of getting a more palatable exit deal for him to present to parliament. The EU has already confirmed that they will not be changing their offer, hence the risk of a hard Brexit has increased significantly.
Bond investing gone mad
As central banks have printed new funds and used them to buy existing government and corporate bonds, we have seen the supply of government debt reduce. As demand for the “safe haven” government bond funds increased funds have been pushing the price of government bonds higher, which has led to the strange phenomenon of negative yielding bonds.
What this means is an investor is now purchasing bonds that are returning them a loss each year until maturity. This is a gross return, so investors also need to take off tax, fees and inflation to confirm what the net real return is to them.
As shown in the table below in Switzerland the yields offered by government debt are negative out to 50 years. This means that investors buying this bond are locking in a loss for potentially the rest of their life. If this does not make sense to you as you read this, then you are not alone. This makes no sense to us either. The only way an investor can make money out of these investments is if the interest rates move lower (more negative) so basically investors in these bonds are playing a game of chicken where they are hoping someone will pay more for a negative return.
Average yields of six nations government debt
This is a new era for financial markets as up until a couple of years ago this had never happened before in history. The economic books around the world have had to be re-written as the lowest interest rates can go is no longer 0%. As of the time of writing this there is currently US$13 trillion worth of government and corporate debt in the world that is trading at a negative yield.
A slowing global economy
The global economy has continued to slow in 2019, and the fear of an escalation in the trade war between China and the US has certainly been a further drag on growth for both economies. The chart below shows the current PMI measure for the globe now firmly below 50, meaning global economies are contracting. The grey shaded also shows the consecutive months of decline which have now been declining for a longer period than we saw in the 2008/2009 global financial crisis.
Global and US Manufacturing Purchasers Manager Index
As you will note from the discussion above there are many storm clouds on the horizon but even with all this negative sentiment global share markets are yet to have a major sell off in 2019. We continue to be mindful of this and are positioning portfolios reasonably defensively as a result.
Several clients have asked why we don’t just move all funds out of the share market given these concerns. The reason is that we do not know where this bubble will end. We are now investing in a world where central banks can simply turn on the quantitative easing again, print more money and push interest rates even lower thereby stimulating the economy and share markets.
At present New Zealand & Australian investors have positive term deposit rates that are returning more than their comparative bonds. This gives investors a free lunch in that they can move to cash and still have a positive return over the next 12-month. The recent OCR rate cut may change this however if local banks do reduce their term deposits rates. This is something that we will watch.