October Market Commentary

New Zealand share market – how high is too high?

We continue to watch in wonder as the New Zealand share market pushes to new highs. Since the start of the year the NZX50 is up almost 10% and a very impressive 11.70% per annum over the past 10 years to 30 September. Some of this staggering growth has come from increased corporate earnings, but most of the gains have come from an expansion in the multiple of the Price to Earnings (P/E) ratio which has grown from a low of 13.3x in 2012 to a record high 26.6x today, according to FNZC. This growth has been mainly driven by offshore investors who today currently own just under 50% of the total market, so the concern is what will happen to prices if the foreign investors leave the New Zealand market for some reason.

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New Zealand economy slowing

We have had an incredibly positive decade of growth in New Zealand, on the back of strong demand from offshore for local assets and globally falling interest rates. This has led to strong business growth/confidence, a falling unemployment rate, as well as more expensive New Zealand share and property markets.

Data released in September shows that business confidence in New Zealand has dropped from a high of over 20% positive in 2015 to 34% negative. The last time business confidence was at such low levels was back in 2008-09 during the Global Financial Crisis.

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This negative view on growth is also apparent in the slowing New Zealand Gross Domestic Product (GDP) which has fallen from a growth rate of just under 5% per annum in late-2014 to just over 2.8% today. The Reserve Bank of New Zealand (RBNZ) is forecasting growth continuing to accelerate into the end of 2018, but there is more data coming in to support a further slowing on the back of interest rates rising globally. To assist in supporting the local economy the RBNZ has reaffirmed that the Official Cash Rate (OCR) is likely to be on hold until 2020, and some local economists are even forecasting a possible rate cut in 2019.

Are all share markets expensive?

One of the ways that we consider if share markets are overvalued or undervalued is to consider the current P/E ratio versus the long run average. As discussed on the previous page, New Zealand top 50 companies’ P/E ratio is at record levels increasing from 13.3x in 2012 to 26.6x today. When viewed on this measure the NZX50 is unquestionably overvalued.

The chart below relates to the US S&P500 index and compares the market price movement to the P/E ratio. It is interesting to note that in 2002, post the end of the “tech wreck” correction, markets were deemed to be cheap at 14.9x P/E. Since the 2002 low the S&P500 has returned just under 500% to investors, but the P/E ratio is now only 16.1x, or 1.2x higher than it was in 2002. This means that over 90% of the growth in the share price since 2002 has come from earnings growth and only around 7.5% has come from P/E ratio expansion.

The S&P500 has now moved into the longest bull market (rising without a 20% fall) in history. With interest rates rising in the US, earnings growth is unlikely to be sustainable at current levels and we could possibly see the S&P500 to drop in value, however, it is also arguable that at 16.1x P/E the S&P500 is still not in bubble territory as we saw in the 2000 tech bubble where the S&P500 was trading at 27.2x.

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Interest rates are on the rise –but not in New Zealand

Inflation in the US has been on the rise since 2015 and data released in September has US inflation at just over 2% annualised – the US Federal Reserve’s (Fed) target range. Rising inflation is seen as good news for the Fed as this allows them to increase the US cash rate, building in some breathing room for when they need to drop rates again during the inevitable next recession.

At the end of September 2018, we have now had the eighth rate rise in US interest rates since 2015, taking the US cash rate to 2.25%, with expectations of a further 0.25% increase in December 2018. Rising inflation/rates has also meant that the US 10-year interest rate (yield) has increased back above 3%, with some economists picking that this will move another 1.00% – 1.50% higher over the next 12-18 months.

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New Zealand rates lagging US

Since the start of 2018 we have seen a steady increase in the US 10-year bond rate, up 26.9%, while the NZ 10-year bond rate has declined by 5.6% over the same period. This has led to the very unusual outcome with the NZ 10-year bond now offering investors a return of only 2.68% gross per annum versus 3.05% for the US 10-year. This means that the extra return NZ investors previously received from hedging USD investments back to the NZD is now a cost.

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China US trade war – don’t talk tough to your banker

As we watch President Trump continue to apply pressure to China with the latest round of tariffs on US$200 billion worth of imports from China we must recall that China is currently the second largest holder of US government debt, behind the US Federal Reserve. As at September 2018 China held US$1.178 trillion worth of US government securities, with the majority being longer dated bonds.

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The trade war has caused confidence levels to drop in many business sectors that are caught in this trade war with China specifically targeting sectors that were strong Trump supporters. The US economy has an ever increasing need to borrow money to fund the President’s tax cuts, and increased spending needs, so it is fair to say that China has a pretty strong “Trump card” up their sleeve in this negotiation. Pun intended.

Where is all the “smart money” going?

The US Dow Smart Money Flows index is a measure of what the so called “smart traders” are doing in the markets on a daily basis. The index is seen to reflect investor sentiment and is based on the assumption that the majority of traders, who are emotionally driven by what has happened overnight, place their trades in the beginning of the trading day. The “smart money” are the trades that are placed closer to the end of the trading day once the traders have had an opportunity to evaluate the daily market news and how the markets are reacting to information.

It would appear that the Dow Jones Industrial Index has a reasonable correlation to the smart money index and the index is suggesting that we may be in for a period of increased volatility coming into the end of the year.

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Conclusion

The volatility that we have seen in emerging markets since February has declined but is potentially a precursor to a more meaningful correction in the wider markets. Indeed, this may already be underway, excluding the US. As inflation continues to rise in the US (potentially above many market commentators views), interest rates may also continue to rise there. This could mean that emerging economies will have further upward pressure on their interest rates, and downward pressure on their bond and share values.

One uncertainty around this view is the unknown impact of the central banks. The ECB and BoJ can keep printing funds to underwrite lower interest rates, and the US Fed can also slow or stop their Quantitative Tightening.