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Rates Generating More Than a Little Interest

Greg Smith of Devon Funds analyses the quarter in the market and finds Omicron, supply chain pressures, OCR rate hikes and inflation are all having an impact.

6 July 2022

The December 2021 quarter promised much, but for the NZX50 index of top Kiwi companies, it was something of a damp squib.

Following a 4.9 per cent gain in the September quarter, the index lost 1.8 per cent despite positivity across many parts of the corporate sector.

Economic data prints were also better than expected, even as Auckland only emerged from a 107-day lockdown in early December, and with restrictions enduring in many other parts of the country during the quarter.

Some of this underperformance can be put down to the Reserve Bank ‘going early’ in terms of increases in the Official Cash Rate, with two rate hikes during the quarter.

That said, a seasonally typical bout of strength in late December helped the broader Kiwi share market finish 2021 effectively flat (-0.44 per cent).

Covid-19 and associated lockdowns were dominant themes in recent months.

The Delta August lockdown led to an economic contraction in the September quarter, but at minus 3.7 per cent, the result was better than feared. On an annual basis, GDP rose by 4.9 per cent, while the unemployment rate hit a record low of 3.4 per cent.

We will see the impact on the December quarter GDP at the next release.

Hiring intentions and consumer sentiment remained stoic late in the year, despite the protracted stay-at-home orders which were all set to end with the government’s move to a ‘traffic light’ system.

A strong housing market helped the mood, with national average prices rising 27 per cent during the year and building consents at record levels.

Pandemic ‘beneficiaries’ have emerged during Covid. In New Zealand, examples have included Mainfreight and Freightways, and these companies continued to enjoy fertile conditions towards late 2021.

Travel companies were less upbeat, with one example being Air New Zealand, which delayed a capital raise and restructured its government support package.

The arrival of Omicron only compounded uncertainties around border reopening. Omicron’s tendency to be a milder, yet more transmissible, version than Delta also weighed on the retirement care stocks, which have been at the ‘pointy’ end of the pandemic.

To give a sense of the sometimes-stark contrast in fortunes for companies over the last 12 months, rubber boots and gloves manufacturer Skellerup was the top riser on the NZX with a gain of more than 70 per cent during 2021. At the other end, shares in A2 Milk lost more than half their value.

The Reserve Bank raising rates proved something of an Achilles heel for the New Zealand market in the December quarter.

The need to tighten monetary policy to combat multi-decade highs in inflation has, however, become much more of a global theme, and we’re likely to see more examples of other central banks raising rates during 2022.

It has also been one of the most volatile starts to a year on record globally, with the catalyst for investor angst not Omicron (or Russia-Ukraine tensions or China concerns) but fears over rising interest rates.

The era of ‘cheap’ money is coming to an end as central banks have pivoted away from the idea that pandemic driven inflation is temporary.

This has given rise to some concerns over share market valuations, because interest rates are used in financial models to value companies based on their future cash flows.

Elevated valuations have been most evident in the technology sector. The ‘bar of expectation’ has effectively risen, and in the US, companies which have delivered a negative surprise (among them Netflix and Meta Platforms) have been severely punished.

The Reserve Bank meets this month and in focus will be guidance on the expected pace of future rate rises after annual CPI inflation hit 5.9 per cent in the December quarter.

Many parts of the economy are doing well, with December quarter unemployment hitting a record low of 3.2 per cent.

On the other side, the overheated housing market appears to be cooling as lending has been tightened up and the ability of highly geared mortgage holders to withstand a number of rate rises comes into question.

Consumer wallets are also under pressure with rising food and petrol prices.

Border plans have been pushed out, and self-isolation requirements will not be very attractive to most overseas travellers.

Adding to the sense of uncertainty is the fact that Omicron has also been slower to arrive on these shores than other countries. This all makes for a delicate balancing act for the Reserve Bank.

Key to our economic fortunes in the next few months will be how the Omicron situation develops.

So far in early 2022, pandemic performers have continued to do well with Skellerup, Mainfreight, and Briscoes all having had strong updates.

The dairy industry is also in a great spot, with Fonterra lifting its forecast farmgate milk price range for 2021-22.

A host of companies reporting through to the end of March are expected to give us a fuller picture of how a cross-section of the economy is handling the latest variant.

In focus will be whether inflation-driving supply chain pressures are easing as the world reopens, as some big US corporates have communicated.

Key, though, will be how the world’s central banks communicate their rate-tightening plans.

If investors tilt more towards companies with strong value propositions, this could augur well for the relative appeal of many NZX50 constituents, with a weaker New Zealand dollar already appearing to be making life easier for some.

Greg Smith is the Head of Retail at Devon Funds Management www.devonfunds.co.nz.

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