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The Good Fight Against Inflation

Optimism for 2022 went out the window with Omicron and the Ukraine War, says Greg Smith of Devon Funds. But if we can get inflation under control there could be positives ahead for investors.

29 August 2022

There were many reasons for investors to be optimistic as we headed into 2022.

We had waved farewell to the Covid-19 alert system and moved to a more fluid traffic light protection framework.

The borders were still closed, but life felt like it was starting to normalise, which gave many businesses greater certainty.

The economy was doing well, unemployment was very low and housing prices were still rising.

The markets had also ‘adjusted’ to the Reserve Bank moving early relative to the rest of the world on rate rises, to head off inflation.

The rest of the world was also opening up, which was good news for many corporations.

Shares that were Covid ‘beneficiaries’ were meanwhile still doing well, and the New Zealand stock market had finished the year with a spring in its step.

A contagious new twist

But, as we know now, the first quarter of 2022 bought some significant developments.

The arrival of the highly contagious Omicron variant provided a new twist to the pandemic.

We coped, but the markets were also starting to fret over the prospect of higher interest rates as the world’s central banks sought to combat multi-decade highs in inflation.

And then, on 24 February, there was a new threat from a not-so-invisible aggressor. Russia invaded the Ukraine.

There was a corporate backlash but, from the market’s perspective, the direct impact to New Zealand was minimal, possibly because Russia ranked only 25th in terms of trading partners.

The main fallout from the invasion was a parabolic surge in commodity prices.

Prices for oil, gas, wheat, corn and nickel, among others, took off on supply concerns. Many of these have since settled back to some degree, but remain higher than before.

This added to already high prices being experienced by a world coming out of the pandemic, confounding central bank officials’ attempts to fight against inflation.

Rate hike expectations ratcheted higher – the yield on the US 10-year Treasury bond has since gone above 3 per cent for the first time since 2018.

Keep an eye on inflation

Inflation and its implications for interest rates look set to remain highly relevant to investors through the June quarter.

No-one knows how the war will play out, but commodity prices appear to have calmed following an initial stratospheric surge.

At the same time, there’s some evidence – but not conclusive – that supply chain blockages are starting to ease in the midst of the global reopening.

Developments here will be closely watched across the corporate sector. Any signs that inflation has peaked will be well received, dampening the prospect of super-sized rate hikes in the coming months.

Some people worry about the prospect of a recession, but many economies are in good shape. This includes the US economy, which is still growing, and where unemployment is at 50-year lows.

The strength of the world’s largest economy was also evident in the March quarter earnings season.

The China question

Investors will be watching China, New Zealand’s largest customer, and developments around its covid-zero stance.

Also of interest will be any stimulus plans to maintain economic growth there, because President Xi faces re-election later this year.

We’ll be closely watching New Zealand’s economy as the first quarter’s gross domestic product (GDP) numbers are due mid-June.

Investors are ideally looking for a ‘Goldilocks’ scenario where the economy is cooling, but not too fast.

The New Zealand property market has softened substantially this year as homeowners faced up to the realities of higher mortgage rates.

Property prices are, however, still some way above pre-pandemic levels. Also encouraging is that unemployment is at the lowest level since the 80s.

Pressure on the border

The borders will remain in sharp focus. Tourism operators got a lift from the removal of restrictions for New Zealanders, Australians and other eligible travellers a few months ago.

This proved to be good timing for Air New Zealand, which pushed through a NZ$2.2 billion recapitalisation package, with strong interest from retail investors for the NZ$1.2b rights offer.

All visa categories are set to open from October, but political pressure could well mount to do this ahead of this date. Again, this would be well received by companies exposed to the touristic economy.

We’ll be closely watching data around consumers’ confidence, retail sales, and trading updates from retail companies.

After enjoying a ‘sugar rush’ for much of the pandemic, consumers’ wallets have been hit by higher prices for just about everything. Leading the charge were food and petrol, even with a reduction in fuel taxes.

With mortgage interest bills also rising, we’ll be closely watching the temperature check of the consumer.

A fair number of companies will be reporting and updating in May and June, which will provide a further gauge on how the corporate sector is seeing inflation and supply-chain blockages, and the overall demand outlook.

Results season looms

The “main event” for the Kiwi results season will however be when companies with 30 June balance dates report from August onwards.

The Reserve Bank meeting, and any comments from officials, will as always be under the microscope.

An encouraging thing for investors is that the central bank has sought to keep its options open and doesn’t have a pre-destined path of interest rate rises.

This could also allow other central banks to effectively play “catch-up” on rate tightening plans. This process has already seen some heat come out of the NZ dollar in recent months, which is good for the export economy.

Overall, inflation may not be as intense or as persistent as many are warning, making the central bank fight against inflation a less harrowing road than some forecasts.

In fact, many old economy stocks and sectors that are tied to the economic cycle could thrive in that environment.

There could be casualties

In the ‘good fight’ against inflation, there could however still be stock market casualties.

The initial stages of 2022 have already seen investors move away from high-priced growth stocks, or those with cash flows weighted towards periods far into the future. The large sell-off in the Nasdaq in the US is a clear example of this.

The New Zealand stock market, meanwhile, is not as endowed with expensively priced growth stocks, and has lots of great businesses trading at fairly modest valuations.

That’s something to be positive about as we head to the halfway point in the year!

Greg Smith is the Head of Retail at Devon Funds Management.


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