Sometimes the stock market seems to seriously lag behind the broader economy's direction — but why? Photo / Getty Images
Sometimes the stock market seems to seriously lag behind the broader economy's direction — but why? Photo / Getty Images
OPINION
As someone who speaks to investors daily, I’m often asked why, when economic data seems solid, the stock markets aren’t necessarily travelling in the same direction as the economy.
Many people assume the economy and stock markets must correlate. But the two are not the same thing. You’d expect both to grow over time, but they do not necessarily move in the same direction at the same time. Investors watching their portfolios over the past two years will have noticed this.
During Covid, governments around the world poured money into their economies to avert the near-term economic pain of failing businesses and mass unemployment.
While this did the job in the short term, it had consequences in terms of overheating economies. Jobless rates fell to the lowest level since the 1960s, and tighter labour markets meant workers commanded higher incomes.
This combined with constrained supply chains to drive up costs for business that in turn fuelled price rises.
Using the only tool they have to cool an overheating economy and tame its inflationary effect, central banks around the world led by the Reserve Bank of New Zealand (RBNZ) and US Federal Reserve delivered the largest simultaneous interest rate tightening in at least 35 years.
All stock markets are sensitive to interest rate movements to some degree, but the New Zealand Stock Exchange (NZSX) is one of the more sensitive. In fact, the valuations of nearly 70 per cent of all companies listed on the NZSX have a strong correlation to interest rates.
In the age of Covid-19, interest rates continued to rise, share prices declined, and the volume of securities traded on the NZSX declined. Photo / Alex Burton
Why is this? It comes down to the make-up of the NZSX constituents — it’s an index heavy with utility, infrastructure, and property businesses.
These are businesses with well-known stable cashflows, but some also have reasonably high debt levels and associated interest costs.
The impact of higher interest costs on business profitability is an obvious detractor from share valuation. But, when it comes to the NZSX, the expected dividend yield compared with the cashflow of other investment options is also a key driver of valuation.
A British colleague once said to me there are two reasons he moved to New Zealand — better beaches and high dividend yields. He was right.
Without a doubt, New Zealand beaches are better and the NZSX is known for good dividend yields.
This is great for NZSX share valuations when interest rates are low, and investors are looking for reliable cashflow. But it can be more challenging when interest rates are rising and there are other ways to achieve a similar cashflow.
We’re now a long way from the low-interest-rate world we had just two years ago. As interest rates continued to rise, and share prices declined, the volume of securities traded on the NZSX has reduced.
Rising interest rates are not the only thing that caused the NZSX’s performance woes.
Several New Zealand-listed businesses have faced strong headwinds unrelated to rising interest rates, and the current NZSX reporting season could prove challenging for some. But a shift in narrative that suggests central banks have finished (or are near finished) with interest rate hikes and may even start cutting interest rates sooner than expected, is good news for stock markets.
This is where economies and stock markets could again move in different directions — this time with softening economies and strengthening stock markets.
What’s the outlook?
Investors, portfolio managers, and investment analysts keep a keen eye on economic data. At present, they are hopeful for signs of increasing capacity in the economy, such as the return of a less-heated job market, and subsequently slower wage growth. This would ease inflationary pressures and allow central banks to taper the outlook for interest rate hikes.
In the United States, the S&P 500 this month recorded its best week of 2023. Photo / NYC and Company
Recent data indicates things are headed in this direction. The latest figures from Statistics New Zealand show inflation dropped in the September quarter to an annual rate of 5.6 per cent (down from 6 per cent in the June quarter) and unemployment rose to 3.9 per cent in the September quarter (up from 3.6 per cent in the June quarter).
While inflation is still high and unemployment still low by historical comparison, these are signs capacity is returning to the economy and the RBNZ is making progress in taming inflation.
Jarden’s view is any further increase in the Official Cash Rate (OCR) seems unlikely if economic data continues this path, and we expect New Zealand’s short-term interest rates to fall towards the end of 2024. BNZ has gone one step further and revised its forecast for an OCR cut by May next year.
A significant easing in long-term interest rates following the dramatic rise of recent months has helped the NZSX this month to produce its best weekly gain since July 2022.
In the US, the unemployment rate also climbed to 3.9 per cent and monthly wage growth slowed — a clear sign the US job market is also cooling.
At the beginning of November this resulted in the S&P 500 recording its best week of 2023, with some commentators now saying the Fed is done with interest rate hikes.
Do the central banks agree with the outlook?
An easing in the financial market mantra that interest rates would be “higher for longer” drove the stock market rallies we saw in the early part of November. Whether these gains are just a bump or something more is in large part contingent on economic data continuing on its present path and central bankers agreeing with the market narrative.
Without doubt, the priority for central banks is to tame inflation and see a return to price stability. With New Zealand inflation still well above the RBNZ target range of 1-3 per cent, US inflation being well above the Federal Reserve’s 2 per cent target, and growth still strong, the “higher for longer” sentiment could reignite very quickly.
The RBNZ publishes its quarterly Monetary Policy Statement and OCR on November 29 — no doubt the market will study the statement keenly for any sign of which way the RBNZ is leaning.
Hunter Fullarton is a wealth management adviser at Jarden.
