December Market Update

Interest Rates on the Rise

In the last month we have seen a sharp fall in bond valuations as interest rates around the globe rise on increased concerns of higher inflation pressures.

A main concern for investors is the increase in the weighted average production price of goods out of China. The consumer producer price index graph below shows that over the past four years, China has been exporting deflation (lower costs of goods); however, prices have increased recently which means Chinese made goods are now more expensive.

China Produce Price Index

china-ppi

Source: DB Global Markets Research

US Inflation

us-inflation

Source: DB Global Markets Research

Eurozone Consumer Price Index

eurozone-cpi

Source: Daily Shot/Investing.com

 

On top of this we have seen increased inflationary pressure being priced into the markets due to the stimulatory package that is expected as a result of a Donald Trump presidency. This has led markets to price in a 100% expectation that the US Federal Reserve will increase interest rates in the US on the 15th December.

US interest rates are seen as the benchmark for lending rates globally. New Zealand banks borrow from off shore and our mortgage and deposit rates are directly influenced by US interest rate increases.

What does this mean for New Zealand?

The table below shows that there has been a large disparity between the level of household borrowing and the level of deposits that banks have received. This has occurred due to the falling interest rates in New Zealand, which has led to increased affordability on funding borrowing costs. This has led to higher levels of lending and a reduction in cash held as investors move to higher risk, higher yielding investments.

Bank Funding and Borrowing Growth

bank-funding

Source: RBNZ. ANZ Research

Percentage of Disposable Income Required to Meet Mortgage Costs

percentage-disposable-income

Source: RBNZ. ANZ Research

Average House Price to Average Income

average-house-price-to-average-income

Source: RBNZ. ANZ Research

Net Immigration vs Resi Building Consents

net-immigration
Source: RBNZ. ANZ Research

One of the RBNZ’s ongoing concerns has been the high level of leveraging in the Auckland residential property market.  Borrowing costs now make up roughly 50% of net residential income, which has increased over the past three years in a period where interest rates have fallen.

Whilst interest rate increases will have a negative impact on overleveraged households we do not anticipate a fall in Auckland house prices, just yet but more likely a slowdown in price appreciation. Immigration into Auckland continues to underwrite property prices.

What impact does this have on bond prices?

We remain concerned about the impact of rising interest rates on retail bond values. As shown in the charts below the increase in interest rates is causing existing bond prices to fall.  And investors are not being compensated for the level of risk they are exposed to.

We continue to monitor this sector in an effort to identify a point where bond prices might present an opportunity to deploy some of the cash held in portfolios, but as the charts show if an investor had purchased the US 10 year government bond in July 2016, they would receive a coupon of 1.37% gross p.a. for the next 10 years. This c.1.1% move up in interest rates has led to the resale value of this bond reducing by over 19%.

NZ Government 10 Year Bond

nz-10-year-govvie

Source: Bloomberg.com

US Government 10 Year Bond

us-10-year-govvie

Source: Bloomberg.com

We still consider there to be further upside risk to interest rates, over the longer term, but this level of short term movement in capital value feels a bit overdone, therefore  we would expect to see a short term increase in bond values before a more steady sustained decline in bond capital values over the next 1 -2 years.

 

We can’t write a post without mentioning him, can we?

Data continues to pour in on the impact that President elect Trump could have on the US and wider markets, and we could write an entire review on this subject if we were so inclined.

We have attached a couple of the more current pieces of data for consideration below. The first is an excellent chart from the US Centre for Responsible Federal Budget showing the forecasted impact of President-Elect Trump.

centre-for-respoinsible-federal-budget

Source: Centre for Responsible Federal Budget

db-global-markets-research

Source: DB Global Markets Research

As has happened in previous years the US is about to retest their public debt ceiling, which is currently set at USD$20.1 trillion. It is expected that this will be reached in March 2017. Previously we have seen government stalemates on this lead to government services being shut down as they kick around the proverbial political football. It is expected that we will not see any such issue this time given the Republicans will have majority control.

6-month global index performance – ending 30th November 2016

market-performance

 Source: Financial Express (FE) Analytics