November Market Update

Labour/NZ First/Greens are in – what does this mean?

National won the NZ election with 44.4% of New Zealand’s voting for them right……? In the First Past the Post era this would have been true, but not with Mixed Member Proportional. Even after National received the most votes, and seats in Parliament, Labour has formed a coalition with NZ First and the Green Party to give them 50.40%, and 63 seats in government. So, what does this new coalition mean for New Zealand?

Expected outcomes

There is a lot of commentary around how Labour will negatively impact the NZ economy with their planned changes. Nothing is confirmed yet, and one would have to think they will be aware of the need to approach the changes in a somewhat cautious fashion to sustain growth. This has not stopped the NZ dollar from falling since the election on an expectation of an overall slowdown in the local economy.

Labour has already confirmed that they will be reviewing the RBNZ’s charter to expand it from a focus on controlling inflation (target between 1% – 3%), to now include allowance for employment. It is yet to be confirmed how the focus on employment will be worded.

We can expect an introduction of a tax credit for businesses spending on research and development. It is expected to be 12.5%. If actioned this will be very supportive for NZ business innovation.

The Greens and Labour can be expected to change the rules around what can and can’t go into New Zealand waterways. They have previously stated they want to restore the waterways to a swimmable standard within one generation. This will likely impact the dairy sector, with increased regulation around their run offs.

Greens and Labour will also look to implement carbon budgeting, to shift to a sustainable low-carbon economy. We can expect this to impact the wider business community, but once again more so for the dairy sector.

Interestingly, we can expect a more collaborative approach to fixing the Auckland transport issues, with discussion already underway around funding for light rail t in Auckland. With regard to increased/improved roads in NZ it is expected we will see none of the “Road’s of National Significance progressed, with the expectation of the Manawatu Gorge replacement.

All three parties are supportive of encouraging more communal transport, and cycling, hence we can expect to see increased funding to support more cycleways in Auckland, with potential funding for the Skypath cycleway across the Harbour Bridge.

Property investing is one of the new governments primary initiatives. They expect to deliver new policy within the first 100 days in office. The changes in this sector may be very wide spread, such as:

  • A ban on overseas investors buying existing stock (as in Australia);
  • Less opportunity for negative gearing through a reduction in the ability to offset losses against other income;
  • Extension of the “bright line test” from two years to five years. The bright line test requires any property owners that sell a property for a gain within 2 years to pay income tax on any capital gains.
  • A stop to the sale of state houses;
  • Construction of 100,000 affordable homes across the country, partnering with private developers, councils and Iwi.
  • A reduction in annual immigration by 20,000 to a new total of 30,000 p.a.

These changes, if implement, can be expected to put pressure on an already stretched investor property sector, which has already slowed due to LVR lending limits placed on it by the RBNZ.

To date we have little concrete data to consider, but we feel that if most of these expected changes come to fruition we could see an increase in inflation, continued drop in the NZ dollar, as well as a much-needed slowdown in the NZ property market.

QE becomes QT

In October we finally had clarity from the US Federal Reserve (Fed) around the end of their Quantitative Easing (QE) programme which has driven share, bond, and some property markets to record levels, and the beginning of Quantitative Tightening (QT).

Since 2008 the Fed has increased their balance sheet from US$900 billion worth of assets to over US$4.25 trillion by the middle of 2014. Janet Yellen announced, at the September FOMC meeting, that the US Federal Reserve would now start removing the historically unprecedented levels of stimulus.

They will commence what the Fed calls “balance sheet normalisation” in October, by allowing the US$4.5 trillion of US Government Bonds & Mortgage Backed Securities (MBS) to mature, without rolling them into new investments.  They have stated they will commence by allowing US$10 billion per month of Govt Bonds and MBS to mature, and then test how this is received by the market. Assuming all progresses well they will increase the amount to US$50 billion per month by December 2018, until the stimulus is reduced from US$4.5 trillion to a more “normal” level of around US$2.9 trillion by 2021.

Over the past decade the Fed’s forecasts have proven to initially be too conservative (during the height of the GFC), and then to aggressive (over the past 3 years), hence the markets continue to discount the Fed’s forecasted rate rises, and to date this extends to the forecasted impact of QT.

Further to this removal of stimulus the US Fed has also announced that they are on track to increase the US cash rate again in December. Their longer-term forecast (blue line) is that they will continue to raise the cash rate through 2018 to late 2021, to a new normal level of around 2.75%, or 1.50% higher than today.

The market (pink line) continues to price in lower for longer interest rates. This means that, assuming the Fed does continue to raise rates as forecast, the bond prices in the US market are miss-priced at these lower for longer yields.

European Central Bank slowing QE

Further to the US’s QT, we are also expecting to see the forecasted end of the European Central Bank’s (ECB) quantitative easing, as well as an announcement that they will also commence “normalising” their balance sheet in 2018.

As stimulus is gradually removed we remain concerned that this will take the downward pressure off interest rates, leading to rates moving to more normalised levels. Any rise in interest rates from the previous historically low levels will lead to shares, and more importantly bonds, having to reprice for a future with higher rates.

At this stage, we are seeing most forecasters anticipating on average a circa 2% increase in interest rates over the next 12-18 months, with the common view being that this small increase in will remove a large percentage of disposable income from the heavily indebted economies, as borrowers are forced to pay more interest.

While all these forecast changes will have an impact on interest rates, they first must happen, and as shown in the chart above, the Bank of England (green), Bank of Japan (red), and European Central Bank (black) continue to pump in US$170 billion per month in new QE. As long as this continues, interest rates can be expected to stay low globally.

New Zealand market update

One of the main reasons for greater caution in this election is the high valuation of New Zealand stocks, with the NZX50 now trading at over 23X Price to Earnings (PE). This bubble has been created by the same low interest rates we have seen globally which has driven a strong inflow from foreign investors hunting higher yields. Any unexpected outcome in the election could spook the international investors enough to drive a sell down, which at current levels could lead to a fall in local share markets.

When will the foreign investors depart? This is anyone’s guess, but at present the ASX200 is now trading at a lower P/E ratio (cheaper) and offering a higher yield for investors than the NZX50, so we may see less support moving forward for NZ shares should this disparity continue.

Whatever the trigger is that leads to foreign investors selling, it is very likely there will be insufficient “buyers” to meet the “seller” demand when they do leave, which may lead to a sharp fall in the NZ sharemarket.

Property

For some time now, the majority of local (and some global) commentators have been debating the arguably overpriced New Zealand property market. PWA have for some time been expressing concern (and recommending caution) in this asset class, as fundamental measures around fair pricing was first exceeded, and then due to stimulus via Quantitative Easing were exacerbated.

Initially we have seen limitations (40% equity on rental properties) being put on bank lending to try to slow the growth. More recently there has been further pressure on banks around their capital adequacy ratios, which has led to bank lending to property investors reducing significantly in New Zealand. This in turn has led to the Auckland housing market slipping into negative territory, with a year on year decline, of -0.7% to September 2017, according to data from the Real Estate Institute of NZ.