Seeing both sides

Why the recent pivot by a major central bank and results thus far from US the earnings season have provided reasons for investors to be optimistic, despite elevated levels of inflation.

By Greg Smith, Head of Retail at Devon Funds

Needless to say, inflation was front and centre for financial markets once again over the course of October. The quarterly inflation print in NZ delivered a shock on the upside, coming in at 7.2%. This was faintly down on the 7.3% in the June quarter, and while expectations were divergent, almost all expected a ‘6’ out front as opposed to a ‘7’. The market wasn’t exactly at “sixes and sevens” over the release - on the day, the NZX50 underperformed many other global indices due to the much hotter than expected inflation print. 

In the end, helped by a strong finish, October wound up being a solid month for the NZ market, with the key benchmark rising 2.5%. The recovery since the June lows stands at over 7%. The rebound faltered through much of September, and early October. However, upward momentum has come back, despite still elevated levels of inflation and an upping of expectations around where the Official Cash Rate will get to. A strong start to the US earnings season has been a factor in lifting sentiment. Locally, annual general meetings have also been positive around the outlook.

In the wake of the hot inflation print, the market is now pricing in an 85% probability of a 75-basis point rate rise in November, with an even chance of a similar move in February. Forecasts for the terminal rate for the OCR (the maximum level it will get to next year) have been lifted to 5.3%.  

Across the Tasman meanwhile, the RBA minutes showed the decision to side with a 25bps rise at the October meeting was finely balanced. The central bank duly followed through with another 25bps rise in early November, despite the September quarter CPI coming in hotter than expected. Officials appear cognisant of the pace of rate hikes already put through and the impacts to the economy and property sector in particular. The RBA has acknowledged that a pivot to smaller increases doesn’t mean that the job around inflation is almost done and has suggested rates will rise into next year. Hints around the word “pivot” were significant. 

Has the RBA though stolen a trick on other central banks in pivoting recently? Australia’s unemployment rate held at 3.5% in September, but job additions missed, with just 9,000 jobs created during the month versus the 25,000 expected. This adds credence to the RBA’s decision to side with just a 25bps hike at the last two meets, and a moderation of rate tightening.

In the US, the Consumer Price Index print showed that annual core inflation increased by 6.6% in September, the fastest pace since 1982. This all but locked in a 75bps rise by the Federal Reserve at the early November meeting. Investors are continuing to grapple with a view on whether inflation has peaked or not. Fed Chair Jerome Powell has indicated this week that there is a “ways to go” in the monetary tightening path.

Bond yields have also been moving around. The 10-year US Treasury hit 4.23%, the highest level since June 2008, but was back closer to 4% at the end of October. Higher priced growth stocks have continued to wear a high degree of the pain during the interest rate tightening phase this year (the Nasdaq rose 4% last month, but lagged the other US indices), and on concerns of further increases in interest rates. 

Inflation remains the buzzword, but officials could well also pay some attention to the softening that has occurred in certain corners of the economy. Data showed that manufacturing in the Philadelphia and New York regions has contracted more than expected. The state of the manufacturing sector in the US will be not lost on the Fed. The US manufacturing sector accounts for around 12% of the economy. US home sales meanwhile also continue to fall.

There have been plenty of warnings on the global outlook (including from certain bank execs, and Amazon’s Jeff Bezos), but nonetheless the current state of affairs of Corporate America remains strong, judging from the start of the earnings season.

So far over 80% of US companies that have reported have exceeded earnings estimates. There have been some high-profile disappointments, but these have largely been confined to super-cap tech stocks such as Meta Platforms, Alphabet, and Amazon where valuations were extended, and against the backdrop of rising interest rates. It is worth noting that Apple shares, which trade on a relatively more modest valuation than many peers, rallied post its results, which were solid enough, but not overly so.

The Dow has closed out its best month since 1976 and it has been old economy/more traditional names (such as the banks, telcos, insurers and industrials) which have led the way.  Numbers from firms such as construction equipment maker Caterpillar, delivery firm UPS, Coca-Cola, VISA, and even Harley Davidson have boosted the mood around the economy.

A lot of pessimism has been priced into markets this year, and there has been significant conjecture about where interest rates, inflation and the broader economy are heading. Many data points have been ambiguous. While early days, the numbers coming from the earnings season thus far suggest that the level of pessimism has been excessive, particularly as it relates to the banking sector. JP Morgan Chase, Wells Fargo, Bancorp, Bank of America, United Airlines and Bank of New York Mellon have all exceeded estimates. 

This has been no coincidence, and while messages have varied over the outlook and provisions have been upped (for what ‘might be’), banking executives have all acknowledged that customers (and the economy) are currently in a good spot. Banks are also benefitting from higher interest rates, with the margin between lending and deposit rates expanding.  The CEO of one major US bank noted that banking customers have plenty of cash in the bank, and consumer credit remains “pristine.” Consumer balance sheets were fortified during the pandemic, and it seems customers have therefore been relatively immune to this year’s rising interest rates. 

It is a similar story in NZ. Savings buffers have also increased significantly. Household saving increased to $2.1b in the June quarter after dropping to $230m in the first quarter of 2022. The decrease in household spending partly reflected reduced purchases of durable goods, such as second-hand cars and electronics. Kiwis are tightening their belts and battening down the hatches it seems, but this is also boosting the financial moat of New Zealand households. The net worth of New Zealand’s households fell 3.7%, or $88.9b in the June quarter, but at $2,347b is still some way ahead of the $2,048b it was at in December 2020. This moat may now be needed for some and is being probed intently by the banks, some of which are now testing mortgage applications at interest rates greater than 8%. 

Globally, inflation prints have generally been moderating, but at the same time have remained elevated. Eurozone inflation came in at 10.7% in October, the highest since the bloc’s formation. In the UK, inflation rose to 10.1% in September. Getting inflation down while balancing the books is a top priority for new PM Rishi Sunak. Challenging times also for the Bank of England which is expected to put through an eighth interest rate hike in early November. One central bank official said that it could take up to 10 years to unwind the emergency bond-buying program. 

The New Zealand economy meanwhile is receiving a boost from the reopening thematic. For tourists (particularly those from the US), the kiwi dollar continues to make the case for a visit here highly compelling, considering the FX rate was over 70 cents in March. It is a long way back, and this is good news for our tourism industry, with travel activity surging on the re-opening. This was evident from Auckland Airport which revised its guidance upwards for FY23 following a “stronger than expected rebound in the aviation market, with high aircraft load factors and continued strength in forward international seat capacity expected to fuel the ongoing recovery.”

AIA is now guiding for underlying profit after tax of between $100 million and $130 million for FY23, a big uplift on guidance provided in August of between $50 million and $100 million. Management noted that the first quarter saw strong travel demand within New Zealand as well as internationally, particularly in North and South American, South Pacific and Trans-Tasman routes. The airport noted the shape of the recovery was consistent with global travel trends. 

Sky City Entertainment was a prominent riser during the month, lifting 7%. The revelation that first quarter earnings are up 10% on pre-Covid levels, even while international visitor numbers are yet to recover fully, has unsurprisingly been well received. 

Air New Zealand was also ascending last month. The airline sector is riding the crest of the global re-opening and are enjoying higher prices; Stats NZ reported that international airfares are up 20% over the past three months.

Air New Zealand has also caught the backdraft it seems from the standout result from Qantas. Shares in the Flying Kangaroo have lifted off as Australia’s biggest airline delivered a very positive trading update. The company said it will be back in black by the end of December and expects half year underlying pre-tax profits of A$1.2 - $1.3 billion. Strong travel demand more than offset high levels of inflation and elevated fuel prices. This marks a huge financial U-turn for the company which reported a pre-tax loss of A$1.86 billion last financial year and has seen five consecutive pandemic-related halves with total losses of around A$7 billion.

The market was not prepared for such a bullish update. There has been a series of broker price target upgrades since. The guidance was more than double what was pencilled in by most analysts. Qantas now looks set to earn as much in the half year as the market was expecting in the full year. This has been a great result for the Devon funds, with the Investment team taking a position in Qantas in advance of the results. Qantas is held in the Devon Alpha, Australian and Trans-Tasman funds. 

It is also not just the reopeners that are providing some optimism around the domestic outlook. Trading updates from pandemic beneficiaries Mainfreight, Freightways and Skellerup were all positive, with management painting the picture that businesses could weather any downturn. Fletcher Building and EBOS are also trading well according to company updates.

Also indicating the resilience of the New Zealand economy, and better than feared outcomes, were the results from the ANZ. The country’s biggest bank delivered a record full-year net profit, with earnings at the kiwi unit surging 20% to $2.3 billion (the first time above $2b). Margins rose, and volumes were robust. While going quieter more recently, home lending jumped $5.3b to $104b. With many loan customers on an interest rate that “began with a 2 or a 3”, and due to roll over in the next year or two, there is however cause for some caution. Also providing cause to be wary for New Zealand more broadly is that fact that economic growth in China, our largest customer, remains patchy in places.

Therefore, while economically things are perhaps not as bad as the outcomes which have been priced in by markets, there is still a strong case for being highly selective as it relates to stocks and sectors. Regardless of the type of economic landing, some companies will fare better than others during any market rebound. The reaction to disappointments from several super-cap US tech stocks provides a poignant reminder here.

Overall, the Devon funds have continued to navigate this year’s financial turbulence well. The Devon Alpha Fund was up 3.8% in the 12 months to 31/10/22 and ranked top in its peer group. The Devon Trans-Tasman Fund was up 1.3% over the same period. All the Devon Australasian funds are ranked in the top 10 on a 3-month, 6-month, 1-year, and 2-year basis.