Macro

The New Zealand economy demonstrated a V-shaped recovery, with third quarter 2020 real GDP growth rebounding to 3.9% on a year-over-year basis. The country’s early closure of international borders and stringent lockdown measures have aided virus containment efforts and allowed for a quicker pace of economic recovery as compared to most global peers. A main driver was the early recovery in consumer confidence, which may continue to serve as a tailwind for the New Zealand economy in 2021. Retail sales had recovered sharply from their trough in second quarter 2020 and grew by 8.2% year-over-year in third quarter 2020, while a sustained rise in house prices should help to create a positive wealth effect and boost domestic spending (Figure 1).

In the meantime, government support to affected households and businesses has also been substantial. Based on Goldman Sachs’ estimates, discretionary fiscal spending in 2020, which included income relief to those who lost their jobs or were impacted by self-isolation measures, amounted to 9.8% of New Zealand’s GDP. Lower costs of borrowing and government incentives to boost business investments should also help to support the economy, with the Reserve Bank of New Zealand’s (RBNZ) NZ$100 billion asset purchase program supplementing its cuts in the RBNZ cash rate.

Despite New Zealand’s head start in normalizing the economy, there remains potential for its growth to outpace that of global peers’ in 2021. Consensus forecasts see New Zealand’s real GDP expanding by 4.5% year-over-year in 2021, as compared to 4.1% in the United States and 3.7% in Australia. Key risks to New Zealand’s growth include a slower-than-expected normalization of the global economy, which will put a drag on the country’s tourism income and net exports. However, the momentum of New Zealand’s domestic economic recovery is likely to remain strong as compared to countries where resurgent COVID-19 cases have dampened consumer and business confidence. New Zealand’s free vaccination program, which is scheduled to begin in second quarter 2021, should also help the process, with a survey by the World Economic Forum showing that the majority of residents are open to receiving vaccinations. Yet despite the positive growth outlook, inflation is expected to remain muted at 1.3% for 2021, relatively unchanged from current levels.

Equities

The S&P/NZX 50 Index returned 13.9% in 2020, outperforming most equity markets in local currency terms and unhedged terms since the New Zealand dollar strengthened over the period. Aside from the country’s early containment of the virus and normalization of the economy, New Zealand equities also benefitted from their larger exposure to defensive and high-yield stocks, which had demonstrated resilience during the COVID-19 crisis amid investor risk aversion and a collapse in global bond yields (Figure 2). The market is also underweight the energy and financials sectors; both have been amongst the hardest hit sectors during the COVID-19 outbreak. However, idiosyncratic risks remain high in the New Zealand equity market. Based on our calculations, a single underlying stock—Fisher & Paykel Healthcare Corporation—had contributed more than 50% of the S&P/NZX 50 Index’s return over 2020.

Given the rally in 2020, valuations remain very expensive based on our normalized P/E metrics, with the return-on-equity–adjusted price-earnings (ROE-adjusted P/E) ratio at the 97th percentile of historical observations and the cyclically adjusted price-to–cash earnings (CAPCE) metric at the 100th percentile of historical observations.^[1]The CAPCE is based on the ten-year average of cash earnings (or earnings excluding depreciation and amortisation) and excludes banks and insurance companies. The ROE-adjusted P/E includes banks and … Continue reading The run-up in New Zealand equity prices has not been matched by a recovery in earnings, suggesting that the current rally may not be sustainable. Except for US equities, which have been driven up by the rally in technology and growth stocks, New Zealand equity valuations are also elevated compared to global equity markets (Figure 3).

While low cash and bond yields have supported elevated valuations in 2020, New Zealand equities are at risk should an acceleration in post-pandemic global growth lead to rising interest rates and a rotation toward cyclical and value stocks. This is in contrast to markets such as Australia and the United Kingdom, which stand to benefit from the cyclical rotation given their high exposure to financials and energy stocks. Based on our valuation metrics and the outlook for global growth, we favour tilting portfolios toward developed ex US equities, as well as toward value, small-cap, and Asia ex Japan equities.

Fixed Income

New Zealand ten-year government bond yields fell to a record low of 0.44% in September 2020 following a 75 basis point (bp) RBNZ rate cut in March 2020 that took the policy rate to 0.25%. This came as the RBNZ and other global central banks turned to aggressive monetary policy easing in a bid to mitigate the economic fallout arising from the COVID-19 outbreak. While yields have since risen to reach 1.10% as of the end of January 2021 due to positive vaccine developments and the easing of investor risk aversion, New Zealand government bonds remain expensive by historical standards and offer limited return prospects over the medium to long term.

Bond yields in New Zealand no longer offer their historical yield advantage versus US and Australian bonds but remain higher than Japanese and European government bonds. We continue to see the risk/reward trade-off for global bonds as worse than New Zealand bonds, with the FTSE World Government Bond Index now yielding only 0.25% (Figure 4). Additionally, the positive implied carry from hedging back to the New Zealand dollar has been greatly reduced following recent RBNZ rate cuts, with the carry-adjusted yields for most developed markets government bonds now being lower than New Zealand government bond yields.

Currency

The New Zealand dollar experienced a bumpy ride in 2020, falling by 11% against the US dollar in first quarter 2020 before gaining 20.5% to finish the year up 7.3% against the US dollar. In trade-weighted terms, the New Zealand dollar was up 1.8% over 2020. The New Zealand dollar’s rally in the later part of 2020 was in part due to the broad-based weakness of the US dollar, as the US Federal Reserve’s rate cuts reduced the US dollar’s yield advantage and the Fed’s decision to adopt “average inflation targeting” in August 2020 pushed US real yields lower. However, the New Zealand dollar was down 2.4% versus the Australian dollar over 2020, in part due to rising commodities prices that boosted the Australian dollar.

Consensus forecasts see the New Zealand dollar gaining modestly against the US dollar and remaining flat against the Australian dollar in 2021. A key risk to the New Zealand dollar is a dovish RBNZ deciding to take the cash rate lower should inflation remain muted and below the 2% mid-point of the target range. Current forecasts see that the RBNZ will bring the cash rate down to 0.15% in second quarter 2021, as compared to the United States and Australia where rates are estimated to be held steady. However, continued strength in the country’s economic recovery may eliminate the need for further rate cuts. Additionally, a rebound in dairy prices would also help to serve as a tailwind for the New Zealand dollar.

Based on real exchange rate valuations, the New Zealand dollar is elevated in trade-weighted terms, and also against both the US dollar and Australian dollar despite the narrowing of interest rate differentials (Figures 5 and 6). A positive correlation remains between global equities and the New Zealand dollar, implying that unhedged exposure helps to lower volatility. Thus, we still see that NZD-based investors could benefit from being partially unhedged.

Conclusion

New Zealand has a head start on the post-pandemic economic recovery, given its early containment of the COVID-19 outbreak. With daily new virus cases remaining low and vaccinations set to be deployed in second quarter, New Zealand has the potential to outpace other countries in terms of economic growth in 2021, backed by strong consumer and business confidence. However, the risk is that past success against the virus results in complacency and a renewed outbreak. The tourism sector may also remain subdued should global vaccination efforts drag on and take longer than expected.

New Zealand equities outperformed in 2020 as investors sought defensive and high-yielding assets and are now vulnerable from a valuations perspective, particularly if interest rates rise and a rotation toward value occurs. As such, we recommend tilting equity portfolios toward developed ex US, value, small-cap, and Asia ex Japan equities, where valuations are less stretched and sectors are poised to benefit from the global economic recovery. Australian equities should also benefit from these trends.

The RBNZ’s rate cuts have greatly reduced the interest rate differentials between New Zealand and broader developed markets and the carry from FX hedging. With carry-adjusted yields for most developed markets government bonds now lower than New Zealand government bonds, we see the risk/reward trade-off to favour New Zealand government bonds.

Finally, the outlook for the New Zealand dollar is mixed, with elevated valuations and reduced support from interest rates offset by the prospect of a recovering economy and a generally weak US dollar. We still recommend that NZD-based investors remain partially unhedged to protect against any downward pressure on the New Zealand dollar and to benefit from reduced volatility on global equity allocations.

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Aaron Costello, Managing Director
Vivian Gan, Investment Associate