Goldilocks conditions still bearing fruit
Challenges could see some investments turn to porridge
After a strong year for returns from New Zealand and Australian equity markets, investors are correct to ask what does 2018 offer? Are the “goldilocks” conditions of solid economic growth, low inflation and easy monetary policy settings likely to continue to support company profitability and equity market returns?
While the near-term outlook for local equity returns remains positive, two scenarios may challenge the “not too hot, not too cold” conditions which have supported equity market returns.
Challenge 1: Profit growth fails to meet expectations
Market consensus is for local equity markets to generate mid-to-high single digit profit and earnings growth per annum over the next few years. Key near-term risks to profit forecasts are a rapid tightening in monetary conditions, and the consequences of government policy changes which slow economic growth.
If monetary policy settings (including official interest rate targets and macro-prudential tools) are tightened too quickly, earnings may disappoint, as constrained access to debt capital slows economic growth and higher interest rates hit business profitability. Current above-average economic growth may give central banks globally the confidence to “tap the brakes” and unwind supportive post-global financial crisis (GFC) monetary policy stimulus. But lead global inflation indicators remain low, meaning central bankers don’t have to act too quickly to increase interest rates. With central bankers globally maintaining a gradual approach to unwinding easy monetary policy settings, in my opinion, near-term risks to equity market returns from a sharp hike in monetary policy settings remain modest.
The re-emergence of modest inflation may contribute to rotation in market performance leadership. Long term (including government bond) interest rates may increase as signs of inflation emerge (even if only modest), or as central banks end their stimulatory bond buying programmes. Equity market sectors that are sensitive to bond yields, such as utilities and real estate, which have supported New Zealand equity market returns as interest rates fell to generational lows, may underperform should bond yields creep up.
If a tightening in monetary settings is sharp or unexpected, a market ‘tail risk’ (low probability, high impact event) could manifest itself with forced deleverage of systematic equity strategies (such as volatility and risk parity targeting) which have boosted market returns, and disruptions to market liquidity.
Changes to government policy settings, both locally and offshore, may moderate what has been a sustained period of above-average growth. Policy changes may impact on robust migration (both inbound and outbound) influenced growth, residential housing activity, business confidence and consumer confidence.
My response: Profitability and earnings may remain elevated for longer
In my view, the outlook for near term profitability remains solid, with economic lead indicators remaining supportive for equity returns. While the rate of global economic upgrades may peak near term, overall activity is at an elevated level. Synchronised global economic growth supports the profitability of New Zealand and Australian companies with offshore earnings.
Locally, the New Zealand and Australian economies remain relatively resilient, with prudent Government and private sector debt levels. Residential housing activity, which had become stretched, is slowly cooling. In New Zealand while the rate of economic growth may slow as net positive migration rolls over, slowing but still firm business confidence supports solid economic activity and elevated employment levels.
Despite varying a lot across sectors, Australian business condition indicators have strengthened significantly over the last year. This improvement in business confidence supports earnings for parts of the Australian equity market, and some NZ companies with Australian operations, which has been missing over the last few years.
Challenge 2: The speed of technology disruption
The speed of technology disruption is challenging many business models. Credit Suisse highlight in their 2018 Global Equity Strategy that this disruption is being driven by the convergence of at least four technologies coming of age, including: smartphone, 4G and unlimited data giving close to 60 per cent of the world’s population huge processing power at their fingertips; 3D printing; battery storage; and machines being able to replicate human tasks.
This rapid convergence is testing businesses in different ways. Increased pricing transparency via the ability to access online searches anywhere, anytime, is exposing previous competitive advantages, such as geographic isolation or the differences between wholesale and retail selling prices, to rapid disintermediation. We all do price checks on our smart phones before buying items, with the more efficient price discovery process increasing our bargaining power. Some companies face the real threat of being replaced by new technologybased business models that offer a more effective solution, with a better delivery mechanism than existing models.
In my opinion, rapid technology disruption is likely to impact on returns from parts of the equity market. The pace of technology change is exposing structurally weak businesses, and the returns that such challenged businesses deliver for investors may remain suppressed until strategies are put in place that address the disruption risk. In most circumstances, the disruptive impact of rapid technology change requires companies to increase their capital investment to keep up with competitors, potentially at the cost of near-term profitability.
My response: New technology supports profit growth for some companies
While technology disruption offers challenges for some businesses, it may offer upside to profitability margins to other businesses, and may allow totally new economic models to emerge.
New technology is allowing businesses to do more with the same or less inputs, boosting profit margins. Technology disruption is improving inventory management, reducing development time lines and improving connectivity with customers. Rapid technology change may be a key reason behind current low levels of inflation.
Ultimately businesses that can pivot their businesses to use disruptive technology well have the potential to grow faster and for longer than others, growing returns to shareholders ahead of expectations. To benefit from technology disruption, businesses will need to be prepared to invest and to challenge existing business models. For most companies, the investment in disruptive technology may take time to be reflected in profitability.
Australian business condition indicators have strengthened significantly
“Goldilocks” environment to continue in the near term
In the near-term equity markets remain supported by robust profitability. Profit growth is being driven by positive underlying economic activity and investment in disruptive technology which boosts profit margins. But with overall market valuations elevated, the potential is for lower local equity market returns than those that have been generated over 2017. Relatively easy monetary conditions remain supportive, meaning equity markets may continue to offer an attractive return relative to cash and bonds.
Not all equity market strategies and industry sectors will do well in this changing environment. Dispersion in stock returns is likely to increase from recent low levels, as monetary policy settings change and as rapid tech convergence continues to impact on business models.
So, while conditions may get a “little colder” (if economic growth peaks) and a “little warmer” (as monetary policy conditions gradually tighten), the “goldilocks” market conditions that have been in place over the last few years are likely to support equity returns from the land of milk and honey and the land of macadamias and vegemite.