Economic Developments

Once again, the US has been through a prolonged government shutdown as Congress has been unable to agree on renewed funding proposals. Unlike most similar countries, Congress must approve government budgets and spending periodically, which means that agreement must be reached between Democrats and Republicans. This requires negotiation and compromise on both sides, inevitably resulting in much wrangling and histrionics. After the longest ever period of 43 days, an agreement was reached last month. Financial markets have taken the situation in stride, perhaps due to similar scenarios in the past. Unfortunately, the shutdown has affected the normal flow of economic data and statistics, which means that investors have been operating blind. Now that a deal has been approved, we should start to again get a clearer picture of the US economic situation. Despite some slowdown in employment and spending, it appears reasonably solid even with interest rates there remaining relatively higher than other parts of the world.

 Locally, the Reserve Bank (RBNZ) delivered a large 0.50% reduction in the Official Cash Rate (OCR) at their meeting on 8th October, and a further 0.25% cut in late November. After peaking at 5.5% in 2023, the OCR now sits at 2.25%, and the RBNZ have given clear guidance that this will be the bottom for the foreseeable future. It seems that these cuts and those previously delivered are finally filtering through, with the economic data now definitely starting to improve. In our view, over the years since the initial Covid outbreak in early 2020, the RBNZ has been reactive to economic developments rather than proactive and have in fact caused the economic cycle to be more extreme in both directions (booming in late 2020/2021 followed by a long downturn since 2022). We have a new RBNZ Governor who started at the beginning of December (Anna Bremen, until recently deputy at the Swedish Central Bank), and it will be very interesting to see how things evolve over the next few years under her leadership.

Market Positioning

Year-to-date investment performance has been across the board, with solid ongoing yields from fixed interest, improvements in the commercial property sector, and very strong sharemarket returns. Whilst the NZ sharemarket has lagged, international shares have continued to outperform. For the first time in a number of years, emerging markets (especially in Asia) have been stronger for the year than developed markets, although these have also been good.

 There is increasing coverage in the media around valuations in the US sharemarket, and especially in the large technology companies. These have ridden the wave associated with the rise of AI since the launch of “ChatGPT” at the end of 2022. It is certainly true that the so-called “Magnificent 7” tech companies are trading at very high valuations, averaging somewhere around 30x underlying earnings (which, for example, means that if the company makes $1 per share in earnings, the share price would be $30). As a major proportion of US sharemarkets, this group is a primary contributor to US markets which as a whole are looking expensive at around 22x earnings, compared to a long-run average of about 18x. Over the last couple of years, the tech sector has grown profits at a rapid rate, which has, to some extent, justified their high valuations. However, the question remains as to whether this growth rate can continue, and if not, whether a normalisation of earnings will result in a decline in US markets.

 My general view is that while I believe AI is undoubtedly going to be a long-term factor in all of our lives (for good and bad, whether we like it or not), the recent hype is likely overdone and the expectations for growth are unrealistic. However, whether this constitutes a “bubble” really depends on what definition is applied to the term, and in some sense, this is irrelevant. The important point is that this sector is trading at high valuations, and history tells us that valuations tend to move toward their long-term averages at some point. Therefore, it is sensible to have a lower relative weighting in your portfolio to the technology sector and hold a higher weighting in areas which are more attractively priced. However, high valuations can persist for long periods of time, and so holding some exposure to these growth companies is still justified. It is worth noting that while valuations in US tech are expensive, when compared with past market “bubbles”, such as that which led to the “Dotcom” crash in 2000, they are nowhere near as extreme. At that time, startup companies which were not even profitable were trading at up to 80x-100x revenue. 

Investment Strategy

Our investment management approach is essentially unchanged is relation to the previous quarter. While always fundamentally "long-term strategic," we are employing three main tactical positions to try to improve returns and reduce risk:

• Mildly Defensive Asset Allocation: Compared to long-term positioning, we maintain a modest underweight to growth assets (shares and property/infrastructure) and a slight overweight to fixed interest across all risk profiles.

• US Equity Underweight: Within international equities, we continue to hold an underweight position in US shares. European, Asian, and Australasian markets offer more attractive valuations by comparison. To provide context: while US markets represent approximately 65% of global market capitalisation, our international equity allocation is approximately 45%, with the remainder allocated to emerging markets (primarily Asia) and Europe.

• Currency Hedging: The NZD is weak at present, trading around US 58 cents, and as a result we are around 50% hedged against the US dollar. In general, we expect the NZD to remain weak over the next 6-12 months, but the risk is that it will rise sooner than expected. Should this occur, even assets with flat USD performance would decline when converted to NZD. While currency movements are notoriously difficult to predict, we are utilising funds that employ various methods to hedge these currency exposures.

 We continue monitoring market and economic developments closely and will recommend portfolio adjustments when we believe they are warranted.

Interesting Article: “Is it a Bubble?” by Howard Marks

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