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  • NZ Funds Monthly Review – February 2021

    23rd March, 2021
  • New Zealand Economic Update

    Over the last decade the performance of the New Zealand and Australian economies has been very similar. However, the path of the respective share markets has diverged. The New Zealand share market has been a star performer and it has significantly outshone its larger Australian cousin. Over the last five years the total return of New Zealand shares has been 92.7% compared to 73.4% for the Australian market. However, this period of outperformance may be coming to an end. Over the last six months the tables have turned. The Australian market is up 17% whereas New Zealand shares are up just 7%. The difference is even more notable if we just look at the first two months of 2021. To the end of February local shares are down 6.6% whereas Australian shares were up 1.09%.

    What is behind this change in fortune? Many of the larger shares in New Zealand are mature businesses that pay out a large percentage of their income in dividends. These shares are bond like in nature and have benefited from the dramatic fall in interest rates. As the interest rate cycle turns, these businesses will be more challenged. Australia is in a very different position as the share market has a larger exposure to cyclical sectors which will benefit from the economic recovery and resulting higher interest rates. These businesses include banks which will earn more as interest rates rise and commodity companies which earn significantly more when demand rises. The New Zealand sharemarket declined by 5.1% in February with Vista Group (+14.1%) and Skellerup (+13.9%) experiencing the largest appreciations. This was offset by falls in Meridian (-20.3%) and Contact Energy (-16.3%). The New Zealand dollar increased 0.56% over the month, ending the month at 0.7233.

    International Economic Update

    For many New Zealanders, the closed international boarders are creating a sense of cabin fever. Even if overseas holidays are a relatively rare event, there is still value in thinking about a potential holiday to Australia or the Pacific Islands. If we are feeling this way, think of how much more extreme it will be for the populations in the United States, Europe and the United Kingdom who have endured lockdown throughout a long cold winter. The vaccine rollout is progressing well in the United States (21% of the population) and the United Kingdom (36% population) and there is now a very real chance that these economies will be fully open by the middle of their summer. With massive pent-up demand after months of lockdown this is a set-up for a summer where people will “party like it’s 1999” to quote the Prince song. Demand will significantly outstrip supply, and this will drive up prices for both service items such as airline tickets and for physical consumer goods, many of which are already experiencing supply challenges. This should continue to be positive for share market returns and build upon the year-to-date performance. Within the major markets, Europe was up 4.45%, United States 2.61%. Japan’s share market rose by 4.75% and the United Kingdom up 1.19% while China’s market started to struggle from increases in regulatory intervention and was down 0.28%.

    Income Generator

    Income Generator had a strong month in February up 2.8%. Returns for the Fund were positive in a month where the New Zealand share market was down -5.1% and the Australian share market was up only 1.0%. February saw many companies in the Fund report their 2020 year-end results. The Fund’s returns were driven by rising interest rates. This included the Australian banks which tend to perform well when interest rates increase and economic conditions improve. Supported by rising commodity prices, Rio Tinto was up 15.3%, making it the single biggest contributor to the Fund. Australia’s leading mining shares are still well placed to benefit from global reflation, as higher commodity prices drive earnings upgrades and higher yields have less impact on valuations. Value shares outperformed growth shares in February. In Australia, value shares have now outperformed growth shares for five months in a row. We continue to expect value shares to outperform as vaccines drive normalisation in the economy, and rising bond yields pressure valuations. New Zealand ‘gentailers’ were the largest detractor during February fuelled by further selling of the sector by a large global green energy fund. This has put pressure on the sector since the start of 2021. The Fund continues to hold five New Zealand dividend-paying companies and eight Australian dividend-paying companies. The average dividend yield of the companies held is 4.33% (including imputation credits).

    Income Category

    Regular readers will clearly know our view that interest rates are too low, and they need to move higher, as we have talked at length on this subject. Here in New Zealand we have had the luxury of seeing first-hand how quickly life can return to normal and how strong the resulting demand has been across many different industries. This experience has helped to form our high conviction view for higher interest rates. This view was rewarded in February as the bell-weather 10-year US government bond increased significantly from 1.06% to 1.40%. Bond prices fall when interest rates rise so this sharp increase meant that many fixed income indices recorded negative returns for the month. Given our high-conviction view, the Portfolios were well positioned for this move and significantly outperformed the market benchmarks as they increased by between 7% and 8% in February. Looking forward, while we do not expect the moves to be as sharp, the trend remains for higher interest rates as we are only now getting back to levels seen prior to the onset of the pandemic in March last year.

    Inflation Category

    The Absolute Return Strategy, which comprises a significant portion of the Inflation Category, had a strong month in February returning 6.49%. The portfolio made strong returns across shares, credit and commodities. The short United States government bond position that performed well in January continued to generate strong returns in the Absolute Return Strategy as United States interest rates pushed higher. This move in interest rates also had a flow-on effect in share markets. High-growth companies including technology shares sold off, while value and cyclical companies performed well. When interest rates increase, share investors tend to favour businesses with strong near-term cash flows that benefit from economic growth, such as energy companies, commodities businesses and banks. To create room to buy these companies they tend to sell growth businesses where the cash flows are expected many years into the future. These tend to be technology, healthcare or other businesses that display strong long-term growth trends. The Absolute Return Strategy positioned its share portfolio to benefit from this rotation out of growth businesses and into value/cyclical businesses, which contributed significantly to returns in February. The Strategy short-sold (profits when the share price falls) several non-profitable technology businesses and bought long Australian and United States banks, as well as some commodity businesses like Rio Tinto. This trade paid off by generating positive returns on both the short side and the long side.

    Growth Category

    The major share market indices reached record highs in February; however, they pulled back sharply at the end of the month, leaving most with modest gains. Despite this, the NZ Funds Growth Category was positioned to take advantage of a change in market expectations for growth, inflation and interest rates, leading to significant outperformance. We saw economic growth coming through stronger than the market was expecting. This led us to believe the market was underestimating the trajectory of interest rates. Taking a short position in 5-year and 10-year government bonds in December 2020 meant the Category would benefit from any rise in interest rates and hedge out the risk of a share market sell-off should interest rates increase. This generated strong performance for the month as 5-year and 10-year interest rates increased 33 bps and 35 bps respectively. We believe there is more to come with expectations that the United States 10-year interest rate will reach 2.0% by year end. At the same time, commodities also performed well following expectations that the reopening of the global economy will be followed by strong demand across both hard and soft commodities. This leads to commodity price increases as the increase in demand was not able to be met by lacklustre supply. Economic signals, as well as the accelerated vaccine rollout in the United States and better than expected fourth quarter corporate earnings, improved as the month wore on. However, as long-term interest rates increased, placing a greater discount on future earnings, investors heavily favoured value shares over growth shares. We have an overweight position in value across the Category including in Australian banks.

     

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