The big picture for Australia and New Zealand 

Energy and food prices have come down sharply from their war-induced peaks. Developed economies have remained resilient and labour markets tight. Australia’s growth slowed as the Reserve Bank of Australia (RBA) started hiking rates and the New Zealand economy entered recession as the Reserve Bank of New Zealand (RBNZ) aggressively raised rates to 5.5%. Meanwhile, regions such as China experienced some recovery following the easing of covid restrictions and greater policy support.  However, Chinese growth stalled over the June quarter as concerns mount about weak consumer confidence, slowing exports, unemployment, local government debt and a weak property market.

Looking ahead, we expect economic activity to continue to slow in Australia and New Zealand, following most parts of the developed world as the impact of the rate rises to date takes its toll. Headline inflation is expected to continue to fall, although core inflation is likely to stay above central bank targets until 2024 given the strength of labour markets and wage growth. Central banks are expected to err on the side of caution, although we are now near the peak of the tightening cycle.

We favour Australian equities over global equities given their relatively attractive valuations and sectorial composition, which should benefit in the event that inflationary pressures persist globally or if market sentiment changes towards the tech sector. We are more neutral on New Zealand equities given the somewhat higher valuations. The relatively higher dividend yields in Australia and New Zealand should provide some downside protection compared to global equities, if economic conditions worsen. Risks to our domestic growth projections lie in real estate markets.

Within fixed income, our view has improved over the past year following the rise in yields and most curves around the developed world are now either flat or inverted. We favour growth fixed income and private debt over defensive fixed income.

Inflation in Australia and New Zealand peaked around December 2022. In Australia, the YoY headline CPI rate peaked at 7.8% and the trimmed mean^[1] at 6.9% in 4Q22, whilst in New Zealand the headline and core CPI measures^[2] rose to 7.2-7.3% YoY during 2Q22-4Q22 and 5.8% YoY in 4Q22. Going forward we expect inflation to continue to decline towards central bank targets.

^{[1] Widely considered to be the RBA’s preferred inflation measure}

^{[2] Core for New Zealand has been taken to be the RBNZ’s sectoral factor model measure}

The RBA and RBNZ responded by raising interest rates rapidly, with the RBA having raised by a total of 4.00% since April 2022 (the fastest such pace since 1989 when cash rates ultimately rose to 19.25% p.a.) and the RBNZ by 5.25% since September 2021 (the fastest pace going back to at least 1999).

In Australia, economic conditions have broadly held up well over the past year. Labour markets remain very tight in Australia with the unemployment rate near multi-decade lows at 3.5% for June, and businesses are only in recent months reporting deceleration in conditions. Retail sales are slowing, notably in discretionary goods, although discretionary services demand remains strong. Headline inflation has also decelerated year to date, with the upward pressure on services components still notable.

Economic conditions in New Zealand have arguably been more challenging, with the economy entering a technical recession as of 1Q23 and house prices correcting between 15-20% from their peak. Many of the themes are however similar between New Zealand and Australia and much of the rest of the world with inflation peaking in 4Q22, led by a moderation in goods prices, and with the rise of official cash rates yet to fully impact household budgets and mortgages. Labour markets also remain tight, with the unemployment rate near a multi-decade low at 3.4% as of 1Q23. Immigration has also been a notable development, with an estimated net intake of 77,800 people for the year to May 2023 (vs an estimate of 400,000 for Australia for the year to June 2023).

Both the RBA and the RNBZ appear to be entering a new phase in their monetary policy setting, keeping policy restrictive with the aim of slowing the economy gently as opposed to tightening policy further to slow quicker. There are signs that conditions may have peaked in a number of areas, including job openings in Australia. On the other hand, there are signs of recovery and acceleration in some parts of the economy, seemingly on the belief that “the worst is over”. This is perhaps most apparent in residential property prices in Australia with the CoreLogic National Home Value Index now having risen for the fourth consecutive month to June and arguably suggests a stronger picture of household finances than indicated by consumer surveys. Unemployment will be a key indicator to watch as a key determinant to housing affordability.

Looking ahead, our base case is for a slowdown in the Australian economy. On a positive note, we do expect the economy to benefit from the recovery in China, although that is proving more sluggish than expected. We expected Chinese authorities to step in with further rate cuts and stimulus.

However, we believe the effect of interest rate rises to date and its impact on domestic consumption will have a greater impact.  One key area to watch remains household consumption as fixed rate mortgage expiries accelerates from the June quarter onwards. We also expect headline and core inflation to moderate this year, albeit the risks remain for core inflation to fall more slowly than expected given the pressures in residential rental markets, services sectors and labour markets. Consequently, we expect that the RBA will keep cash rates elevated in the near term as it seeks to manage these risks.

New Zealand is arguably more advanced in the economic and interest rate cycle, and expectations for rate cuts in 2024 may be more justified than in Australia. 

Despite continued concerns on geopolitics and also the banking sector, equity markets have performed well over the financial year to 30 June 2023 as economic growth continued to be strong, inflation declined and with optimism about the tech/AI sector. Much of the gains were concentrated in a few US mega-cap names.

Against this backdrop, Australian and New Zealand equities performed relatively well despite the lack of exposure to the technology names, although still underperforming global equities. Listed real estate lagged equities with concerns on financing and rate rises. The past year was a more challenging year for developed market bonds with yields rising significantly. 

We favour Australian equities over global equities given their relatively more attractive valuations and sectorial composition, which should benefit in the event that inflationary pressures persist globally or if market sentiment changes towards the tech sector. We are more neutral on New Zealand equities given the somewhat higher valuations. The relatively higher dividend yields in Australia and New Zealand should provide some downside protection compared to global equities, if economic conditions worsen. Risks to our domestic growth projections lie in real estate markets.

Within fixed income, our view has improved over the past year following the rise in yields and most curves around the developed world are now either flat or inverted. We favour growth fixed income and private debt over defensive fixed income.

Finally, the recent events remind us of the importance of having a long term investment strategy and the discipline to stick with it. Mercer formulates its investment strategy based on its Investment Beliefs. These include the belief that:

(i) an investor’s true risk is not being able to meet their obligations,

(ii) genuine diversification is beneficial for investment outcomes, and

(iii) ESG considerations can have a material impact on long term risk and return outcomes.