New Zealand’s recession is a warning for the rest of world

The canary in the coal mine might be New Zealand where interest rates were aggressively lifted ahead of most of the rest of the world, peaking at a lofty 5.5 per cent in May 2023.

Stagflation risk

The latest data from across the ditch suggests that NZ is the first advanced economy to enter into a bona fide “stagflationary recession”. This week’s national accounts data show that economic growth in NZ contracted 0.3 per cent in the September quarter and by 0.6 per cent over the prior year.

This conflicts strikingly with the Reserve Bank of New Zealand’s forecasts, which had expected GDP to rise by 0.3 per cent over the quarter and 0.6 per cent over the year.

Employment also fell by 0.8 per cent in the September quarter, which has helped push the unemployment rate up from 3.2 per cent to 3.9 per cent. NZ’s central bank is projecting that the jobless rate will continue to ascend to 5 ¼ per cent, a full percentage point above what the RBA assumes will happen in Australia where nothing short of “immaculate disinflation” (aka “hopeium” that inflation will magically disappear) will be required to bail everyone out of strife.

While it is entirely possible that the RBNZ will be the first advanced economy central bank to cut interest rates next year, inflation remains highly problematic – running at 5.2 per cent over the year to September, according to the RBNZ’s preferred sectoral factor model and by 5.2 per cent on a six-month annualised basis using the trimmed mean measure (the RBNZ targets 2 per cent).

This highlights the central stagflationary risk the entire world faces – while the global economy is all but certain to soften, and serious distress is sure to spread, it may not be enough to snuff out recalcitrant services sector inflation pressures.

Bond opportunities

Notwithstanding a spate of robust economic and inflation data in the world’s largest and most important economy, the United States, there has been a massive recent reduction in 10-year government bond yields, which are the benchmark for the risk-free rate. Equity junkies have gleefully jumped on the bandwagon, which stinks of a seasonal Santa rally.

This has driven spectacular returns for holders of high-grade, fixed-rate bonds, which has been a key opportunity this column has repeatedly canvassed. That is, the benefits of averaging into very high-quality fixed-rate bonds, also known as “duration”, while retaining substantial exposures to liquid floating-rate notes.

In the one-and-a-half months since the end of October, the main fixed-rate benchmark in Australia – the AusBond Composite Bond Index – has returned 4.7 per cent. Active managers should have added another 50-100 basis points (0.5 to 1.0 per cent) to that outcome.

Fixed-rate bond prices appreciate when yields decline. In late October and early November, Aussie and US 10-year government bond yields pierced 5 per cent due to concerns about persistent inflation pressures. As these crucial discount rates climbed, equities and other risky asset classes were hammered.

Yet since the start of November, government bond yields have declined monotonically. In the case of US Treasuries, 10-year yields have slumped from 5.0 per cent to 3.9 per cent. Aussie government bond yields have fallen from a similar peak to 4.1 per cent. Equities have followed suit, appreciating hard.

The Aussie 10-year government bond yield is, in fact, roughly 20 basis points higher than its US equivalent, which has helped support demand for the Aussie dollar. The latter has climbed from a low around US63¢ to about US67¢ at the time of writing as the market warms up to the notion that the RBA is behind the inflation curve and will not be cutting rates as quickly as the Federal Reserve.

Aussie dollar appreciation has been another key idea I have been ruminating on. Whereas bond markets have circa 150 basis points of rate cuts priced for the Fed by the end of 2024, there is only 50-60 basis points handicapped for the RBA.

US inflation

While I am happy to welcome the interest rate duration rally, the sheer magnitude of the boom in fixed-rate bond prices has been surprising given a disconcerting sequence of US data that both bond bandits and stock jockeys have seemingly ignored.

Last week, we received the November payrolls report. Remarkably, the US unemployment rate actually declined from 3.9 per cent to 3.7 per cent as job creation surprised with its vigour. This is only a smidge above this current cycle’s trough of 3.4 per cent. There was also a modest uptick in private sector average hourly earnings (i.e. wages).

This week furnished the latest US inflation reading, which revealed a bounce in core inflation powered by a sharp increase in core services, or demand-side, prices. Most of the improvement in US inflation has come via the temporary bout of goods deflation that has ensued since supply chains reopened.

In November, we estimate that the annualised trend in core goods inflation was negative 3.7 per cent. That is, goods prices are falling. But this cannot continue indefinitely. The more worrying dynamic has been a resurgence in US services inflation, which has increased to 5.6 per cent on an annualised trend basis (or to 6.1 per cent if we quantify core services inflation excluding rents).

On Thursday, the US reported better-than-expected retail sales in November (up 0.3 per cent versus the -0.1 per cent consensus forecast) and lower-than-projected jobless claims (202,000 versus 220,000 forecast).

And yet the Fed has bent its knee to clamours for a dovish pivot, boosting the number of rate cuts it has pencilled in for next year from two to three, which lent further momentum to the bond market boom. It is sobering to note, however, that this is still half the quantum of cuts priced by the market.

There are several other dynamics that should give one pause. Around the world, governments remain chunky net borrowers because they persist in producing inflationary budget deficits that are working in direct opposition to restrictive monetary policy settings seeking to destroy demand.

With wars in Europe and the Middle East, and the risk of an existential conflagration across the Taiwan Strait, non-trivial geopolitical hazards remain ubiquitous.

Finally, Coolabah research signals that neutral or normal cash rates are on the rise, which means that when central banks do take their foot off the pedal, the relief may not be as large as investors hope. This is especially likely if central banks are able to engineer the historically rare soft-landings that many take as a given.