Mark Lister, 9 August 2019

It’s been a highly eventful week for financial markets, both here and offshore. After a stunning first seven months of 2019, which saw shares in the US as well as New Zealand hit fresh record highs, sentiment turned sour during the first few days of August.

President Trump announced fresh tariffs on Chinese imports into the US, reportedly against the wishes of most key advisers. The 10 per cent tariffs on some US$300bn of goods are due to take effect from 1 September.

China retaliated in kind at the start of this week, fixing its currency at the lowest levels in a decade. This has the effect of making Chinese exports more competitive, but it also reduces the global purchasing power of Chinese consumer and businesses. More importantly, it is a signal that China is willing to take action in response.

Trade tensions are likely to create more volatility in the months ahead, and this could be a drawn out process. An escalating trade (or currency) war represents a significant risk to global economic growth, and could even trigger a recession if the situation intensifies.

There are few winners from a trade war, and even though the US appears to be in a stronger position, many sectors and companies would suffer. In addition, US consumers will ultimately foot at least part of the bill for higher tariffs.

President Trump will have one eye on the 2020 election, and a weakening economy and falling sharemarket are unlikely to be part of his campaign strategy. This could mean he softens his stance at some point, although we would be hesitant to rely on that happening in the short-term. Instead, investors should expect more volatility in the weeks ahead.

Closer to home, the Reserve Bank of New Zealand (RBNZ) reduced the Official Cash Rate (OCR) from 1.50 per cent to 1.00 per cent this week, which is the lowest it’s ever been. That was a bigger move than expected, with most commentators predicting a 0.25 per cent decline.

In the past, the only examples of the RBNZ cutting as aggressively as that were in times of crisis – after the 9/11 terrorist attacks, during the depths of the Global Financial Crisis and following the Christchurch earthquake.

It was a particularly surprising move given that barely 24 hours before the announcement, unemployment fell to the lowest levels in a decade (at 3.9 per cent), which implies the economy isn’t doing too badly.

Understandably, many have found themselves wondering what the RBNZ knows that they don’t. This is definitely a risk for the central bank, as some businesses and consumers might see the dramatic rate cut as a reason to be even more cautious, rather than as a signal to get on with things.

It appears the RBNZ would rather move pre-emptively to ensure the economy remains solid, rather than wait for a slowdown to emerge before reacting. After all, most economists were expecting another two or three rate cuts over the coming months, and that is still the case. It’s really only the timing that differs.

The RBNZ is clearly a little nervous about the outlook for global growth, particularly in light of the aforementioned trade tensions worsening. These might have played a part in the bigger than expected cut, and this could explain why the RBNZ’s economic forecasts (which will have been finalised a couple of weeks ago) look more upbeat than a 0.50 per cent rate cut suggests they should be.

Negative interest rates and quantitative easing weren’t ruled out in the future, and the RBNZ is clearly keeping an open mind about other tools it might need to use if we do see a genuine slowdown. The actions of other central banks also appear to be on its mind, given the similarly accommodative stance that we have heard from Europe and the US lately.

This move is likely to put further pressure on deposit rates and keep borrowing costs low. Floating mortgage rates have fallen by a similar degree to the OCR, although fixed rates have only fallen marginally. The vast bulk of borrowers elect to fix their mortgage rate, so in this regard, the impact on behavior could be minimal.

However, savers will again face the brunt of lower interest rates. Deposit rates have fallen below three per cent to new record lows, which doesn’t leave much return at all when tax and inflation are accounted for.

This is likely to fuel the demand for yield even further, and it’s no surprise the NZX 50 rallied strong in the wake of the rate cut. With gross dividend yields at around four per cent for the overall market, and as high as six per cent for some sectors, shares will continue to look enticing to income seeking investors.

We’ll just have to wait and see whether the increasingly supportive interest rate backdrop is enough to offset the growing risks to the global economy that trade tensions pose.