Positive global share market momentum carried into the second quarter of 2024 for the USA, although share market returns in other regions were variable.
The outlook for interest rates remained unchanged, however there is growing expectation for a general reduction in interest rates around the globe. In June, the European Central Bank and the Bank of Canada became the first of the major banks to begin cutting rates. With local inflation heading in the right direction, it looks as though the Reserve Bank of New Zealand may soon follow suit.
In the key US market, the Federal Reserve held the federal funds rate steady at 5.25% throughout the quarter, with officials there citing the need to cool persistently high inflation.
Against this backdrop, the US share market extended its bull run that began in late 2022, with the S&P 500 Index reaching all-time highs during the quarter. This performance was led, once again, by the strong performance from a handful of large capitalisation companies in the information technology sector. Unfortunately, the New Zealand share market continues to lag many of its global peers with weak economic growth, and stubborn inflationary pressures, continuing to challenge local policymakers.
On the global political stage, uncertainty and change seems to be in store in 2024. After a relatively brief campaign, the Conservatives have just relinquished Downing Street after 14 years in power in the UK. Emmanuel Macron’s snap election resulted in no clear winner, leaving France without a new prime minister or government and in political chaos just weeks before they welcome the world for the Olympic Games. Meanwhile, the lead-up to the US presidential election has been even more volatile than pundits expected, including the shocking attack on former president Donald Trump in early July. The race between Biden and Trump will no doubt include many twists and turns before the nation votes in November.
Bigger isn’t necessarily better
Over recent months, share market news has been dominated by the strong returns of some of the largest companies in the world, including several of the technology giants based in the USA.
If we look at the leading US share market index – the S&P 500 – we can break it into ten different company groupings (or deciles) of 10% each, according to company size. In other words, we can group together the largest 10% of firms in the index all the way down to the smallest 10% of firms. If we calculate the past five year returns from each of these groups, we can see that the largest 10% of firms have beaten all other size segments. This seems consistent with the reported strong performance of many large technology companies.
However, concluding that the largest companies have performed the best would be incorrect. What the analysis as described above only tells us is how the current largest companies have performed looking backwards in time, not how the largest companies five years ago performed over the subsequent five years. If we use company size as they were five years ago as the starting point and then calculate the forward-looking returns of each size grouping, the analysis changes quite significantly.
Median 5 year forward annualised S&P 500 return by market cap decile 5 years ago[1]:
[1] Data sourced from Ritholtz Wealth Management as at 18 June 2024
The largest companies from five years ago have still performed well (+10.8% pa), but the top performer over the period, by a healthy margin, has actually been the smallest decile of companies (+16.0% pa).
This is the case because some of the big companies today were actually much smaller five years ago and some of the smaller companies today were also much bigger.
It’s generally unusual for the largest companies in an index to continue to outperform all others, and history tells us the best time to buy these companies is before they become large, not after.
New Zealand interest rates – the wait goes on
The chart below shows the annualised inflation rate (dotted blue line) plotted against New Zealand’s Official Cash Rate (OCR) which is the short-term interest rate set on a periodic basis by the RBNZ (orange line).
New Zealand interest rates versus inflation:
The RBNZ aims to keep inflation within the range of 1% to 3% over the medium term (the area shaded in white). For the most part they have achieved this fairly consistently over the last 25 years. Up until 2021, there had been only occasional deviations of inflation outside this band, and most had returned back to the target range within 12 months.
However, the cost-of-living crisis has been a different story. The significant ‘spike’ in inflation that commenced in 2021 has so far not returned to the target band. This is why the orange line is not budging yet. The length of time that inflation has stayed above target (now three years and counting) has backed the RBNZ into a corner. They are highly reluctant to reduce interest rates until they see inflation back inside their target band. This caution has resulted in the OCR being stuck at 5.5% since May 2023.
The good news, as you can see from the chart, is that inflation is heading in the right direction, and many commentators consider that we could see interest rate reductions later this year (ahead of the RBNZ’s own forecasts). Whenever it begins, it will mark the end of the most restrictive interest rate settings New Zealand has experienced in 15 years.
