With the Budget confirming the weakness in our economy, and inflation within the RBNZ’s target range, there is a clear case to argue that the OCR should already be at the neutral rate (according to the RBNZ) of 3% right now, and the central bank should cut rates by 0.50% this week. Greg Smith, Devon Funds head of retail, does the numbers…
What a difference a few weeks makes. After what was a very volatile April, markets have gained a semblance of calm. Most indices have recouped all their post “Liberation Day” losses, and then some. The S&P500 was down over 18% from its peak at one point but is now roughly flat year to date. The global trade standoff is far from resolved, but has de-escalated, and it continues to look as if the worst-case scenarios from a trade perspective will not eventuate. Following the initial first deal with the UK, the 90-day pause on trade hostilities between the US and China have given further credence to this narrative, even though a deal is far from done. Meanwhile domestic attention is swinging to our earnings season, and the RBNZ meeting. With the Budget confirming the weakness in our economy, and inflation within the RBNZ’s target range, there is a clear case to argue that the OCR should already be at the neutral rate (according to the RBNZ) of 3% right now, and the central bank should cut rates by 0.50% this week.
April was a volatile month for financial markets, but one that in the end produced a relatively benign outcome for investors. Angst around “Liberation Day” was replaced by relief as Donald Trump announced a 90-day pause for trading partners to negotiate trade deals. Frictions with China also ebbed and flowed as tit-for-tat tariff increases gave way to olive branches, and exemptions on various categories of goods, and as the talk of the potential for negotiations continued to bubble away. After a hectic and volatile month, US markets staged a huge comeback – the S&P500 was down 11% at one point, but closed April down just 0.7%, and just 9% off its record high, set in February. The tech sector surged back, with the Nasdaq closing the month 1.6% higher.
The reaction to the pause was vindication of our comments to clients about the need for “cool heads” during the volatility that was seen in March, and at the start of April. The tariff measures unveiled by Trump were always likely to represent the maximums for those countries willing to engage in negotiations and the worst-case scenarios. Crises such as that which was effectively launched by the White House are not regular, but can and do happen throughout history. The performance of equities through each of these periods continues to provide valuable lessons and a reminder of the importance of holding one’s nerve.
Investor nerves have been calmed further in May by the White House slashing duties on China goods from 145% to 30% and China reciprocating, lowering its tariffs on the US from 125% to 10%. This has come as a huge relief to markets, with the quantum as well as the swiftness of the tariff reduction much better than expected. The VIX Volatility index/”Fear gauge” went below 20 for the first time since March.
Both sides had their own narratives in the wake of the ceasefire agreement. Donald Trump claimed a win, saying that China had agreed to “fully open up” to US goods. Beijing, meanwhile, also claimed victory, noting that a publicly defiant stance was the reason Chinese officials were able to strike a deal with relatively few concessions.
Some will argue that the US has ceded to pressure, backtracking again, appreciating that America needs China more than vice versa. In any event, the truce also means that severely disrupted global trade can get back to some sort of normality. It may mean that this has all been about “muscle flexing” rather than driving US jobs, or boosting the coffers. It could also be argued that the “Trump put” is alive and well, with the President also having an eye on the stock market. Only Trump will know to what extent he caved to the pressure, and the reaction to his “economic and market vandalism,” or whether it was all part of a master plan. In any event, the market reaction was one of huge relief.
The data that has emerged of late certainly reinforces that the US did (and does still) need to a deal more than China. US gross domestic product fell at a 0.3% annualised pace in the March quarter, driven by a surge in imports ahead of Trump’s tariffs deadline. It was the first quarter of negative growth since 2022. Imports (which subtract from GDP) surged 41.3%, driven by a 50.9% increase in goods – the biggest surge (outside the pandemic) since 1974. The White House spun the claim that it was “the best ever” negative GDP print, given a 22% increase in domestic investment, and 3% growth when stripping out the negative effects of the surge in imports because of the tariffs.
Time will tell if this narrative is correct, as it is conceivable that the import bump will reverse, and substantially so, into negative territory. In any event, over the same period, China’s annual growth rate steadied at 5.4%, the strongest rate of expansion since the second quarter of 2023, and well above estimates for a slowdown to 5.1%.
The rapid reduction of tariffs between the US and China, along with the prospect of similar outcomes with other major trading partners, has also raised hopes that inflation will continue to fall. The CPI in the US fell to 2.3% year over year in April, its lowest since February 2021, and below expectations for 2.4%. Core CPI printed in line at 2.8%.
12-month CPI
There remains much uncertainty about how tariffs will impact inflation, but the picture is more encouraging than it was. Donald Trump has of course berated Fed Chair Jerome Powell for “not being fair to America, while everyone else is cutting rates.” However the Fed has a very difficult balancing act given the inflationary pressures that tariffs (wherever they settle at), will bring. Walmart, the world’s largest retailer, has already said (much to Trump’s displeasure who said they should “eat” the tariffs) it will be forced to put up prices. Nike has made similar comments. How this plays out will all be hugely relevant to US consumers. US consumer sentiment (printed prior to the China pause) hit its second-lowest reading in May, with year-ahead inflation expectations at the highest since 1981.
Source: University of Michigan
In any event markets still are pricing in two moves 0.25% lower by the end of the year, on the notion that the Fed will prioritise economic growth over inflation. Fed officials of course have a base case to defend, having already claimed that tariffs will deliver a one-off inflation shock that will be transitory.
The complexities of the situation are compounded for a data-driven Fed, with different data reports appearing to be telling different stories. While some prints have been weak, the Non-Farm Payrolls report in early May showed that the US economy created 177,000 jobs in April, around 40,000 more than expected. The unemployment rate held 4.2%, with no sign “yet” of any negative impact from trade policy induced uncertainty.
US Job creation
Source: US Bureau of Labor Statistics
There is also another issue for the Fed to consider, and again one that sits with the policies of the Trump administration. The 1,000-page One Big Beautiful Bill Act has been passed by Congress and includes measures to lower taxes and boost military spending. The Congressional Budget Office putting the price tag for the bill at nearly US$4 trillion, increasing Federal debt and deficits, at a time when tariffs are increasing the inflationary outlook. The prospect has heaped further pressure on Treasuries ( following Moody’s recent debt downgrade), with the 30-year Treasury bond yield trading to levels not seen since October 2023.
Inflation is already pushing higher, with recent PMI numbers showing prices are rising. More positively, the US economy is still proving relatively resilient. Both the services and manufacturing sectors have rebounded more than expected this month, with confidence improving, and both sectors in expansion mode.
Back to the trade side, and a lot is still hanging on how negotiations pan out between the US and China. The latter can take some comfort (in the event negotiations derail) in that parts of its economy held up relatively well despite the tariffs in place in the early weeks of trade frictions and the back-and-forth tariff moves. China’s industrial output rose 6.1% year-on-year in April. Exports to the US plunged, but Chinese companies diverted goods to Southeast Asia and Europe to compensate. Retail sales data was also solid although a 5.1% year-on-year rise was below estimates. Regardless of how the trade side plays out, Beijing may need to inject further stimulus to boost the domestic economy.
While there are still hundreds of trade deals to be done before the 90-day pause ends, two other huge trading partners will be of particular interest to markets. While Japan was the first to start the bilateral trade talks with the US, (and there were reports it would be the first deal done) negotiations appear to have stalled. The country has been amongst the hardest hit with the 25% tariff on autos having a big impact – autos were 29% of all exports to the US in 2024, and fell by nearly 5% last month. Conversations with Europe will be interesting, given the Continent runs a trade “arbitrage” between China and the US. Europe has a ~€300 billion annual trade deficit with China, effectively funded by a ~US300 billon surplus with the US.
The performances of the Australian (+3.6%) and New Zealand sharemarkets (-3%) were quite different during April. This highlighted the differing relationships of the indices to the trade war, and also the contrasting states of each economy and the situations the respective central banks find themselves in.
The Aussie quarterly CPI came in a little higher than expected but fell back into the RBA’s target range for the first time since 2021, paving the way for another rate cut. This is also while the central bank will not have to worry about any dramatic changes to the local political landscape – Labor swept to a landslide victory in the Federal election in early May.
Australian CPI
Source: ABS
Governor Michele Bullock said it was a “confident cut” but acknowledged that the Australian economy was still dealing with a “tight” labour market, but by the same token said the bank may need to relook at its approach to monetary policy due to “the completely different” shock to the global economy caused by trade tariffs.
She said she did not know if that meant Australia was headed “into a long series of interest rate cuts”, but said officials were ready to act if needed. Bullock noted that consumption was however rising at a slower pace than expected despite an increase in disposable incomes and real wages along with falling interest rates. Aussie households are being much more cautious, and she said consumption was a key factor in determining the health of the domestic economy.
Bullock noted that things were “finely poised” with worse than expected trade outcomes potentially leading to a downturn with unemployment hitting 6%, while inflation could go either way. Markets are now pricing in another 2-3 rate cuts by early next year.
What is really interesting is that the RBA has considered cutting rates by 0.50% and their economy is in a far better position than New Zealand’s. The Aussie cash rate of 3.85% is only one further cut away from the current OCR rate. The consumer, which Bullock emphasised was a big focus, is much more fragile here. March quarter retail sales in NZ beat estimates but consumer confidence reads have been tepid, and retail stalwarts such as Briscoes have highlighted how challenging conditions are.
So while the RBNZ has price stability as its primary mandate (and inflation is in the target range) where does this leave our central bank which is widely expected to deliver a 0.25% this week?
The RBNZ delivered what was seen as a “dovish cut” of 25 basis points last month, and there is a clear argument (even though we may not get one) for a cut of 0.50% this week. Notwithstanding the uncertainties from the tariff situation, the reality is that our economy is still only crawling out of a recession, and the neutral OCR according to the RBNZ is 3% (and arguably it is lower).
The quarterly inflation print last month should not deter the RBNZ from further rate cuts. The CPI came in at 2.5% on an annual basis, up from 2.2% annually in the December quarter, but within the RBNZ’s target band of 1 to 3% for the third consecutive quarter. We have also had another deflationary shock – oil prices are down over 20% since the start of April. Meanwhile it is possible that there is an element of offshore driven deflation as goods are rerouted from the US to other places, including here, at cheaper prices.
Economic confidence by many metrics is very low in historical terms. Dairy and tourism are doing well, but pretty much every other sector is struggling. Manufacturing has improved, but from a depressed base and the services sector is not exactly pumping (we are one of the few countries where it is in contraction).
Employment is 1.5% lower than a year ago and unemployment is rising. The NZ Institute of Economic Research’s Quarterly Survey of Business Opinion showed that a net 17% of firms reduced staff in the March quarter. Firms are planning to reduce investment in buildings, plant and machinery. Cost pressures remain (the weak currency will be a factor), but the proportion of firms that are raising prices is at historic lows. The currency aside, inflationary pressures are continuing to ease against a backdrop of falling capacity pressures. Any green shoots in the business sector appear to be wilting.
Last week’s Budget 2025 highlighted a weaker economy than expected, with less tax revenue, and the with surplus is delayed until 2029, and only $200 million at that.
There were some positive surprises.
The new tax incentive called Investment Boost looks a big positive. It allows firms to deduct 20% of the value of new assets in the year they are purchased. This should increase business investment and boost economic growth. The initiative will cost $6.6 billion over the four years through 2029 but is expected to lift GDP by 1% and wages by 1.5% over the next 20 years, with half these gains in the next five years. As the government notes, business investment raises the productivity of workers, lifts incomes and drives long-term economic growth. We need this, given NZ has one of the poorest rates of productivity in the OECD.
The Investment Boost policy could also be significant for listed NZ company earnings, short-term. It is also positive for commercial property developers who lost the ability to deduct building depreciation from their earnings (for tax purposes) a couple of years ago.
The changes to KiwiSaver look to be a net positive. The government is halving contributions and higher earners are cut out, but 16 and 17-year-olds will start getting them. There effectively is a transmission of burden from the government to employers, lifting the default minimum rate to 3.5% of wages and salaries on April 1 next year from 3% currently. It will rise in steps to 4% in April 2028. Workers can opt down to a 3% contribution, but the higher rates are the default levels.
Phasing in a higher contribution is the right move. We are a bit behind Australia’s 11.5% (compulsory super there has enriched the economy and Australians generally hugely since its inception in 1992 – it also started at 3-4%), and this is a step in the right direction. Kiwis are historically pretty bad savers, and the move is a great way to prompt more saving, and diversify wealth. It also should be positive for first home buyers in the future, and give them a little helping hand to get on the ladder.
Ultimately the budget highlights what a soft position our economy is in, current trade developments notwithstanding. Meanwhile current inflation levels provide plenty of cause for the central bank to deliver a big rate cut this week.
CPI inflation
We will hear also more about what kiwi corporates make of the economy and trade situation as the reporting season progresses. It could well be domestic factors however that determine how long it is before our market plays catch-up with others, and we see a re-rating of some high quality names which continue to present good value.
Devon Funds Management is an independent investment management business that specialises in building investment portfolios for its clients. Devon was established in March 2010 following the acquisition of the asset management business of Goldman Sachs JBWere NZ Limited. Devon operates a value-oriented investment style, with a strong focus on responsible investing. Devon manages nine retail funds. For more information please visit www.devonfunds.co.nz