November was on track to be another good month, continuing the strong momentum from October until the last week of the month.

Global markets took a fall initially on concerns around heightened inflation and the news of the newest Covid-19 strain, Omicron.

The virus mutates
Touching on Omicron first, we should not be surprised with news of mutations of a virus as this is how they survive. However, mutations that make a virus more deadly may not allow the virus to circulate efficiently.
In South Africa, the case rates are high, but they do not see the same level of hospitalisations as expected. As one doctor said in South Africa recently, “So I actually think there is a silver lining here and this may signal the end of Covid-19, with it attenuating itself to such an extent that it’s highly contagious, but doesn’t cause severe disease. That’s what happened with the Spanish flu.”

Severe drawdowns
Now looking to markets, beneath the surface, despite the main indices holding up, there have been some severe drawdowns in the most highly valued sectors of the market. I attribute this to the market envisaging lower liquidity in the future as the Federal Reserve (Fed) begins its tapering of asset purchases. Tapering refers to the Fed systematically decreasing the amount of assets it purchases each month. The Fed recently stated that they would start to reduce the amount of bonds they are buying each subsequent month by US$15 billion. This does not mean the Fed is selling all of the securities it has already purchased. Instead, they are reducing the amount they continue to buy each month. At this rate, purchases would end by the middle of 2022.

Implications of reduced liquidity
The implications of reduced liquidity is that more speculative assets are likely to be less supported, money flows back in assets generating cash flows. Long-term interest rates would also be expected to increase. However, so far, we have seen US 10-year rates decline by ~20% from 1.67% to 1.35% at the time of writing.

The typical correlations in these scenarios are USD strength, large-cap outperform small-cap, and market breadth reduces as investors crowd into the most stable assets; speculation reduces, so assets like crypto, art etc will fall in price first. At the time of writing, Bitcoin was down to US$42,000, down 38% from its level in early November. The Nasdaq Emerging Cloud index, which is dominated by high-growth software companies, has also fallen significantly. It is down 22% from its highs in early November, despite the 10-year treasury rate declining. Usually, lower rates would support growth asset valuations, but this time appears there is a flight to safety.

We are also witnessing this reduced liquidity in local property markets, especially in NZ. The funding rates have moved well ahead of the official cash rate (OCR). Three-year mortgage rates are now up from 2.7% in May to 4.35%. NZ banks rely on wholesale funding rates, which are impacted by contracting global liquidity flows.

The sharp rise in mortgage rates is likely to cause the property market to stall from here. Interest rates are the most critical determinant of property prices, and as borrowers roll off onto new, much higher fixed-term rates, their debt serviceability reduces. Combined with higher property supply coming onboard, less favourable tax treatment and macro-prudential limitations on high loan to value borrowing, less money will likely be flowing into the property market, causing prices to stagnate at best.

Markets have had an extraordinary run
As market indices are still close to all-time highs despite poor market breadth, and given the backdrop of reducing liquidity, we implemented some market hedging in mid-November.

It is unlikely we will see a significant correction unless there is a recession. This doesn’t appear very likely given employment markets current strength. However, we may see a re-run of what happened in the fourth quarter of 2018, where markets fell on fears of tapering and interest rates increases until the Federal Reserve meeting in late December, where they took a more accommodative position and markets rallied ~40% significantly in 14 months until February 2020.

Once again, thank you for entrusting your capital with us.

Information is current as at 30 November 2021. Pie Funds Management Limited is the manager of the funds in the Pie Funds Management Scheme. Any advice is given by Pie Funds Management Limited and is general only. Our advice relates only to the specific financial products mentioned and does not account for personal circumstances or financial goals. Please see a financial adviser for tailored advice. You may have to pay product or other fees, like brokerage, if you act on any advice. As manager of the Pie Funds Management Scheme investment funds, we receive fees determined by your balance and we benefit financially if you invest in our products. We manage this conflict of interest via an internal compliance framework designed to help us meet our duties to you. For information about how we can help you, our duties and complaint process and how disputes can be resolved, or to see our product disclosure statement, please visit www.piefunds.co.nz. Please let us know if you would like a hard copy of this disclosure information. Past performance is not a guarantee of future returns. Returns can be negative as well as positive and returns over different periods may vary.