December 2005 Quarterly Review

OVERVIEW

The global economy is forecast to remain relatively robust over the 2006 calendar year. This prediction is based upon the US economy maintaining steady growth, China continuing its expansion (albeit somewhat more slowly), improved economic conditions in Japan and solid growth in many emerging markets. Economic prospects in Europe, particularly Germany, are also more upbeat.

It is unlikely that there will be much relief from high oil prices over 2006 and central banks will remain vigilant in preventing inflation from getting out of control.

WORLD OUTLOOK

Table 1: GDP Growth

The OECD forecasts were released in November and IMF in September.

The OECD has revised its world economic growth forecast for the 2005 calendar year from 2.6% in its June Economic Outlook to 2.7% and for 2006 from 2.8% to 2.9%.

It has revised its Australian growth forecast for the current year from 2.5% to 2.6% and from 3.4% to 3.2% for 2006. Australia is expected to perform relatively strongly in 2006.

As far as New Zealand is concerned the OECD has revised GDP growth for the 2005 year from 2.6% to 2.7% and from 2.8% to 2.9% for 2006. The latter figure is slightly higher than most domestic forecasts.

CURRENCY

The NZD continues to defy gravity and the negative predictions of most economists on the Kiwi have been wrong. In the global investment markets New Zealand interest rates are still very attractive and this situation continues to attract capital flows into the country.

Investors in Japan and Europe in particular have invested billions of dollars in New Zealand denominated fixed interest securities and this has been a major contributor to the strong NZD.

Table 2: New Zealand Dollar against Major Currencies

As at 31 December

While we do not expect domestic interest rates to fall in the short term, there are substantial maturities through 2006 of existing debt and it will be interesting to observe whether these issues are rolled-over or redeemed. Such decisions will also have an impact on the direction of the NZD given the high overseas ownership of New Zealand debt.

As noted in our last Quarterly Review, we expect the NZD to ease over 2006 against most of the major currencies particularly as New Zealand recorded a further large trade deficit of $6.6bn for the November 2005 year.

FIXED INTEREST

Short term interest rates rose steadily throughout 2005. At the beginning of 2005 the Official Cash Rate was 6.5% and three rises of 0.25% each have increased the rate to 7.25%pa with the Reserve Bank becoming increasingly concerned about the inflation outlook.

With low unemployment, a strong housing market and the high dollar making imports relatively attractive the Bank has to battle with a fairly blunt weapon – ie short term interest rates. There are signs that higher interest rates are having some impact on economic activity but they are also keeping the currency high with a consequential negative impact on the export sector.

The New Zealand interest rate curve remains inverse as short term rates have increased sharply and longer bond yields have fallen. Over the last three years average annual cash returns have equalled or exceeded the returns from longer bonds. This indicates that little if any reward has been available to investors from locking funds into longer-dated securities as opposed to simply operating a cash management strategy.

With call interest rates at high nominal levels we shall not hesitate to maintain cash in portfolios for the time being.

SHAREMARKETS

World sharemarkets continued to outperform New Zealand over the year and the NZX was one of only four developed markets to have a negative December 2005 quarter. The ASX was a strong performer in 2005 although the currency was a small negative factor from an NZD perspective.

Table 3: Gross Sharemarket Returns

(per annum in local currencies)

Source: MSCI

We are not overly optimistic about the outlook of the New Zealand sharemarket in 2006. However we feel that companies generally have strong balance sheets and dividends will likely be maintained. If the NZD does fall then increased benefits will flow through to companies in the export sector over those that are exposed to the domestic economy, particularly consumer spending.

There is a risk however of overseas investors selling local shares if the currency outlook deteriorates.

Australia still looks to be a strong economy especially on the back of the resources boom and this situation has been reflected in the strong performance of listed mining companies. The Australian government has a fiscal surplus and is likely to cut income taxes. As a consequence there may need to be interest rate increases if the Reserve Bank of Australia gets concerned about the inflation outlook.

Where it has been appropriate we have placed a modest amount of NZD’s into offshore sharemarkets. However we still have some concerns as to the New Zealand Government’s intentions for a capital gains tax on offshore portfolio holdings. We shall continue to monitor this situation on behalf of clients.

OUTLOOK

The major forecasting agencies remain generally optimistic about world economic growth. This is positive for company earnings and share price performances.

We remain of the view that the Australian economy - and probably the Australian sharemarket - will outperform New Zealand in 2006.

The NZD remains a large uncertainty and may continue for some period to be stronger than most commentators expect. We are making no predictions except to say that in the short term New Zealand interest rates will continue to be attractive to overseas investors.

Our objective this year is to continue to achieve superior returns for clients.

Alan Moore