December 2006 Quarterly Review

OVERVIEW

The global economy should remain relatively strong in 2007 although there are a number of dark clouds on the horizon. These include overheated residential housing markets in many western countries and excessive debt, particularly amongst households and private equity acquired companies.

New Zealand faces a challenging year as the Reserve Bank continues to attempt to cool the housing market and convince individuals to save rather than borrow. If the Reserve Bank is successful the domestic economy should have a soft landing with the prospect of renewed economic growth in 2008 and beyond. If individuals continue to borrow and spend then 2007 could be better than expected but this would substantially increase the prospects of a hard landing in 2008 or 2009.

WORLD OUTLOOK

The OECD has revised its 2007 GDP forecasts for most developed countries over the past year as indicated in Table 1.

Table 1: OECD GDP Growth Forecasts for 2007

The OECD, which publishes comprehensive economic forecasts in May and November each year, has reduced its 2007 GDP growth projection for the United States from 3.3% in November 2005 to 3.1% in May 2006 and 2.4% in November 2006.

Its 2007 GDP forecast for the 30 country OECD region has gone from 2.9% in the November 2005 and May 2006 forecasts to 2.5% in its latest projection publication. The OECD believes that a number of western economies are overheated, particularly the residential property sector in the United States. However it predicts that there will be a rebalancing of growth in 2007, rather than an overall downturn, with the US and Japan slowing while Europe will improve and China and India, the two largest non-OECD countries, will continue to boom.

The outlook for the Australian economy is mixed with Western Australia and Queensland, the two resource states, experiencing strong economic growth while New South Wales and Victoria are relatively depressed. The widespread drought is also having a negative impact on economic activity. The OECD’s latest Australian 2007 GDP growth forecast of 3.0% is consistent with the consensus forecast of economists.

The short-term diagnosis for the New Zealand economy is difficult to assess because it is being driven by consumer confidence, household borrowing and spending. The OECD believes that 2007 will be a difficult year for NZ with the economy expected to grow by only 1.3%, the second lowest OECD growth rate after Iceland which is expected to grow by only 1.0%. The Iceland economy has also been adversely affected by a huge current account deficit.

The OECD is forecasting NZ growth to rebound to 2.0% in 2008 on the basis that consumer borrowing and spending will ease this year and the Reserve Bank will be able to take a less hawkish stance on monetary policy.

CURRENCY

The NZ dollar continues to defy gravity although it did ease against a number of currencies in 2006. In the twelve months ended 31 December 2006 the NZD fell by 9.8% against UKStg, 4.4% versus the AUD and 6.9% against the Euro.

The main problem is that the United States dollar, which is the country’s main trading currency, was weak during most of 2006. This meant that the NZD appreciated by 3.1% against the Greenback in the twelve months ended 31 December 2006.

Table 2: New Zealand Dollar against Major Currencies

The major economic forecasting groups are expecting the NZD to ease this year although it should be noted that most NZD forecasts have been well wide of the mark in recent years.

The consensus forecast is 0.61 for the NZD/USD at the end of 2007, 0.81 for the NZD/AUD and 0.57 for the TWI. If these forecasts are correct – and this is a long shot based on recent experience - the NZD will fall by 14% against the USD, 9% versus the AUD and by 18% on a TWI basis. Forecasters believe the NZD will be even weaker against the UKStg, Yen and Euro.

Milford Asset Management expects the NZD to ease in 2007 although a relatively weak USD may mean that the decline against our major trading currency could be relatively muted.

FIXED INTEREST

New Zealand continues to have a negatively shaped yield curve with short-term interest rates higher than long-term rates.

In the year ended December 2006 the interbank cash rate rose from 7.25% to 7.40%, 90 day bank bill yields from 7.68% to 7.74% and 5 year and 10 year Government bond yields from 5.75% to 6.37% and  5.67% to 5.94% respectively.

We continue to look for opportunities to switch from short to long-dated securities. Such opportunities will become clearer when there are definite signs that consumer borrowing and spending is beginning to wane and the Reserve Bank is in a better position to ease rather than tighten monetary policy.

SHAREMARKETS

The 2007 year, particularly the final quarter, was another good period for the New Zealand sharemarket with the benchmark NZX 50 Gross Index increasing by 20.3% over the twelve month period. By comparison the Australian All Ordinaries Index, Dow Jones Industrial Average and MSCI World Developed Markets Index rose by 19.9%, 16.3% and 13.5% respectively. It should be noted that the NZX 50 Index is a gross index, which takes into account dividends, whereas the other three indices are capital only.
The second half of the year was particularly strong as markets throughout the world were boosted by frenzied merger and acquisition activity, particularly by private equity funds.

Table 3: Sharemarket Performances

The outlook for the current year is difficult to assess because equity markets are expected to be influenced by a number of conflicting factors.

On the positive side the world economy remains relatively strong, there is excess liquidity and further merger and acquisition is anticipated.

From a negative perspective markets have had a strong run, it is difficult to identify undervalued companies and any contraction in consumer spending will impact on economic growth and company profitability.

Milford expects the benchmark NZX50 Gross Index to rise by between 5% and 10% in 2007 with the ASX All Ordinaries having a similar performance (this would mean that the ASX performed slightly better because the NZX index includes dividends whereas the ASX index does not). A more conservative approach will be adopted towards stock selection in all markets with a strong preference for defensive companies. The main aim will be to avoid companies that could be adversely affected by slower than anticipated economic growth in Australasia and the rest of the world.

OUTLOOK

The outlook for the world economy is reasonably positive although many economic forecasting groups have reduced their 2007 forecasts for a number of countries, including New Zealand and Australia.

As long as economic growth doesn’t fall below the forecast ranges then sharemarkets should achieve positive returns, albeit below 2006 levels. We will be adopting a more conservative approach to stock selection in light of the high valuations and the prospect that less buoyant housing markets throughout the world will have a negative impact on consumer spending.

The New Zealand fixed interest market, particularly the long end, should offer better prospects this year if a slowdown in consumer borrowing and spending allows the Reserve Bank to start reducing interest rates. However there is a limited range of securities available for domestic fixed interest investors.

The biggest uncertainty regarding the next twelve months is the direction of the New Zealand dollar. Milford believes that it will ease during the year, particularly against the AUD, European and Asian currencies. With this in mind a bias towards offshore markets and listed stocks with a strong export base and/or offshore operations will be adopted.

In conclusion 2007 is expected to be less buoyant than 2006 and 2005 from an investment point of view. Milford’s main goal in this environment will to be to achieve superior returns for clients.