December 2007 Quarterly Review

GLOBAL ECONOMY

The December quarter saw increasing acceptance that a material United States economic downturn will occur in 2008.  This is mainly due to the impact of a residential housing slump and a credit crunch.  US consumer confidence held up remarkably well for most of 2007, on the back of low unemployment and the benefits of a lower US dollar.  However, unemployment levels are rising and the US consumer is now reining in their spending.

Japan faces the reality of a slowing economy, as does Europe.  Australia still appears to be “the lucky country” with GDP growth of over 3% still expected in 2008. 

As has been the case over the past few years the engine room of global economic growth sits with China.  It is still growing at double-digit pace and 2008 will see the authorities look to slow this, as inflation levels are now high.  China still holds the key on whether a US recession will also cause a global recession. 

Expectations are still for global growth of about 4% for 2008, above the average for the past 10 years of 3.7%.  However, the risks are on the downside.

Table 1: Global Growth Forecasts

Source: OECD Real GDP forecasts, released 6/12/07

NEW ZEALAND ECONOMY

While the Reserve Bank of New Zealand (RBNZ) frets about inflationary pressures brought about by low unemployment, rises in government charges and high oil and dairy prices, the underlying economic outlook is poor.  Economic growth could be below 2% in 2008, with a downturn in the residential housing market, a high kiwi dollar and low net migration levels, key drivers behind our cautious outlook.  This is accentuated by what will probably be a tougher global market for our exporters.

The poor current state of the domestic economy was confirmed by the September quarter GDP figure of +0.5%, announced just before Christmas.  Without rising Government spending and Tui oil field revenues, economic growth would have been negative!

The upside for the New Zealand economy is that after years of fiscally tight policies the Labour Government is likely to announce significant tax cuts (possibly implemented pre-election). This will be matched or exceeded by the National Party – it is election year after all!  However, the RBNZ has already stated it will raise rates if it considers the fiscal stimulus to be too great, thus capping the upside for the economy.

NEW ZEALAND DOLLAR

The December quarter was relatively benign for the Kiwi dollar compared to the volatile times of previous quarters in 2007.  The Kiwi was mixed against most of the major currencies with the greatest rise being 4.2% against Sterling, while it was down 1.1% against the Yen.

With the US Federal Reserve seemingly more prepared to ease rates in 2008 than the RBNZ, the Kiwi may stay stronger for longer.  For the Kiwi to fall from here an easing in interest rates is required and that will require clear evidence of a significant New Zealand economic and housing slowdown.  We think this is unfolding and will force the hand of the RBNZ to moderate their currently hawkish views and even contemplate easing rates.  However, the expected election year spend-up may limit how far down interest rates (and therefore the Kiwi) will go.

Table 2: New Zealand Dollar moves against Major Trading Partners

SHAREMARKETS

Most sharemarkets were down for the December quarter with New Zealand being one of the worst performing with a -5.3% return for the period.  For the year ending December most markets were up (in local currency terms) with New Zealand being one of the few to post a negative return for that period.  After allowing for Kiwi dollar strength the overall result for 2007 was a slightly positive return from global markets (+0.4% for an unhedged investor) versus the slightly negative return (-0.3%) from New Zealand.

As shown in Table 3 the stand outs on the plus side were the Asian emerging markets (+39% in local currency terms) and Australia (+16.5% on the same basis).  The worst market was Ireland which was down 27.5% in local currency terms and Japan, which was down 10.1%.

Table 3: Sharemarket returns ending 31 December 2007

*local currency, ** in NZ dollars

Amongst leading companies the top three shares for the quarter were in completely different sectors with PGG Wrightsons up 14.5%, NZOG 11.7% and Michael Hill 10.6%.  The worst performers were also in different sectors, being Goodman Fielder (-27.6%), Air New Zealand (-23.9%) and Rakon (-17.3%).  Michael Hill was the best performer for the year (+22.0%) while Cavalier was the worst, at -11.1%.

FIXED INTEREST

It was a poor year for the New Zealand bond market with cash significantly out performing bonds. The New Zealand Government Stock Index was up 0.5% for the quarter and only 3.9% for the year, compared with the NZX 90 Day Bank Bill up 2.2% and 8.5% for the same periods.  Government Stock should do better in 2008 on the back of an expected slowdown in the New Zealand economy. The rise in yields earlier in 2007 has provided good opportunities for long-term investors to lock in some attractive yields on some very credit worthy companies.

OUTLOOK

The 2008 year could be a tale of two halves.  Economic and corporate news from the United States and New Zealand may be ugly through the first and second quarters but may start to improve as the year goes on.

For the first half of the year, financial news from the US is likely to be dominated by rising unemployment, continued problems in the residential housing sector, poor corporate earnings and massive write-offs from banks and other companies with exposure to the sub-prime mess.  All this is likely to weigh on the consumer in terms of their sentiment and spending levels.

A key issue is how deep the downturn will be in the US and whether it will have a substantial negative effect on the rest of the globe.  The good news is that global growth is much more balanced compared with the last, short-lived, US recession in 2001.  Moreover, now much more growth in the Asian economies is being generated from internal demand rather than the previous heavy reliance on exports to the US.  For example, Japan now exports twice as much to the rest of Asia than it does to the US and as much to China alone as the US.

Despite all this if the US consumer really does put away their credit card, then it is hard to believe that the Asian economies will not be materially impacted.  After all the US is still about a quarter of the world’s total economy and US consumption is about 70% of the US economy.  Thus the US consumer is ultimately responsible for about 1/6th of the world’s economy and a lot of related downstream related activity.  So what the US consumer does still matters!

The impact of a significant US downturn on China was untested in 2007 as the US residential housing downturn has a very small imported Asian component and so did not materially impact on Asian growth last year.  A more widespread US consumer downturn is likely to be much more material for Asia.

Given the factors outlined above the first half of the year in the US is also likely to see a continuation of a very active Federal Reserve.  With still relatively high rates there they have some scope to cut rates.  However, given inflationary pressures from high oil prices, a material US downturn is probably required before any significant further cuts can occur and this appears to be unfolding.

This reinforces the tale of two halves with the likelihood that, ironically, bad news is required from the US economy before the good news of significantly lower interest rates perks investors up.

New Zealand may see a similar pattern with a hawkish RBNZ requiring a run of bad news before contemplating any material easing in rates.  We think they will see this with the trigger to be a significant residential housing down turn.

The New Zealand sharemarket for the first half of the year will be struggling to deal with poor overseas financial news, poor NZ company earnings announcements, lower consumer confidence and spending and, possibly, rising unemployment.  The flip side of this will be a possible lower Kiwi dollar later in the year, which will help exporters and a strong dairy sector.  However, as mentioned above the extent of the interest rate (and Kiwi dollar) falls will be mitigated by the RBNZ’s negative view on any fiscal stimulus from a Labour Government spend-up pre-election.
 
Overall though, a combination of a less hawkish RBNZ and a free spending Labour Government, should make things appear less bleak for New Zealand through the second half of the 2008 year.
So what does this mean for our approach to markets in 2008? Given our outlook it is our current intention to:

1. Be very selective with any purchases of New Zealand listed companies.  A choppy market environment does not necessarily mean all stocks will go down and also means some quality stocks may be over-sold on a 12-18 month view.

2. Maintain, and in some cases increase, exposure to the Australian share market as the outlook for its domestic economy is sound and the Kiwi should weaken against the Aussie dollar as growth rates in the two economies increasingly diverge.

3. Look to gradually increase investment in international markets.  Thus is partly a currency play and partly recognition that the narrow NZ economy has greater inherent risk than the much more diverse global economy.  Our over weighting to the emerging markets will continue as they continue to have better growth prospects than many of the more developed markets.

4. With the roll-over of existing and new issues of quality fixed interest securities we shall aim to take advantage of very attractive yields and extend duration to maximise the gains that will occur when short term interest rates start to fall as the New Zealand economy weakens.