December 2008 Quarterly Review

GLOBAL ECONOMY

Economic growth and expectations for future growth fell sharply during the quarter.  Consensus estimates now expect global growth to be just 1.5% in 2009 down from 4.9% in 2007.  The slowdown in growth has impacted all countries and reflects the integration of the world’s economies.  Slowing growth has led to a sharp fall in commodity prices and inflation expectations.  The oil price fell from over $US100 per barrel to $US40 during the quarter.  Australia which to date had been growing relatively strongly is also expected to slow going forward.

In response to slowing growth and falling inflation pressures central banks around the world reduced interest rates.  The US Federal Reserve, the Bank of England, the European Central Bank and the Reserve Bank of Australia all cut rates sharply.  The US Federal Reserve has stated that it will use less conventional measures of policy to support growth and reduce borrowing rates for consumers and businesses.

In addition, many Governments around the world announced economic stimulus packages to help stabilise economic growth and prevent large rises in unemployment.  Unemployment in the US has started to rise with unemployment now estimated to be 7.2%.

Table: Global Growth Forecasts

Source: Consensus Economics December 2008

NEW ZEALAND ECONOMY

Economic growth in New Zealand was -0.4% for the September quarter, the third consecutive quarterly fall.  In response to falling growth and inflation the Reserve Bank of New Zealand cut interest rates by 2.5% to 5.0% during the quarter.  Slowing global growth has also impacted demand and prices for our key exports with the price of some dairy products down by over 30% in $US terms.  To date unemployment has remained relatively steady.

SHAREMARKETS

Sharemarkets fell again during the quarter with the MSCI World Index down 20.0% in $US terms.  A fall in the $NZ helped cushion the fall with the index down 10.0% in NZ dollar terms (100% unhedged).  The NZX50 Index fell by 12.1% with commodity and building related companies hardest hit.

FIXED INTEREST

New Zealand bonds were the best performing sector for balanced fund investors over the quarter rising 5.8%.  Government and most corporate bond yield rates fell significantly over the period, generating reasonable capital gains.  The reduction in NZ interest rates was supported by the substantial easing in the OCR by the Reserve Bank of New Zealand. 

PROPERTY

The NZX50 property index fell by 9.6%.  The fundamentals for New Zealand commercial, retail and industrial property have deteriorated with demand muted and supply increasing. 

ECONOMIC OUTLOOK

The outlook for the global economy remains difficult for at least the first half of 2009 and potentially longer.  We believe that faced with falling revenues and profits many companies will look to reduce costs and employees.  This will lead to further increases in unemployment and falls in consumer confidence and spending. 

However, the news is not all bad.  Economies will receive a significant boost from increased government expenditure and sharply lower interest rates.  However, the effectiveness of policy in terms of magnitude and timing remains highly uncertain.  Given the extent of the wealth destruction and the financial leverage in the system, we believe, that it will take some time for consumers and businesses to start increasing spending. 

The outlook for New Zealand and Australia also remains poor.  However, both countries started the economic downturn with significantly more room to move in terms of reducing interest rates and increasing government spending.  Accordingly, these economies should respond relatively quickly and the depth of the recession be lower.  A key risk for New Zealand remains our continued current account deficit and the potential for further falls in house prices.

MARKET OUTLOOK

Against this economic backdrop valuations of equities have fallen sharply and now reflect a very poor outlook for future earnings.  However, we believe that it will be difficult for equity markets to make significant gains until the economic outlook stabilises and confidence returns.  Given the contradicting forces of attractive valuation and poor news flow we believe that equities will remain volatile.  We believe that in this environment some companies will generate strong returns whilst others will struggle.  This underscores the importance of stock selection.

Fixed income rates have fallen sharply following falls in official interest rates.   Despite falls in yields we believe that bonds remain attractive given the prospect for a prolonged period of low rates.  However, we believe that continued strong capital gains from recent months are less likely.  The main risk with fixed income is that the increase in number of companies raising money pushes interest rates higher.

Following falls the risk for the New Zealand dollar are now more balanced.  On a global basis growth in New Zealand and our interest rates look relatively attractive.  However, we believe that the risks for the New Zealand dollar are to the downside given the need to continue to raise a large amount of capital from offshore. 

INVESTMENT STRATEGY

1. Remain cautious in terms of our overall asset allocation.  This means we retain our increased allocation to income assets for most clients with an under weighting in growth assets.  This includes an allocation to offshore cash, offering some exposure to further falls in the Kiwi dollar.

2. Maintain the overall exposure to New Zealand equities at current relatively low levels.  The existing bias to defensive domestically oriented companies and to exporters will continue.  We are also looking closely at companies which have been oversold.

3. Maintain current exposure to Australia and international equity weightings but review some existing sector exposures. 

4. Continue to take advantage of the attractive yields on high quality corporate bonds to maximise gains that should occur as short term interest rates fall due to a weak New Zealand and global economy.  Selectively introduce a Global Fixed Income option to portfolios.

5. Avoid listed property companies with high debt levels, retail exposure or development risk.