June 2006 Quarterly Review

OVERVIEW

The global economy remains strong although the latest OECD Composite Leading Indicators shows that the United States economy may be slowing.

Table 1: OECD Composite Leading Indicators

The Composite Leading Indicators, which contains a number of items including unemployment data, interest rates, sharemarket indices, building permits and business and consumer confidence, is a reliable indicator of future short-term activity.

All OECD countries, with the exception of New Zealand, have had positive momentum over the past 12 months with Europe, particularly Germany, looking strong. China and India, the two major non-OECD countries, also continue to have positive leading indicators.

The United States, with two successive negative months, is the only major economy to show a weakening trend. According to the Composite Leading Indicators the New Zealand economy faces the biggest slowdown as it has had twelve consecutive negative months.

NEW ZEALAND ECONOMY

The New Zealand economy experienced a welcomed rebound in the March quarter with GDP rising 0.7% compared with the previous quarter. Nevertheless GDP growth for the March 2006 year was only 2.2% compared with growth of 3.7% and 3.6% in the March 2005 and March 2004 years respectively.

Table 2: Real GDP – quarterly change

A major concern is the country’s huge current account deficit, which blew out to $14.5 billion or 9.3% of GDP for the March 2006 year.

The massive current account deficit clearly demonstrates that New Zealand’s economic recovery will have to be export led. Exports are showing some signs of picking up but annual GDP growth is expected to slow to the 1.0% to 1.5% range before it improves.

NEW ZEALAND DOLLAR

The sharp decline in the New Zealand dollar has been one of the biggest business stories of 2006. On a Trade Weighted Index (TWI) basis the dollar fell 11.1% in the March quarter and 3.6% in the June quarter, giving an overall decline of 14.2% for the first half of the year.

Table 3: New Zealand Dollar against Major Currencies

The dollar has performed particularly poorly against £Stg and the Euro while the decline against the Australian dollar has been more modest.

We expect the NZ dollar weakness to continue over the remainder of the year although most of the decline may have occurred in the March quarter. The extent of the fall against the US dollar will be determined by the US Federal Board’s interest rate policy. There are signs that the Feds tightening maybe coming to an end, which could lead to a weaker US dollar.

FIXED INTEREST

New Zealand has traditionally had higher interest rates than the United States, particularly for short-term borrowings. The gap widened between 2000 and 2004 but has narrowed in recent years. This is one of the major reasons why the New Zealand dollar strengthened in the first half of the decade and has weakened in recent months.

The gap has narrowed from 414 basis points in March 2004 to 178 basis points at the end of June.

Table 4: One-Year Government Securities – NZ & USA

Higher US interest rates over the past twelve months have encouraged overseas investors and speculators to leave New Zealand and have put downward pressure on the Kiwi.

New Zealand continues to have a negatively shaped yield curve with short-term interest rates higher than long-term rates. As a result the return from cash exceeded the returns from long-dated securities during the June quarter.

The Reserve Bank has given a number of indications that the interest rate tightening cycle is coming to an end and rates are close to their peak.

As a result we shall endeavour to raise client’s exposure to long-dated securities, particularly top rated corporate bonds that are backed by strong balance sheets and good cash flow. However there is a scarcity of top rated corporate bonds as companies are redeeming these securities and demand is high as finance company investors are looking for more secure investments.

Over the remainder of 2006 we may look to introduce high quality property securities as a substitute for generic fixed interest securities.

SHAREMARKETS

Global sharemarkets had a disappointing June quarter with the MSCI Developed and Emerging market gross indices both falling 2.9%. The MSCI New Zealand Index experienced one of the biggest declines because Telecom, which performed particularly poorly, has a 30% plus weighting.

Table 5: Gross Sharemarket Returns in Local Currencies

(Periods ended 30 June 2006)

Telecom has had a huge influence on the performance of the NZX in the June quarter as the NZX50 Gross Index, which has a large Telecom weighting, fell 3.1% whereas the NZX MidCap Gross Index, which does not contain Telecom, rose 11.1%.

Telecom’s poor performance was caused by the Government’s dramatic May 3 announcement to deregulate the industry. Since then Wayne Boyd has replaced Dr Roderick Deane as chairman.

We have had a recent meeting with Boyd and believe he has the leadership skills and vision to restructure Telecom and substantially improve its operating performance. Although the company continues to face regulatory issues its long-term prospects are more encouraging under the new chairman and Milford Asset Management will maintain a hold strategy on the stock.

OUTLOOK

The outlook for the global economy remains positive although the New Zealand economy is beginning to lag.

The domestic sharemarket has been stronger than anticipated, particularly when the negative influence of Telecom is excluded. The market’s performance has been strongly influenced by corporate activity.

We expect the NZ economy and NZX to continue to underperform in the months ahead although the NZ dollar should receive some buying support when it reaches 56-58 US cents.

The lower Kiwi is making New Zealand assets extremely cheap for overseas investors and is continuing to create substantial interest for our companies and property. This will help underpin the sharemarket and property values although the continuing sale of assets to offshore interests is negative for the economy in the longer term.

The good news is that the lower Kiwi is beginning to revive the export sector and the prospect of lower interest rates later this year/earlier next year is also encouraging.

Australian economic activity is beginning to pick up and the huge growth in investment funds, which is being driven by compulsory superannuation, will continue to fuel the country’s corporate sector and investment markets.

Investment returns have been more modest over the past thee months although Milford Asset Management performance has been satisfactory in light of the tougher market conditions and Telecom’s share price dive. Although we expect further corporate activity in the months ahead it will be a challenge to achieve double-digit returns on an annualised basis.