June 2008 Quarterly Review

GLOBAL ECONOMY

Economic conditions in the United States continue to remain weak centred around the housing market, with unemployment rising sharply over the quarter to 5.5%.

European growth appears more robust than in the US but is also softening with continuing falls in consumer and business confidence.  However, inflation pressures limit the ability of the European Central Bank (ECB) to ease interest rates.  A very strong Euro provides further headwinds to growth.

Asian lead indicators have also worsened albeit that growth in that region remains high.  Continued strength in commodity prices suggests ongoing strong demand from Asia, in the short-term at least.  However, high inflation is starting to impact negatively on the region.

Australia’s economic situation is mixed with a strong mining sector offset by falling consumer and business confidence.  The Reserve Bank of Australia remains wary of inflation pressures and is ready to increase interest rates if domestic demand does not slow.

NEW ZEALAND ECONOMY

Economic forecasts were reduced further over the quarter with the RBNZ projecting year-on-year growth to slow below 1% for the 2009 March year.  The housing sales slow-down is starting to impact on house prices with consumer confidence rattled by this, as well as rising fuel and food costs and higher interest rates.

Despite the signs of a slowing economy, inflation pressures remain high.  As a result the RBNZ has kept monetary conditions very tight with high interest rates.  However, the RBNZ stance is becoming less hawkish as it finally recognises the significant economic downturn that is unfolding, particularly in the major urban centres.

The good news is that compared to other countries the RBNZ has significant scope to cut interest rates if required.  This should lead to a falling Kiwi dollar through the rest of the 2008 calendar year, which should help contribute (eventually) to an export-led recovery.   This appears to be the most likely way that New Zealand will emerge from its current economic malaise with the domestic economy not likely to be a source of strong growth for some time.

NEW ZEALAND DOLLAR

The June quarter saw continuing weakness for the Kiwi dollar.  As shown in the table below the Kiwi dollar was down against all the major currencies, other than against the Yen.

The belated recognition by the RBNZ of weakness in the New Zealand economy and an effective change in policy to focus upon medium-term inflation pressures was significant.  The RBNZ stance now contrasts with a tightening bias amongst many foreign central banks (such as the US, Europe, China, India and Australia) as they deal with rising inflation pressures.

The Kiwi dollar therefore looks vulnerable to a substantial fall with its relative yield appeal declining, large economic imbalances in this country and significant EuroKiwi and Uridashi maturities over the rest of 2008 that may not be re-invested.

         
Table 1: New Zealand Dollar moves against Major Trading Partners

SHAREMARKETS

All major sharemarkets were down for the June quarter with New Zealand being a bottom quartile performer with a negative 7.9% return for the period.  The MSCI Index was up 1.8% in NZ dollars (100% unhedged).

The big out performers in the quarter were emerging areas such as Eastern Europe (up 11.6% in NZ$) and Latin America (up 14.6%).  In contrast the Emerging Markets Asia Index was down 6.1% with China and India performing very poorly.  The United States market, which started the global sell-off, was a reasonable performer being up 1.2% for the quarter (in NZ$), although it did suffer a significant fall in the June month. 

Table 2: Sharemarket returns for quarter ending June 30 2008

There was a huge variation in returns for stocks in the NZX50 Index. The top performers for the quarter were currency/commodity related: NZOG (+37.4%), Sanford (+26.1%) and NZ Farming Systems Uruguay (+24.3%).  The three worst performers for the quarter were domestically oriented companies: Hallenstein Glasson (-28.7%), The Warehosue Group (-26.1%) and Fletcher Building (-24.3%).
 

FIXED INTEREST

New Zealand government stock had another reasonable quarter, being up 1.9%.  Government 5 and 10 year rates were down slightly over the quarter, in marked contrast to overseas bond markets where government bond yields generally rose.  This is due to a significant divergence in central bank policy in New Zealand compared to most central banks around the world.  The Reserve Bank of New Zealand is now likely to lower rates from here whereas most overseas central banks are contemplating rate increases due to concerns over inflationary pressures.
 
New Zealand corporate bond rates fell, resulting in the Investment Grade Corporate Bond Index being up 2.5% for the quarter, out-performing the Government Bond Index.

OUTLOOK

We continue to have a cautious view on the global economic and market outlook as:

- the global housing crisis has still not bottomed
- the banking sector is still going through a significant deleveraging process
- the upcoming corporate earnings result season is likely to be poor
- interest rate yields have more upside than downside potential (other than in New Zealand) due to rising inflation pressures.

For the US economy and sharemarket, to make a substantial and sustainable recovery the US residential housing market must start to improve markedly. The good news is an adjustment process is under way with new home sales and building levels down dramatically.   This will eventually lead to lower US housing inventory levels.  The bad news is that this process will take some time to conclude. In the meantime there are increasing numbers of foreclosures adding to housing inventory levels.

The deleveraging of the US financial system is another key factor behind our caution about the US outlook.  Deleveraging also applies to households, who are being squeezed by rising costs, falling house values and the increasing possibility of losing their jobs.  Companies are also being affected by having to borrow at higher rates.  Finally, banks themselves are capital constrained with multiple bad debt exposures and face increased regulation.  There appears to be little scope for this deleveraging process to be completed quickly.
 
The market’s expectations for corporate earnings growth has progressively decreased over the past six months.  For the US June quarter earnings are now expected to be down 7% with a large variation in company results and outlook statements.
 
Ironically at a time of a global economic slowdown inflationary pressures are rising.  Much of this is stemming from the emerging economies with inflation in those areas effectively being exported to the developed world.  In emerging countries an economic slow-down may need to be carefully engineered to ensure that inflation does not run out of control.  There is some risk, in a vulnerable economic environment, that this adjustment may not be smooth.

New Zealand is a variation on the above themes with the economy currently in recession and a savage residential property sector adjustment unfolding.  Not only is there a volume and price down turn but property developers (and their financiers) are also “hitting the wall”.  Other areas of concern are the retail sector, where companies are really struggling, and the prospect of rising unemployment levels across most sectors.  Throw in banks dealing with increasing credit delinquencies and rising funding costs and you have a recipe for a very tough domestic economy for the next 6-12 months.

The good news is that the current (and future) New Zealand Government has a tax cut programme and the RBNZ has significant scope to cut rates.  Both tools will be used to boost a flagging economy but will take time to take effect.  All this should lead to a lower Kiwi dollar benefiting New Zealand based exporters.  Thus, an export led recovery appears the most likely scenario for New Zealand to lift itself out of its current economic downturn.   Allied to this is some selective value is starting to emerge in the New Zealand sharemarket, after it has been one of the poorest performers over the past six months.

So what does this mean for our approach to markets from here?

Given our outlook it is our current intention to:

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

2. Maintain the overall exposure to New Zealand equities at current levels.  Within this sector the existing bias to defensive domestically oriented companies and to exporters will continue.  We are also looking closely at over-sold opportunities in the sector.

3. Maintain current exposure to Australian with a slight increase in exposure to materials and commodities via very selective additions to these sectors.

4. Maintain the international equity weighting. 

5. Aim to take advantage of attractive corporate 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.