March 2005 Quarterly Review

ECONOMIC BACKDROP

Although New Zealand’s December 2004 quarter seasonally adjusted GDP growth was slightly less than anticipated it was the eighteenth consecutive quarter of positive economic growth.

As the table below shows the last time the country experienced negative economic growth was in the June 2000 quarter when seasonally adjusted GDP declined by 0.4 per cent compared with the March 2000 quarter.

New Zealand: Real Gross Domestic Product Growth

(Seasonally adjusted)

The December 2004 quarter figure had a strong contribution from the export sector but domestic activity slowed, particularly residential property and business investment.

Although the latest quarterly figure is the lowest since the June 2003 quarter the economy is still remarkably buoyant. Consumer spending, non-residential construction and the rural sector remain relatively strong.

Most economists believe the economy will grow between 2.0 per cent and 3.0 per cent in the 2005 calendar year. Milford Asset Management expects 2005 calendar year GDP growth to be in the upper range of these forecasts, between 2.5 per cent and 3.0 per cent.

The Australian economy has also had a strong run with sixteen consecutive positive quarters.

The slower growth rate in the December 2004 quarter was due to bottleneck problems in the production sector, mainly labour shortages, and inadequate port and transport infrastructure for mining exports. Domestic demand remains strong and economists are forecasting that 2005 calendar year GDP growth will be slightly higher than the 3.2 per cent achieved in 2004.  

Australia: Real Gross Domestic Product Growth

(Seasonally adjusted)

The United States economy had a poor start to the 21st century following the Nasdaq sharemarket crash in early 2000. The world’s largest economy experienced three negative quarters immediately following the Nasdaq meltdown and quarterly growth in excess of 1 per cent wasn’t achieved until the June 2003 quarter.

The US economy continues to expand at a healthy rate although inflationary pressure has forced the Federal Reserve to raise interest rates. Economists believe that US GDP growth should be approximately 3.5 per cent in 2005, compared with 4.4 per cent in 2004.

United States: Real Gross Domestic Product Growth

Seasonally adjusted)

SHAREMARKETS

The MSCI World Gross Index (in local currencies) rose 0.6 per cent in the March 2005 quarter. This was largely due to the strong performance of a number of European bourses, including Austria, Belgium, Finland, France, Italy, Netherlands and Norway. All of these achieved gross returns in excess of 5 per cent for the three-month period.

Annualised Gross Sharemarket Returns (local currencies)

(To March 31, 2005)

                                                                                              Source: MSCI

The New Zealand sharemarket peaked on March 9 and fell by 6.2 per cent over the remaining 22 days of the quarter. The sharp and sudden decline was strongly influenced by the sale of shares by offshore investors.

The table below which shows sharemarket returns in US dollar terms, gives a clear indication why overseas investors are selling out of New Zealand.

 In US dollar terms the New Zealand market has been one of the best performing markets over the past five years. It had an annualised return of 17.5 per cent in the five years to March 31,
second only to Austria, which had an annualised return of 25.0 per cent (Australia was in third place with 15.2 per cent per annum).

The Kiwi hit 74 US cents on March 9 and the overseas selling started. Overseas investors took the view that they had done extremely well out of New Zealand and it was time to take a profit.

The sharp drop in the Kiwi over the last two weeks of the quarter indicated that their decision was justified, at least in the short term.

Annualised Gross Sharemarket Returns (US dollars)

(To March 31, 2005)

                                                                                              Source: MSCI

However the overseas sell off does not affect the fundamental value of the larger NZX companies. For example Telecom, which closed at $6.06 on March 31 and represented 26.2 per cent of the benchmark NZSX50 Index, had a prospective June 2005 year price/earnings ratio of 13.3 and a prospective gross dividend yield of 9.7 per cent.

The Australian sharemarket performed much better in the March quarter because it hasn’t been subject to offshore selling. This is primarily because its resource sector is perceived as a proxy for the booming Chinese economy.

Earlier this year we forecast that the NZX and ASX would achieve gross returns between 10 - 15 per cent in 2005. In light of the March quarter performances the ASX has a better chance of achieving this target than the NZX.

CURRENCY

The New Zealand dollar continues to be one of the biggest investment stories and one of the more difficult to predict.         

The following table illustrates the New Zealand dollar peaked between March 17 and March 22 against the currencies of our major trading partners. Since the end of the quarter the Kiwi has stabilised.

NZ$ versus our Major Trading Partners

The trading banks believe that the New Zealand dollar will weaken over the remainder of the year as US interest rates rise and the Greenback firms.

The general consensus is that the New Zealand dollar will be in the 59 to 67 US cents range by year end with a number of economists predicting 63 US cents.

In its March 2005 Monetary Policy Statement the Reserve Bank predicted that the Trade Weighted Index (TWI) will steadily fall over the next few years.

The central bank predicts an average TWI of 68.25 in the second half of 2005, 65.5 in the first half of 2006, 63.0 in the second half, 61.25 in the first half of 2007 and 59.75 in the second half.

FIXED INTEREST

New Zealand has traditionally had higher interest rates than the United States, particularly for short-term borrowings. The gap widened in recent years and is one of the major reasons why the New Zealand dollar has performed so strongly against the US dollar.

However as the table below shows the gap has narrowed in recent months and has contributed to the fall in the Kiwi against the Greenback.

(Although one year Government/Treasury Bonds are not the most widely traded securities in either New Zealand or the United States they do give a good indication of the overall short-term rate structures in both countries.)

One-Year Government Securities – NZ & USA

United States interest rates are expected to rise this year as the Federal Reserve tightens monetary policy in response to rising inflationary pressure. New Zealand rates should remain relatively steady as long as our rate of economic growth slows.

However if the economy doesn’t slow then this, together with the weaker Kiwi, will create inflationary pressure. In this situation the Reserve Bank of New Zealand will have little option but to increase its OCR (Official Cash Rate), which will raise the country’s overall interest rate structure.

OUTLOOK

The outlook for the world economy remains positive with Australia expected to perform relatively better than New Zealand.

The sharp drop in the New Zealand dollar has encouraged overseas investors to crystallise profits on their New Zealand shareholdings. As a result the NZX will struggle to achieve our forecast gross returns of between 10 per cent and 15 per cent in the current year. The outlook for the Australian sharemarket is slightly better.

Inflation concerns have increased because of a combination of a strong domestic economy and the fall in the New Zealand dollar. The Reserve Bank will have to raise interest rates again unless economic activity eases.

The New Zealand dollar continues to be the biggest uncertainty. In the December 2004 quarter review we stated that a range between 60 and 65 US cents would be the best scenario. At this stage that looks like a reasonable assumption for the Kiwi at the end of 2005.
    
Brian Gaynor
6 April 2005