March 2006 Quarterly Review

GLOBAL ECONOMY

June quarter data confirmed that the global economy continues to be in good shape with the OECD leading indicators of activity showing increasing momentum. US economic indicators such as retail sales, capital goods orders, export levels, manufacturing and non-manufacturing surveys all pointed to a rebound in activity following a muted March quarter. Data across Europe and Asia continued to show a period of above-trend growth was being maintained.

The healthy world economy was reflected in buoyant sharemarkets around the globe with Asian (ex-Japan) and European markets particularly strong. However, a high Kiwi dollar over the quarter meant returns for an unhedged New Zealand investor were not as good, as shown in the table below.

Table 1: Global Equity Returns for the June Quarter

Source: NZ First Capital

NEW ZEALAND ECONOMY

It was a quarter of contrasting fortunes for different parts of the New Zealand economy. The very high Kiwi dollar made life tough for most manufacturing exporters but buoyant dairy prices boosted payouts for that sector. March quarter GDP was released recently and on the surface appeared strong at 1.0% (quarter on previous corresponding quarter). However, this gives a somewhat false sense of the robustness of the economy with higher consumer and government spending being key drivers. Export volumes continued to struggle with the external trade balance being negative for the past 16 straight quarters. This reinforces the unbalanced and unsustainable nature of New Zealand’s current growth profile.

There are signs that activity levels were slowing in the June quarter. Consumer confidence slipped to a nine-month low in June and retail sales for the quarter appear sluggish after a buoyant start to the year. With weakening net migration numbers the slow down the Reserve Bank is looking for may be beginning to unfold.

NEW ZEALAND DOLLAR

As mentioned above the kiwi dollar was very strong through the June quarter. It was boosted by hawkish Reserve Bank rhetoric and actions, with a 3rd interest rate rise for the year boosting the Kiwi to post-float highs against the US dollar and the TWI. Global demand for high yield currencies such as the Kiwi continues unabated, including strong uridashi issuance due to strong Japanese retail demand for our high interest rates.

The Reserve Bank’s action to sell the kiwi dollar seemed strange to us given it had raised rates so soon previously and the lack of success of the move was not a surprise.
For the kiwi to fall from here an easing in interest rates is required but economists keep putting off the day when they think the Reserve Bank will signal this. Except for a one-off shock specific to New Zealand (such as an earthquake or foot and mouth) the kiwi looks set to remain strong until there is clear evidence of a significant New Zealand economic and housing slowdown. This day will come eventually, with our estimate being later this year or early 2008.

Table 2: Rise in the kiwi dollar versus our major trading partners

FIXED INTEREST

With strong global growth and higher short-term rates it was a tough time being a bond investor in the June quarter. Bond yields rose sharply with global bond returns (hedged into NZD) down 0.3% and the NZX Bond Index down 1.1% for the quarter. The rise in yields has provided good opportunities for long-term investors to lock in some attractive yields on some very credit worthy companies.

AUSTRALIASIAN SHAREMARKETS

Markets in this part of the world produced solid, if not spectacular, results for the June quarter. Australia continued its reputation as the lucky county with strong commodity markets boosting activity and helping it to maintain its long record of economic growth. As is the case world-wide, corporate activity (including private equity acquisitions) is helping underpin the Australian sharemarket.

Despite a sluggish domestic economic outlook the New Zealand sharemarket did well, boosted by continuing high levels of corporate activity. This factor was a key reason why Auckland Airport was the top performer for the quarter, up 36%. NZ Refining (+22%) and NZOG (+21%) were the next best followed by NZX (+21%) and Infratil (+18%).

The poorer performing stocks for the quarter tended to be export or interest rate related. Examples of the former were Skellerup (-27%), Pumpkin Patch (-23%) as well as Fisher & Paykel Healthcare (-4%) and Fisher & Paykel Appliances (-2%).
Listed property stocks and utilities such as Vector (-6%) and Contact (-2%) also had a disappointing quarter.

OUTLOOK

The most likely scenario for the global economy is a continuation of its current solid performance. However, there are risks.

Global imbalances remain with the United States’ twin deficits a key feature along with its very weak residential housing market. If the latter worsens it could finally crimp US consumer spending, which remains so important for the rest of the world. The good news is that the growth outlook in Asia and Europe continues to look positive. Even if the US economy sneezes the rest of the world may get away with only a minor cold!

Global sharemarkets reflect this good economic outlook and have been underpinned by strong corporate earnings growth for the past four years. Again there are risks, however.

A period of low interest rates has encouraged increasing leverage amongst some investors and companies married with a binge in private equity activity. Higher interest rates and stagnant or falling sharemarkets could see some of this activity having to unwind, placing some pressure on markets. Combine this with slowing corporate earnings growth in the US and lower sharemarket performances than the past few years would not surprise, with a moderate correction a real possibility.

Turning to this part of the world, the outlook for the Australian economy and sharemarket continues to look better than New Zealand’s. Strong demand from Asia for Australian produced commodities; along with its more moderate central bank are positive factors when compared with this country.

We think there is the potential for the New Zealand economy to surprise on the down side over the coming year as interest rate rises finally start to bite leading to lower consumer spending, rising unemployment and poor export performance. We expect this will contribute to New Zealand’s economic growth being the lowest in the OECD over the next year.

Given the outlook set out above it is our intention to:

1.Continue to monitor very carefully the guidance given at New Zealand company announcements and also bear in mind that when the dollar does fall there will be some re-rating of export orientated stocks.

2.Maintain exposure to the Australian share market.

3.Look to gradually increase investment in international markets

4.With the roll-over of existing and new issue 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.

5.Remain watchful for the impact of Merger and Acquisition activity on stocks.