March 2008 Quarterly Review

GLOBAL ECONOMY

Economic conditions in the US steadily deteriorated over the March quarter.  Consumer and business survey data significantly worsened over the period with unemployment also starting to rise.

European growth appears relatively stronger than in the US but is also easing with 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.

As has been the case over the past few years the engine room of global economic growth sits with China.  It is still growing at double-digit pace but inflation levels are now high.  China still holds the key on whether a US recession will also cause a global recession. 

Australia’s recent growth profile has been aided by high Government spending and price growth in some key commodities. However, consumer confidence is being affected by rising costs and concerns about the residential housing market.

Table 1: Global Growth Forecasts

Source: IMF Real GDP forecasts, released April 2008

NEW ZEALAND ECONOMY

Growth forecasts for the New Zealand economy were reduced by most commentators through the March quarter.  In particular the Reserve Bank of New Zealand (RBNZ) finally recognised its 3% growth expectation for the 2008/09 year would not be met and so reduced its forecast to 2%.  This appears to still be too high with the BNZ now forecasting a recession.

The housing market is showing clear signs of a slowdown with a significant drop in turnover figures, with prices expected to follow.  Consumer confidence is low, impacted by rising costs and falling sharemarkets. 

Despite the signs of a slowing economy, inflation pressures remain high with significant capacity pressures, particularly in the labour market given very low unemployment rates.  As a result the RBNZ has kept monetary conditions very tight with high interest rates currently underpinning a strong Kiwi dollar.

NEW ZEALAND DOLLAR

The March quarter saw some weakness starting to emerge for the Kiwi dollar.  While it was relatively benign against the US dollar (up 2.2%) and the Aussie dollar (down 1.2%) the Kiwi dollar was down significantly against the Yen (-9.0%) and the Euro (-5.7%). 

With the US Federal Reserve having a policy of substantially easing rates the Kiwi may stay strong against the US dollar, given the latter is so weak currently.  For the Kiwi to fall materially from current levels against the US and Australian dollars an easing in New Zealand interest rates is probably required.  This will require clear evidence of a significant domestic economic and housing slowdown.  This scenario is starting to unfold and we think will force the hand of the RBNZ to ease rates later in 2008.  However, the expected election year spend-up may limit how far down interest rates (and therefore the Kiwi) will go.
         
Table 2: New Zealand Dollar moves against Major Trading Partners

All major sharemarkets were down for the March quarter with New Zealand being a mid-table performer with a negative 14.1% return for the period.  The FT World All Share Index was down 10.9% in NZ dollars, if 100% unhedged. 

The big under performers this quarter were emerging countries as investors fled smaller markets.  The Emerging Markets Asia Index was down 14.2% with China and India being two of the worst performers.  Ironically the United States market, which started the global sell-off, was a reasonable performer being down “only” 9.3% for the quarter (in local currency terms). 

There were few places to hide in the New Zealand sharemarket with only three stocks in the NZX50 having a positive return for the quarter. These were NZOG (+17.4%), the Warehouse Group (+2.8%), Sanford (+2.5%).  The three worst performers were Hellaby Holdings (-31.7%), Fisher & Paykel Appliances (-31.5%) and Methven (-30.7%).

Table 3: Sharemarket returns for quarter ending March 31 2008

New Zealand Government Stock had its best quarter for some time being up 2.9%.  Most of this gain came from shorter-dated bonds with 10 year bond yields actually up slightly.  The rally in shorter dated bonds was a result of lower global rates and the market pricing in a greater likelihood of easing monetary policy by the RBNZ.  The difference between NZ and US 10 year Government Bonds rose to be over 300bps, the highest in about 17 years.

While five year Government Bond rates were down 60bps over the March quarter, corporate bond rates with the same maturity were actually up over the same period.  The extent of the rise varied depending on the perceived risk of the specific corporate bond.

Global bond returns reflected a similar pattern with strong returns from Government bonds but rising corporate credit spreads hurting returns from corporate bonds.

OUTLOOK

At the start of this year we said that the 2008 year could be a tale of two halves with economic and corporate news from the United States and New Zealand likely to be ugly through the first and second quarters but possibly starting to improve as the year goes on. 

Unfortunately this is probably now the best case scenario with significant potential head winds in place for the local and global economies that may stretch into 2009. 

There has been a significant “relief rally” recently in many developed sharemarkets.  This reflects the reality that the US Federal Reserve (Fed) has brought back the market from the edge of an abyss with its active moves around the Bear Sterns debacle.  However, the Fed’s actions do not overcome the fundamental issues that lie at the centre of the current global economic malaise, namely residential housing and financial sector deleveraging.

For the US economy, and therefore US sharemarket, to make a substantial and sustainable recovery the US residential housing market must start to improve markedly. This does not appear to be imminent. 

In the US new and existing home inventories are about 10 months with this likely to rise as increasing numbers of foreclosures put more homes on the market.  As an example 5% of home sales in January 2007 in San Diego were foreclosures.  This has risen to 34% of all home sales in January 2008!

The impact of this will be that new home building levels need to fall further to enable the inventory overhang to work its way through the system.  Given the potential negative impact on the US economy of this a move by the Federal Government to help distressed mortgage holders would not surprise.  However, how effective such a measure will be is still open to debate.

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 facing increased regulation.  There appears to be little scope for this deleveraging process to be completed quickly.
 
The story in New Zealand is little better as we seem to be on the brink of a significant housing down turn which appears to be unfolding at an even more rapid pace than we had anticipated. The number of house sales appears to have plunged in March and the inventory overhang has ballooned from 4 months in early 2007 to 12 months supply currently. 

The bad news is that New Zealanders are more dependent on housing for their net wealth than many other countries and have used equity in their homes to fuel over consumption.

The good news is that in contrast to the US the New Zealand Government has a surplus that can fund tax cuts and the RBNZ has significant scope to cut rates.  We see both tools being used later in 2008 to boost a flagging economy but in both cases the measures will take time to take effect.  All this should lead to a lower Kiwi dollar benefiting New Zealand based exporters who have been struggling with a high currency.  Thus, an export led recovery appears the most likely scenario for New Zealand to lift itself out of its current economic downturn. 

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 an increase to income assets for most clients.  This is to occur through a rise in exposure to the NZ Fixed Interest sector and to offshore cash; the latter 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 there is an increasing bias to defensive domestically oriented companies and to exporters.  We are also looking closely at over-sold opportunities in the sector.

3. Slightly decrease overall exposure to Australian companies by decreasing weighting to the financial sector.  Some defensively positioned sectors and companies are to be introduced.  The significant underweight in materials/commodities is to be decreased by very selective additions of companies in this sector.

4. The international equity weighting is to be slightly decreased. This is to be mainly through the sale of the JP Morgan India fund, on the basis that the Indian sharemarket has potential downside risks given the huge appreciation it has enjoyed over the past few years and the over speculation that has ensured.

5. With the roll-over of existing and new issues 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 as the New Zealand economy weakens.