September 2006 Quarterly Review

OVERVIEW

The global economy remains buoyant with most regions meeting or exceeding their expectations for the first half of 2006.

Growth was particularly strong in the United States in the March 2006 quarter although it has slowed since then. Economic expansion gathered momentum in the European Union and has continued in Japan.

Emerging countries are growing rapidly, especially China. According to the International Monetary Fund’s September 2006 forecasts the world’s advanced economies are expected to grow by 3.1% this year and 2.7% in 2007 whilst developing countries are forecast to grow by 7.3% and 7.2%in 2006 and 2007 respectively.

Overall the IMF expects world growth to be 5.1% this year and 4.9% in 2007 (the IMF world growth forecasts are higher then the OECD because the former includes developing countries).

Table 1: GDP Growth

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Economists believe that the balance of risk to global growth is on the downside, mainly because of the US housing slump, the prospects of high oil prices during the Northern Hemisphere winter and inflationary pressure leading to tighter monetary policy and higher interest rates.

NEW ZEALAND ECONOMY

The New Zealand economy continues to slow with Gross Domestic Product (GDP) growing by less than 1 per cent for four consecutive quarters and in eight quarters out of the last nine.

Table 2: Real GDP – quarterly change compared

with previous quarter

The annual growth rate has fallen from 3.1% for the June 2005 year to 1.9% in the twelve months ended June 2006.

The main contributors to GDP growth in the June 2006 quarter were services and Government spending. The residential housing sector, business investment and householder expenditure made negative contributions.

There are two views on the domestic economy. Most private sector economists believe that activity is soft and GDP growth will be in the 1.0-2.0% range over the next 18 months.
The Reserve Bank believes that the economy is still relatively buoyant and interest rates may have to be raised again to dampen domestic demand. Another rate hike should have a negative impact on consumer spending although fierce competition amongst lenders is keeping a lid on mortgage rates.

NEW ZEALAND DOLLAR

The volatile New Zealand dollar has had a major impact on investments both in terms of the performance of NZX listed exporters and importers and the value of offshore assets in local currency terms.

Table 3: New Zealand Dollar against Major Currencies

The Kiwi recovered against most currencies in the September quarter, particularly against the Yen, US dollar and Euro.

The future direction of the NZ dollar is difficult to predict although most of the major forecasting groups expect it to fall over the next 15 months (Table 4).

The major trading banks are the most pessimistic with ANZ National, Bank of New Zealand and Westpac predicting 18% to 20% declines in the Trade-weighted Index (TWI) by the end of 2007. The Reserve Bank is slightly less pessimistic as it expects the TWI to fall by only 12% over the same 15-month period.

Table 4: TWI Forecasts

It is extremely difficult to predict the performance of the NZ dollar but in light of the Reserve Bank’s hawkish stance on monetary policy we believe the Kiwi could stay higher for longer than expected.

FIXED INTEREST

New Zealand continues to have a negatively shaped yield curve with short-term interest rates higher than long-term rates.

As at September 30 the 90-day bank bill rate was 7.56%, overnight cash 7.25%, 5 year Government bond yields 6.19% and 10-year Government bonds 5.80%. Thus income returns from cash exceeded those from long-dated securities by a wide margin.

We continue to look for opportunities to switch from short to long-dated securities. However there is no urgency in this regard as the Reserve Bank believes the economy remains fairly robust and continues to adopt a hawkish approach towards monetary policy.

SHAREMARKETS

The September quarter was a much better period for the NZX, particularly when compared with world markets in NZ and US dollar terms  (Table 5). This was due to Telecom’s recovery and the pick up in the New Zealand dollar.

Table 5: September 2006 Quarter MSCI Gross Returns

The NZX continues to be affected by a number of factors namely a weak domestic economy, increased regulation and merger and acquisition activity.

The rest of the world’s sharemarkets have performed reasonably well since the beginning of the year. As long as the developing countries continue to achieve their growth forecasts, and a soft housing market doesn’t have a negative impact on the United States economy, then the outlook for sharemarkets remains reasonably positive.

OUTLOOK

The outlook for the global economy, particularly the developing countries, remains positive although economic activity has slowed in New Zealand.

The benchmark sharemarket index, the NZX50 Index, rose 6.5% over the first nine months of the year even though the share price of heavily weighted Telecom fell from $6.01 to $4.35. With the prospect of further merger and acquisition activity we continue to believe that the domestic sharemarket can achieve total returns of between 5% and 10% for the full 2006 year.

Returns could be higher if cash rich Australian private equity organisations continue to target listed New Zealand companies. These corporate raids are a serious threat to the long-term viability of the New Zealand sharemarket.

Australian economic activity is mixed with the two resource based states, Western Australia and Queensland, growing strongly but New South Wales and Victoria remain subdued.

The ASX has risen 11.8% for the nine months ended September 30, as measured by the MSCI Gross Index. We anticipate another small positive return in the final quarter of the year.

Investment returns have been relatively modest over the past six months because of the volatility of the domestic sharemarket and the renewed strength of the New Zealand dollar. Although we expect further corporate activity in the months ahead it will be challenging to achieve double-digit returns on an annualised basis.