Wednesday 5th January 2005
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Key themes for 2005
For 2005 we see four main themes:
Firstly, global growth is likely to slow but not return to recession. Leading indicators of global growth point to some moderation, driven by the lagged effect of high oil prices in 2004 along with the modest rise in US interest rates. While some see this as the start of the next recession it seems too early for this. Strong corporate balance sheets and cash flows point to strong business investment, there has been no involuntary surge in stockpiles and there hasn’t been enough monetary tightening to bring on recession. More likely, the coming moderation in growth is just a mid-cycle correction, much as occurred in 1985 and 1995 (in the midst of ongoing economic recoveries).
Secondly, commodity prices are likely to remain high, but expect momentum to slow. While the big cyclical rise in industrial commodity prices is likely over for now, the continuation of strong growth in China, reasonable activity levels in the industrialised world and constrained supply should mean commodity prices remain solid. Oil prices are likely to remain off their highs but our analysis suggests they should average around US$35-$40/barrel.
Thirdly, relatively benign interest rates. Further rises in interest rates are likely in the US, but a moderation in economic growth is likely to keep a lid on inflation and ensure rates stay relatively low. Interest rates in Japan will likely go nowhere and may even fall in Europe. Domestically, economic activity in New Zealand will moderate, but should remain reasonable by historical standards. The expected slowdown in housing investment should detract from growth, but this is likely to be offset by ongoing business investment, reasonable consumer spending, and a gradual upswing in exports. Unemployment is therefore likely to remain near its current level (3.8%) over 2005, which may put some upward pressure on wages.
The Reserve Bank of New Zealand (RBNZ) should keep the official cash rate (OCR) steady for most of 2005. The combination of the current 6.5% OCR (an increase of 1.5% over 2004), the high level of the currency, and the expected moderation in economic activity should be enough to keep inflation within the 2 to 3% medium-term range going forward.
Looking at the major asset classes
Against this backdrop, we discuss the outlook for the major asset classes and balanced funds below.
Global shares should provide further gains, helped by reasonable valuations, solid profit growth (albeit slower than in 2004) and plenty of cash on the sidelines searching for returns. However, like 2004 it should prove to be a relatively constrained year. We are now into the third year of recovery in the US share market and history suggests more modest gains at this point in the cycle. The easy gains have already been seen and rising costs will constrain profit growth. The US presidential cycle also augurs poorly for US shares as the first year of the president’s four-year term usually sees below average gains in shares. Against this, US companies are cashed up and much of this is finding its way into dividends, share buy-backs and takeovers – all of which are positive for shares. Finally, in both the 1985 and 1995 mid-cycle growth corrections, US shares did very well. Overall though, while US shares should set a positive direction, better gains are likely outside the US, particularly in Asian share where valuations are relatively good and so is growth. We see global shares returning around 8% with the US underperforming and Asia outperforming.
As in 2004, we don’t see the New Zealand dollar (NZ$) being a major issue for investors in 2005. The NZ$ is likely to continue trading in a range between US$0.65 and US$0.75. It will be buffeted by the NZ$ negatives of Fed tightening and New Zealand’s trade deficit, versus the NZ$ positives of a falling US dollar (US$) and solid commodity prices. While the risks are on the upside versus the US$, the NZ$ is likely to be offset by falls against other currencies.
Further gains in New Zealand shares are likely over the next 12 months on the back of attractive yields, and ongoing profit growth. However, given the strong performance in 2004 and the fuller-valuation starting point (as summarised in the current P/E ratio of 15.5 based on prospectus earnings), gains over 2005 should be more modest.
Bonds offer poor returns. Just as occurred in mid-2003, bond markets have factored in a way too pessimistic outlook on global growth. Global bond yields are well below fair value and are likely to rise as it becomes clear that economic growth is not collapsing. New Zealand bond yields should be pushed higher in that environment. Those rising yields would lead to capital losses on bonds, offsetting the ongoing running yield benefit.
After huge gains in 2004, listed property returns are likely to be far more constrained as bond yields rise. However, their still attractive yields should see returns remain reasonable. Unlisted non-residential property should have another solid year.
Overall, while investment returns are likely to be down on 2004 levels they should still be solid. This should provide a good platform for returns from balanced growth funds (and similar investment strategies).
What could go wrong?
As always, it seems easy to think of what might go wrong. US imbalances – the trade deficit, high household debt and the US budget deficit – top most worry lists. The main fear is that US consumers take fright at their high debt levels and cut their spending and/or foreign investors tire of financing the US budget and trade deficits, sending the US$ into free fall. Both risks must be monitored. But so far, US consumers seem to have no trouble servicing their loans, there are strong signs President Bush will undertake spending cuts, Asian central banks are likely to continue their role of buyers of last resort for the US$ (thereby slowing its fall), and there is no sign that the falling US$ is causing problems in the US, like higher inflation. In the absence of higher inflation and bond yields, a falling US$ is actually good news for US shares.
China might have a hard landing, cutting into global growth and commodity demand – but this seems unlikely given that Chinese growth is heading steadily back to a sustainable level and inflation is benign.
Geopolitical risks may return to centre stage (e.g. Iraq, Saudi Arabia, Iran, North Korea), as may the terrorist threat. But to have a major and lasting impact, a terrorist attack would need to result in significant economic disruption in a major economy.
In New Zealand, the main risk is that the slowdown in economic activity might be sharper than currently expected. This could occur through a confluence of events, i.e the high exchange rate and/or lower commodity prices reduces export incomes, relatively high interest rates dampen business investment, and the slowing housing market might leave consumers more reticent about spending based on prospective capital gains.
Possible non-consensus surprises to watch for in 2005
The following are plausible but unrelated and non-consensus events that are not our central case but are worth watching for:
1. The US$ rises and the NZ$ falls dramatically
2. Global shares surge and the NZSE50 breaks 3,500
3. Osama bin Laden is captured
4. The US budget deficit falls, helped by spending cuts
5. Oil prices rise above US$100/barrel
6. US Fed Chairman Greenspan retires early
7. The New Zealand housing market takes off again
8. The RBNZ raises the cash rate above 6.50%
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