By Anthony Quirk
Friday 3rd February 2006
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The consensus scenario
As 2006 kicks into gear I find myself agreeing with the general consensus that this year:
So we have a scenario of a better balanced "goldilocks" global economy, which is neither too strong nor too weak.
Part of this pleasant outlook is Japan (2%-plus growth) and Germany starting to contribute after the US and China have had to make much of the economic running over the past few years.
The Asian outlook is particularly rosy with domestic demand now driving those economies, rather than totally relying on the US consumer.
This shift and a more balanced regional growth profile makes the world economy better able to withstand the impact of an (inevitable) slowdown in US consumer demand over the coming years and also help to address the significant US external account imbalance.
January's numbers supported this thesis with the hedged MSCI up 3.6% while the New Zealand sharemarket was down 0.6%.
Domestic bonds out performed overseas bonds and the kiwi dollar was weaker against most currencies, other than the US dollar and the Yen where it was flat.
While this is heartening it does make me somewhat nervous that the consensus is panning out so smoothly, with low volatility and with such great returns over the past three years. It makes me wonder where the surprise potential for markets lies.
The rest of this month's commentary explores three scenarios that might cause the consensus to founder.
Surprise Number One:
Too much global growth rather than too little
Alan Greenspan has now retired and looks to have handled very well the various crises that have landed on his plate.
He has managed to steer the US (and the global) economy through:
without inducing a major recession.
The lessons of the Great Depression occurring after the 1929 crash have been well learnt it seems.
He has generally erred on the easier rather than tighter side of monetary policy to help the US cope with the various problems it faced in his tenure.
The legacy of Greenspan, however, appears to be the potential problem of too much growth, induced by relatively easy monetary conditions over the past few years.
This has kept the US consumer spending and has resulted in an unbalanced US economy and a potential asset bubble in the US housing market.
Most would prefer to have this situation than a recession and too little growth. However, when such imbalances and bubbles unwind it can get pretty ugly!
Whether it is induced by the market or the new Fed Chairman there is the risk of higher global bond yields as a reaction to higher than expected global growth and the need for a lower US dollar.
As we saw in 1994 such bond rate adjustments can have significant short-term negative market impacts.
Surprise Potential Number Two:
The NZ economy and sharemarket surprises on the downside.
In looking at the New Zealand economy I feel it is easier to see more downside surprise potential than upside.
Very low business confidence, falling consumer confidence, softer commodity prices and a high kiwi dollar all combine to suggest that we could experience a recession this year (that is, two consecutive quarters of negative GDP).
While the domestic sharemarket appears sanguine about this I think it faces the risk of a material sell-off as the number of companies reporting profit downgrades accelerates.
While analysts have already allowed for this to an extent in their forecasts they may have under estimated this – as they tend to do in significant up and downturns.
That is, analysts are generally loath to decrease their earnings forecasts in one hit – it tends to be more death by a thousand cuts.
The New Zealand equity market is especially vulnerable to a significant correction as it remains highly priced relative to historic levels.
This contrasts with most major global markets which appear fairly but not overpriced.
Price/Cash Earnings Region Current 20 Yr Range US 12.3 6.3-19.7 Japan 10.2 7.1-18.4 MSCI Europe 9.4 4.8-16.6
20 Yr Range
Surprise Potential Number Three:
Oil goes through the roof.
Thankfully, the influence to date on global growth from significantly higher oil prices has been muted.
This has come from a mixture of more oil efficient economies than in the 1970s and many companies crimping margins rather than passing on the full cost of higher oil prices.
Also helping is that much of the oil price rise is from the demand side (the China effect) rather than the supply side.
From a global perspective better than expected growth from China and the rest of Asia has helped overcome the negative impact of higher oil prices – although there have been regional differences. It is clear, however, that the global economy is now vulnerable to an oil price shock from various unpredictable outcomes such as the House of Saud falling, Iran and/or Venezuela declaring an oil embargo, civil war in Nigeria and/or Algeria and infrastructure attacks in Iraq.
One or some of these occurring could see oil into the US$100 plus range, with obvious negative short-term consequences.
However, this might have a positive long-term effect of forcing countries to look at alternative sources as well as increasing oil exploration activity.
So, as always, there are many and varied scenarios that could occur and I think all have the possibility of upsetting what appears to be a global economy that is currently in a "sweet spot".
However, in this environment a long-term balanced approach is still the most likely to be the optimal approach to take, rather than a portfolio positioned on an extremely pessimistic or optimistic outlook.
To see how the numbers stacked up for various markets around the world in the past month and over the year, visit our Monthly Market Review here
Anthony Quirk is the managing director of Tyndall Investment Management New Zealand Limited (Tyndall).
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