Market Review: January - a continuation of the patterns of 2004

By Anthony Quirk

Friday 4th February 2005

January this year felt a bit like groundhog day as the New Zealand sharemarket, yet again, out performed global equity markets. Having said this, the returns were not stellar from equities with the New Zealand market basically flat for the month (NZSX +0.4%) versus the US market which was down (S&P 500 �2.6%).

It feels like some sharemarkets are running out of steam, with New Zealand being one of these. For the domestic market the cumulative effects of an expected slowing economy, relatively high interest rates (with no sign these will come down soon) and a strong kiwi dollar are starting to make an impact.

The upcoming earnings result round in this country should confirm this with many companies likely to announce very healthy profit results, tempered by cautious comments about the outlook. Companies will be also making these comments with an eye on upcoming wage negotiations, given union comments on the need to provide workers with a greater share of the strong rise in company profits. The current very low unemployment rate strengthens unions' hands for forthcoming wage round negotiations.

A higher than average wage round is potentially inflationary and another reason for caution from the Reserve Bank of New Zealand (RBNZ). Late last year some commentators were picking the RBNZ may look at cutting rates by the second quarter of 2005 but this seems a remote possibility now. Barring a shock for the domestic or global economies, or a strong rise in the kiwi they are likely to hold rates at current levels for some time with one further rate rise even possible.

Combined with a slowing earnings outlook is the reality that the New Zealand sharemarket is now valued at high levels relative to overseas markets, compared to where it usually sits. A wild card factor that could help the New Zealand sharemarket have one more leg upwards is merger and acquisition activity (M&A).

You might expect companies to be interested in other companies when the sharemarket is depressed and valuations are low � that is, companies try to buy others cheaply. However, higher (late cycle) sharemarket valuations do tend to bring out takeover and merger bids for the following reasons:

companies utilise high valuations on their own scrip (shares) as part of a takeover bid;
lenders seem more open to financing bids when the sharemarket and general economic conditions are good;
company balance sheets are usually strongest at the tail end of a strong sharemarket and economy period;
at this stage of the cycle some companies are keen to maintain earnings momentum by acquisition as organic growth starts to wane.

We are starting to see M&A activity emerge in the US. The same factors apply as above, particularly the slow down in corporate profitability, after the strong rebound from the 9/11 induced recession.

On the surface the latest US earnings reporting round seemed to go well with over 80% of US corporates in the S&P 500 that have so far reported their December quarter '04 meeting or exceeding expectations. However, most US companies are well versed at massaging analysts' profit expectations down to a level to minimize the risk of a negative earnings surprise announcement.

Looking behind these numbers it is significant that the size of the average US listed company December quarter earnings increase of 8% is lower than last year's double digit rises. Moreover there was a 44% decrease in companies that upgraded their earnings outlook through the December quarter.

Therefore many US companies will look outside to merge or acquire companies to try to maintain the double digit earnings growth the market has enjoyed over the past few years. This was already evident with the value of M&A activity in 2004 almost double that of the 2002 year. The 2005 year has already yielded some mega-deals and it all points to even more M&A activity this year. With rising interest rates and slowing earnings growth rates for the US, M&A activity may be one of the few remaining catalysts to lift its sharemarket higher.

Looking elsewhere around the globe European markets surprised on the upside with some trading to two-and-a-half year highs at month-end. This is occurring despite the stronger Euro hurting exports and relatively weak growth in the moribund German economy. The German, French and United Kingdom's sharemarkets have all risen more than the US over the past year, a sign that company valuations were too low in Europe and too high in the US.

Helping global economic activity are signs that the Chinese economy is having a "soft" landing � if 9.5% annual growth can be considered to be any landing at all! This is certainly helping exporters of "hard" commodities, such as Australia, where the sharemarket reached new all-time highs through the month.

As is the case with equities the pattern of 2004 continued in the first month of 2005 with global bonds performing well above New Zealand bonds. Global bonds were up 1.1% for the month (Lehmans Global Aggregate Index) against a return of 0.2% for New Zealand. The return pickup from hedging global bonds continues to under pin the returns from global bonds given the likelihood of positive significant capital gains from bonds for the next year, here or overseas, is relatively low.

With all the talk of a weaker US dollar (with even Microsoft founder, Bill Gates, positioning for a further sell off!) the kiwi dollar was down slightly against the greenback, as well as the Australian dollar and the Yen. However, the kiwi was slightly stronger against the Euro. Overall the movements were not significant and a continuation of the strong kiwi dollar will start to bite this year, particularly if agricultural commodity prices start to fall from their currently high levels.

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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