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Market review: A mid-year report card

By Anthony Quirk

Friday 8th July 2005

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Tyndall Investment Management New Zealand Ltd managing director Anthony Quirk provides a mid year report on the state of the markets

As we are now half way through the year it is an opportune time to reflect on:-

    1. the results of the various sectors for the six months to June 30;
    2. how this compares with the outlook we had at the start of the year; and,
    3. how the sectors might perform for the rest of 2005.

1) The results

We are now already half way through 2005 and it is time to reflect on how the year has gone so far and what it may hold for its remainder. The year to date index performance figures for the investment sectors that we invest in are shown below. Note that, apart from Global Shares, Tyndall has added value over the index for each sector for the period through our active management.

Sector

6 month index return to 30/6/05

Index Used

Global Property*

+9.6%

UBS Global Real Estate Total Return

NZ Shares

+5.9%

NZSX50 Gross

Global Bonds*

+5.7%

Lehman Global Aggregate Index

Global Shares*

+5.5%

MSCI World (net dividends reinvested)

NZ Bonds

+3.9%

NZX Government Stock

Global Shares**

+3.6%

MSCI World (net dividends reinvested)

Cash

+3.4%

NZX 90 day Bank Bill

Hedge funds*#

+1.9%

Tremont Fund of Funds

*fully hedged, **unhedged, #figures used for the 6 months ending May

2) How this compares with our outlook at the start of the year

So while it has felt like a volatile period, in reality the returns have played out in relatively orthodox fashion with most sectors out performing (high) cash rates over the past six months. Yet again a balanced approach paid dividends, reinforcing the difficulty of trying to “time” markets and switch optimally between them.

The stand out sector was Global Property with its hedged return for the past twelve months being a stunning 38%! A relentless thirst for yield has helped drive higher the prices of property companies around the world. This is particularly true in the low interest rate environment of Europe which has been the best region for this sector over the past year. There is clearly rising interest in Global Property as investors warm to its yield and diversification benefits.

Last year's other star, the New Zealand Sharemarket, sold off mid way through the quarter but finished with a bang in June, being up 7% for that month alone. It is up 20% for the past year and 21% per annum for the past two. Its good return for the year to date comes despite increasing concerns about a slowing domestic economy.

Once again Global Shares surprised on the upside with the major European markets performing well with fully hedged global shares producing a 20% per annum return over the past two years. The impact of the strong Kiwi dollar is shown in the 13% per annum difference between the fully hedged and unhedged global equities' return over that period. However, the Kiwi did start to ease in June against the US and Australian dollars.

Bonds were, somewhat surprisingly, a good performer with long-term yields falling around the world. The decline in New Zealand yields was understandable as our economy slows and as they reacted to global falls. The dramatic drop in US yields over the period was surprising. The core of this move seems to be acceptance of the permanence of low inflationary pressures, continued buying of US securities by Asian central banks and lower European rates.

The most disappointing sector recently has been hedge funds, where the Tremont fund of funds index eked out a 2% gain (for the 6 months ending May), including the hedging benefit. There seems little doubt that the flood of funds into this sector is making it harder for some hedge funds to make the gains of yester-year. This is particularly true of so called non-directional (or arbitrage) based funds where their gains are becoming marginalised. A well constructed fund of funds hedge fund remains an excellent diversifier for a balanced fund, although the days of high double digit returns from this sector may have passed.

3) How the sectors might perform for the rest of 2005

Looking forward a key issue for New Zealand based investors is deciding on the attractiveness of investing in short term cash versus taking a more balanced portfolio approach. Many domestic investors are parking some or all of their funds in cash at present given the very high rates obtained relative to the risk of investing in the more volatile bond and equity sectors.

There is no problem with this approach as long as investors are quite prepared to wear an "opportunity cost" if the riskier sectors continue to do well (as has been the case for the past few years). Moreover, high cash rates will not stay in place forever with New Zealand now probably at the peak of its interest rate cycle. Over the next six months the attention of the Reserve Bank in this country is likely to switch to looking at whether they should decrease rates – although this is not likely to start until mid-2006.

Therefore cash investors will eventually receive lower rates and a "wall" of funds may start looking for a (high yield) home over the next year. Thus, areas such as high yielding shares or enhanced income products may start to become increasingly popular at the next stage of our economic cycle. The issue, as always, is to be mindful of the risks involved with the various approaches, relative to the potential rewards.

A related issue is trying to "time" a move out of cash into other sectors as cash rates (inevitably) start to fall. We urge caution on this approach as it is extremely difficult to judge this perfectly and an investor may find the opportunity cost of moving too late from their cash position may out weigh the benefit of sitting in cash in the first place.

The slow down in the New Zealand economy and the subsequent easing in interest rates, as well as our significant balance of payments deficit, increase the likelihood of an easing Kiwi dollar over the next year. Again, timing the turning point is difficult but the risk for the Kiwi does now seem to be biased to the down side.

A brief look at other markets suggests that the US and New Zealand sharemarkets are at or slightly above "fair value", while Japan and Europe are still near 20 year lows in terms of their average price to cashflow and price to book valuations. This suggests some potential upside, particularly for Japan, if either of those regions start to (finally) see some growth.

On the bonds side it is hard to see significant downside for bonds yields, here or overseas, unless a deflationary environment eventuates. Of course oil prices remain a wild card with widely divergent scenarios being currently promulgated. The safest bet at present is probably to assume they continue at current levels, which is manageable (just!) for the global economy.

So the rest of 2005 could be an interesting period after a good start to the year for most sectors.

Anthony Quirk is the managing director of Tyndall Investment Management New Zealand Limited (Tyndall).

Bond Offer: Infratil Ltd, 7.2 year & 10.2 year unsecured unsubordinated bond


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