Market Review: A look into our crystal ball

By Anthony Quirk

Friday 10th December 2004

As the year draws to a close it is time to reflect on the performance of the various markets through 2004 and to preview next year. The year to date performance figures for the key investment sectors that we invest in are shown in the table below.

Sector	11 month return to 30.11.04	Index
Global property*	+27.9%	UBS Global Real Estate Total Return
NZ Shares	+22.0%	NZSX50 Gross
Global Shares*	+11.8%	MSCI World (net dividends reinvested)
Hedge funds#	+8.6%	HFR Fund of Funds
Global Bonds*	+8.3%	Citigroup World Government Bond Index
Cash	+5.5%	NZX 90 day bank Bill
NZ Bonds	+5.1%	NZX Government Stock
Global Shares**	+0.8%	MSCI World (net dividends reinvested)

* fully hedged, ** unhedged, #estimate included for November

So while it has felt like a volatile year, in reality the returns have played out in relatively orthodox fashion with bonds making a come back in the second half of the year while hedged global equities returns produced a respectable return. So yet again a balanced approach paid dividends, reinforcing the difficulty of trying to �time� markets and switch optimally between them.

The hedge fund return was respectable while the impact of the strong kiwi dollar is shown in the 11% difference between a fully hedged and unhedged investor for global equities. As stated many times in previous commentaries the twin deficits of the US, and the need to fund these, is a negative influence on the US dollar. This was accentuated in November by the negative comments by Alan Greenspan on the US deficits, the apparent current willingness for a weak dollar policy from the Bush administration and less appetite for US bonds (in favour of European bonds) by the Asian Central Banks.

The surprises for 2004 have been the continued strong runs of the NZ shares and global property sectors with both up over 20%, after rises of 31% and 35% in the 2003 year. For NZ shares the positive influences of a relatively strong and robust economy, inflows from the NZ Super (�Cullen�) fund and global equity investors taking a positive view on our high yield market have all contributed. The worldwide drive for yield has also been a key factor behind the continued rise of global property. This really does seem to be a sector with increased interest as investors warm to its yield and diversification benefits.

But what of the outlook for 2005? It is important to start by emphasising how difficult it is to pick investment market turning points. Rather, this outlook is more about how long-term trends might unfold in 2005, rather than providing a short-term market timing strategy.

From a global stand point three key issues stand out for next year:

1) how the US reins in its twin deficits
2) the China effect
3) oil prices

The US seems determined to take the relatively soft line of letting a US dollar easing do most of its �dirty work� in trying to decrease its current account deficit. However, if the US dollar falls much further an interest rate response (i.e. rises) will be required from Alan Greenspan at the Federal Reserve. This, combined with the likely maintenance of a significant budget deficit does not bode well for a smooth adjustment. While the exact timing is difficult to pick, a lower US dollar and higher US interest rate environment seems likely to occur through next year.

The good news is the positive influence of China on global growth. While there is the chance of a short-term speculative bubble occurring, the long-term potential of China (and therefore the rest of Asia) is undoubted. Thus it is important to keep a long-term perspective if any short-term negative news comes out of China or the markets' exposure to that country.

The oil outlook relates to this as demand from China is set to under pin prices. So oil may be lower on average across 2005 than it has been but is unlikely to return to US$20-25 a barrel.

With these counteracting forces at work the most likely scenario is the US sharemarket has an average year in 2005, with risks more to the downside than the upside. The European economy (and its sharemarkets) seems likely to remain an under performer. This leaves Japan, which could be the best of the major markets given a potential rebound in its economy and corporate sector as well as a positive benefit from the China effect, although a strong Yen will not help.

On the New Zealand front, a slowing economy, a higher kiwi dollar and easing earnings growth should constrain the domestic equity market. However, whilst this has been my view for the past six months the market continues to climb. A return to more normal return levels or even a negative return (before dividends) for the full 2005 year would not surprise, although there is sufficient current momentum to move it higher in the short term.

For bonds a return around coupon would be a good result, with the local bond market more likely to achieve this than the global bond market. The global property sector probably won't return anything like the past two years, with many property companies looking fully valued. This means a return based around the high yield in the sector and the kiwi dollar hedging benefit.

Currency is a fascinating sector with US dollar weakness likely to dominate the first half of the year but with some easing in the kiwi down to more normal levels possible by year's end. Finally with hedge funds a return in the mid to high teens is unlikely but a reasonable return at relatively low risk is feasible. This combined with the low correlation with other asset sectors means we believe this is a sensible portion of a balanced portfolio.

So all in all a muddling year for 2005 in prospect, but as always expect the unexpected! Finally, I'd like to wish all our readers a very happy Christmas. This year has turned out to be an excellent year in terms of returns and may 2005 be a prosperous year for all investors.

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

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