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Market review: The runaway (sharemarket) freight train

By Anthony Quirk

Friday 5th August 2005

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It was yet another strong month for the star sectors of the past two years New Zealand shares and global listed property. Throw in resurgent global equity markets, with returns boosted for a fully or partially unhedged investor by a falling kiwi dollar, and it was a great month to be a sharemarket investor.

Key factors driving the strong sharemarkets here and overseas were:

  1. a better than expected June quarter reporting earnings season in the US. Coming into this there was some market nervousness with earnings growth expected to be single-digit (about 7%) for the first time in over three years. The majority of S&P 500 companies have now reported their June quarter earnings. The outcome has been better than this expectation with the average earnings increase so far being comfortably double digit (over 11%). Moreover, the outlook statements from many companies have been promising.

  2. good economic data from around the globe. The data out of the US over the July month suggests a continuation of a "goldilocks" economy. That is, not too hot (which could fuel inflation) and not too cold (which would mean a recession). But of equal significance were signs that Japan's economy was starting to recover (Tokyo land prices, bank loans and jobs all rising) and even Germany's as well, with business confidence jumping there.

  3. some corporate activity. As mentioned in my commentary at the start of the year, late cycle bull markets often get a (final) boost from corporate activity as companies try to keep earnings momentum from waning. That is, they use their highly rated share price to purchase companies and thereby have at least a short-term lift in performance. In Australasia we have seen a variation on this with cash box private equity firms sprouting up (some with over NZ$1 billion to invest). They have money burning a hole in their pocket and low rated, high yielding companies in this country, with latent debt capacity, are perfect candidates from their perspective.

To me, the most significant of the above positive factors is the possibility of a coordinated global recovery after previously relying on the US for the past decade and, more recently, China to lift global growth. Remember the angst in the markets three years ago on whether the US consumer could keep the global economy going, post 9/11?

The answer is they seem to have done so for long enough to allow some other countries to step up to the plate. The world's second largest economy, Japan, has taken over 15 years to work through its issues but factors such as better Central Bank and Government co-ordination are helping to start to lift it out of the economic mire.

That is the good news but what could derail the momentum we are seeing in sharemarkets at present? The list is a long one as shown below.

  • global imbalances remain. Focus on the US twin deficits seems to have waned with seemingly some market acceptance of this remaining in place witness the recent strength in the US currency. I'm not sure what event may be the trigger but it is hard to believe there will not eventually be some market adjustment (lower US$/higher US interest rates) to this. The longer this is delayed the more savage the adjustment might be!

  • earnings disappointments. New Zealand is about to enter the half-year earnings reporting round but the likelihood is that results will be mixed, with outlook statements the key focus for analysts. NZ economic data over the July month was not great with a slowdown evident plus a substantial trade deficit (the worst in almost 30 years!). Moreover, some companies are facing a squeeze on margins in the face of declining domestic demand. The corporate sector's saving grace may be a decline in the kiwi dollar as our economic slowdown and ballooning current account deficit bites. However, there is a black cloud to this silver lining which is higher imported input costs. Throw in a continuation of high oil prices and you could have a scenario in this country of company margins being squeezed further.

  • high oil prices. The global economy is managing to cope with current prices but is clearly very vulnerable to the over US$100 per barrel scenario. This would bring a repeat of the oil shock period of the early 1970s a terrible time to be an equity investor.

  • the China currency revaluation. A lot has been written about this already by commentators so I will be brief. There is no doubt this is a very significant event for global trade but anyone expecting much more than the initial 2% move was always going to be disappointed. While it will help US exporters, the domestic US economy is now more vulnerable to higher interest rates arising from the Chinese buying less US Treasuries and from higher imported inflation. So while the Bush administration may be pleased in the short term it could be the catalyst for some issues for the US domestic economy.

  • terrorist attacks. Unfortunately in this day and age this is a wild card factor that could occur at any time. The tragic London bombings did show that in order to have a significant negative global impact terrorists are going to have to "top" 9/11. Now that is a chilling prospect.

  • residential housing price bubbles. The United States is the latest country to question whether they are vulnerable to a housing price collapse. As I have mentioned before, any house price drop has a much greater impact on the economy and individuals than a sharemarket fall.

  • political uncertainty. This is a New Zealand specific issue with our upcoming election. A week is a long time in politics and we have seven of them to go! The actual outcome of Labour versus National is too tough to call currently but whichever party is the largest will almost certainly have to be in coalition with another party (or several). This means the days and weeks after the election are likely to be very unsettled. However, history shows any market weakness around political uncertainty is a good buying opportunity. Nowadays the discipline of the markets means that any rogue policies from coalition partners are likely to be ironed out. No politician wants to be responsible for a significant rise in interest rates (and therefore mortgage rates) because of unorthodox policies.
The above factors are well known and therefore probably already impounded in share prices. However, it does suggest some vulnerability for the world markets to some external shock and for this reason investors need to be realistic that a sharp downwards correction is possible some time over the next 6-12 months. However, looking past this there is reason for optimism if growth across the globe occurs in sync as this would be a very powerful positive force for sharemarkets.

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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