Markets ugly, but there are some good signs

Fear and greed can drive extremes in financial market behaviour and June was a very good example of the former.

The reasons for the demise of world sharemarkets are now well known and documented but a key feature that was re-introduced into the equation in June was simply the "fear" factor. This had not been seen since the period immediately following September 11.

This time it was not terrorist attacks that provoked panic selling, although rumours of a future strike resurfaced during the month. Rather it was the unravelling of the reputation of corporate America with the WorldCom accounting scandal seeming to be the "straw that broke the camel’s back".

There is now a perception that overly generous company management options, which are supposed to align shareholder and management interests, actually incentivised some managers to try to push up short term share prices through misreporting accounting earnings.

Any way you look at it the performance from world share markets was ugly. The US sharemarket (S&P 500) was down more than 7% for the month and is down 14% for the past six months, which is the largest first-half drop since 1970.

The UK sharemarket (FTSE100) was down more than 8% for the month and is down 11% for the past six months, which is the largest first-half drop since 1994.

Continental European markets fared even worse with the German and French markets both down 9% for the month and 19% and 17%, respectively, for the quarter. Even Japan, which had for much of 2002 been immune from world sharemarket declines, was down 10% for the month.

Note that all of these figures are before any currency impacts from an appreciating Kiwi dollar.

For the US market in particular this is significant with the Kiwi up 22% versus the US dollar over the past 12 months. This is a double whammy for any investors who are unhedged on their US sharemarket exposures.

After adjusting for currency effects, our estimate is that global sharemarkets are down more than 30% over the past 12 months for a New Zealand based unhedged investor.

The New Zealand sharemarket stands head and shoulders above this carnage with a negative return of (only) 3% for the month and positive returns of 1% for the quarter and 5% for the past year.

While the (current) positive economic cycle in this country is a key driver of this, the reality is that we did not have the excesses of overseas markets in the late 1990s, when "greed" rather than "fear" reigned.

While it is a distant memory for some the fall out from the 1987 crash in New Zealand, which flushed out many of our market excesses, has meant a healthy investor scepticism in this country. This, combined with a simple lack of investment opportunities in our market, prevented any wide ranging market rise in the 1990s on the back of over-hyped earnings and company growth expectations.

In contrast the US and now other world markets are seeing a weeding out of this corporate hype and they may look at dramatic sharemarket falls of 2002 in much the same way that New Zealanders viewed 1987 as a catalytic event. There were some lessons learnt then that probably apply now.

These include being beware of "second round" effects from such fall out.

For example, suppliers and bankers will suffer from the crash of former highflying companies. Some suppliers themselves may go to the wall while this may constrain banks' willingness/ability to lend – and we have all seen the impact of this latter issue in Japan.

A further lesson was that it took some time for all the second round effects to appear – in some cases it was a matter of years rather than months.

A related issue is the potential loss in consumer confidence from negative wealth effects of the market fall and a general sense of unease with company management ethics. This is potentially the most damaging effect, with consumer confidence in the US being vital for any sustained world economic recovery.

However, there are some positives to come out of this. There is now the potential for the conflict of interest in accounting firms (between auditing and consulting arms) and within stockbroking firms (between research and investment banking) to be rectified.

The need for improved ethical behaviour from some companies will also come into prominence. A key issue is how much more regulation will be imposed in an effort to boost sagging confidence in financial markets and company reporting.

Moving to bonds, as the saying goes: "bond managers enjoy doom and gloom" and this was very much the case in June.

Both the New Zealand and global bond markets had good returns for the month, up 0.9% and 1.3% respectively. With the sharemarket woes the likelihood is that the potential for significant interest rate rises in the remainder of 2002 has decreased.

This sows the seeds for a liquidity-led recovery later in the year in overseas markets. Ironically the current extreme gloom in world markets could also fuel a market lift as a turning point can occur when market participants are most negative. We will look at the potential for this in more detail in next month’s commentary.