Market Review: And so the waiting continues…

The spectre of war continued to hang over markets, dominating sentiment in yet another poor month for global equities. All major equity markets were down for the month with the UK market (FTSE 100) being the worst, with a fall of 9.5%. Other continental European countries also fell significantly, including Germany (DAX down 5.0%) and France (CAC 40 down 4.1%). This continues their recent poor performances with the German sharemarket now down 46.2% for the past twelve months. Note that this is before any allowance for the rise in the kiwi dollar over that period!

Relatively speaking the US out performed, with the S&P 500 down “only” 2.7% for the month. This came after a very strong start to the calendar year on expectations of a better corporate reporting round in that country. While the December quarter results themselves were good (up almost 10% on average) the muted outlook expectations from most corporate CEOs weighed heavily on markets. Combine this with increasingly aggressive rhetoric from the Bush administration towards Iraq and it wasn’t hard to see why US equity markets started to tail off after such a positive start.

The monthly result from the Japanese market (using the Nikkei 225) was –2.8%. This market is trading at close to 20-year lows with no sign that the Japanese economy could pick up soon from its third recession in a decade.

Added to this was the ongoing appreciation in the New Zealand dollar, with the kiwi up 4% against the US dollar and 5% against the Yen for the month. For the year, it is now up 31% and 17%, respectively, against these currencies. This reinforces the necessity of global equity investors having a currency hedging policy in place.

So, once again, the standout performers for a balanced portfolio were the New Zealand sharemarket and global and domestic bond markets. In contrast to most developed markets the NZSE 40 Index was up 1.1% for the month. This reflects increased investor interest in our market as well as strong domestic activity levels in the retail and construction sectors, in particular.

Bond markets continued to provide diversification benefits with domestic and global bonds producing strong monthly respective returns of 1.0% (CSFB Government Stock Index) and 0.8% (Lehman Global Aggregate Hedged Index) respectively. This means double-digit returns for the past twelve months for global bonds (+11.9%) and close to this for domestic bonds (+9.0%).

In terms of the immediate outlook, the outcome of a possible war against Iraq remains crucial. Most commentators are now discussing what will happen when an Iraqi invasion occurs, rather than if it occurs.

The general consensus is that, while it may not be quite as quick as the Gulf War, the military power of the US will swamp Iraq. Certainly one of the reasons George W Bush has spent such a long time pre-signalling a war is that it allows him to mobilise all the necessary forces to maximise his chances of a quick and successful result. Thus, the outcome of an Iraq war seems relatively certain – although of course most people thought World War I would be over quickly too!

The key to managing the after shocks in the region and globally will be whether the United States (and it seems the UK and Australia) go it alone or wait for United Nations sanctioned approval. Unfortunately the US presidential elections in 2004 may play a role here with George W Bush potentially not having the time to wait for due process from the UN. He does need to lift the spectre of war as soon as possible to maximise his chance of significantly lifting US economic sentiment in time to positively impact on his election chances. Moreover, climatic factors also play a role with the US needing to move soon to avoid the prospect of warfare occurring in very hot temperatures in the northern summer in mid-2003.

From a world economic perspective the best case scenario if the US invades is: it is a quick battle, a new and stable regime in Iraq emerges, oil prices fall and then the war premium depressing financial markets is removed.

However, there are some risks on this actually occurring. If Iraq does have “weapons of mass destruction” it may be tempted to use them in the battle itself, in a futile gesture of defiance. In addition, any war means an increased risk of instability in the region (particularly in Saudi Arabia). This would result in material increases in oil prices, even from their already high levels. Add to this the prospect of increased global terrorism in reaction to a US invasion of Iraq and one might find the US has won the battle, but lost the (economic) war.

There remains a chance that no military action will take place soon. One scenario is that the US does wait for the weapons inspectors to fully complete their work and for UN authority. This scenario would probably preclude any military action until late 2003, at the earliest. This is not a great outcome from for financial markets, as a war premium would continue to be placed in oil and equity prices. Another non-war option is that the current regime in Iraq goes into exile before any invasion. However, this seems unlikely with military action probably required to be a catalyst for this to occur.

In summary, the most likely scenario is an invasion over the next few months, which will probably result in a quick defeat of Iraq. This could result in a relief rally in equity markets but could also increase the chances of global instability over the coming years - ironically the outcome George W Bush is trying to avoid if he does to decide to invade Iraq.

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 Reveiw here

Anthony Quirk is the managing director of Guardian Trust Funds Management

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