Spicers' Quarterly Strategy Paper

New Zealand immigration trends have historically shown sharp changes in direction, and the transition from very strong migration growth to modest, flat or even negative growth could bring significant problems. There is no clear way to manage monetary or fiscal policy to smooth migration fluctuations or to offset the effect of these fluctuations on demand and prices.

Global equity earnings

Most comparisons of current share prices relative to 2003 prospective earnings put global P/Es at around the 14-15 times mark. Some commentators argue that trailing earnings, as opposed to prospective earnings, are the better measure and that on this basis P/Es are still too high at over 20 times. We are quite comfortable basing our views on prospective earnings and our current assessment is that valuations and the state of the corporate profit cycle provide reason for optimism about future equity market returns.

With depressed earnings having been the order of the day for the last two years, however, it is important to consider how a return to healthier rates of corporate profit growth can be achieved.

When reviewing the present state of the global profit cycle, it is significant that margin expansion is cited as a key driver of improved earnings. During the tougher times, one expects weaker firms to fall by the wayside, allowing those remaining to enjoy some improvement in their ability to hold and increase prices.

There are some good examples of this process inside different industry sectors. Telecommunications is an area that has recently seen a number of new entrants drop out. As a result, evidence of improved operating margins being enjoyed by the major service providers is now clearly evident. Close to home we are beginning to see a better return on equity performance from Telecom New Zealand, while our international equity managers also report improved operating performances from companies such as Vodafone.

Another sector where similar trends are evident is the general insurance market. In Australia for example, there has been a continuation of the trend toward fewer providers, which began in the mid 1990s.

SECTOR OUTLOOK

US equities

It appears that some of the impediments to US corporate earnings growth are receding. Concerns about the Iraq situation have faded, the inventory retrenchment has been completed and consumer confidence is in the process of being rebuilt. The return to sustainable positive earnings growth will be gradual; what is important is that it translates into higher capital spending.

A wide range of US companies are likely to benefit. In particular, our managers currently favour technology equipment manufacturers and selected consumer cyclical exposures.

Non-US equities

European equities have the most appealing valuation characteristics. Their recent performance has been driven by forced selling from financial institutions, which was always going to be a temporary phenomenon. The UK equities market contains many attractively priced multi-nationals, with mobile telecommunications and pharmaceuticals our favoured holdings.

Japanese equities have hit new 20-year lows and a recovery remains dependent on aggressive restructuring of the financial sector. Our managers are avoiding the Japanese banking sector in particular.

Australasian equities

Despite the challenges posed by low business confidence and high levels of household debt we remain positive on selected Australasian equities. The attractive cash flow yields of a number of companies compare favourably with both short and long-term interest rates and we consider any downside to be minimal, especially given our belief that monetary policy settings are more likely to be eased than tightened.

Australasian property

We have reduced our exposure to property and infrastructure reflecting the relative out-performance of this asset class in the past 12 months. However, we remain positive on property, and believe performance will be underpinned by low interest rates and deceleration of growth in the broad economy. Given the composition of New Zealand’s prevailing net inward migration trends we favour retail property assets over industrial and commercial property.

US fixed income

The low level of real yields and the higher federal deficit outlook are combining to make US government fixed income assets decidedly unattractive. While the bond market has not yet moved a great deal, any signs of a rebound in spending and activity in the economy will have a detrimental effect on the market.

Non-US fixed income

Yields on European bonds are now more attractively priced than US bonds and this helps to explain the increase in interest in the euro currency. European economic growth rates appear less likely to reaccelerate than the US, and upside risks in yields are less significant.

Australasian fixed income

The Australian and New Zealand bond markets have range-traded so far this year, with a bias toward better performance than many other bond markets. This can be attributed to higher real interest rates and strongly performing currencies. However, it does not mean that the local economies are free from any imbalances. Household debt levels have risen rapidly and are amongst the highest in the world. Although higher house prices and lower funding costs reduce the burden of this debt, it is our view that Australia and New Zealand interest rates need to remain high to attract foreign investment.

Currencies

Currency volatility continues to cause difficulties for exporters, central banks and investors. It is our view that the New Zealand dollar is now close to fair value against the US dollar and somewhat overvalued against the Australian currency.

ARCUS’ MARKET ASSESSMENT

With more clarity of the Iraq situation, markets have begun the second quarter in a position better able to evaluate the economic outlook without the fog of war – and the removal of war concerns are already having a positive effect on consumer sentiment and spending. We expect confidence in the economic recovery to gradually improve and risk premiums implied by asset prices to slowly reduce.

The one asset class where there has been a substantial adjustment in risk-premia over recent times is international equities. While corporate earnings are growing from a depressed level, they are not accelerating swiftly enough to attract a wave of reinvestment into this asset class. We believe that the risk aversion investors feel toward equities will fade only gradually, but during this process equity returns will be able to outpace the low returns from cash and bonds.

Local equity markets have not received the extreme re-rating as international equities, however they do not share the concerns around earnings quality, pension liabilities and excess capacity that plague overseas markets. We believe the Australian and New Zealand equity markets share similar attractive valuation characteristics to international markets and possibly lower risk characteristics. Recent surprise earnings downgrades in the local market however remind us not to be complacent about risks in this market.

Fixed income investments are popular with investors seeking to reduce portfolio risk. We remain concerned however that many fixed income assets carry risks and that the increase in market volatility in shares and currencies may also show up in bond markets.

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