Market review: Better to take the medicine now

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The 2004 first quarter results in the US will go down as some of the best in corporate history. Tyndall Investment Management New Zealand Ltd managing director Anthony Quirk comments on the state of the markets.

Tuesday, May 4th 2004, 11:55AM

by Anthony Quirk

I noted in last month's commentary that "in order for the (US) market to "kick on" from here companies will need to significantly exceed (earnings) expectations. And boy, did they! The 2004 first quarter results in the US will go down as some of the best in corporate history. According to Thomson First Call (a company which records company earnings forecasts from stockbroking analysts) the market was expecting a 13% rise in first quarter earnings. The actual outcome was 25% growth! Moreover, more than ¾ of companies produced positive earnings surprises.

And the market outcome from these sublime earnings performances? The US market (S&P500) was down almost 2% for the month! Of course for unhedged kiwi investors the collapse in the kiwi dollar helped generate positive returns from global equities but more on the kiwi later.

So the good news is the very accommodative monetary policies of the US Federal Reserve ("the Fed") has helped engender an economic recovery. It seems not so long ago (in early 2003 in fact) that there was considerable debate on whether such a recovery was possible. Thus, the significant market rally of last year, and resultant high P/Es, was justified as the market correctly anticipated an economic recovery and an earnings boom.

But the lack of follow through to push the market higher over the last month shows that the market is now concerned about the future earnings outlook and the prospect of higher interest rates. In terms of the former, while US corporate earnings are in a "sweet spot" at present this is not sustainable.

So there is real doubt that earnings can be maintained at a level that will see the US equity market rise significantly from here. Instead steady sub-teen growth in line with nominal economic growth is the most likely scenario. That is, 6-10% per annum for the next few years.

On the interest rate front, the consensus view is that the Fed will start raising rates in August. The key issue is how far and how fast this will occur. There is little doubt the US election in November is going to get in the way of any dramatic increase in rates over the next six months. However, there is a real possibility of significant rises in the six months after this.

In terms of the timing of the rate rises history shows that you are better to take your "medicine" now and raise rates gradually over time. If not, the Fed runs the risk of another "bubble" developing and then having to raise rates dramatically. Sharemarkets could be hurt by either scenario with interest rate rises a significant head wind. However, in the long run the former scenario is much more preferable to the latter.

So my view is that any reluctance from the Fed to raise rates over the next 6-12 months should be viewed as a significant negative for equity markets.

Fortunately from a global perspective any slow down in the US from rate rises will be mitigated by the domestic recovery that is occurring in the world's second biggest economy, Japan. This has been stagnant for some time with only the export sector showing any signs of life. Finally domestically oriented Japanese companies are also recovering and this is being reflected in the strong performance of the Japanese sharemarket so far this year.

Of course part of the Japanese recovery stems from the ballistic Chinese economy with the first signs of a (welcome) slow down occurring there. Without this there is some risk of this being the next "bubble" in investment markets. The talk of a Chinese slow down did take the wind out of the Japanese equity market's sails in April. However, this is likely to be temporary with China likely to be a strong and growing portion of the World's economy and Japan likely to make a much more significant contribution than over the past fifteen years.

I cannot finish this month's commentary without some discussion on the kiwi dollar. While most were predicting (as I was) a fall in the kiwi at some stage, its fall from grace was surprisingly dramatic. It was hit by the double whammy of a stronger US dollar and global investors taking profits on their kiwi positions, some of whom held significant positions relative to the kiwi's share of global currency markets.

From here the mix of the twin deficit problems of the US and rising rates in New Zealand should mitigate any further falls over the short term. In fact a small bounce back in the kiwi in the short term would not surprise, particularly if there are any disappointments on the jobs front in the US. Long term the direction of the kiwi is probably down on a trade weighted basis, making it sensible for most investors to have some currency exposure, usually via unhedged or partially hedged global equities.

Comment on the month's numbers.

In terms of the market numbers for April the main issue was the collapse in the kiwi dollar, which was down 6.0% against the US dollar but less against other major currencies. The New Zealand equity market, continued its great run, being up 1.5% for the month and up 30.7% in the past twelve months.

On the bond side, the lack lustre domestic bond market continued with the New Zealand the CSFB Government Bond Index down up 1.0% for the month.

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).

Anthony Quirk is the managing director of Guardian Trust Funds Management.

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