Market Review

Interest rates – will they or won’t they?
On the interest rate front the October month was dominated by the debate about Central Banks in Australasian and US markets on “will they or won’t they” raise rates. In the end the US Federal Reserve took a glass “half full” approach to petrol pump price declines with the perspective that the risk of second round price rises from high oil prices had eased. They could have taken the opposite approach that petrol pump increases were economically stimulatory but in the end it was a reasonably clear cut decision not to raise rates with only one dissenting vote.

This approach was replicated in New Zealand but was a much closer run thing. Our Reserve Bank (RBNZ) does not have the luxury of the high productivity levels of the US economy. However, it was surprising to see how seriously they looked at raising rates. To do so could have easily plunged this country into an economic “hard landing” scenario.

Apart from the productivity issue one of the key differences between the US and New Zealand at present is how the respective residential housing markets are responding to bubble like characteristics. The US residential housing market hit new lows during the month with a country wide decline in house prices for the calendar year now almost certain.

Of course, New Zealand has yet to go through such a decline and, in fact, house prices here have stood up pretty well here, much to the chagrin of the RBNZ. This was reinforced by the robust rise in residential building consents in September, up 6.1%. A recovery in net migration and consumer confidence were drivers behind this.

Despite the contrasting housing markets in the US and New Zealand the views from the two Central Banks are likely to coincide some time in 2007, with an easing of rates on the cards. A rate fall in the US is likely before one in New Zealand unless a hard landing does eventuate here. For that to occur a housing and employment downturn is probably required.

Earnings outlook – the end of the golden weather?
Usually any interest rate fall provoked by Central Bank easing would be viewed positively by sharemarkets (due to lower discount rates on future company cashflows). However, looking forward this may be more than offset by the lowering of company earnings growth rates.

Company earnings performance in the US has been truly astounding with thirteen straight double digit returns of quarterly earnings growth. The US September quarter reporting season looks like being a boomer. Based on the 2/3rds of companies that have reported so far First Call estimates a 17% growth out turn!

This is clearly much higher than GDP and inflation growth would suggest and means US companies continue to become more efficient, primarily through the use of technology and outsourcing. However, a slowing global economy may make it tough for the double digit growth to continue with estimates for next year currently being for single growth digit outcomes. To date the earnings risk has been on the upside, which has helped keep US sharemarket multiples respectably in the mid-teens. However, the risks may now be moving to the downside for earnings.

A key driver forcing down earnings growth rate expectations is the increased risk of a global slowdown. Recent data suggests that the growth of many of the major economies is easing. In some cases this is planned for. For example, China would be quite happy for this to occur given the speculative bubbles that have emerged in some parts of its economy, as well as helping to mitigate the rural/urban societal dislocation that is unfolding in that country.

Along with the long foreshadowed US slowdown, Japanese GDP looks like it may not now be accelerating strongly and next year’s German economic outlook is soggy as it strains under the weight of increased taxes and a relatively high Euro. Moreover, growth in the United Kingdom is likely to ease next year.

Previously global sharemarkets have been in a virtuous cycle of positive earnings surprises leading to reasonable P/E multiples. Of course negative earnings surprises have the opposite effect and could result in market P/Es in the high teens or low 20’s. Such an outcome could impact negatively on market sentiment and direction.

M&A Activity is helping our local sharemarket – at least in the short-term

In contrast to the US corporate sector New Zealand company earnings have struggled recently in comparison. First NZ Capital estimates 2006 full year earnings growth for the core market of 2% with their estimate being 5% for the 2007 full year (with downside risk). This reinforces our market as high yielding but low growth.

While the fundamentals are deteriorating merger and acquisition (M&A) activity is helping support our local market. This was vividly illustrated in October with the market up over 5% at a time when interest rates and the currency are both high. Private equity based activity is a key factor behind this and for every deal that is announced there seems to be several unsuccessful parties as well. M&A activity is also helping the Australian and US sharemarkets.

The large number of private equity firms trying to do deals means we have a “weight of money” argument being used to justify higher sharemarket multiples. I am always cautious about such views as it was used to justify the last stages of the Japanese sharemarket bubble of the late 1980s and the tech bubble in the late 1990s.

I believe that private equity firms have the potential to be squeezed on both their entry and exit on deals in this country. They are facing higher acquisition costs due to high competition for deals and also must face the reality of a more sceptical investing public when they try to exit. Situations such as Feltex will only reinforce cautiousness from investors as private equity firms try to realise any investment via an IPO.

While M&A activity will help keep our market bubbling, fundamental factors usually prevail. If so this may mean a tougher time for sharemarkets here and overseas as lowering earnings start to bite.

Anthony Quirk - Managing Director of Tyndall Investment Management
Ph: (09) 377 7262 or 0274 895 568
Email:anthony_quirk@tyndall.co.nz

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 Guardian Trust Funds Management.

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