Given what we have noted regarding the accelerating New Zealand economic recovery, the company earnings environment is clearly very positive. We anticipate non-forestry earnings growth of 14 per cent and 9 per cent this year and next respectively. These are the highest growth since 1995. In addition consensus earnings revisions have already turned to net upgrades after years of net downgrades. The improved earnings outlook dominates the higher 10 year bond yield that we are now using for our fair value modelling purposes.
A regular feature in past cycles is that when our economy outperforms the world economy in terms of GDP growth, and when commodity prices are rising, then New Zealand equities outperform offshore equities. It is our view that once New Zealand’s key commodity prices commence a sustainable rise and the NZ economy proves its resilience in maintaining economic growth, foreign investors will become significant buyers of our market at its current cheap level in international terms. The PE ratio on the NZSE at 15 times compares very favourably in terms of value with the range of 16 in Italy to 24 in the US and 44 in Japan. Given our positive view on offshore equities we expect a positive absolute capital return from the local market this year.
The future trend in domestic interest rates is a vital input to the picture. Rising short rates traditionally go hand in hand with falling share prices as cash becomes more attractive as an investment alternative in portfolios and the expectation takes hold that monetary policy will eventually dampen the economy, forcing earnings growth momentum downwards. We anticipate steadily rising rates over the whole course of 2000.
Regarding long term interest rates, however, our 10 year bond yield forecast is for a slight drop to 7.3 per cent from the current 7.5 per cent - certainly not enough to spark an equity market recovery on the basis of improved valuations, but at least not adding to the adverse influence of rising short term rates.
Overall, on the basis of our earnings and long bond yield expectations the fair value forecast for the NZSE 40 capital index implies a modest capital gain. The gross dividend yield on the market of 6.9 per cent remains a significant contributor to the total expected return of over 10 per cent.
Michael Daly is manager investment strategy for Bank of New Zealand Investment Management.
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