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Spicers' Quarterly Strategy Paper

Spicer's Quarterly Strategy Summary paper looks at global investment themes, the outlook for individual sectors and our overall assessment of markets. The full version of the paper was written by Arcus.

Wednesday, January 29th 2003, 1:00PM

This quarter, we focus on the following key themes:

  • The changing of the guard at the world’s central banks.
  • Increased currency volatility and its impact on asset markets.
  • The impact of US military action in Iraq.
The changing leadership of the world’s central banks

The next 18 months will potentially bring changes in leadership at the four most influential of the world’s central banks - the Bank of England, the Bank of Japan, the European Central Bank, and the US Federal Reserve.

It is quite possible, depending on the final appointments, that many of the new leaders could be less concerned than their predecessors about fighting inflation and more concerned about reducing volatility in the economic cycle. Such a focus could involve smaller movements in interest rates and a greater tolerance for fluctuations in inflation rates. The impact on investment markets would be gradual but possibly far reaching. Risk premiums on growth-sensitive assets (which have risen sharply in recent years) could fall as greater stability in the real economy is seen. The 20 year rally in bond prices, resulting from declining inflation, could draw to a close.

Drivers of the recent increase in currency volatility and the likely impact on asset markets

Historically, currencies have usually displayed far more volatility and in recent months we have seen this volatility return with a vengeance for many exporters in New Zealand, Europe and South Africa. In the past 12 months, there has been a 26% rise in the NZ dollar, a 17% rise in the euro and 28% rise in the South African rand, relative to the US dollar. A widening in interest rate differentials is thought to have driven these moves, along with an improvement in the global risk appetite.

The most obvious implication of these moves is that many exporting sectors in these countries will suffer reduced profitability. The direct impact on investors is that, in some cases, the value of the foreign assets will have fallen when expressed in NZ dollar terms. For others where currency hedging strategies are available, the impact will be far smaller. All investors should bear in mind that currencies are a cyclical asset, their values rise and fall over time with the ebbs and flows of economies and capital flows. Over the long run, apart from countries with hyper inflation or civil unrest, currency values neither rise nor fall forever. The greatest danger is that investors flip-flop from one approach to another and make ill-advised decisions at either end of the swing in the currency pendulum.

The potential impact of US military action in Iraq

The more widely discussed an impending event becomes, the less likely it is to impact on markets. In fact, historically, there has not been a strong connection between military events and financial market volatility. Nevertheless, the threat of war remains a drag on the performance of equity markets through the fears of further terrorism and higher oil prices. These fears are perfectly understandable, but could abate quickly if the most likely scenario unfolds of a quick victory with low levels of resistance. The oil price may rise sharply for a brief period and investor risk appetite may reduce until some stability is seen. Provided consumer confidence is not unduly dented, equity investors may return quickly and unleash considerable buying power in the investment markets.

A more prolonged period of unease is a less likely scenario and in this situation oil prices would remain high despite any release of strategic stockpiles, and consumer confidence would be impaired for a much longer period. Stockmarkets would be weak during such uncertainty but economic policy actions can be expected that would add greater impetus to the market rebound once stability returns.


International equities

Many quantitative models suggest that the world’s major equity markets are somewhere below fair value due to the sharp decline in prices over the past three years and the reduction in long-term interest rates over the same period. The degree to which equities are undervalued is the matter of great debate due to the importance of the level of, and expectations for, underlying earnings.

US equities

The US market has started the year with the strongest price action as the tax reform agenda announced by President Bush has been received very favourably by equity investors. The removal of double taxation on dividends is expected to highlight the attractiveness of many value companies, especially in comparison to very low cash rates. In addition to the dividend changes, the Bush administration is bringing forward a raft of economic measures that will stimulate economic activity from the second half of 2003 onwards.

Non-US equities

The key development for European equities has been the 0.5% cut in interest rates by the European Central Bank in early December. Low interest rates, combined with attractive valuation levels for European companies outside of the technology sector, provide a very favourable environment for equity performance. UK equities have struggled after the insurance sector concerns of September and October. By most measures, the UK market entered the bear phase earlier and remains closer to its lows than other markets. As such, the valuations of UK stocks remain attractive and it is interesting that the New Year has brought an increase in takeover activity in the UK.

Australasian equities

We remain bullish on selected Australasian stocks. We consider the appreciation of the New Zealand dollar against its major trading partners will impact earnings in the export sector and this will eventually affect domestic growth in New Zealand. Nonetheless, monetary policy is expected to remain stimulative and the fiscal situation remains sound. One growing concern we have regards the prospect of a significant downturn in the Australian housing market. Our portfolios are avoiding stocks exposed to this sector, instead favouring those companies open to the lift in global industrial production we expect in the second half of the year.

Australasian property

Having enjoyed a prolonged period of out-performance, we feel that the listed property sector has reached fair value whilst continuing to provide an attractive income yield. We maintain that superior value exists within select infrastructure stocks in Australasia and intend increasing our weighting toward this sector in the near term.

US fixed income

US treasury yields have been trading close to 40 year lows and there is some risk of price weakness in this sector over the year. Although US bonds offer a significant yield pick-up over cash and may perform well in any period of military action, the valuation fundamentals still appear unattractive. The US Federal government is aggressively pursuing expansionary fiscal policies. Such policies both increase the supply of government bonds and, at the same time, raise the attractiveness of growth assets.

Non-US fixed income

Some areas of the non-US fixed income market are at less risk. The European bond market has not had the aggressive interest rate cuts that the US has experienced and is not so vulnerable to a resurgence in economic growth. The UK gilt market is also less vulnerable and may indeed benefit over the short term from any slowing in the housing market. But Japanese bonds remain very unattractive despite the lack of any significant turnaround in the economy.

Australasian fixed income

Locally, fixed income markets are still torn between the superb performance of the local economies and the lacklustre performance of international economies. A new twist to this dynamic has come from the sharp rise in the local currencies. We caution against making fixed income investments on the basis of expected capital gains from interest rate reductions as these remain conditional upon the inflation path.


We expect currency volatility to remain high this year. Both the New Zealand and Australian dollars could remain well supported, however, we expect a transition to occur at some stage during the year, at which point the deterioration in external balances will begin to weigh on these currencies. The downtrend in the US dollar is expected to continue, but could contain some sharp reversals, especially once US dollar weakness and euro strength becomes a consensus view. We still favour hedging US dollar exposure in our portfolios, but fully expect volatility in both directions.


Very little has changed in our minds over the past three months, and we still don’t believe that the outlook for the global economy is negative enough to warrant high weightings to bonds and cash.

Equity markets, both locally and offshore, are well positioned to benefit from any easing in geopolitical tensions or a continuing recovery in global economies. Much of this favourable outlook comes from the very pessimistic stance that individual investors and institutions adopted during the second half of last year. As is often the case, market positioning can have a great influence on the size of a reaction to any developments.

The only growth asset we have any concern with is the property market. Low interest rates have encouraged property booms in many parts of the world and, while this may continue for some time, the fundamental valuations relative to income have become stretched. Much of the action has been in the residential property markets, although we will be reviewing our overweight exposure to listed commercial property in light of the strong performance of this sector.

Bond markets remain a modest risk for investors. An extreme sell-off in bond markets is not a high probability, although valuations at current levels suggest that a conservative stance is appropriate. Inflation pressures may manifest themselves at some stage during the year, but a surplus in the world’s capacity to produce consumer goods should keep the lid on prices. We are somewhat concerned about the narrow gap between corporate bond yields and government bond yields in New Zealand. A return to a more normal relationship could result in poor total returns to investors in non-government bonds.

Currency decision-making will, as always, be extremely difficult. The New Zealand dollar is now close to our estimates of fair value and even overvalued relative to the Australian dollar. However, just because a currency is close to fair value doesn’t mean that it will also be stable. We continue to recommend selective hedging of the most vulnerable foreign currencies where possible.

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