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Market Review: The end of the golden weather?

In his first commentary for 2004 Guardian Trust Funds Management managing director Anthony Quirk gives a brief outlook for possible returns for the year.

Wednesday, February 4th 2004, 10:00AM

by Anthony Quirk

This market summary is provided by Guardian Trust Funds Management. 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

As this month's commentary is my first for 2004 I thought I'd look into my crystal ball and give a brief outlook for possible returns for the year, with all the usual caveats of how hard it is to predict markets given that you learn to expect the unexpected!

I'll start with what I think is the easiest prediction: last year's magnificent performance of the domestic share and residential property markets will not be matched in 2004. The combination of the high kiwi dollar, rising interest rates and falling net migration levels is likely to take the "fizz" out of both markets.

Already New Zealand exporters are hurting and the Reserve Bank of New Zealand's move to raise rates last week should ensure our dollar stays higher for longer, given our interest rates are still very attractive for global investors.

With New Zealand company valuations substantially higher than this time last year a "buy the market" approach will not be successful in 2004. Rather, with a dearth of truly cheap companies investors will need to pick stocks very carefully, looking for companies with positive earnings surprise potential. That is, companies with the capacity to grow earnings at rates faster than the market expects and than what is already reflected in their share prices. Conversely companies which disappoint with their earnings will be savaged.

Such an environment suits stock pickers but means the overall market return will be more muted than the 25% return of last year and the New Zealand sharemarket will be doing well to record a double-digit return for the 2004 year.

To date the investment inflows from the NZ Super Fund do not appear to be having a significant impact on the prices of New Zealand's largest companies. However, it has much more potential to positively impact on smaller companies given their lack of liquidity. This seemed to be the case in January with the NZSX Small Companies Index up over 5% versus the NZSX 50 being up only 0.9%. This comes at a time when the Fund's manager in that sector was only half way through its buying at the end of December.

Residential property in New Zealand currently has all the hallmarks of an asset bubble with sentiment now appearing to drive prices in some sectors. There seems to be less regard to fundamentals such as yield (rental income divided by purchase price). Add into this falling net migration levels, rising interest rates and increasing vacancy rates and it is easy to see the potential for a pause in the rise of residential prices, and even a slight reversal. Such turns in sentiment can be more savage in property than in the sharemarket, as was experienced in the UK in the late 1980s/early 1990s.

With long-term interest rates likely to rise globally over the next year, bonds will be doing well to provide a coupon return after doing only slightly better than this in 2003.

Likewise, global equities will struggle to match 2003 return levels. While the strong kiwi dollar took the gloss off this sector for some investors, the half hedged global equity return was 17% for the year (MSCI World 50% hedged). This came from a combination of strong earnings growth and P/E expansion.

Looking forward an eventual rise in interest rates will taper any further P/E expansion while earnings growth cannot be sustained at current levels. These factors may not come into play until the 2004 second half but when combined with a weakening fiscal stimulus in the US, global equities will also be doing very well to record double digit returns for the full year.

Having said this having some unhedged currency exposure would be sensible for any New Zealand based investor, as the kiwi dollar will probably correct at some stage – although this may be a 2005 story (or beyond) rather than for this year.

So where do investors go who are looking for double digit returns without undue risk?

We think having some exposure to hedge (or multi-strategy or absolute return) funds may be the answer for 2004. This complex sector can produce mixed results due to high manager selection risk. However, there is no doubt that the very best individual hedge funds or fund of hedge funds can provide consistently strong returns. For example, our fund of funds hedge fund produced a double digit return in 2003 with lower than bond level volatility, and had a positive return in every month of the year.

My suggestion is that for 2004 if such an outcome for this fund recurs (and there are no guarantees that past performance will be repeated) then it will stack up very well against other asset classes when returns are tallied up at the end of this year. I also believe such funds will increase as a proportion of investors' portfolios although their complexity means they are not suitable for all investors.

In terms of the market numbers for January the New Zealand equity market was up 0.9%. Before any currency effects overseas equity markets were also up for the month with the NASDAQ continuing its rise (up 3.1%) with the UK the only major market to fall, being down 1.9%. Currency ate into these returns with the kiwi continuing its rise. The MSCI in NZ$ was down 0.5% for the month.

On the bond side, in New Zealand the CSFB Government Bond Index was flat for the month and up 1.8% for the past three months. Global bonds continued to out perform their domestic counterparts, with the Lehman Index up 0.9% for the month and 2.7% for the three months.

In summary, the stellar equity returns from 2003 are unlikely to be matched and any double digit return without undue risk will be a valuable commodity at year end.

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 Reveiw here

Anthony Quirk is the managing director of Guardian Trust Funds Management

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

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