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Extract from July 2010 newsletter

Share markets and interesting economic facts

Share markets have suffered falls of around 10% since April. For a diversified portfolio this has resulted in a more subdued drop of 3-5%. Markets appear to have bottomed and are now showing signs of recovery.

Key risks which drove the share markets down have been; sovereign debt concerns, the potential for a double dip US recession and around a Chinese slowdown.

We believe the likelihood of a double dip recession is low, shares have become good value again, and that consumers will drive up the markets once they start spending again. At the moment while Governments are borrowing consumers are focusing on debt reduction rather than spending.

The US equity long term trend price to earnings ratio data from 1900 to 2005 shows P/E multiples during this period were 16 times, currently P/E multiples are 13 times. The current 13 times P/E multiple is on the back of low consumer demand and low corporate earnings. This means that increased share prices on the back of increased consumer demand will translate to increased corporate profits without pushing P/E ratios up to the extremes experienced in the late 90's when P/E ratios on technology stocks peaked at 45-60 times.

The world share markets are still influenced by the US market as it is the largest share market by capitalisation (refer to facts below). July is the Corporate reporting season in the US. This month corporate profit news and forecasts have been a mixed bag, but have been more surprising on the positive side.

We expect share markets to continue to recover and move higher in 2011.

Currencies:

The New Zealand dollar to the US dollar exchange rate was at a low of 0.39 in October 2000. Today it is around 0.7. We are around the top of a trend line of 0.72. After the crash of October 2008 the NZD/USD exchange rate had come down to its lowest point of 0.49 since October 2000 when it was 0.39.

Regression analysis is often used by economists for forecasting. The regression line of the NZD/USD over the last ten years shows the NZ dollar should have a value of 0.77 against the USD. The regression line over a 5 year period shows it should have a value of 0.68. These lines indicate that our dollar in the current range of 0.71 to 0.72 is normal. We do not appear to have an undervalued, or overvalued dollar.

Both the Australian and New Zealand dollars are considered to be fairly valued currently.

The New Zealand dollar is getting stronger against the Euro.

The Kiwi dollar is likely to remain around 0.48 (against the UK pound) for several years as the UK recovers from the GFC.

Economic Data:

The world GDP is 57 trillion ($57,000 billion) and of this:

USA is a quarter of this $14 trillion.
Europe is $12 trillion – another quarter.
Japan $5 trillion
China nearly the same as Japan at 4.7 trillion
India $1.2 trillion
Australia and NZ $2 trillion
Other countries make up the remaining $18.6 trillion.

The GDP of China is four times what it was 9 years earlier (from 2000 to 2009).

India has grown 2.7 times.

Europe and the UK are expected to be the weakest economies over the next two years in contrast to Luxembourg which is the wealthiest country in the world based on the ratio of assets per capita.

China’s GDP per capita is $5,000 p.a. That of the US is $35,000 per capita. There are huge growth expectations for China as it catches up.

The percentage of exports from Australia to China has increased from 2% in 1988 to 14% in 2008.

China's exports were up 43.9% in June from a year ago. There has been a slow down in imports indicating domestic demand growth is losing its momentum. This is positive news in that the Chinese Government is trying to slow down the economy from 14% to 8% GDP growth, which is a more sustainable level.

The Reserve Bank and the Playing field analogy - interest vs inflation

The Reserve Bank raised interest rates by 0.25% in June. This signalled the end of the interest rate drops we have experienced since the GFC which were used to stimulate the economy. While there was some debate from economists that it was too early in the recovery phase to raise interest rates there is a strong case for them to move now rather than waiting.

Interest rates are the only effective monetary policy that has been shown to control inflation. The theory goes, raising interest rates increases the cost of money and dampens the economy. New Zealanders generally go for fixed interest rate mortgages, in contrast to this most mortgages in Australia are floating. Interest rate changes in NZ are a blunt tool because of the time it takes (12-18 months) for changes to work through the economy.

The analogy that we like as to why interest rates are moving now, rather than waiting for the economy to have advanced more strongly was explained quite well by Tony Alexander, BNZ economist at a Hutt Chamber of Commerce meeting earlier this year. Tony explained it in terms of thinking of a playing field surrounded by barbed wire. Interest rates normally reside around the middle of the field at around 5.5-6%. But because of the GFC some countries had to drop interest rates and increase monetary supply to try to stimulate growth. This resulted in moving away from the middle of the field to the edge surrounded by the barbed wire fence.

For the US and the UK with 90 day bank rates of 0.25% they had their backs to the barbed wire fence. Japan at 0.1% was sitting on the fence. Effectively these economies have no room to move if another GFC event was to happen. So as soon as they can Governments will be moving interest rates to get back to the middle and have a buffer in their economies.

Australia is in a strong position having moved its interest rates three times over the last 6 months. New Zealand and Australia both still have a buffer capacity with interest rates.

New Zealand's interest rates will always be around 1.5% higher than the US as this reflects country risk.