Market Review: Are the markets skating on thin ice?

By Anthony Quirk

Friday 6th August 2004

The markets are at a fascinating juncture, uncertain in which direction to move given the opposing forces currently influencing investors. Tyndall Investment Management New Zealand Ltd managing director Anthony Quirk comments on the state of the markets

The markets are at a fascinating juncture, uncertain in which direction to move given the opposing forces currently influencing investors. On the positive side are exceptional corporate earnings as well as low US interest rates. On the negative side are inflation risks (which would probably then be associated with rapid interest rate rises), rich equity valuations, country trade imbalances and geopolitical concerns.

There is no doubt that strong corporate earnings have been a strong positive force, particularly in the United States. The June quarter US reporting season reinforced this, with most earnings meeting or exceeding already high expectations. Overall, average year-on-year earnings growth almost reached 30% for the June quarter.

This great performance from US companies reflects a good domestic and global economic environment through the first half of 2004 as well as the return of pricing power for many sectors and companies.

Normally such earnings results would be sufficient to underpin an equity market but cautionary comments from many US companies, particularly in the technology sector, hit many stocks hard in July.

Analysts and the market appear to be readjusting long-run earnings growth expectations for the global technology sector from 15-25% to 5-10%. This is below what was impounded in the very high share prices of many technology companies and hence their substantial recent declines. The end result was the technology laden NASDAQ was down almost 8% for the July month.

Confirmation of the tougher long-term technology environment was the decision by Microsoft to pay a massive dividend. This was partly to do with new US tax laws and the desire for income from their employees. However, it was also an admission from Microsoft that it cannot see as many growth opportunities to invest in for its funds as previously.

New Zealand investors are used to companies signalling that they cannot justify retaining funds for capital investment rather than paying out dividends. However, this is new territory for many US companies.

Many New Zealand companies have also been experiencing strong profit rises. Some major New Zealand companies are about to enter their June half year reporting period and, again, the market has reasonably high expectations that should at least be met. As in the US, analysts and investors will be scrutinising comments from senior company executives on the market and profit outlook. Overall the comments should be positive but much of this appears to be in share prices already.

Telecom is the first example of this with a good result and some positive reaction to this but much of this has already been anticipated.

Low US interest rates have also been a positive influence on share markets, even with the recent sell off in bond markets. While the US Federal Reserve has signalled a rising rate environment, short term interest rates remain very low by historic standards.

It now has a critical balancing act of ensuring inflation does not rise above acceptable levels while also not causing a recession through overly aggressive interest rate rises. Increasing rates too dramatically also runs considerable risks given the significant leverage (borrowing) by many investors in global markets at present.

It seems the Fed will take a middle course, partly for political reasons given the upcoming US election. It is also the style of the Fed Chairman, Alan Greenspan and one gets the impression he does not want to preside over a sharp recession before he retires. However, this may simply be putting off "judgement day" as asset bubbles in residential property, highly leveraged consumers and country current account imbalances must correct at some stage.

It feels like the markets are skating on thin ice; hoping they can do as many circuits as possible before the ice cracks!

In such cases it may be better to have the adjustment sooner rather than let the imbalances build to a point where a crisis occurs.

Even if the Fed continues its "softly, softly" approach it is hard to get too bullish about global equity markets for the rest of the year given the positive factors mentioned above are fading while potential negatives remain.

Any global equity market fall would have some effect on the New Zealand equity market. This comes at a time when it faces the head winds of very high relative interest rates, given the RBNZ's recent decision to keep raising rates These high rates have already increased the value of the kiwi dollar and will make economic growth that much harder to achieve in 2005.

The contrast in central bank policies could not be more marked. While the Fed and RBA have erred on the side of caution in terms of rate hikes, the RBNZ has been quite prepared to raise rates. This will increase the structural soundness of our economy and ensure we don't replicate the current imbalances of some of the larger western economies. However, it does also mean that 2005 may be quite tough for the domestic economy.

In summary, we see good reasons for the current market caution on the global market outlook with the next six months a crucial period in terms of the direction of markets in 2005 and beyond.

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 Tyndall Investment Management New Zealand Limited (Tyndall).

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