Investors react in advance to signals

By Peter V O'Brien

Friday 20th August 2004

Investment markets seem headed for a period of uncertainty arising from another of the regular bouts of noble tension between economists and purveyors of investment products.

It could have interesting effects given both are often employed within the same organisations.

Strong statistics prompted economists to issue warnings about inflation pressures and the likelihood of interest rate hikes. The Reserve Bank would lead the way with rises in its official cash rate beyond the current 6%.

Recent economic news supported the economists' views but, almost paradoxically, heartened share investors, who had a flow of good company profit statements to bolster their optimism.

Statistics New Zealand figures last week showed an increase of almost 8% in nationwide retail sales across all store types for the year ended June. These always need to be treated with some caution, because a lift in "big ticket" items, usually associated with housing, can distort trends to the extent they are one-off purchases.

People do not decide suddenly to splash out on new appliances, furniture and furnishings and other housing-associated products.

While a boost in retail sales should not be overemphasised, the latest increase had to be seen in the context of other figures.

Much was made of the decrease in unemployment to the lowest level since the late 1980s. That was seen as another pressure point for inflation, despite the obvious irony in classifying low unemployment as a "bad thing."

Opposition politicians have always railed against unemployment levels while government politicians defended their record.

That phenomenon has been a constant of life under governments and oppositions of all political hues.

Everyone favours a reduction in unemployment. Getting people back to work, off the dole, no longer a charge on taxpayers, paying taxes and becoming useful members of society (in an economic sense) is a "good thing." Governments regularly use sanctions to get the work-shy off the dole, as an enforcement of the "good thing" concept.

Success in reducing unemployment triggered economists' odd theory that some undetermined level of jobless was necessary to control inflation and therefore also a "good thing." (The theory obviously excluded unemployment among economists.)

Increases in interest rates arising from economists' and Reserve Bank concerns about inflation would have inevitable results, some of which should flow to the sharemarket. How much flowed would depend on equity investors' assessment of the benefits for the sharemarket from controlling inflation.

Rises in all interest rates follow a lift in the official cash rate. That makes New Zealand debt securities more attractive to overseas-based investors, who have already seen such securities outstrip those of other countries.

Surprise, surprise, higher demand from overseas investors for our securities pushes the New Zealand dollar's value up against other currencies, particularly the all-important US dollar. Returns from exports fall, subject to the relationship between prices and currency movements, farmers get less at the farm gate and that moves through to other sectors.

A higher New Zealand dollar depresses the landed cost of imports, which could be a "good thing" in terms of what happened recently to oil prices.

Traditional sharemarket theory, and practice, showed dividend yields went up when interest rates rose, resulting in a drop in share prices. That relationship was broken in recent years. Countervailing factors included the impact of dividend tax imputation, financial and operating health of individual companies, ebbs and flows of overseas investment interests, the influence of substantial funds with their adherence to index weightings as performance benchmarks, and a lift in general market analysis and sophistication.

A relationship still exists, which has meant a rise in interest rates cannot be guaranteed to produce solely beneficial economic and investment results.

Recent company reports and comments made at annual meetings suggested many companies were enjoying buoyant trading conditions. This suggested the whole economy could be overheating and needed an economic cold shower to dampen inflation pressure.

Inflation is an economic bloodsucker but its eradication can affect the economic organism in other ways.

Equity investors these days have an advantage over people in former times in that they get signals of impending official action and react in advance. Upheavals after the event seem less likely when the Reserve Bank next lifts interest rates.

The impact on markets will come during the rundown to the bank's formal announcement.

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