NZ bucks trend as international shares take bashing

By BRENT SHEATHER

For international share investors, last year was the second disappointing year in a row.

As measured by the Morgan Stanley Index, global share prices fell by 11.3 per cent in New Zealand dollar terms.

Like the previous year, things would have been worse were it not for the weaker New Zealand dollar. In US dollar terms, international shares fell by 16.5 per cent, meaning US-based investors have now suffered cumulative losses of 27.4 per cent over the past two years.

By now, even the most seasoned investor must be feeling a little disheartened.

And don't point the finger of blame at the US. American shares had a relatively good year, falling by only 6.6 per cent (in NZ dollar terms).

The culprits were the previous year's favourites - Japanese shares, down by 24.9 per cent, and European shares, off by 14.7 per cent.

The cult of equity has taken a bashing just about everywhere except New Zealand where, in sharp contrast with much of the recent past, local shares showed the rest of the world a clean pair of heels, recording an impressive 16.8 per cent gain last year (including dividends).

In a period where overseas companies' earnings have come under pressure, New Zealand corporate profits have proved resilient.

But don't sell your international shares just yet - one swallow does not a summer make. The five-year record still shows New Zealand shares underperforming their international counterparts by an average of more than 13 per cent a year.

Locally, the smaller company sector again led the charge with a 25 per cent gain for the year.

What a pity there is no managed fund which tracks the smaller companies index.

Analysis of the 10-year history of New Zealand share returns suggests that as New Zealand companies get bigger their performance falls. Over the past decade the top 10 index of the biggest companies has risen by 8.6 per cent a year on average, but the mid-cap index of middle-sized companies rose 13.1 per cent and the small companies index produced returns averaging 18.3 per cent a year.

Internationally the "small company effect" comes and goes depending on the time period chosen, but rarely manifests itself as dramatically as it did in New Zealand from 1992 to last year.

The figures may also represent the lack of success that many larger New Zealand companies - Fletcher Challenge and Brierley, for example - have experienced when they have ventured outside New Zealand and financed much of their expansion with expensive debt.

For international shares, last year represented something of a battle between declining earnings, which put downward pressure on share prices and falling interest rates, which tended to support share values. Falling profits appear to have the upper hand in that contest, although markets have staged a 9 per cent recovery since their October lows.

However, it is not yet clear whether this recovery is based on the reality of improving fundamentals or is just a euphoric high on the back of too much liquidity.

With price-earning multiples in the United States some 50 per cent above their long-term average and dividend yields of barely 2 per cent providing virtually no support, there is scope for disappointment this year - particularly if the profit increases the market is betting on don't materialise.

With short-term interest rates in the US now very low and only limited signs of recovery from corporate profits so far, this is shaping up as another tough year for share investors.

Although the US Federal Reserve has been able to engineer a 4 per cent fall in short-term interest rates, the bond market is clearly not convinced that inflation is dead, given that 10-year yields, which started the year above 5 per cent and touched 4 per cent shortly after September 11, have bounced back above 5 per cent.

Global bonds, although outperforming equities by 16 per cent, managed only a modest 5.4 per cent over the year.

Similarly, New Zealand Government bonds had a disappointing 12 months with just a 4.8 per cent gain, well below 90-day bills at 6.1 per cent. The New Zealand dollar again defied the experts by continuing its downward trend, falling by about 6 per cent last year. One wonders what the kiwi will do if and when our short-term interest rates fall to the level prevailing in civilised countries like Australia and the USA. New Zealand's 5 per cent cash yields must look compelling to hot money when their domestic market yields barely 3 per cent.

S O MUCH for last year, what of this? For what it is worth, statistically the chances of a third down year in a row for global share markets are not great.

The last time that happened in the US was during the Second World War, from 1939 to 1941, and that was followed by four excellent years when the S&P 500 index of US shares rose by a total of 150 per cent.

Before that we must go back to the Depression years, 1929-1932, to find another three consecutive down years.

But one need only look to Japan to see a more recent example of a sustained bear market; since that bubble burst in 1999, the Nikkei index of Japanese shares has fallen by 53 per cent. Hopefully, historians will record Japan's performance as being a special case, although it does warn of the dangers of deflation and perhaps explains why US Federal Reserve chairman Alan Greenspan has so aggressively lowered US interest rates.

Is it any wonder that Japanese consumers are loath to spend when, with falling prices, each year their debt burden grows in real terms and their houses are worth less. A lesson here perhaps for local devotees of borrowing heavily to invest.

With international shares performing so badly it will be no surprise to learn that the average New Zealand pension fund and balanced unit trust did not have a great year before fees, let alone after.

The typical asset allocation favoured by balanced funds is around 40 per cent in bonds, 10 per cent in property and 50 per cent in shares - with one-third of the share component invested locally and the rest in overseas shares.

Applying these weightings to the approximate index returns generates a pre-tax, pre-fee return of 1.8 per cent for a typical balanced fund - not enough to cover the annual management fees in most cases. Nevertheless, investing is rarely done with a one-year horizon. In 2000 the return on the same basis was 6.1 per cent. Over the past 10 years the return of 9.7 per cent a year - less a couple of per cent for fees - is well in front of inflation. However, it is only just above the average 7.2 per cent per cent a year that investing in 90-day bills would have produced in the period.

With returns declining across the board, the worry is that financial advisers - many of whose clients subconsciously compare their returns with the 5 per cent or so they could earn at the bank - will increasingly opt for more risky asset allocations in an effort to beat the bank, after deducting fees.

This sort of strategy, in tandem with a global sharemarket which looks fully valued from most historical perspectives, suggests that investors may need to exercise more caution than usual this year.

The average New Zealand pension fund has around half its money in bonds and pension funds in the UK are scrambling to lower their exposure to shares, which may suggest that individual investors should do the same.

My guess is that the next 12 months will provide investors with the opportunity to do marginally better than the bank, or a lot worse.

* Brent Sheather is a Whakatane stockbroker and investment adviser.