Shelter from the storm

By KEVIN ARMSTRONG

The world is certainly full of great uncertainty with many things for all investors to worry about. These range from the aftermath of the war in Iraq, to the debt that has been built up - and continues to build - in the largest economy of the world, the United States.

Two questions that all investors must now face are: can the US really be an engine of world growth in the near future, burdened as it is with almost unprecedented levels of borrowing? And if it can't, what nation can be?

In addition to these highly tangible concerns are the questions of whether the world will slip into a "double dip" recession, will the US and Europe follow a Japanese style deflationary slide, will unfunded pension liabilities bring down corporate earnings even further, and can the earnings that are being reported be trusted yet?

All of these concerns are buttressed by the apparently obvious knowledge that shares are not yet cheap on a historic basis and the frequent outpourings of the new gurus. The very concerned Steven Roach of Morgan Stanley now seems to have replaced the bull market's very bullish Abby Joseph Cohen of Goldman Sachs as the most frequently quoted expert of choice, and the legendary Warren Buffet has been reaccepted after being ignored at the top of the previous bull market frenzy.

What a difference a bear market makes. In investment markets the status of guru is both fragile and dangerous; their peak of recognition often coincides with a fall from grace.

As a result of all these fears and concerns many investors are flocking to the perceived safety of bonds. But assuming that what has been working is going to continue to work is wishful thinking, not investment.

Equally, assuming that shares will continue to fall because that is what they've been doing is as ludicrous as assuming that the seemingly unstoppable bull market of the 90s was indeed unstoppable. For those fortunate enough to be unaware of the last few years, it wasn't.

In New Zealand a similar reaction is now being seen with the popularity of the apparently sensible advice to avoid international sharemarkets and focus instead on the safer market here at home in New Zealand and Australia.

During periods of panic and uncertainty it does feel safer to focus on the familiar, but is it the basis of prudent portfolio management?

For the last couple of years New Zealand has had a number of favourable tailwinds that have dramatically altered local attitudes to domestic investment, perhaps by as much as 180 degrees.

These tailwinds have been: one of the strongest currencies in the world over the last year; one of the best-performing economies in the world over the last couple of years; and one of the best-performing share markets in the world over the last few years.

The questions that have to be asked are, will these favourable forces be present over the next few years and is now, after the relative position of New Zealand has been so good for so long, the time to prefer New Zealand over the rest of the world?

What has to be borne in mind when considering this question is what the position of New Zealand was up to the last few years. This can best be summed up with the fact that very few people outside New Zealand either knew or cared.

Through the latter half of the 1990s the NZSE40 index dramatically under-performed virtually all share markets of the world. At the same time our currency drifted lower and lower and our economy saw none of the miraculous growth that most developed economies experienced.

After these negative trends had been well established, by the late nineties, would have been a great time to switch from the then-overvalued world markets into either bonds or the relatively depressed New Zealand market. By doing so an investor would have avoided the devastation of the last few years.

Perhaps now may not be the right time to hunker down and hide in New Zealand shares.

The chart (below left) compares the total return (share price movements plus dividends) of the New Zealand sharemarket each year, compared with the total return of the US market (as measured by the S&P500 index), converted to New Zealand dollars. What is immediately apparent is that the remarkable out-performance of the New Zealand market over the last few years is as about as dramatic as has been seen over the last 50 years.

What also has to be considered is the outlook for the New Zealand dollar and our economy when compared to the rest of the world.

From an economic standpoint it will be difficult for our growth to compare to that seen over the last couple of years if only because we are no longer benefiting, as an exporter of primary produce, from an undervalued currency.

The National Bank of New Zealand's outlook for New Zealand's economic growth this year is 2.6 per cent, and 2.5 per cent next year. This has to be compared to consensus forecasts of 2.4 per cent growth in the US this year and 3.7 per cent next year.

New Zealand's outlook is reasonable but nothing compared with the remarkable performance over the last couple of years when much of the rest of the world slid into a recession that went largely unnoticed in New Zealand.

Additionally, from a currency perspective, a lot of the overvaluation of the US currency and relative undervaluation of the New Zealand dollar has now been unwound. Some further rise is certainly possible in the NZ dollar but it is unlikely to be as dramatic as that which has already been witnessed.

So, in conclusion, while it may feel more comfortable to keep one's attention focused closely to home during times of such historic uncertainty and turmoil, and it may even appear sensible, it may not in fact be the best investment decision.

Unfortunately, being comfortable and successful investing rarely go hand in hand. Comfort in investing is usually most readily found in following the prevailing conventional wisdom that is often borne out of extrapolating the recent past way into the future. The most successful investment decisions usually entail extensive periods of loneliness and discomfort.

None of this is intended to imply that the New Zealand sharemarket can't continue to perform. But staking a big bet on its happening after it has already enjoyed a historically lengthy period in the sun is more likely based on emotion than on dispassionate analysis.

* Kevin Armstrong is chief investment officer, private banking division, at the National Bank of New Zealand. His views, as expressed in this article, do not necessarily reflect the views of the bank.