16 October 2014

September 2014 Quarterly Report Investment markets were mixed over the quarter but the sharply lower NZ dollar provided a benefit for client portfolios with overseas assets and NZ shares and NZ bonds also performed well. Global themes impacting markets over the quarter included the many geopolitical tensions ranging from the Ebola breakout, the ongoing ISIS terror in Syria and Iraq, pro-democracy protests in Hong Kong, Ukrainian border war and the Israeli invasion of Gaza. Economically, the Eurozone is struggling again with parts of it on the verge of returning to recession while Chinese growth also stalled again over the quarter leaving markets to worry about its prospects. With weaker demand from a slowing China and an embargoed Russia, commodity prices fell across the board including energy, industrial materials and soft commodities. Australian mining stocks, particularly iron ore producers, were badly impacted as were New Zealand dairy exports. On the positive side, US economic growth continues (like a beacon) to steadily improve, Australian growth is now being supported by a construction surge and our sharply weaker NZ dollar and reasonable local growth prospects provide some protection for our economy. With the election out of the way and a stable government formed, stronger investment, construction and consumption activity will help offset some of the economic drag we will have from weaker dairy prices. The outlook for the final quarter of 2014 is mixed given the uneven global economic backdrop and geopolitical risks but continued low interest rate policies globally will underpin broader economic activity and asset prices. Kind regards,

Wayne Ross Director of Investments NEWTON ROSS

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ECONOMIC AND MARKET SUMMARY Global growth became increasingly dislocated this quarter with different economic blocks following different trajectories. The three main themes dominating global growth prospects and the outlook for investment markets include slowing Chinese growth and stalling Eurozone activity while the US economic recover becomes selfsustaining. Geopolitical risks also remain elevated (particularly the Ebola spread) but at this stage are not likely to swamp the broader themes. China has achieved a 10% p.a. compound growth since the late 1970s to become the second largest economy (on track to be the largest by 2035). This growth came through leveraging low cost wages, cheap exports and investment activity including massive construction programs. Their economy is now highly leveraged with overpriced realestate, massive credit expansion, capacity excesses, systemic inefficiencies, pollution and cultural arrest. Consequently, China is changing direction for growth but is now at the cross- roads. While its central government has the financial capacity and power to achieve its reformation goals, it could take a generation. China will also have a slower economy (currently running below the official 7% rate) which will reduce demand for global commodities and services and provide a headwind for global growth. The Eurozone is once again close to recession as its prized German economy slows on weaker Chinese, Russian, Italian and French orders. Export embargoes to Russia, weak lending levels in peripheral countries, high persistent debt levels and slow or no labor market or taxation reforms means the Eurozone remains on the edge of deflation.

With record low interest rates (German 10 year bonds are just 0.9%) the European Central Bank will likely have to resort to unorthodox policies to try and stimulate activity. Although European growth has provided only limited impetus to global growth, it still remains the biggest trading block and any deflation and recession risks will unsettle markets. In contrast, the UK continues to beat data forecasts as its relatively buoyant services sector underpins growth. On the bright side, the US economy continues to steadily improve with June data showing running 4.6% annualized growth (some of which is a recovery from the first quarter). Growth for 2015 is forecast at 3.8%. US unemployment fell in the September quarter down to 5.9% which is the lowest since the start of the GFC. Importantly US average weekly earnings have also risen some 11% since 2008. Other recent US data remains more mixed with consumer confidence, factory orders and real-estate prices softer. Overall, the US economy remains solid and slightly ahead of Federal Reserve expectations. The Federal Reserve is expected to keep US interest rates accommodative for now but markets are finally starting to anticipate the prospects of rising cash rates in 2015 and this has resulted in a sharply stronger US dollar. The New Zealand Reserve Bank used the rising US dollar impetus to further accelerate a decline in the value of the NZ dollar by intervening in markets and selling NZ$521m. The NZ dollar though recently stabilized, fell over the quarter -11.7% against the US dollar and -4.8% against the Australian dollar. It can be argued the Reserve Bank is just trying to unwind the damage it did to our exporters by raising interest rates too early and ahead of the rest of the world.

While the fall in the NZ dollar will assist our terms of trade, it cannot offset the impact of rapidly falling dairy prices (down -48% since February) which will take an estimated $5bn off our economy. Economists are now forecasting slightly slower growth rates for NZ but still relatively robust at +2.6% for 2014 and 3% in 2015. With global share markets having a flat to negative quarter valuations for markets and some sectors (particularly mining and energy) have improved and remain around 5 year average levels. Reasonable earnings growth prospects should assist further rises for markets. The table below shows the gross returns (before tax) from the benchmark index for each asset class. Market Returns

Sep

1 Year

3 Years

5 Years

Quarter

p.a.

p.a.

p.a.

$NZ v TWI

-7.0%

-1.7%

+2.1%

+3.3%

$NZ v $US

-11.7%

-6.2%

+0.4%

+1.6%

$NZ v $AUD

-4.8%

+0.0%

+4.0%

+1.6%

NZ Cash

+0.9%

+2.9%

+2.7%

+2.7%

NZ Bonds

+1.8%

+5.2%

+3.7%

+5.6%

+2.4%

+8.8%

+6.3%

+6.5%

+3.3%

+8.6%

+13.5%

+8.1%

Global Shares 50% hedged to $NZ

+6.2%

+19.3%

+20.3%

+11.9%

Alternative Assets 50% hedged to $NZ

+7.3%

+11.5%

+7.2%

+5.8%

NZ Listed Property Gross Index

+3.0%

+12.3%

+12.1%

+10.5%

Global Bonds 100% hedged to $NZ Australasian Shares 50/50 Indexes

SECURITIES RETURNS FOR THE QUARTER The following tables show the returns from the securities recommended by NEWTON ROSS. Depending on your investment strategy you may hold all or only a portion of these securities and the returns for the securities held may also differ slightly depending upon cash flows and transactions in your portfolio over the quarter.

CORE AUSTRALASIAN SHARE PORTFOLIO

Sector

Quarterly Performance In NZ$ terms

Auckland Airport

Ports

-1.3%

DNZ Property

Property

+7.7%

F&P Healthcare

Healthcare

+9.1%

Fletcher Building

Building

+2.5%

Fonterra Shareholders

Agriculture

+8.6%

Freightways

Transportation

+3.1%

Port of Tauranga

Ports

+5.5%

Sky TV

Media & Comms

-5.3%

Trade Me

Consumer

+3.9%

Vector

Energy Processing

+9.8%

APA Group

Energy

+13.1%

BHP Billiton

Resources & Energy

-1.0%

Brambles

Professional Services

+10.5%

Coca Cola Amatil

Consumer

+0.4%

Commonwealth Bank

Financials

-2.3%

IAG

Financials

+10.0%

Sonic Healthcare

Healthcare

+9.3%

Scentre

Property

+3.2%

Westpac

Financials

-0.2%

Woodside Petroleum

Energy

+7.9%

Woolworths

Consumer Staples

+5.1%

Company New Zealand Shares

Australian Shares

Stocks to feature during the quarter: 

BHP announced it has been looking at possible ways to simplify and focus business operations by splitting off non-core assets. There are a number of potential options and includes selling aluminium, alumina, nickel and manganese assets. The planned demerger is expected to enhance the market’s view of the company’s core iron ore, copper, coal, petroleum and potash assets which currently

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represent around 85% of the company’s value. It may also be possible to unlock the potential from unused tax franking credits. BHP posted a record US$13.8b profit for the year. 

Fonterra announced a $615m joint venture investment in Beingmate, a large Chinese baby food company, together with a $555m investment in new mike processing facilities in New Zealand. Rating agency Standard & Poors lowered the credit rating of Fonterra from A+ to A due to concerns that the company was taking on more financial risk. However Fitch Rating agency was comfortable leaving their rating at AA- citing the company’s financial flexibility, scale, defensive characteristics of its ingredients business and margin protection offered by the integrated operation.



Auckland Airport’s land bank has been revalued upwards by $734m to $2.6b. This reflected increased in Auckland residential land values over the past 3 years since the regulators require AIA to value the bulk of their land as if the airport wasn’t there and the land was available for residential housing. The increase in value also reflects the new commercial and logistical hubs which have attracted major new tenants. The company posted a 21% increase in profit for the year and is investing more than $3m in a new energy conservation programme with tenants which they hope will be worth more than $2m a year in savings.



Sky TV posted a better than expected 21% increase in profit as more people signed up to higher value services such as MySky. The company is investing over $100m over the next 3 years in alternative content delivery models such as DVD mail order service Fatso, low cost pay-TV service Igloo and internet based video-on-demand. Sky is also investigating offering season tickets to individual sports on-line without requiring customers to sign up to other services. Proposed new digital decoder boxes will allow access too twice as much information via current satellite bandwidth at no extra cost. Sky currently reaches 49% of NZ households.



Brambles, the world’s largest provider of pallets, reported a 5% increase in yearly profit to US$585m driven by solid growth and new business in the core pallets operations. Brambles has been looking to diversify business streams and have recently purchased Transpac Intl, a German based provider of pooled bulk container services, and UK based Ferguson Group who provide specialist containers to the oil and gas sector.



Despite posting an A$2.5b profit result and improving market share, Woolworths are finding it very difficult to break the market dominance of rival Bunnings in the DIY home improvement market. Woolworths have experience greater than expected costs at their Masters hardware stores and have had to slow down the roll-out of new stores to around half of what they originally predicted.



Woodside Petroleum posted a first half net profit of US$1.1b, up 24%, as production increased and the benefits of new contract prices kicked in. After shareholders rejected the company’s plan to repurchase Shells’ remaining 10% shareholding, the company has significant cash reserves and is concentrating on locking in long term gas sales contracts with Japanese buyers and continuing exploration work around the globe.

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AUSTRALASIAN MANAGED FUNDS For portfolios with a lower level of overall funds invested in the Australasian sector a portfolio of individual securities is not an efficient or effective option due to trading costs and rebalancing issues. In this instance NEWTON ROSS combine complementary Australasian managed funds to form the Australasian allocation.

Security

Devon Trans-Tasman Fund

Harbour Australasian Equity Focus Fund

Quarterly Performance In NZ$ terms

Commentary

+7.1%

Corporate reporting season has been in full swing and largely in line with expectations. Highlights included CSL, Metlifecare and Slater & Gordon. The fund participated in the successful IPO’s for Vista Group and Metro Performance Glass. Transpacific was sold down due to concerns over operating conditions and prior to the company announcing a lift in provisioning for landfill remediation work.

+4.0%

NZ equity market valuations remain relatively high versus historical measures and against world markets. The reporting season met expectations with strong results from Diligent and F&P Healthcare. Key themes influencing company profits include limited economic tail winds for growth, headwinds from strong NZD and AUD, benefits of low interest and tax rates, cost out programmes, higher dividend pay-out levels and share buybacks.

ALTERNATIVE ASSETS Security

Quarterly Performance In NZ$ terms

iShares S&P Global Infrastructure Index Fund

+8.3%

iPath Dow Jones UBS Commodity Index Note

-1.3%

Cash Allocation (AUD$ deposit in NZ$ terms)

+5.6%

Commentary Passive index fund exposure to infrastructure and commodity sectors. Oil prices recovered slightly on supply on OPEC producers restricting supply however inventory levels are high due to the increased production from fracking, especially in the USA which is producing 8.6m barrels a day, the highest since 1986. Cash is held in an Australian term deposit pending future investment in private equity and global property.

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GLOBAL SHARE PORTFOLIO

Country Weighting Net Liquid Assets Other Emging Mkts Asia Pacific ex Japan Japan Europe – UK Europe – Euro North America 0%

10%

20%

ACWI World Index

30%

40%

50%

60%

NEWTON ROSS Portfolio

Sector Weighting Other (incl cash) Utilities Health Care Energy Consumer Discr. Consumer Staple Telecoms Information Tech. Materials Financials Industrials 0%

5%

10%

ACWI World Index

Security

Quarterly Performance In NZ$ terms

15%

20%

25%

NEWTON ROSS Portfolio

Commentary

Platinum International Fund

+8.2%

The manager has 27% of the fund invested in Asia, the highest level in 20yrs. Consumer orientated co’s in China are flourishing via e-commerce. Instead of building new export factories the focus is on warehousing and logistic centres to handle the distribution of goods to wealthy consumers. Throughout Asia real economic, market and political reforms are taking place. The favoured currency is USD with no exposure to AUD or Yen.

Monks Investment Trust

+5.0%

Local UK financial markets were impacted by uncertainty surrounding the Scottish Yes/No vote on whether they should self-govern.

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+10.5%

The manager has lifted the cash weighting in the portfolio to around 10% as a defensive measure prior to the US raising interest rates back to more normal levels. Global interest rates are at historically low levels and there has been a massive reduction in risk between assets since 2013. The manager believes when this is unwound in the coming 1-2 years, credit and equity markets are likely be become substantially more volatile without necessarily leading to a market crash. The last time a prolonged period of stable rates ended was in 1994 when US bond yields rose 2% and Australian bonds rose 3.5%.

Vanguard Intl Shares Index Fund Hedged to NZD

+1.5%

This fund provides passive exposure to all major developed share markets and is hedged back to the NZD.

iShares Russell 2000 Index Fund

+4.9%

Magellan High Conviction Fund

These funds provide passive exposure to smaller companies in the USA and around the world.

Vanguard FTSE All-World ex US Small Cap Index Fund

+4.4%

Vanguard Emerging Market Index Fund

+10.6%

The fund provides passive exposure to companies listed in emerging markets and is valued in USD.

NZ FIXED INTEREST / BONDS

Security

Quarterly Performance In NZ$ terms

NZ Government Bonds

+1.8%

NZ Corporate Bonds Investment Grade Rating

+2.0%

Commentary Key factors to influence NZ interest rates during the quarter were falling European bond yields and a shift in focus for the RBNZ. Long term bond yields fell globally, dragged lower as the European central bank signalled further monetary policy easing to try and promote economic growth. This is at odds with the US where strong growth is raising the expectation for an increase in interest rates. In NZ the RBNZ confirmed a halt to further short term interest rate increases. They are now more comfortable with inflation remaining under control. Of concern for them is the stubbornly high dollar and as well as trying to talk the dollar down it is likely the RBNZ has intervened in the currency market by selling NZD. Global investors are showing signs they are prepared to take gains on their bond holdings before a lower NZD starts to erode the benefit of our higher yields.

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ECONOMIC AND MARKETS UPDATE

Economic Update



The IMF recently downgraded its outlook for 2014 global growth from 3.4% to 3.1% (3.8% for 2015) on weaker Eurozone, Chinese and Russian activity. German industrial production and factory orders have taken a sharper downturn than expected as Russian, Chinese, French and Italian demand for their output dropped. Without Germany, the already fragile growth from the Eurozone area runs the risk of heading back into recession (IMF say a 40% chance). Continuing large public debt levels, a still weak banking system, low credit grow (particularly in peripheral states) and a lack of bold structural reform is keeping Europe in a malaise and close to deflation despite near 0% interest rates and other ECB stimulatory policies. Europe looks difficult and further stimulatory monetary and fiscal policies (including tax cuts) will be needed swiftly to prevent recession.



The UK (despite some recent industrial production weakness) is sustaining reasonable growth driven largely by internal demand for services rather than exports. Rising real-estate prices and higher employment levels have improved consumer confidence and businesses investment is rising. The Bank of England remains cautious of the recovery and recently stated the economy was not ready for interest rate rises yet and when it is, they will be gradual and steady. None-the-less, the relatively good performance of the UK against a week Eurozone backdrop has seen the GBP strengthen over the quarter (+4.8% against the NZD) with further rises likely as economic divergence continues.



There were hopeful signs of recovery in Chinese activity in the second quarter though much of this was stimulated by renewed construction activity and exports stimulated by a credit impulse rather than from stronger domestic demand /consumption which they seek. Third quarter growth was disappointing with industrial production sharply down (back to 2008 levels) and their Purchasing Manager Index levels have also softened. After 10%+ annual compound rates of growth since the late 1970s, China is now at a cross-road. Growth to date has come through leveraging low cost wages, cheap exports and controlled investment activity including, massive construction programs. Their economy has become highly leveraged with overpriced real-estate, rapid credit expansion (much of it shadow banking), excess production (and building) capacity, systemic inefficiencies, pollution and cultural arrest. China is now changing direction for Iron Ore Prices vs Dairy Index sustained growth. While central government retains enormous financial capacity (through foreign reserves) and power to achieve its reformation goals, it could take a generation. Changing direction equates to a slower, higher value add economy (currently running below the official 7% growth rate). This will

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reduce their demand for many global commodities and services and provide some headwinds for global growth. Weaker demand has significant implications for commodities suppliers. Australia sends 36% and NZ 25% of all exports to China. With Iron ore, energy and dairy prices falling sharply over the quarter both economies face an impact on earnings. Chinese leadership also faces social reform and political challenges including the management of the Hong Kong’s pro-democracy protests. They tread a fine line between retaining face without damaging the Hong Kong economy (world’s 5th largest share market) so integral to China’s future. 

Despite aggressive monetary policies, Japan seems unable to stimulate final demand in its economy and remains close to dipping back into recession. Recent BOJ Tankan surveys were slightly ahead of market expectations but Japan is sluggish and not likely to add to global growth momentum as was expected earlier in the year.



The US, in contrast to China, Japan and Europe, continues to steadily improve with September data showing their economy enjoyed + 4.6% annualized rate of growth in the second quarter (some of this was a catch up from the weak first quarter). Unemployment was down further to 5.9% in September which is the lowest level since the GFC. Importantly, personal incomes are also lifting with average weekly earnings now 11% higher than in 2008 and 4.5% higher on a year ago. Other recent data remains more mixed with consumer confidence, factory orders and real-estate prices all slightly softer while chain store sales and are 5.4% stronger than last year. Overall, the US economy remains steady and on trend and slightly ahead of Federal Reserve expectations. The Federal Reserve will keep US interest rates accommodative for now but will complete its long bond buying program this month. While cash rates are likely to stay low well into 2015 (and possibly longer), markets are finally starting to anticipate the prospects of rising cash rates lifting US dollar higher over the quarter. Looking ahead, the US has taken over from China as the key driver for global growth. Interestingly, the gap between the rates of growth from emerging markets (still positive) is forecast by the IMF to shrink to a 2.6% difference in 2015 which is down from a high of 6.5% difference in 2008. The world is re-balancing.



It was an interesting quarter for the NZ economy with our currency falling sharply -11.7% against the US dollar and -4.8% against the Australian dollar driven both by a strengthening US dollar story and New Zealand Reserve Bank intervention. While the fall in the NZ dollar is certainly welcome and will assist with our terms of trade, it doesn’t offset the impact of rapidly falling dairy prices which went lower again this quarter on excess supply from embargoed Eurozone exports to Russia and on lower global demand (including China). Some of the price fall is seasonal but lower farm gate prices will take an estimated $5bn off our economy.



The recent quarterly NZIER Survey of Business Opinion shows NZ business confidence is slightly softer but expectations for the future remain good with high levels of ‘own activity’ reported. The weaker NZ dollar will provide support for exporters. Despite higher demand for labor and materials, inflation currently remains benign but this may change with high net migration levels and on with the weakening NZ dollar. With the election out of the way and a stable government formed, stronger investment, construction and consumption activity will help offset some of the economic drag we will have from weaker dairy prices. Economists are now forecasting slightly slower growth rates for NZ on lower farm incomes but overall it is still expected to be relatively robust at +2.6% for 2014 and 3% in 2015.

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Markets Update 

The softer NZ dollar assisted returns from offshore holdings in client portfolios. This offset flat to slightly negative returns from many share markets over the quarter. The US share market (S&P 500 index) produced a flat return in local terms at +1.1% but more recently (October) the US market has retreated on weaker European and Chinese economic data. The Australian share market fell -2.8% in local terms over the quarter (just +0.4% over 1 year) on falling commodity prices, particularly iron ore (down below $80 per tonne) and lower energy prices which hit Australian mining and exploration companies hard. European share markets were sharply lower in local terms with the Eurostox 50 down -7.5% on weak Eurozone economic data and increasing concerns it may head back into recession while the UK was also lower -0.9%. Despite slower growth data the Chinese share market actually rebounded over the quarter +16.3% and Japan +5.8% in the expectation of renewed government stimulus. The NZ share market continued to move up steadily + 2.3%. The prospects of a further decline in the NZ dollar and a longer possible pause for interest rate rises assisted the market while NZ share market valuations are now about 16% above 5 year averages (on market share price to forecast earnings basis). Yield chasing investors and continuous inflows from Kiwisaver funds are underpinning prices.



Global share market valuations are generally running close to their 5 year average levels (on a 12 month forecast earnings to price basis). The MSCI AC World Index PE is at 15x with much of the rise in prices over the last year due to an expansion of the price/earnings multiple rather than Source: UBS, Harbour Asset Management through earnings growth. US analyst expectations are for S&P500 companies (PE at 15.6x) to grow their earnings at 8.4% next year and 11.5% the year after. This implies a future 10% share price growth (approximately) on earnings improvement alone. While this sounds bullish, at the current pace of economic recovery in the US, these earnings growth targets are not unreasonable. While not as overvalued as the NZ share market, global share markets are generally at full value (excluding recently hit sectors such as mining) making them increasingly more susceptible to earnings uncertainty and price volatility. Relative to cash and bonds, shares still remain good value even with the prospects for interest rate rises. Rate rises signal a stronger economy ahead. With the US 3rd quarter reporting season about to get underway, investors will be looking for good results to validate price levels.



Global bond markets rallied over the quarter on weaker economic data in Europe and on the hot pot of rising geo-political tensions ranging from the Ebola breakout, the ongoing ISIS terror, prodemocracy protests in Hong Kong, Ukrainian border war and Russian tension and the Israeli invasion of Gaza. Capital seeks safety during uncertain times and despite the US economy being relatively robust over the quarter, US bond prices also lifted. 10 year US Government Bonds finished +0.7% and NZ 10 year Government Bonds + 1.83%. Longer-term and providing the global recovery stays on

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course bond prices are likely to come under pressure and we subsequently remain cautious about positioning client portfolios too long in bond maturities. 

Using a stronger US dollar as impetus the RBNZ climbed into the market to accelerate the decline of the NZ dollar selling $521m saying the exchange rate was ‘unsustainable and unjustified’. This intervention was surprising but possibly reflects some recognition by the RBNZ of the damage our high and divergent interest rates were having on our currency. In hindsight the RBNZ has probably raised our rates too early, primarily to address housing inflation when other macro-prudential tools have proven to be just as effective. The sharply lower dollar has assisted terms of trade for most exports though dairy prices have fallen faster and further than the currency. Given inflation remains muted and house price growth weakening, the RBNZ has some room to pause on the next round of interest rate hikes. Some commentators are suggesting the next hike may be put back to mid-2015 providing for a further weakening of the NZ dollar against potentially stronger USD, AUD and GBP this quarter.



Despite sharply falling dairy prices (down 48% since February) other primary produce export prices are faring ok. Beef prices in particular have been very strong being up + 41% since April. Other commodities including sheep meat, seafood, wool, logs and kiwi-fruit were also higher over the quarter. NZ terms of trade remain at the highest level since 1973 but are likely peaking. The recently weaker NZ assists but it still too high and will remains a headwind particularly for manufacturing exporters.



The NZ residential property market is currently ‘idling’ according to REINZ data. Sales volumes are 16.3% lower than August 2013. The national median price is up + 7.7% over the year. Christchurch + 11%, Auckland +5.8% and Wellington +2.8%. Prices also lifted for the Waikato, BOP, Southland and Central Otago Lakes. Elsewhere prices were flat. Sales volumes will pick up as we move into spring and now the general election is out of the way. While LVR restrictions are having a significant effect on demand, strong net migration numbers into Auckland and Christchurch, combined with structural housing stock shortages is supporting prices. The accompanying chart from Quotable Value shows that the rate of price increases has eased over the last year but with building land shortages in Auckland and rising land, building material and labor costs house price inflation may still lift further. The Government and Reserve Bank may need to look to additional measures (restrictions for foreign buyers?) to alleviate the pressure rather than blunt monetary policy tools.

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