Your Quarterly E-Zine
Edition 11 • December 2019

This website contains the latest edition of Forsyth Barr Focus, a quarterly on-line magazine written by senior members of Forsyth Barr's investment team.

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The equity bull market that began in March 2009 has endured several corrections, none more so than the severe market volatility and drop in value during the last three months of 2018. During January and February most global equity markets bounced back strongly from the December lows, yet major market values are not back to the cyclical peak seen in late September 2018.

Trying to predict the future for equities has always been part science and part art. The quantitative input is the calculation of two variables – earnings and the price ratio to earnings. However, many factors need to be considered when coming up with a value for both. Economic and financial market conditions such as underlying growth, inflation, interest rates, and productivity are measurable and have a direct impact on earnings.

However, the valuation metric is prone to more subjective influences such as investor confidence, market psychology, fear, greed, conviction etc. This is why markets can sometimes have a positive earnings cycle but lose overall value if there is a multiple recession – that is, investors only willing to pay less for the earnings than previously. Usually, their outlook for the foreseeable future is tainted by some worry.

Earnings tend to be more predictable and usually trend with the long-term growth rate of the economy. These days, however, this contribution is more complicated as the global economy and capital markets are more inter-related than ever.

Many companies have multiple sources of revenue from around the world. Manufacturing supply chains are usually the same with various sources of input. That's why the global outlook or trend rate of global growth is more important when considering the longer-term outlook for equities. In the short-term, equities tend to fluctuate with the business cycle.

The main risk for all equity investors is recessions. Recessions almost always result in either severe market corrections (-10%-20%) or bear markets (>20%). Over the last 30 years, the global economy has suffered many shocks – 1987 October's Black Monday, the nasty Y2K bear market which lasted from early 2000 to late 2002, and the Great Recession from October 2007 through to March 2009. Before that period the global economy suffered from periods of high inflation, oil shocks and geopolitical crises such as the Israeli-Arab conflicts and the Cuban missile crisis in the 1960s.

The lesson learned from looking at the past is the understanding that although the market can suffer due to economic or financial corrections, the pain is usually relatively short. Economic expansions have always tended to be much longer than recessions.

Politics, either geopolitical or domestic very rarely influence the long-term trend in equities. Headlines can spook investors as investors tend to worry about the pain of loss more than we enjoy the pleasure of gain. Some strategists also rely on charts and the technical gyrations of market performance. Technical signals such as resistance and support levels can be useful from time to time, particularly when market momentum is changing, but investors who rely solely on charts to predict the future for equities often ignore the underlying fundamentals.

A macro approach usually considers the relationship between all financial market asset classes – bonds, currencies, commodities and equities. Historically, the usual sequence of events signalling a change in market direction starts with base metal prices such as copper, followed by bonds, equities, oil then currencies. This is ‘the market' acting as the most seasoned and rational investor.

Over the past 30 years (December 1988-December 2018), New Zealand's annual real GDP growth rate has been +2.62%, with a high of +7.3% during Q3 1993 and a low of -2.30% in Q1 2009.

The trend growth rate in weighted earnings per share (EPS) for the New Zealand equity market has been 3.10% over the last ten years. This seems reasonably consistent with a long-term average real GDP growth rate around 3%. The number will range higher and lower during cycle peaks and troughs, but the long-term averages look about right.

The multiple investors have historically paid for earnings in New Zealand are around 16x. Currently the multiple is above 20x. The central defence for the higher valuation is the change in inflation and interest rates. New Zealand monetary policy has tended to err on the tight side which has kept real interest rates high. In recent years, both nominal and real interest rates have fallen substantially. The relatively high average dividend yield and high payout ratios have resulted in investors being prepared to pay more as inflation and interest rates have fallen.

Since 1957, the annual capital appreciation of New Zealand equity index has averaged +6.1%. Over a shorter time frame, the last 15 years, the yearly capital appreciation has averaged +3.58%, again consistent with real GDP growth. New Zealand has a higher payout ratio compared to most other developed markets, and so the gross annualised return (which includes dividends) from New Zealand equities has been +8.91% over 15 years. This compares to a government bond index return of +5.78% and nominal annual average GDP growth around +5.0% over the same 15 year period.

Regulations, tax policies, mergers and acquisitions, buybacks and new issues all have an impact on market values as do investment flows. However, over the long-term, it's the earnings and the valuation of those earnings that determine the long-term performance for equities. The equity market is not for those wanting to get rich quick. But you can get rich slowly if you accept that equity prices will continue to rise over time as they have done in the past. The uptrend in earnings will always drive an uptrend in prices.

Investors often buy high when the markets are expensive and sell when the markets are cheap. Following the herd is a common human instinct as is the fear of missing out. The best advice we give clients is to ensure portfolios are diversified, you buy wisely as often as possible (when equities are relatively cheap) and hold them for as long as possible, accruing the compounding benefit of reinvested dividends.

Kevin Stirrat
Head of Investment Strategy

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