commodity prices and emerging Asia activity. … direction and leadership of China ... rise further yet on better earnings prospects but any delay or retrenchment of ... Depending

T 09 377 5777 | PO Box 2683 | Shortland Street | Auckland 1140 |www.newtonross.co.nz

March 2017 Quarterly Report

Investment markets generally performed well over the quarter.

Despite the world entering a period of greater political uncertainty the impact on economic growth and investment markets has been limited to date. This is because world economies were already performing steadily and improving before the US elections.

The prospects of additional government fiscal stimulus in most major economies has further lifted market confidence and also kept volatility surprising low over the quarter despite the sharp rise in geo-political risks.

It will be an interesting year with Brexit negotiations underway and with Trump already struggling to implement his health and taxation reforms. Some commentators are suggesting those reforms are unlikely to have any meaningful impact until 2018/19.

However, in the absence of any further significant geo-political shocks (and there are several possible) the global economy should continue to grow at reasonable pace this year and be synchronised across developed and recovering developing nations.

This growth should continue to be supportive for most investment markets though potentially higher inflation and higher interest rates will continue to make it difficult for bond investing.

Kind regards,

Wayne Ross Director Investments

ECONOMIC AND MARKET SUMMARY Geo-political issues continue to grab all the headlines. Brexit has been formally triggered, European elections have seen a worrying right wing swing, Turkish constitutional elections are coming (threat to NATO), the US has re-entered the Syrian mess while Russian aggression is rising. Elsewhere, North Korea is testing ballistic missiles while the US Navy sends a strike group to the Korean peninsula in response. Over in the US, Trump is having trouble implementing his agenda reversing and diluting policy on the run. While in China, the elites are already jockeying before this year’s 19th National Congress of the Communist Party - which will set the direction and leadership of China for the next 5 years. Amongst all this uncertainty, global economic growth has continued to tick-up at a steady rate. Though not back to pre-great recession levels (and not likely) global growth has become more synchronized with better activity in Europe, Japan and developing economies (on better commodity prices). The US is going well and has the promise of tax cuts and infrastructure spending ahead while China has managed to keep its economy running above a 6.5% growth rate ahead of its Congress. The chart below shows the broad nature of the recent pick-up in global manufacturing. Japan and Europe have been

benefiting from their weak currencies while also experiencing some stronger internal growth dynamics. Europe had its highest index reading for 6 years. Rising demand from China is also supporting

commodity prices and emerging Asia activity. Surprising, UK industrial production showed its sharpest rise in many years though this is not expected to continue as their EU free access narrows under Brexit. Closer to home, indicators for New Zealand economic activity remain robust and consistent for continued strong growth despite some recently weaker data in December. Record immigration, tourism and construction and better dairy prices mean our business sector remains upbeat about the domestic outlook. Despite the better economic growth, inflation though lifting slightly over the quarter, still remains relatively subdued and patchy. This is because excess production capacity and constrained demand still overhangs the global economy. Should the Trump administration succeed in implementing tax cuts and commencing large infrastructure projects then capacity constraints are likely to show in the US economy and lead to further inflation and interest rate hikes this year. Interest rate markets are now however starting to discount this possibility (or at least push it out to 2018/19) as Trump struggles with his ambitious agenda. Against a background of good growth, sharemarkets rose strongly over the quarter factoring in better corporate earnings growth. Sharemarkets have become relatively fully valued since rising sharply post the US elections. Prices may rise further yet on better earnings prospects but any delay or retrenchment of government stimulus plans may cause a pull-back in some markets. The New Zealand sharemarket bounced back this quarter after a difficult end to 2016 following offshore selling and local profit taking. Bonds also had a better quarter despite an interest rate rise in the US and despite the prospect for further Federal Reserve rate rises in 2017. Bonds rallied on the many geo-political risks that spiked over the period. It also remains to be seen whether inflation has really taken hold. Although the deflationary risks appear to have gone, inflation remains

stubbornly subdued and continues to be a challenge for central bank policy. The New Zealand Reserve Bank kept interest rates on hold over the quarter, being unconvinced of the inflationary risks while softer property prices and a weaker New Zealand dollar have supported their ‘steady for now’ thinking. REINZ data shows property prices in the ever-hot Auckland market dropped marginally over the quarter on sharply slower sales (-8.9% yoy) while property sales were also much lower in the BOP/Waikato (-19.6%) and Wellington (-16.6% yoy). Lending restrictions, rising borrowing rates, tighter currency controls in China and the funnel of housing stock now coming onto the Auckland market (and elsewhere) appears to be cooling turnover and prices. Cashed up buyers are still active but leveraged homeowner buyers are increasingly subdued especially in the Auckland market. The table below shows the gross returns (before tax) from the benchmark index for each asset class

Market Returns Mar

Qtr.

1 Year

p.a.

3 Yrs

p.a.

5 Yrs

p.a.

$NZ v TWI -2.2% 3.9% -2.0% 0.8%

$NZ v $US 0.9% 1.0% -7.0% -3.1%

$NZ v $AUD -4.6% 1.4% -0.9% 3.0%

NZ Cash 0.4% 2.0% 2.8% 2.7%

NZ Fixed Interest 1.4% 1.0% 5.6% 4.3%

Intl Fixed Interest 100% hedged to $NZ 0.3% 1.4% 6.5% 6.1%

Australasian Equities 50/50 Indexes

7.3% 12.7% 10.4% 11.8%

NZ Listed Property 1.4% -1.0% 13.5% 11.4%

Intl Equities 50% hedged to $NZ

5.7% 15.8% 10.6% 11.6%

Commodities $NZ -2.6% 8.0% -7.5% -6.6%

P a g e | 1 NEWTON ROSS LIMITED| www.newtonross.co.nz | PO Box 2683| Auckland 1140 | New Zealand

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.

AUSTRALASIAN EQUITIES

Company Sector Quarterly

Performance In NZ$ terms

New Zealand Equities

Auckland Airport Ports 10.4%

F&P Healthcare Healthcare 13.9%

Fletcher Building Building -18.9%

Freightways Transportation 13.6%

Meridian Energy Energy 10.4%

Port of Tauranga Ports 10.1%

Stride Property Property -0.5%

Trade Me Consumer 4.8%

Vector Energy 2.2%

Australian Equities

APA Group Energy 12.1%

BHP Billiton Resources & Energy 3.6%

Brambles Professional Services -19.6%

Commonwealth Bank Financials 12.8%

IAG Financials 9.1%

Scentre Property -0.2%

Sonic Healthcare Healthcare 10.0%

• Fletcher Building was sold heavily following a $100m write down in expected

2017 earnings from their construction division. The company has confirmed significant losses which are project specific and largely due to changes in scope which has necessitated adding labour and expensive sub-contractors quickly rather than the typical aggressive pre-project bidding process. The lack of management oversight has angered investors and it is not surprising that the company has put in place a new team to oversee the division. Large scale construction projects are necessarily complex and risky however. The rest of the business is going well even if we are starting to see the first signs of a slowdown in the NZ residential housing market.

• After a tough few years Woolworths is finally showing signs of stabilising. The company is seeing sales growth following a big push to improve labour standards, shrinkage and refurbish stores. The competitive landscape is still tough however and the company will be keen to completing the sale of their fuel retailing business to BP to assist the balance sheet and avoid any messy capital raising.

• Auckland Airport continues to benefit from international passenger growth with net profit up 18.6%. Improved connectivity and competitive pricing by airlines is ensuring more passengers come through the doors but they are spending less on the retail shops so that part of the business was only up 4%. AIA is still to work through the outcome of the Commerce Commission review into what is a reasonable return for the sector.

• Sonic Healthcare is back on the acquisition trail. The company has signed an agreement to purchase a medical laboratory practice in Germany which is known for its specialist testing and is a national reference site for hospitals, universities, physicians and other laboratories. SHL will be using existing cash and debt facilities to fund the purchase and is generally able to quickly take advantage of cost synergies in procurement and back office expenses.


Westfield Corporation Property 2.0%

Westpac Financials 12.7%

Woodside Petroleum Energy 10.9%

Woolworths Consumer Staples 17.3%

• Scentre announced a 10% increase in net profit for the year and a higher

dividend. SCG has been very successful in creating significant value for investors with an average 60% development margin on activities since 2004, largely because they have been able to undertake all aspects internally rather than pay away fees to third parties. With gearing levels at the top of their 30-35% target range the challenge is to find and fund future developments without having to raise additional capital. New residential developments close to existing SCG shopping centres looks set to ensure earnings grow sufficiently to fund more expansion. SCG already accounts for 8% of all Australian retail sales and 20% of fashion and footwear.

• Commonwealth Bank posted a strong earnings result and remains one of the leading banks in Australasia and worldwide. Despite margins being under pressure recently core earnings were good and regulatory risk around capital requirements has reduced. CBA are positive on the Australian economy with better commodity prices, the downturn in mining capex expenditure coming to an end and a lower AUD benefitting export sensitive industries. The move higher in interest rates is also allowing many of the banks to reprice loans at better margins.

• Brambles share price hit a 2 year low partly due to concerns over the impact of higher lumber prices in the US. Recent decisions in a long running dispute between Canada and the US over lumber imports could see tariffs introduced and higher prices for the soft wood which is used to build pallets. A 10% price increase would reduce group earnings by around 2%. The company has also been actively restructuring its business which has led to the departure of several members of the US management team.

AUSTRALASIAN MANAGED FUNDS

Fund Quarterly


Commentary

Devon Trans-Tasman Fund 6.2%

Despite the strong performance the fund was slightly behind the market benchmark over the quarter. Positive contributors included Vista Group, Aurizon, GTN and CSL. Vista was up after announcing their Movio division has signed a data licencing agreement with Screenvision Media, a large US cinema advertising business. CSL is benefiting from having an established plasma supply and distribution base when their competitors are struggling with collection and processing facilities. The manager has just completed their annual research visit to China. As Australia’s largest and NZ’s 2nd largest trading partner China has a significant influence on both local market returns and sentiment. Overall prospects look bright despite the risk of very high debt levels, particularly among corporates. A key portfolio influence this year is expected to be the managed slowdown in capital investment as policy makers restructure property and commodity sectors with excess capacity. This will be a negative for Australian and NZ commodity related companies and the manager is slightly underweight this sector despite the high free cash flow yields. More positively the Chinese consumer is stepping in to fill the void by increased discretionary spending on cars, white-ware, travel and services so any local companies exposed to those sectors should benefit.


Harbour Australasian Equity Focus Fund 11.0%

The fund outperformed the market benchmark due to overweight positions in strongly performing companies such as a2 Milk, CSL, FPH Challenger and Sirtex. In particular, a2 Milk jumped 26% as new Chinese regulations reduced the risk of accessing this core market. The manager’s view is that the NZ economic cycle has matured but 2% growth is still strong and supportive for company earnings. They are watching operating leverage closely and remain focused on those companies which can pass on cost increases or improve productivity as costs inevitably grow. This means investing in companies in the healthcare, financials and information technology sectors rather than yield proxy stocks such as utilities and real estate.

INTERNATIONAL EQUITIES

Fund Quarterly


Commentary

Active Fund Managers

Platinum International Fund 9.0%

The fund was up 3.5% in A$ terms and above benchmark. Key to this outperformance has been the stocks held rather than regional tilts. Cyclical stocks such as materials, financials, industrials and consumer discretionary companies are up on average 17% over the past 9 months while the ‘safe-haven’ defensive companies in health, telecommunications, utilities and consumer staples fell 2%. So investors chasing ‘safe’ yields have fared worst. The manager’s view of global growth is positive and accelerating. Europe is seeing traditional recovery cycle and growing well, Japan is resurgent and China is a year into its upswing and building momentum. The only danger signal is the high US valuations given they are further into their economic cycle and tightening monetary policy.

Monks Investment Trust 14.0%

The fund was up 8.4% in GBP terms. The success of the new management team has been evident over the past year with the fund up over 55%, a reduction in the share price discount relative to the value of the underlying portfolio assets (from -14% to less than -2%) and the manager has just announced they will lower their tiered fees from July 2017 due to the increase in scale. Their annual research paper highlights that portfolio positioning for US industrial activity to recover and interest rates to normalise started a long time ago with some transport shares purchased in 2013 with this in mind. Promised tax relief for business investment and repatriation of overseas company cash holdings could be a greater catalyst for long overdue capital investment in the US which is hamstrung by old, rundown and failing infrastructure and company management which has favoured self-serving share buy-backs over forward looking capital investment and R&D. A strong US market and dollar is not necessarily a problem for emerging markets as China continues to stimulate growth and build greater links across Asia, Africa and Easter Europe. Particularly if improving governance and reduced corruption in large markets such as China, India, Brazil and South Korea increase the opportunities and reduce the hurdle for foreign investors keen to participate in this growth.


Magellan High Conviction Fund 11.5%

The fund was up 6.4% in A$ terms. The manager remains focused on capital preservation given risks they see in global share markets which have been rising for 8 years (the second longest bull run in history). Risks in Asia Pacific include the stability of the Chinese currency and North Korea, in Europe the French election will be important and in the US the potential for quicker than expected interest rate rises later this year. The manager is cautiously optimistic about the impact of Trump republican policies to improve corporate productivity via lower taxes and less regulation. A strong US will help the portfolio which holds mainly (>70%) US domiciled companies with over half of their earnings in US dollars. Historically the fund has done well in a down market (falling less than 25% vs the market) and around 10% of the portfolio is currently in cash which can be used to invest in new opportunities.

Passive/Index Funds

Vanguard Intl Shares Select Exclusions Index Fund Hedged to NZD

4.4%*

This fund provides passive exposure to all major developed share markets and is hedged back to the NZD. International equity returns were supported by strong global growth and a more benign political environment in Europe. The US market gave back some of its more recent gains as the failed healthcare reforms meant investors were less confident of the Trump administration delivering the promised stimulatory policy changes. *Increased investor demand saw Vanguard recently launch a more socially responsible version of their developed markets international share fund which is screened to exclude companies involved in the production or significant sales of tobacco, controversial weapons or nuclear weapons. Following an investment review of the screening process, the change in sector and security weightings and potential impact on performance we now recommend the new fund and transferred all existing client holdings during the quarter. This is the total return across the two funds for the period.

iShares Russell 2000 Index Fund 1.7% These funds provide passive exposure to smaller companies in the USA and around the world. The funds are valued in

USD. Returns from smaller US companies dropped back from recent highs in March due to the reassessment of Trump’s ability to roll out small company friendly policies such as tax reform and reducing regulatory burden. Vanguard FTSE All-World ex

US Small Cap Index Fund 9.8%

Vanguard Emerging Market Index Fund 10.7%

The fund provides passive exposure to companies listed in emerging markets and is valued in USD. Emerging markets benefited from the weaker US dollar, strong global economic data, investors attracted to the lower share market valuations and ebbing fears of a trade war with the key US market. Individual companies which have no direct US rivals and limited opportunity to be replaced in the supply chain are expected to benefit from any protectionism policies.

iShares S&P Global Infrastructure Index Fund 8.8% The fund provides passive index exposure to listed infrastructure assets and is valued in USD. This sector is benefiting from

strong global growth and the expectation that governments will look to increase long overdue infrastructure spending,


COMMODITIES

Security Quarterly


Commentary

iPath Dow Jones UBS Commodity Index Note -3.8%

The fund provides passive index exposure to commodities and is valued in USD. Energy and agriculture declines dragged the commodity index lower over the quarter. Oil suffered due to increases in US production which offset OPEC production cuts and a warm northern winter weighed on natural gas prices. Strong crop yields meant lower agriculture prices. The only commodity sectors to increase were industrial and precious metals which were supported by the weak US dollar and gold investors concerned about share market valuations.

NEW ZEALAND FIXED INTEREST

Security Quarterly


Commentary

NZ Government Fixed Interest 1.4%

Global fixed interest yields were generally flat over the quarter despite the US Federal Reserve continuing on its path of raising short term interest rates over 2017. Sectors to do well included lower quality credit and emerging market debt which had sold off further in 2016. Strong US economic data did suggest the Fed may need to be more aggressive in future but this will largely depend on how effective the new administration is on rolling out promised fiscal, infrastructure and trade policies. The challenges in this were evident in the failure to make changes to healthcare and meaningful tax reform will be just as problematic. Strong global growth will put upward pressure on long term interest rates over the coming year despite the continued monetary policy stimulus in Europe and Japan. The RBNZ kept short term interest rates on hold and appears to be happy to leave rates at 1.75% for the short term in the absence of any further global shocks. While inflation is now back within the target range and expected to rise further it appears the RBNZ is happy to focus on core inflation rather than short term headline increases. This is likely to anchor short term interest rates around current levels until late in 2017 or early 2018 when wage inflation is expected to increase despite the continued strong net migration boosting the labour supply.

NZ Corporate Fixed Interest Investment Grade Rating 1.8%


ECONOMIC COMMENTARY

Global Strong economic data Plenty to worry about Growth may surprise to the upside

Global sentiment improved over the quarter caused by more than just the promise of Trump’s proposed stimulatory policies. Global economic data has generally been stronger across the board with manufacturing indexes better in key economies and at their highest levels since early 2014.This supports the argument for better global activity for the rest of the year. The surprises to growth are coming from China, Europe and Japan where their low currencies continue to support exports while more recently internal demand has also improved on better domestic conditions. With manufacturing (though recently weaker) at a multi-year high, Britain is yet to feel the effects of potentially restricted EU access. At the same time, better commodity prices have assisted emerging economies particularly Russia and Brazil while the Australian business conditions index recently hit its highest level since early 2008. China has once again eased credit conditions to keep their economy on track and US data has been solid all round. Meanwhile our economy is performing well with the additional impetus of better dairy profits. What could go wrong? Everywhere you look there are geo-political risks that could spoil the party. To date markets have reacted calmly to potentially disrupting news with only the bond market recently showing cracks and rallying late into the quarter after earlier being sold off on rising US interest rate prospects. Lower bond yields and slightly higher sharemarket volatility reflects a growing uneasiness by investors, particularly post the UK Brexit commencement, US airstrike on Syria and now with a US Navy battle carrier group deployment to the Korean peninsula. There also remains concerns about the potential fallout from rising protectionist sentiment and the impact it may have on global trade. To date this has not materialised though the graph opposite shows global trade has generally been declining since 2010 anyway but recently started to improve on better commodity prices. US trade protectionist rhetoric is softening with China now less at risk of being labelled a ‘currency manipulator’. While there can be much to worry about but there is presently a market expectation that issues will moderate and the environment remain supportive for growth. Forecasters are still predicting global growth to come in at 2.9% to 3.3% (World Bank, IMF and OECD) with the prospects of better growth should government fiscal stimulus policies (particularly in the US) eventuate.


New Zealand Continued expansion Australia Out of the pothole US Who needs Trump?

After a strong Q3 2016, Q4 2016 was softer in NZ likely due to the Kaikoura earthquake and impact on transport and business activity. Manufacturing was also weaker (food and beverages) while business confidence dipped over period the period on geo-political concerns. The slightly weaker numbers and benign inflation data enabled the Reserve Bank to put interest rate changes on hold. The NZ dollar weakened over the period which with better dairy prices improved our terms of trade. Indicators for economic activity remain robust and the underlying stronger growth trend remains intact. The key drivers remain the same, record net immigration (all time high in January) and tourism numbers (NZ is creaking), along with strong residential and infrastructure activity. With business hiring intentions rising, labour becoming scarcer sand better employment conditions supporting consumer spending, inflationary forces must be building. Forecasts remain on track for 3%+ growth this year and there is potential upside if we see new fiscal stimulus ahead of the elections. After a very poor Q3 2016, the Australian economy rebounded strongly in the last quarter of 2016 and again in Q1 2017. They are well out of the pothole. Annualised GDP growth rose to 2.4% in Q4 and 3% growth is starting to look achievable for 2017. The biggest improvement came from the re-bound in commodity prices which has sharply lifted export receipts and improved the trade balance well above expectations in February ($3.54bn vs an expected $1.9bn). The recent NAB survey of business conditions also rose sharply in Mar-17 to “a booming level” of +14.2. This is the highest since the global financial crises and is being reflected in the rise in manufacturing employment (see opposite). Despite better commodity prices, mining investment remains weak while eastern states construction continues to be supportive. Recently weaker retail sales are more likely reflective of poor weather with consumer confidence steady though unemployment has ticked up slightly to 5.7%. Following the elections confidence in the US has reached a multi-decade high while practically after 100 days in office, the Trump administration is struggling to get its policy agenda (such as it is) off the ground. The failure to repeal and replace Obamacare (which was critical to enable tax cuts) shows just how tricky it will be for Trump (despite congressional domination) to get things done. Tax reform, protectionist policies and infrastructure spending plans may not provide the US economic boost markets expected this year particularly given the recent damping of protectionist rhetoric. None the less, underlying economic momentum is intact with solid employment (4.7% unemployment rate), robust construction and manufacturing activity, steady consumer spending (slightly weaker auto sales) and home sales at 7 month highs. The Conference Board Economic index data opposite show leading economic indicators back up to 2007 highs and consistent continuing good growth prospects through 2017. At the same time, US companies are poised to report their strongest earnings growth in years.


China Pro-growth backdrop Europe Currency Manipulator? UK Brexit triggered

The Peoples 19th National Congress of the Communist Party will be held this autumn. The Party Congress is held every 5 years and represents the political cycle in China. There is a wide expectation that the Party will seek to reiterate its commitment of doubling GDP by 2020 from the 2010 level which requires the economy to grow at an average annual rate of 6.5% p.a. (actual 6.9% Q1 2017). They are on track for this. How the Party balances short term growth targets with longer term quality objectives will be key. Leading up to the Congress, authorities have loosened (but more targeted) credit conditions and increased direct investment to stimulate activity. The surge in industrial profits (higher producer price inflation from rising commodity prices) is driving industrial investment and supporting trade activity with Chinese imports rising 38.1% year on year, Domestic demand is robust and the feared housing bubble correction has not materialised as sales are outstripping current construction rates. Excess housing stock in key cities has declined a long way since 2015. China continues to experience significant reductions in foreign currency reserves (now below US$3 trillion, a 6 year low) sparking renewed capital outflow restrictions. Meanwhile Trump looks like backing down on labelling China a currency manipulator allowing China to avoid the imposition of import tariffs on exports to the US. Europe may not be so lucky to avoid being labelled a currency manipulator. The ECB has continued to maintain an aggressive easing bias with their bond market purchasing programme though this has since been scaled back. The ECB are not convinced that the recent jump in inflation is structural (see opposite chart). The easy policy setting suppresses the value of the Euro in turn supporting strong export activity, industrial production and investment within Germany and now France. Europe’s purchasing manager’s index also rose to a 6 year high in March and well above economists’ forecasts. With the prospects of higher government spending this year, domestic demand may also improve further and put Europe on track for a multi-decade high 2% GDP growth for the year. Clearly there are significant risks to this outcome including election surprises, Brexit negotiations potentially damaging the EU structure and Trump imposing tariffs on EU exports to the US. Theresa May formally triggered Article 50 on the 29th March. This will start the 2 year countdown to Britain leaving the EU. Already there are signs the negotiations will be difficult. Brexit will be a fraught process as the Economist Editor writes, ““Brexit increasingly resembles a faith based initiative, voters… first contact with reality of losing preferential access to their main market will be traumatic….Britons backed Brexit because they wanted to cut immigration and regain sovereignty, but they did not vote to make themselves poorer. While the economy has been resilient to Brexit recent data (opposite) show cracks appearing. Should the UK lose its financial passport to provide services into the EU London stands to lose up to a million financial services roles. London based financial services houses are working quickly to establish re-location options (Dublin likely).

Source: CBA

Source: Bloomberg

Source: Bloomberg


Japan Steady

Emerging Markets Recovery continues

Macro-economic policy does not appear to work in Japan. Despite aggressive monetary policy easing and substantial infrastructure and targeted industry spending, a rapidly aging population (and workforce) and poor structural reform (labour and capital markets) has prevented Japan from achieving ‘escape velocity’. None the less, easy monetary policy still keeps Japan’s manufacturing businesses competitive as evidenced by the February current account surplus rising 18.2% year on year. While there are tentative signs of better domestic demand, exports (14% of the economy) continue to provide the source of Japan’s growth which the IMF have recently upgraded from 0.8% to 1.5% for 2017. The recent Tankan business sentiment survey was broadly improved over Q4 2016. The table opposite shows that Japan is the second largest trade deficit party with the US. While Trump has already assured Shinzō Abe of the strength of their relationship, it would be difficult for Trump to label the EU a currency manipulator and not Japan. 23% of Japan’s exports go to the US so any tariff imposition would have significant impact on Japan. Resurgent Chinese industrial and construction activity, the promise of increased infrastructure spending in the US and lower supply agreements have assisted in the strong recovery of commodity prices. Rising oil, materials, metals and food prices are lifting emerging market earnings though the picture is diverse. China, non-Japan Asia, Russia and eastern Europe counties are doing well while Latin America has had additional financial headwinds and Mexico faces US restrictions. Middle East/Africa suffers civil strife while India is recovering from chronic cash shortages from their recent currency note change. The graph opposite from the World Bank shows the late 2016 improvement in emerging economies growth

and their expected acceleration through 2017. Capital flows are also moving back into developing economies after significant flight in 2015/16. Those countries with weak external balance sheets however continue to be exposed to the risks of higher inflation, interest rates and particularly a higher US dollar. The table shows the vulnerability of some emerging economies to a higher US dollar (the currency their external borrowings are denominated in).

Source: World Bank

Source: BCA


Cash Rate cut cycle completed.

Fixed Interest

Sharp rise in bond yields.

Equities NZ pricing a concern

MARKET COMMENTARY Globally there was an uptick in inflation over the quarter primarily due to rising commodity prices but labour conditions in some markets are also becoming tight. NZ is no exception. We expect new CPI data will show inflation is running at closer to 2% year on year rather than the RBNZ forecast of 1.5%. For now the Reserve Bank sees inflation as temporary, leaving the official cash rate unchanged at 1.75% with forward guidance intimating no further rises for 2017 and most of 2018. Such longer term guidance assisted the NZ dollar lower over the quarter. While the OCR rate remains unchanged higher offshore funding costs for NZ banks is putting upwards pressure on retail term deposit rates and lending rates. Should offshore interest rates rise further, for example another US rate rise, then NZ funding rates and deposit rates are lift further regardless of the OCR. The graph top right from First NZ Capital shows the shift in interest rate curves over time. The implied 1 year curve (yellow line) shows an expectation that interest rates will rise strongly across all durations of the curve. This is consistent with the perception that economic growth is accelerating and inflation will start to become more structural. The Federal Reserve rate rise in the quarter and the expectation of further rises saw global bond yields rise sharply in early 2017. 10 year US treasuries which had moved from 1.5% out to 2.6% in late 2016 have since rallied back into 2.3% as geo-political risks see investors moving back into bonds while headline inflation is not yet translating into core inflation. Though the outright risk of deflation appears to have gone, central banks globally appear to be prepared to let economies “run hot” until core inflation has firmly taken hold. Given the trajectory for global growth and possibility of additional fiscal stimulus, long dated bonds appear to be a high risk investment at these levels. Global share markets had another good quarter rising on better corporate results and earnings growth prospects. Using 12 month forecast price to earnings ratios most major markets now appear to be fully valued on an historical basis but still provide better value compared with cash and bond rates. After moving lower over the December 2016 quarter from offshore selling and local profit taking, the New Zealand sharemarket bounced back this quarter extending valuations back above 22 x earnings for the market. Although there will be increasing bouts of market volatility from geo-political risk headlines, we expect shares will rise further over 2017 given the favourable economic growth prospects.


Property Auckland prices softer. Commodities

The listed commercial property sector also had a poor quarter underperforming the broader share market index. The commercial sector however remains in good shape with low vacancy rates and tight office supply supporting rents particularly in quake affected Wellington. According to ANZ data NZ commodity prices in March are 16.5% higher in local terms and 23% higher in international terms than in March 2016. Dairy has been the big mover up 48% on a year ago and likely to support a + $6.50 per kg pay out for 2017. Rising dairy prices are likely to add another $6bn to $8bn into the economy this year and provide some welcome relief particularly for leveraged farming operations. Elsewhere all commodity categories prices (aside from seafood) have had a good rise over the year in world price terms.

While it is far too early to tell, rising interest rates, restrictive lending, new dwelling supply and Chinese capital controls appear to be impacting our housing market. While cashed up buyers are still active, clearance rates are down sharply across a number of regions including Auckland, BOP/Waikato and Wellington. According to REINZ data overall house sales were down -8.9% in February compared with February 2016. Auckland median prices were still 11% higher than a year ago and Northland and Otago reached new record highs. Prices did however dip month on month. Auckland remains one of the most expensive markets in the world on an incomes basis and with rising net migration and still relatively restricted supply it is difficult to see prices falling too far over the medium term despite local leveraged investors and first home buyers being increasingly left out of the market.

Documents

commodity prices and emerging Asia activity. … direction and leadership of China ... rise further yet on better earnings prospects but any delay or retrenchment of ... Depending