Market volatility has continued to increase over the last few weeks following further fallout from sub-prime mortgage delinquencies in the US.

The failure of a large credit hedge fund saw a flight to safety, with US 10-year yields temporarily dipping below 5.00% and equity markets retreating from recent highs. However, the correction proved short-lived, with positive liquidity, M&A activity and share buy-backs helping to remind investors that stocks still offer value and are able to withstand higher interest rates.

In the US, second quarter data show improved cyclical momentum after the country appeared to be in a mild downturn just six months ago. A consistent run of healthy data releases from most parts of the economy show the downturn may have bottomed at the start of the year, with a gradual re-acceleration now unfolding.

This does not mean that all risks have passed, as energy prices remain volatile and the inventory overhang in the housing market is still not completely digested.

However, upside risks could also materialise as prospects for the manufacturing sector have improved substantially on the back of an elimination of excess inventories and resilient external demand. Business spending could well react positively to these developments.

Inflation continues to moderate in the US. However, with the labour market remaining robust, we expect the Fed funds rate to remain unchanged at 5.25% in 2007.

The Eurozone economy has grown 'above potential' for five consecutive quarters now. A substantial part of this is the shift in corporate sector behaviour, which is currently clearly in an expansionary mode, as indicated by investment and hiring data.

In addition, increases in real disposable income, as well as the substantial decline in consumers' unemployment fears, have caused the household sector to step up its appetite to spend.

Meanwhile, despite the recent appreciation of the euro, external demand remains firm. This is because Eurozone firms are increasingly and successfully focusing on the fast-growing markets of Eastern Europe, China, Russia, etc., at the expense of the US and Japan.

The European Central Bank (ECB) continues to see upside inflation risks in the labour market and, coupled with the unabated high money and credit growth rates, this should convince the ECB to continue tightening. We therefore expect the refinance rate to be at 4.5% by the end of 2007, and we foresee a peak of 4.75% in the first half of 2008.

Year to date % returns for major asset classes

although the manufacturing sector is digesting an inventory correction, and household consumption has been disappointing, the Japanese economy continues to grow above its potential. What's more, conditions in the domestic economy are likely to improve further as corporate Japan's willingness to hire and invest still looks relatively firm.

However, with inflation failing to turn decisively positive in 2006, and tighter labour markets failing to accelerate household income growth, it seems likely the Bank of Japan will continue to hike up interest rates gradually over the next two years towards a 'neutral' level in the 2-3% range.

Australian data shows an economy faced with a strong labour market and robust consumption, but benign inflation to date. The main concern for the Reserve Bank of Australia (RBA) will be demand-fuelled inflation, particularly when the Government's fiscal handouts start to take effect. Any hint of inflation surprises and the RBA will be back on a tightening path.

After a strong first quarter, we expect real New Zealand GDP growth to consolidate at a slightly below-trend pace, remaining below major trading partner growth.

Higher effective interest rates will restrain growth in domestic demand, although a degree of fiscal stimulus will continue to provide support. The strong New Zealand dollar will ensure that most of the export sector remains sluggish. The clear exception is the dairy sector, given the remarkably high world pricing.

We believe the NZ dollar has reached levels that are unsustainable in the longer term, but we don't expect any weakness in the currency to be sustained until there is evidence the Reserve Bank of New Zealand (RBNZ) has inflation firmly under control.

Second quarter inflation data indicates that another rate rise is in store later this month.

In the local sharemarket, breadth is deteriorating. Companies exposed to the strong NZ dollar and rising cost pressures continue to be under pressure, although M&A activity continues to provide an offset for selected stocks in the market.

 

Investment markets

International shares

In June, the MSCI World Index fell 0.9% (-5.4% in NZD terms). Returns to New Zealand-based investors were reduced by the still-rising NZ dollar, which rallied 4.9% after the RBNZ raised interest rates for the third time this year.

Global shares gave back some of the gains made in April and May, but still ended up 6.2% for the quarter. A spike in bond yields caused concern that higher borrowing costs may crimp corporate earnings, and fears that sub-prime issues were spreading into broader credit markets rattled already-nervous investors.

MSCI regional performance

Latin American emerging markets continued their run of outperformance, adding another 2.8% in June, while Japan added 1.1%, buoyed by a recovery in the China A-Share market. The developed regions underperformed again this month, with North America and Europe ex UK falling 1.6% and 1% respectively.

New Zealand shares

top and bottom performing stocks (NZSE50)

The NZX50 Index fell 1.5% over the month, mirroring the equally weak US market. However, against that backdrop were two standouts; the Property sector was up 4.0% after a poor showing in May, and Auckland Airport gained 22.4% on information that offers had been received for the business.

The Qantas stake in Air New Zealand was sold into the market, adding an additional 4.2% to the free float. Companies facing the headwinds of a rampant NZ dollar underperformed, despite some experiencing strong growth in their offshore markets.

Australian shares

top and bottom performing stocks (ASX26)

The Australian sharemarket was unable to maintain its recent strong momentum, finishing June 0.2% lower ‚¬Å“ despite setting a new record-high intra-month. However, in New Zealand dollars, the return of the ASX200 was worse, down 2.6%.

Sectoral performance showed considerable divergence with Resources up 5.8%, Industrials down 1.8% and Financials down 2.1%.

International fixed interest

In the US, initially stronger economic data saw treasury yields rise sharply, with the 10-year yield reaching a high of 5.32%. However, concerns about the US sub-prime mortgage market
re-emerged as Bear Stearns was forced into bailing out its hedge funds. This saw a 'flight to quality ', resulting in 10-year US treasuries rallying strongly to close the month at 5.03%.

Globally, the key issue will be the US housing market. Any further deterioration is likely to add stress to secondary margins of mortgaged-backed securities. although defaulting loans are currently contained to just the US sub-prime market, this has caused risk aversion to rise across a number of asset classes.

The net result is that the Fed will be watching the market closely to ensure no liquidity crisis develops. If it does, the possibility of easing may come back into play later this year. At present, this seems unlikely given the current health of the corporate sector and the labour market.

Regional yield curves

 

The New Zealand bond market returned -0.73% for the month, underperforming Cash, which returned +0.66% over the same period. Over twelve months, the New Zealand bond market returned +1.83%, underperforming Cash, which returned +7.88%.The RBNZ raised the cash rate again by 25 basis points (bp) on 7 June, surprising some in the market. While the accompanying press release provided no guidance on future policy moves, the Monetary Policy Statement pointed to significant upside risks to inflation.

Swap rates rose sharply in the first half of June, reaching their highest levels since the Official Cash Rate (OCR) regime was introduced in 1999. With US interest rates rising at the same time, the New Zealand two-year swap traded as high as 8.53%, from 8.18% at the start of the month.

REINZ house price and sales data showed a total number of house sales of 8,846 for May ‚¬Å“ down from the recent February 2007 peak. However, the number of sales is still well above past cyclical lows of around 5,500 a month. The median house price reached a new high of $350,000, which is an increase of nearly 15% on an annual basis.

First quarter GDP came in reasonably strong, showing a 1.0% increase; this was above the RBNZ's expectation of a 0.8% increase. Details highlight unsustainably strong domestic demand (+2.5% for the quarter), sucking in cheap imports at a rapid pace.

The ANZ Commodity Price index rose a further 6.1% in June to be 29.6% higher than a year ago. World dairy prices rose a further 13%.

New Zealand listed property

The New Zealand property index rebounded 4.0% in June, after a couple of weaker months, outperforming the NZX50 Index which returned -1.5%. The sector is now up 5.5% for the year to date ‚¬Å“ slightly outperforming the NZX50, up 4.4% over the same period. Over a 12-month period, the property sector has been even stronger, with a gross return of 22.8%, compared to 20.2% for the broader sharemarket.

Australian listed property

The Australian property sector returned -4.8% during June, underperforming the S&P/ASX300 Accumulation Index by 4.7%. Year to date, sector performance is flat (0.2%), significantly underperforming the 12.9% return from the broader sharemarket. Over the last twelve months, the sector has underperformed by 2.9%.

International listed property

The UBS Investors Index was down heavily with a -8.5% total return for the month of June. Higher bond yields were the main catalyst behind this correction, while valuations had also become stretched following the stellar rise at the start of the year.

After leading the globe with the best returns (year to date) through May, Japan produced the worst returns in June, down 11.9% for the month. Europe continued its underperformance, with Continental Europe down 10.3% in local currency terms, and the UK down 9.0% in local currency terms.

Unlike Japan, Singapore continued its strong performance by producing a +2.7% total return, the only positive regional return for the globe in June.

Currency

The RBNZ lifted the OCR another 25bp to 8% at the start of June, with strong terms of trade (particularly the unexpected rise in dairy prices) clearly influencing its decision.

Just two days later, the Bank surprised the market again by intervening in the currency for the first time since it was first floated in 1985. The initial surprise shocked the kiwi back as low as 0.7488, but before long, renewed carry trade enthusiasm and a weaker US dollar outweighed the RBNZ's influence, to end the month at a post-float high of 0.7726.

Economic data released during the month offered little scope for the RBNZ to relax. May's REINZ housing statistics showed a slight pick-up in turnover and house price inflation running at around 14.8%. The March year-end current account deficit moderated slightly to 8.5% of GDP, and first quarter GDP of 1% confirmed the economy had a good start to the year.

The US dollar underperformed all of the major currencies in June, with the exception of the yen. The spike in US 10-year bond yields was initially positive for the dollar, but concern about funding pressures on the credit market and confidence rattling sub-prime fallout weighed on the US dollar over the remainder of the month. Mixed data failed to give any clear direction and the change in expectations of higher interest rates lagged every other central bank, except for the ECB.

Number of the month: 300,000

The average number of new share-trading accounts opened daily in China over the second quarter of 2007. Chinese investors of all ages continue to be drawn by the lure of the monster returns their local sharemarket has provided over the last 18 months. Since the beginning of 2006, the CSI300 Index has risen over 300%, defying continued speculation the 'bubble' is due to burst. The index is valued at around 40 times reported earnings, making comparable shares almost twice as pricey as those in Japan and India, Asia's next most expensive markets. This year, the Chinese government has announced tighter regulations on borrowing to invest in shares, and tripled tax duty imposed on securities trading. On both occasions, these changes have led to a double-digit fall in shares ‚¬Å“ the February 27 decline prompting the sharpest global equity sell-off since the September 11 terrorist attacks. However, despite these dips and the rationale that 'what goes up must come down ', the Chinese public is becoming more and more confident in the returns of shares, with some going as far as quitting their jobs to become full time day-traders! Hmmm, sound familiar?