Investment Outlook Clouds Gathering But No Recession Forecast

Transcription

1 June 2017 Investment Outlook Clouds Gathering But No Recession Forecast NZ Equities Australian Equities BUY NZ King Salmon, Metlifecare and Z Energy - page 12 BUY Boral, Caltex Australian and Ramsay Healthcare - page 16 Global Equities BUY exposure to Europe and technology - page 20 Interested in economic and financial market developments, then follow us on LinkedIn -INFINZ Sharebroker of the Year (2017) for the eighth time in ten years

2 Overview June 2017 From an economic perspective the global economy appears to be in good heart. However, we sense an element of complacency in financial markets. While there are no signs of an imminent recession (the usual precursor of a bear equity market), investor complacency leaves little room for error when equity markets are at record highs. After all, the world is far from being risk free. With this in mind we discuss the complex geopolitical tensions unfolding in Asia. The outlook for the NZ economy is positive and has been given an additional boost from an election year budget. Furthermore, it appears that the Reserve Bank of NZ wants to be in no doubt that inflation is back before raising interest rates. Conversely, the US Federal Reserve appears keen to get on with the job of reducing monetary policy stimulus. The NZ dollar is thus left trapped in the middle of an unsupportive interest rate environment and a solid economy. We examine the adage that time in the market is more important than timing the market. In doing so, we note that an extremely small number of the best and worst days in equity markets have a significant impact on investment returns. It also reminds us of a very important quote from Donald Trump, Some of the best investments are the ones you don t make. Financial markets are all about people. With this in mind we introduce two new sections to the Investment Outlook where we profile a notable NZ Chief Executive Officer and one of our analysts. In noting that our analysts form the core of FNZC investment research we would like to acknowledge our Head of Research, Arie Dekker. Arie was named INFINZ Analyst of the Year (2017) for the fourth year in a row. In aggregate the research team was ranked in the top 3 for 16 of the 18 research awards, and achieved 9 firsts. First NZ Capital Securities Ltd NZX Firm 2

3 Investment Outlook June 2017 Contents Clouds Gathering, But No Recession Forecast 4 Portfolio Structure 6 Asset Allocation 8 PGG Wrightson s CEO: Mark Dewdney 9 FNZC s Healthcare and Technology Expert - Tristan Joll 11 NZ Equities 12 Australian Equities 16 Global Equities 20 Geopolitics in Asia 23 Interest Rates - Sure to Rise 25 NZ Dollar - Sidelined 27 Time in the Market is More Important than Timing the Market 28 FNZC Investment Portfolio Series - Model Portfolios 30 A Useful Lesson when Investing in Offshore Securities 32 Calendar of Major Events: June- August If in Doubt Contact Your Adviser 35 First NZ Capital Securities Ltd NZX Firm 3

4 Clouds Gathering, But No Recession Forecast Key Takeaways + + Bear markets generally require a recession. + + Does elevated investor confidence suggest complacency? + + Investors should give due consideration to global uncertainties. Looking for the Elusive and Inevitable Market Downturn Equity markets generally spend a much larger portion of time rising than falling. Despite this, financial market participants spend a high proportion of time worrying about the arrival of the next downturn. By downturn we mean the occurrence of a bear market which is defined as a fall in equity values of 20% or more (since 1972 there have been 5 such declines in the US). Such downturns can inflict material damage to investment portfolios. As illustrated on page 28 it is far more beneficial when considering long term investment returns to miss the worst downturns than it is to enjoy the best upturns. However, both downturns and upturns are hard to identify ahead of time. Not unexpectedly the key attribute of equity market downturns is the onset of an economic recession (a period of at least two successive quarters of negative economic growth). When the economy is weak a greater proportion of companies experience declining profits. In isolation high equity market valuations and high Forecasts Economics As at 25 May 2017 Fiscal Balance % GDP 1 GDP Growth % Inflation % 3 month Libor % 2 10 Year Government % 2015 A 2016 F 2017 F 2016 A 2017 F 2018 F 2016 A 2017 F 2018 F Spot 3 mth 12 mth Spot 3 mth 12 mth New Zealand Australia US Japan Europe United Kingdom China n/a n/a Source: FNZC, Credit Suisse, UBS, Bloomberg 1 New Zealand fiscal balance is 30/6 2 NZ are 90-day bank bill yields Equities and Commodities Spot 12 mth forecast Past Month Past Year Australia ASX 200 5,790 5,560-6, % 7.8% Emerging Markets MSCI EMF GEM 1, , % 26.9% Europe Stoxx 50 3,585 3,560-3, % 17.1% Japan Nikkei ,813 19,100-21, % 18.2% New Zealand NZX 50 7,434 7,100-7, % 7.6% UK FTSE 100 7,518 7,000-7, % 20.0% US S&P 500 2,415 2,280-2, % 15.5% Oil Brent USD/Bbl % 3.5% Gold USD/Oz 1,256 1,050-1, % 2.6% Source: FNZC, Credit Suisse, UBS, Bloomberg Foreign Exchange USD NZD Spot 12 mth Spot 12 mth NZD AUD EUR JPY GBP CNH Source: FNZC, Credit Suisse, UBS, Bloomberg First NZ Capital Securities Ltd NZX Firm 4

5 Investment Outlook June 2017 degrees of investor optimism do not trigger equity market falls. However, they do leave equity markets more vulnerable to a correction. An equity market correction typically results in a 5-10% decline in the value of the equity market before the rise resumes. Investor Complacency Strong Investor Confidence Source: FNZC, Financial Markets Authority We believe that equity markets are not currently factoring in enough risk given the uncertainties which currently exist. This is evident in the high level of equity markets, high investor confidence, the low level of implied volatility in the US equity market and economic indicators outside of the US and UK which appear to have limited capacity to positively surprise. Proportion of Net Confident Investors % Reasons for the perceived complacency regarding risks include: 1. The commonly held belief that there is no alternative, often shortened to TINA. Essentially this means that due to historically low interest rates investors are compelled to invest in equities and other riskier assets. 2. Over the past eight years investors have become accustomed to central banks doing whatever is required to support financial markets whenever they appear shaky. However, like antibiotics, central bank actions are becoming less effective over time. To be clear while we are not expecting a recession and therefore are not expecting a bear market. Although an equity market correction isn t out of the question. Considering the Uncertainties growing problems for President Trump, potential stalling of Chinese economic growth and an Italian election The uncertainties include North Korea and the developing geopolitical situation in eastern and southern Asia (discussed in detail on page 23), potential for higher interest rates, the risk of trade protectionism, growing problems for President Trump, potential stalling of Chinese economic growth and an Italian election. Considering these in turn: 1. The US Federal Reserve (Fed) appears on track for interest rate normalisation. However, if as we have seen before, the US economic outlook deteriorates then monetary policy tightening will be put on hold. We discuss this further on page The threat of trade protectionism at this stage appears confined to a renegotiation of the North American Free Trade Agreement (NAFTA). 3. Day by day President Trump s problems seem to grow, which reduces the chances of his policies being implemented. Following the sacking of FBI Director, James Comey, there is speculation of Trump being impeached. The road to impeachment is First NZ Capital Securities Ltd NZX Firm 5

6 long and complex and seems unlikely while the Republicans have a comfortable 45-seat majority in the House of Representatives. However, this may change if the Democrats have success in the 2018 mid-term elections. 4. An unexpected tightening of liquidity conditions in China has been associated with a downturn in construction activity and adverse impact on commodity prices, such as iron ore. We still expect the Chinese economy will be resilient ahead of the 19th Communist Party Congress in November. 5. Italian voters are expected to go to the polls sometime between October 2017 and March Being Europe s third largest economy and with a much greater desire to leave the European Union than the French, the outcome of this election is expected to be important for Europe and could unsettle financial markets. Portfolio Structure Based on the mix of high equity market valuations and perceived investor complacency we have tactically reduced the exposure to global equities by 2%. With a more favourable NZ equities outlook we have increased the exposure by 1%. The 1% balance we put into cash on a temporary basis and would look to redeploy into equities on any equity market pull back. Global Equities The world is in better shape than it was a little over a year ago. Fiscal tightening has eased, bank balance sheets are much improved and hard commodity and oil prices have recovered from the low levels where they were having a negative impact on the global economy. However, we sense some investor complacency, which we believe is dangerous when global equity markets are trading at historically high valuation ratios. Furthermore, we see less upside potential from a weaker NZ dollar than has previously been the case. We discuss further aspects of global equities on page 20. Australian Equities The Australian Federal Government budget was instrumental in retaining Australia s AAA credit rating. However, it was done largely by a levy on the liabilities of the big five Australian banks which could negatively impact bank profits by 2-3%. Combined with lacklustre profit announcements and the recent fall in interest rates bank share prices have fallen. While the banks aren t exciting investments due to limited loan growth, very low bad debt levels and a reliance on cost reduction to drive profit growth, we now see value in the banks. Furthermore, they have solid balance sheets and pay sound dividend yields which should be sustainable, except in a recession. Resource companies are expected to record a 20% increase in FY17 earnings and are the main contributor to Australian corporate earnings growth. This reflects higher commodity prices driven by Chinese demand. We expect the Chinese economy to be solid ahead of the 19th Communist Party Congress in November. However afterwards, economic growth may ease as economic reforms are initiated. The valuations of Australian companies look relatively high once the banks and resource companies are excluded. Consequently, our best investment ideas are First NZ Capital Securities Ltd NZX Firm 6

7 Investment Outlook June 2017 Resource companies are expected to record a 20% increase in FY17 earnings typically companies which appear to offer good value, but have challenging outlooks. For example, Henderson Group, AMP, Ramsay Healthcare and Caltex Australia. The main economic concern in Australia is the inflated state of the housing market. NZ Equities Economic indicators continue to paint a solid outlook for the NZ economy in the short term. There are some pressures in the economy with tourism facing infrastructure constraints, house construction is running at close to full capacity and some mortgage interest rate increases. However, consumer confidence is solid, supported by firm house prices, low unemployment, tax cuts and increased government spending. The wild card for future growth is immigration, which remains high. Recent changes to immigration rules suggest future growth will moderate. However, potentially not as much as forecast. In the medium term we are monitoring Asia s economic growth and signs of trade protectionism. Even though the NZ equity market is trading at a historically high PE ratio of 18.8x this appears fair relative to global equities. Hence we reduce our underweight to NZ equities. NZ Debt Securities A detailed discussion of the outlook for interest rates is given on page 25. Property Property stocks typically underperform the broader equity market when interest rates rise and outperform when they fall. Given our expectation that interest rates will rise we are cautious on property investments. Already there are signs that credit availability for property investment and development is getting harder to source. Warehouse Property is Benefiting from Retail Property s Demise Source: Bloomberg The impact of on-line shopping is a key theme for property stocks. Over the past quarter we have seen US retailers announce the closure of hundreds of stores in order to better align their cost base with declining sales. This is expected to be an ongoing trend as store leases come up for expiry. Retailers are exiting low quality shopping centres and clammering to get into high quality centres. However, to date investors do not appear to have discriminated between the owners of top and lower quality shopping centres. The beneficiaries of on-line shopping are providers of warehouse space, such as Goodman Group, Goodman Property Trust and Prologis. In Australia and the US there has been a significant difference between the performance of shopping centre and warehouse owners. This has resulted in Goodman Group appearing expensive while Scentre Group and Westfield Corporation appear cheap. This trend is yet to emerge in NZ /01/17 14/02/17 21/02/17 7/03/17 14/03/17 28/03/17 11/04/17 18/04/17 25/04/17 2/05/17 9/05/17 Goodman Group Simon Property Group Prologis Westfield Scentre Group 16/05/17 First NZ Capital Securities Ltd NZX Firm 7

8 Asset Allocation June 2017 Based on the Portfolio Structure discussion (page 6) we have altered the tactical asset allocation by reducing global equities by 2% and increasing NZ equities and cash each by 1%. The strategic asset allocation represents the average weighting over the long term (circa ten years or an entire economic cycle). The tactical asset allocation represents a deviation from the strategic allocation to take advantage of expected changes in asset class returns over the short term (say 6 months plus). % Strategic Allocation Tactical Deviation % Income Assets Growth Assets Conservative Cash NZ Debt Securities Property NZ Equities Australian Equities Global Equities Alternative Strategies Balanced/Conservative Cash NZ Debt Securities Property NZ Equities Australian Equities Global Equities Alternative Strategies Balanced Cash NZ Debt Securities Property NZ Equities Australian Equities Global Equities Alternative Strategies Balanced/Aggressive Cash NZ Debt Securities Property NZ Equities Australian Equities Global Equities Alternative Strategies Aggressive Cash NZ Debt Securities Property NZ Equities Australian Equities Global Equities Alternative Strategies First NZ Capital Securities Ltd NZX Firm 8

9 Investment Outlook June 2017 PGG Wrightson s CEO - Mark Dewdney Key Takeaways + + Mark has been moulded by a variety of influences. + + PGW s key strength is people employees and customers. + + Technology is creating risks and opportunities. While Chief Executive Officers are far from being the sole person determining the success of a company they none-the-less play a vital role in setting the tone of the company and the direction it will take. Consequently, we plan to include quarterly articles on New Zealand CEO s in the Investment Outlook. This quarter we are delighted to profile the CEO of agricultural services company, PGG Wrightson (PGW), Mark Dewdney. Moulding the Man To understand Mark s approach to the role it is worthwhile considering the events which have shaped him. Growing up in the Waikato his playground was the Tatua Dairy Factory, which was managed by his father. His father was an early role model who instilled an ethic of hard work and having a passion for what you do. Mark currently lives on a dry stock farm in the Waikato. When he is not travelling around PGW s various businesses or at the Christchurch head office he works out of the Hamilton office. On these days Mark tries to fit in some farm work before he undertakes his day job at PGW. Mark believes that being a farmer teaches you to be practical and how to deal calmly with unexpected challenges. Mark returned to NZ from the UK, having decided to follow a career in business rather than as a professional cricketer. Since then he has had a diverse career. His first port of call was the Tatua Dairy Company, followed by roles at Crean Foodservice which was acquired by Bidfood, the Livestock Improvement Company (LIC), Fonterra and finally back to LIC, before being approached to run PGW four years ago. The wide variety of roles took him from NZ to Singapore and Japan and resulted in significant involvement in China. The time in Asia gave Mark a deep appreciation of the different ways of doing business, building relationships across cultures and the benefits of setting long term goals. Strengths So what are PGW s strengths? According to Mark they are: 1. People; 2. People; 3. PGW s diversity across many geographies and all agricultural types except forestry and aquaculture and; 4. Longevity - PGW has been serving the agriculture industry for more than 150 years. In terms of people, Mark spends a significant amount of time meeting staff to ensure they understand where PGW is heading and clearing road blocks in order to make their jobs more satisfying and productive. Equally important is working with customers in order to understand their needs. First NZ Capital Securities Ltd NZX Firm 9

10 Technology Risk and Opportunity As with many industries technology is increasingly having an impact on agriculture. These days on farm data is enabling all aspects of farming to be understood at a granular level. This allows for precision agriculture and for farmers to make comparisons between farms so as to quickly adopt the best farming practices. Furthermore, the way farmers interact with suppliers and service providers is changing. Consequently, technology on farms appears to have reached a tipping point. Technology will need to be used by PGW to develop solutions to farmers problems Technology is both a risk and an opportunity for PGW in the medium term. While PGW has relationships with many farmers, its technology offering, and the ability to create its own technology solutions, is still developing. Meanwhile, on the other side of the fence there are many entrepreneurial developers who have exciting technology, but no access to customers. The opportunity for PGW is to team up with selected technology developers. In time PGW is likely to have to rely on technology to survive, rather than solely on its personal relationships with farmers as it does today. This transition is likely to need careful management in order to ensure staff are not divided between the old ways of doing business and the new ways which rely on technology. The transition is likely to see a significant change in the supply chain which provides farmers with goods and services. For instance, stock is less likely to go through a saleyard and farm supplies are more likely to come straight from the manufacturer rather than via a rural store. Technology will need to be used by PGW to develop solutions to farmers problems. The changes being brought on by technology are forcing PGW to think about new ways of serving farmer customers. For example, developing methods for farmers to manage the risks which they have no control over, such as through the use of milk futures in order to manage milk price risk. While in the farm supplies space PGW might move to provide private label products to farmers, in the same way supermarkets offer private label groceries to customers. With respect to the challenges and opportunities brought about by technology there is a careful balance between being too conservative and becoming irrelevant (no one wants to be remembered as another Kodak), and being too aggressive and not bringing staff and customers along with you. Clearly thinking about and executing strategies for the future are important. However, PGW s management team also spends significant time looking to improve the existing business and grow market share from the 30-50% share across various activities that PGW has currently. Under Mark s direction PGW has grown earnings per share from 3.5c in 2013 to 5.2c in While PGW is to be commended for this achievement the company is well aware that there is no room for complacency, taking their eye off the ball or becoming over confident about their success. On 25 May 2017 PGW s share price was $0.60. FNZC currently rates PGW outperform with a target price of $0.65. First NZ Capital Securities Ltd NZX Firm 10

11 Investment Outlook June 2017 FNZC s Healthcare and Technology Expert - Tristan Joll Key Takeaways + + Through innovation FPH is generating strong revenue growth where it counts. + + Further options exist to reduce production costs. + + Key risks for FPH litigation, changes to the reimbursement regime, regulatory change and competition. Price $10.38 Target Price $10.50 Tristan Joll joined the FNZC Equity Research team in July 2016 having spent the prior ten years in equity research positions, first with Goldman Sachs JB Were then more recently with UBS. His current research focuses are Technology, and Healthcare; this includes Fisher and Paykel Healthcare (which we profile below), Xero and Trade Me. Past research interests have included telecommunications, media and manufacturing. Prior to his career in equity research Tristan held roles with Telecom New Zealand, Level (3) Communications UK and Air New Zealand. A highlight of this period was working for a global provider of telcommunications infrastructure through the technology bubble (then crash) of the late 1990s. Tristan is based in Auckland with his young family; with the spare time this leaves he enjoys cycling and fishing. Fisher and Paykel Healthcare (FPH) FPH has an enviable track record having grown earnings by 20%pa over the past four years which has been reflected in a 34%pa investment return to shareholders. The recent 2017 profit announcement showed that this phenomena is ongoing. To quote Tristan, FPH is Not stopping for a breather. In 2017 FPH grew earnings before interest and tax (EBIT) by nearly 14% despite incurring $21 million of litigation costs, and without appearing to compromise investment in future growth. Ignoring the impact of currency changes revenue in the hospital focused respiratory and acute care (RAC) business revenue grew by 19%. The growth being underpinned by strong growth in consumables (masks and tubing etc) used in the new applications of non-invasive ventilation, oxygen therapy, humidity therapy and surgery. These are all areas where FPH faces minimal competition and are gaining greater hospital acceptance. In the homecare obstructive sleep apnea (OSA) business revenue grew 8%. This included 13% growth in nasal mask sales where FPH is gaining market share through the steady release of new models. The one area where FPH has been lagging the market is its OSA flow generator. However, the new SleepStyle flow generator has built-in cellular and Bluetooth connectivity, a patient app and patient management software which matches that of the competition. For both RAC and OSA the growth in sales of consumables is critical as they earn the highest profit margin. FPH further boosted profit margins through the transition to a direct distribution model for RAC in the US and increasing the proportion of product made in Mexico (currently only 34%), as it is 20% cheaper than producing it in NZ. FPH is able to continually innovate through research and development, which amounts to nearly 10% of revenue annually. A 67% increase in litigation costs to $35 million saw 2018 profit guidance a little lower than expected at $ million. This cost should ease in The outcome of the litigation is unlikely to be known for another year and could result in a positive, neutral or negative for FPH. First NZ Capital Securities Ltd NZX Firm 11

12 New Zealand Equities share prices as at 25 May 2017 A2 Milk Company (ATM) Price $3.43 Target Price $3.92 Rating Outperform ATM continues to evolve from a branded Australian liquid milk company to a global dairy nutrition company that promotes the digestive benefits of A2 type milk dairy products. ATM has had great success with its a2 Platinum brand in China where it currently has 0.5% infant formula market share. As a result, ATM s share price has risen by 63% year-to-date. We remain positive on ATM s outlook as the company skews its revenue mix towards higher margin infant formula product. ATM is expected to deliver infant formula volume growth of 23% and 14% in FY18 and FY19 respectively. Profit margins should be supported by the successful implementation of a 4% price increase. Excluding losses generated in the UK and US this drives forecast profit growth of 26% in FY18 and 16% in FY19. While we remain optimistic about the outlook for ATM, we acknowledge the rapid share price appreciation probably warrants an element of caution in what can be a volatile industry. Key risks for ATM remain market and regulatory changes in China, execution of its US strategy, new competition and ongoing legal challenges. Auckland International Airport (AIA) Price $6.98 Target Price $5.20 Rating Underperform International passenger growth has been the primary driver of AIA s strong profit growth in recent years. Strong growth in Chinese visitation to New Zealand has arisen as the middle class continues to expand in China. In addition, lower jet fuel prices and a competitive airline industry have resulted in attractive air fares for travelers, and consequently more passengers using AIA s facilities. We expect these trends to continue, with international seat capacity growth of 13.8% forecast for The profit from AIA s aeronautical business is capped by regulation. However, the nonaeronautical part, of which retailing is a major part, is not. AIA s retail business benefits from more airline passengers passing through the airport and the increase in the average spend per passenger. Despite the solid track record and strong outlook we believe AIA s share price is expensive (our 12-month target price is $5.20). There is little doubt that AIA is a high quality infrastructure asset. However, its ability to generate returns in excess of its cost of capital, and thus justify its current share price, is limited primarily to its retail operations and, to a lesser degree, property development. Therefore it is difficult to justify the current 33x price-to-earnings ratio. Goodman Property Trust (GMT) Price $1.25 Target Price $1.27 Rating Neutral We like GMT s strategic bias of investing in Auckland industrial property and reweighting its portfolio away from suburban office and Christchurch property. Operating conditions within the industrial property sector remain favourable with sustained economic growth supporting solid tenant demand. This has resulted in an improved occupancy rate of 98% in FY17 across its entire portfolio and 100% across its industrial properties. GMT s focus on industrial property provides exposure to the theme of increased internet shopping which requires warehouse and distribution facilities. Overseas this has seen the share prices of shopping centre companies fall First NZ Capital Securities Ltd NZX Firm 12

13 Investment Outlook June 2017 while those of industrial property companies have risen. This is yet to occur in a meaningfully way in NZ. GMT is committed to funding its future development activity through the recycling of non-core assets as opposed to raising new equity capital. We believe that lowering targeted gearing to between 30-35% (currently 30.6%) is a sensible response to rising asset values and provides greater capacity to absorb a property market downturn should it occur. GMT has begun a transition to a more sustainable distribution policy. This is evident through GMT s ratio of dividends paid to underlying earnings (adjusted for management fees) reducing from 122% in FY16 to 103% in FY17. Metlifecare (MET) Price $5.59 Target Price $7.46 Rating Outperform MET has an attractively positioned retirement village portfolio. Its villages have seen a significant uplift in the value, due to the very strong residential property market in recent years. With the growth in retirement unit prices appearing to have peaked, MET is evolving its strategy to include new retirement village developments much like its peers Ryman Healthcare (RYM) and Summerset (SUM). MET s development capability is supported by its considerable funding capacity. While MET needs to increase the amount of land owned for development to provide more confidence in its strategy and diversity, MET has a clear objective of heading towards constructing 200 plus new retirement units in FY17 and FY18, and a sustainable build rate of 300 plus units post MET remains our preferred retirement village stock with no development potential incorporated into its share price. Recently, MET s share price has declined following the placement of Infratil s 20% stake at $5.61. As a result, MET is currently trading on a price-to-net tangible assets (NTA) ratio of 0.8x, substantially less than RYM and SUM on 2.5x and 1.8x respectively. Risks to MET include its untested development capability, the older age of its villages and the potential for increased competition in the retirement village sector, particularly in Auckland. NZ King Salmon (NZK) Price $1.35 Target Price $1.49 Rating Outperform NZK is the world s largest producer of King Salmon, operating eight salmon farms in the Marlborough Sounds. We believe NZK is well placed to exceed its prospectus profit forecasts for FY17 and FY18 from a combination of higher expected salmon prices and a larger salmon harvest. The recent global shortage of Atlantic Salmon has caused salmon prices to rise significantly over the past 18 months. This has been caused by algae issues in Chile, which has decimated production, and reduced Norwegian production due to sea lice, which has adversely impacted fish quality and increased production costs. NZK should be able to increase salmon production through an improvement in feed conversion and lower fish mortality rates due to increased production at high-flow sites, including three new salmon farms, and the use of new summer diets for the salmon at low-flow sites. Our $1.49 target price incorporates higher production expected at NZK s existing salmon farms. However, it includes no upside from being granted consents for additional fish farms, or consents allowing fish farms to be shifted form less productive low-flow sites to more productive high-flow sites. First NZ Capital Securities Ltd NZX Firm 13

14 Vector (VCT) Price $3.26 Target Price $3.44 Rating Neutral VCT has a relatively stable, defensive business that is expected to deliver relatively modest earnings growth. VCT s electricity business should continue to experience incremental growth from the strong housing growth in Auckland. The resulting growth in customer connections helps to offset the ongoing impact of falling electricity consumption per household. It is worth noting that VCT s regulated earnings are sensitive to interest rates. If interest rates track higher as we expect, VCT should benefit from a higher regulated rate of return, which supports higher earnings. Offsetting the earnings growth from electricity distribution is the continued profit decline in VCT s gas trading business as legacy gas contracts roll onto lower gas prices and VCT s gas supply declines. In time, VCT s technology division (which includes metering services) is expected to deliver earnings growth. Recent acquisitions have targeted energy solutions businesses such as E-Co Products (also known as HRV) and PowerSmart Solar. While VCT s NZ metering business is approaching saturation, VCT is now focusing on Australia where it recently installed 20,000 meters. We believe VCT can sustain an attractive dividend yield (7.2% forecast in FY18). Xero (XRO) Price $24.35 Target Price $23.50 Rating Neutral Investors have become more confident with XRO s growth profile. In the UK and Australian accounting software market competition appears benign. XRO continues to add more subscribers than Sage and Intuit in the UK. In Australia MYOB is showing little improvement in subscriber numbers which suggests MYOB is struggling to convert customers from desktop to cloud based software. Other positives include better cost control due to increased scale and a decisive strategy to move the business to cash flow breakeven, thus avoiding the need to raise new equity capital. We expect XRO will achieve this target in late The challenge in valuing XRO is balancing its success to date with its forecast growth in North America, which continues to struggle to gain traction. XRO s share price has risen 38% year-to-date and is now trading above our target price. Consequently, while we expect strong subscriber growth, good revenue conversion and improving profit margins, we recommend a degree of caution. Z Energy (ZEL) Price $7.78 Target Price $8.22 Rating Neutral ZEL faces a short term risk from the Government s review of fuel prices. The issues around what is an appropriate fuel margin are complex and vary across fuel distributors. The review is expected to be completed by the end of June. Higher fuel margins have made fuel distribution a profitable business, with new service stations being opened following a period of closures three years ago. In the long term electric vehicles pose a threat to a large part of ZEL s business. ZEL has time to evolve and is serious about considering future growth options as illustrated by the existence of a Chief Innovation Officer. If ZEL is unable to evolve it could simply decide to maximize profits until its ultimate demise by discontinuing many of its current activities and running the business hard to maximize profit. ZEL is benefiting from a lift in aviation fuel margins as imported fuel become a greater proportion of aviation fuel used in NZ. In the immediate future we believe that ZEL has opportunities to run its business more efficiently. Finally, as ZEL pays down debt we believe that it will be able to almost double its dividend in 2019, giving a forecast gross dividend yield of 10.9%. ZEL s Board plans to reassess its dividend policy at the end of First NZ Capital Securities Ltd NZX Firm 14

15 Investment Outlook June 2017 Security AFT AIA AIR ARG ARV ATM AUG AWK BGR CEN CNU DGL EBO ERD FBU FPH FRE FSF GMT GNE HBL HLG IFT IPL KMD KPG MCY MEL MET MFT MHJ MPG MVN NZK NZR NZX OHE OIC PCT PEB PFI PGW POT RBD RYM SAN SCL SKC SKL SKT SML SPG SPK STU SUM TGH TME TNR VCT VGL VHP WHS XRO ZEL NZ50 Issuer Name AFT Pharmaceuticals Auckland Airport Air NZ Argosy Property Arvida A2 Milk Company Augusta Capital* Airwork Holdings Briscoe Group* Contact Energy Chorus Delegat Group Ebos Group* EROAD Fletcher Building Fisher & Paykel Healthcare Freightways Fonterra Shareholders Fund Goodman Property Trust Genesis Energy Heartland Bank Hallenstein Glasson Holdings* Infratil Investor Property* Kathmandu Kiwi Property Group Mercury NZ Meridian Energy Metlifecare* Mainfreight Michael Hill International Metro Performance Glass Methven New Zealand King Salmon NZ Refining NZX Orion Health Opus International Consultants Precinct Properties Pacific Edge Property For Industry PGG Wrightson Port of Tauranga Restaurant Brands Ryman Healthcare* Sanford Scales Corporation SkyCity Entertainment Skellerup Sky Network TV Synlait Milk Stride Property* Spark NZ Steel & Tube Summerset Group* Tegel Group Trade Me Turners Vector Vista Group International Vital Healthcare Property Trust* Warehouse Group* Xero Z Energy NZ Equity Market Source: FNZC, Bloomberg. The P/E ratios and Gross Dividend Yield use earnings and dividends forecasts for the next 12 months. *Consensus forecasts NZ Equities Valuation Metrics and Ratings As at 25 May 2017 Gross Dividend Yield % SPG STU SKT GNE TPW WHS PGW P/E Ratio x TGH AWK KMD ARG MVN AIR SPK MPG FBU MEL NZX SKL GMT NZR IPL IFT Gross Dividend Yield % VHP HBL VCT KPG PCT SCL THL PFI P/E Ratio x AWK OIC MPG STU TGH KMD MVN HLG NZR FSF WHS AIR SKT PGW FBU MHJ SCL TPW HBL SML AUG SAN SKL THL BGR ZEL ARV TRA ARG CNU MET GMT DGL IPL NZK SPG SPK NZX RBD SKC EBO KPG FRE PCT PCT MFT VHP XRO CEN TME PFI NZ50 ATM VCT TLT GNE MCY FPH AIA VGL MEL POT SUM RYM Ratings P/E Ratio x Underperform Neutral Overperform OIC CEN CNU MCY AIA AIR ARV AWK AFT ARG FBU POT DGL CNU FPH GMT CEN ATM MET RYM SKT HBL FRE KMD MVN ERD MPG SKC IFT FSF NZR PEB MHJ SKT MEL GNE NZX PGW NZK SPK MFT KPG SAN RBD SCL TME THL OHE ZEL TLT TGH TRA OIC PCT PFI STU SUM TPW VCT VGL WHS XRO ZEL FSF TLT MET MCY RBD TME NZ50 FRE MHJ SUM SKC TRA SAN ARV AIA NZK WHS RYM POT MFT FPH DGL RYM VGL SUM MET First NZ Capital Securities Ltd NZX Firm 15

16 Australian Equities share prices as at 25 May 2017 AMP (AMP) Price $5.18 Target Price $5.50 Rating Neutral Unsurprisingly AMP s share price has been de-rated in recent years due to the challenging operating environment that has been marked by weak funds flow, regulatory changes, the steady decline of its mature business, pressure on adviser remuneration and fees. However, we believe that these issues are broadly reflected in AMP s share price. We consider a significant cost reduction strategy as the most likely catalyst for a share price rerating, but there is also the potential for incremental revenue growth. Disappointingly, in the March quarter AMP experienced a $199 million funds outflow from its flagship Wealth Management business. While this was unexpected annual funds flow is expected to be marginally positive. The combination of further cost out and new Advice and Self-Managed Super Fund initiatives should help offset margin pressures in a business that contributes 39% of group earnings. We remain comfortable forecasting 5-8% of operating earnings growth for the next five years. However, this is dependent on stable financial markets. AMP is in a strong capital position, even after completing a share buyback. AMP appears to offer good value relative to the broader Australian equity market, with a 5.9% forecast FY18 cash dividend yield. Boral (BLD) Price $6.82 Target Price $7.05 Rating Outperform BLD remains a preferred stock with its dual exposure to emerging Australian infrastructure spend and the US housing recovery. In Australia, there are a number of major road and infrastructure projects on the east coast that BLD is currently tendering for, with a total value of A$25 billion. Construction material intensity, which can vary from 1.5% to 6.0% depending on the project, is critical for BLD. Hence, concrete intensive projects such as concrete roads and tunnels are preferred. The influx of proposed work has created a favourable pricing environment. We estimate every 1% increase in prices equates to approximately $30-35 million of earnings or 4-5% to group earnings. However, our price growth forecast is a conservative 0.5% over FY18/19 due to patchy outcomes in the past. In the US, the Headwaters acquisition has been approved and did not include any forced asset sales. Headwaters combines a niche portfolio of building products and an extensive distribution network, which will expose a greater proportion of BLD s earnings to the cyclical recovery in US residential and non-residential construction. The acquisition is also complementary to BLD s existing US cladding and roofing business. Therefore, we believe there is further upside from additional synergies. The other key focus for BLD is the sale of non-core assets worth around US$450 million to reduce debt. While gearing is expected to peak in FY18 at 2.5x net debt to EBITDA, a successful sale of these businesses and retained cash flow could see gearing fall to 1.5x by FY19. First NZ Capital Securities Ltd NZX Firm 16

17 Investment Outlook June 2017 Caltex Australia (CTX) Price $32.78 Target Price $39.70 Rating Outperform CTX s share price has responded positively to the announcement that Australia s antitrust regulator (ACCC) won t oppose the acquisition of Milemaker Petroleum s retail fuel distribution business in Victoria. Attention now turns to the ACCC s decision on the Woolworths/BP transaction expected on 13 July If fully approved it would likely reduce CTX s earnings by A$ million per year from the loss in supply volumes. However, there remains a possibility that the ACCC will want the proposal amended, which may reduce the impact on CTX. Nonetheless, CTX are confident it will be able to close the earnings whole through organic growth, potentially supplying some of BP s NSW fuel requirements or using its excess capacity to service other higher margin customers. CTX s earnings continue to face fluctuations in refining margins, which are not expected to return to the high levels seen in 2014/15 but should remain firm. In the medium term, CTX management believes that there is significant upside from convenience retailing which has shown some early success in three pilot sites where sales increased by 20-35%, albeit early days. CTX has a very strong balance sheet with gearing (net debt/net debt + equity) expected to drop to around 10% in FY19. Consequently, management remain committed to returning surplus funds to shareholders. Commonwealth Bank of Australia (CBA) Price $81.26 Target Price $89.00 Rating Neutral The Australia banking sector has recently underperformed following slightly weaker than expected profits in the March quarter and the 2017 Australian Budget, which implemented a surprise levy of 0.06% on the liabilities of the big Australian banks. We expect the levy will adversely affect CBA s profit by 2%. Adding to the weaker sentiment is Australia s prudential regulator (APRA), which is expected to provide clarity on unquestionably strong capital requirements in the coming months. In aggregate, all of the above has resulted in a subdued earnings outlook for the banks and therefore dividend growth has stalled. The banks are experiencing pressure on their net interest margin, which is attributable to higher wholesale funding costs, increased competition for deposits and lower commercial lending margins, which has been partially offset by repricing loans to residential property investors. On the positive side bad debts are low, costs are being reduced and bank capital positions are strong. Despite these pressures the reduction in bank share prices has left the sector offering good value for investors. While CBA s share price has fallen less than the other banks recently it currently offers a FY17 forecast cash dividend yield of 5.3%. The big concern for the Australian banks is a potential fall in house prices. Henderson Group (HGG) Price $41.20 Target Price $41.00 Rating Neutral The last 12 months have been underwhelming for HGG because of the Brexit vote, which adversely affected the value of its UK business due to depreciation of the British pound, and triggered retail investor fund outflows. However, the consistent gradual improvement since retail net outflows peaked in November 2016 is encouraging. The merger with Janus has now been approved, resulting in a combined $340 billion of funds under management. The merged entity provides a broad product offering with Janus having a US equity, emerging market equity and US fixed income platform and HGG having a European equity, global equity and global fixed income platform. We expect the merged entity will capture 90% of the US$110 million expected cost synergies and a modest improvement in funds flow. While HGG is First NZ Capital Securities Ltd NZX Firm 17

18 trading at similar FY17 valuation multiples to its peers, if HGG can achieve our forecast earnings growth of 11%pa over the next three years, its FY19 valuation multiple will be at a 10% discount to peers. It is worth noting that HGG s earnings are highly sensitive to the performance of equity markets due to the impact on funds under management, funds flow and performance fees. We believe that this is the biggest risk faced by HGG, as it is estimated that a 10% movement in equity markets affects earnings by 12%. Ramsay Health Care (RHC) Price $70.15 Target Price $73.00 Rating Neutral RHC is a private hospital operator with operations in Australia, Indonesia, China, UK and France. While the long-term Australian healthcare thematic of an aging population and an underfunded public health system remain positive for RHC, demand is likely to be more subdued than in the past due to health insurance affordability issues and campaigns targeting over-utilisation of health services. RHC s UK and French hospital businesses continue to face challenging conditions with government tariffs largely offsetting price growth. The company s proven expertise in procurement is expected to deliver cost savings of up to $ million by FY19. Another area of profit growth is the ongoing Australian retail pharmacy expansion. While pharmacy is a relatively small part of RHC it has been estimated that by adding 50+ pharmacies each year it could grow earnings by 1-2%. From a valuation perspective, RHC appears fair value relative to the broader Australian equity market. It is worth noting that RHC s long standing Chief Executive, Chris Rex, is retiring after 9 years over which RHC grew earnings by 500%. RHC s Chief Operating Officer, Craig McNally, will take over from July Resmed (RMD) Price $9.34 Target Price $9.70 Rating Outperform RMD is a developer, manufacturer and distributor of medical equipment for treating, diagnosing, and managing sleep-disorder breathing and other respiratory disorders. Following the very successful launch of the AirSense10 flow generator in August 2014, RMD have now released new generation masks with a new soft interface on the inside that should be replaced every days. This results in improved pairing of the product, and when linked with the flow generator and app, it can self-diagnose the performance of the mask and provide an alert when the interface becomes substandard. This automation provides a compelling value proposition for distributors of RMD s products in terms of a higher replenishment rate at a lower administration cost. Disappointingly, backorder issues with manufacturing deprived any success being observed in RMD s recent profit announcement. If RMD can succeed with the new mask (i.e. achieve at or above market mash sales growth), margin expansion and profit growth will be seen in FY19. RMD s latest acquisition, Brighttree, continues to evolve by providing software innovation to enhance the integration capabilities of RMD s product range, which should benefit the company s gross margin. Despite appearing fairly fully valued relative to the broader Australian equity market on FY18 forecast earnings, RMD appears relatively cheap on FY19 forecasts relative to its key listed peer, Fisher & Paykel Healthcare. First NZ Capital Securities Ltd NZX Firm 18

19 Investment Outlook June 2017 Security Issuer Name AGL AGL Energy AMC Amcor AMP AMP ANZ ANZ Banking Group APA APA Group ASX ASX AZJ Aurizon BHP BHP Billiton BXB Brambles CTX Caltex Australia CCL Coca-Cola Amatil CBA Commonwealth Bank CPU Computershare CWN Crown CSL CSL Ltd DXS Dexus Property Group GMG Goodman Group GPT GPT Group IPL Incitec Pivot IAG Insurance Australia Group JHX James Hardie Industries LLC Lend Lease MQG Macquarie Group MPL Medibank Private MGR Mirvac Group NAB National Australia Bank NCM Newcrest Mining OSH Oil Search ORI Orica ORG Origin Energy QBE QBE Insurance Group RHC Ramsay Health Care RIO Rio Tinto STO Santos Ltd SCG Scentre Group SEK Seek SHL Sonic Healthcare S32 South 32 SGP Stockland Group SUN Suncorp Group Limited SYD Sydney Airport TLS Telstra Corporation TCL Transurban VCX Vicinity Centres WES Wesfarmers WFD Westfield Corporation WBC Westpac WPL Woodside Petroleum WOW Woolworths 7% 6% 5% 4% 3% 2% 1% 0% 30x 25x 20x 15x 10x 5x Australian Equities Valuation Metrics and Ratings As at 25 May 2017 Cash Dividend Yield % CWN VXC NAB WBC SGP ANZ TLS AMP RIO MQG CBA SCG SUN CCL MGR SYD APA GPT AZJ LLC TLC DXS BHP IAG ASX200 WES MPL QBE AGL WFD AMC WPL ASX S32 SHL CTX WOW GMG IPL JHX ORI BXB SEK CPU NCM RHC OSH CSL STO P/E Ratio x 78x 48x 47x ASX200 Australian Equity Market 0x RIO S32 LLC BHP NAB Ratings ANZ STO WBC TLS ORG MQG CBA VCX CTX MGR SGP AMP QBE ASX200 SUN DXS CCL NCM IPL GPT SCG WES IAG CPU AGL AMC ORI MPL GMG WFD SHL BXB WPL WOW AZJ JHX ASX CWN OSH Underperform Neutral Overperform RHC CSL SEK SYD APA TCL P/E ASX Ratio x APA BXB AGL AMC AMP CPU CCL CTX AZJ DXS IPL GMG ANZ CBA CSL NAB WPL MPL QBE IAG BHP MQG GPT RIO NCM TLS ORI CWN ORG JHX S32 SYD SEK STO RHC LLC SCG WOW SHL WES SGP MGR WFD VCX OSH WBC SUN TCL Source: FNZC, Bloomberg. The P/E ratios and Gross Dividend Yield use earnings and dividends forecasts for the next 12 months. *Consensus forecasts First NZ Capital Securities Ltd NZX Firm 19

20 Global Equities Key Takeaways + + Backing Europe over Stars and Stripes. + + Diminishing returns for share buybacks. + + UK s weak poker hand. Ryder Cup In what could be termed the Ryder Cup of investing, we are firmly on team Europe over the USA. Economic data appears to be rolling over in the US after Donald Trump election enthusiasm increased consumer, business and investor confidence, but has failed to spur hard economic data like retail sales, automobile sales and economic growth. In Europe, macro-economic data continues to trend upwards. Europe recently recorded 1.7% economic growth, and survey data suggests growth will improve towards 2%. The recent French election essentially removed the risk of Frexit to the European Union (EU), which was a major political hurdle for the block after Brexit last year. In the year ahead some political risks remain in Europe including: French parliamentary elections in June, where Macron needs a favourable result to implement his reforms; German election in September, although the anti-european Union party is now polling below 10%. The biggest risk is the Italian election, which has to be held no later than the 18th of May There is a strong anti-european Union movement in Italy led by the Five Star Movement political party and pro-european Union sentiment has been dropping in Italy, unlike other European countries. Eurozone inflation bounced to 1.9% in April from 1.5% in March, which should be positive for revenue growth and subsequently profit margins for European companies. However, the European Central Bank (ECB) is likely to retain accommodative monetary policy, which is positive for equity markets. ECB Chairman, Mario Draghi has said he sees core inflation staying low and remains concerned about the fragile banking systems in peripheral European countries and Italian politics. In the US, the Fed is currently normalising monetary policy by lifting interest rates, which separates the Fed from other major central banks. Economic Surprise Index: USA vs, Eurozone Source: Datastream, Credit Suisse /05/15 18/09/15 18/01/16 18/05/16 18/09/16 18/01/17 USA Eurozone First NZ Capital Securities Ltd NZX Firm 20

21 Investment Outlook June 2017 Since World War 2, there have been 13 Fed interest rate hiking cycles. Ten of these ended in recession, while in the other three, the Fed acted early in the economic cycle resulting in a soft landing. In the US, company valuations are in the top 20% historically, corporate leverage (excluding financials) is back above previous peaks and profit margins are near record highs Lastly, it appears the EU is in the earlier part of the economic cycle than the US. Consequently, company earnings have a significant amount of catching up to do in Europe. In the US, company valuations are in the top 20% historically, corporate leverage (excluding financials) is back above previous peaks and profit margins are near record highs. A tight labour market in the US could pressure profit margins in the future as employees gain pricing power. For exposure to Europe we recommend WisdomTree Europe Hedged Equity Fund (HEDJ.US) and JP Morgan European Smaller Companies Trust (JESC.LN). Are US Buybacks Running out of Steam? Share buybacks have delivered a substantial amount of company earnings growth in the US since the Global Financial Crisis. However, there are reasons to think this trend has run its course. Firstly, share prices are not cheap anymore. The US equity market is trading on a price-to-earnings multiple of 18x, which is in the top quintile historically. Therefore, companies buying back shares at these levels are facing diminishing rates of return. Perhaps more importantly though, with interest rates near zero since 2009, companies have borrowed large sums of money to buy back shares. As the Fed has begun increasing interest rates, debt servicing costs for companies are increasing making the economics of share buybacks less favourable. Consequently, our enthusiasm for Powershares Buyback Achievers Fund (PKW. US) is waning. US corporate leverage is high Source: Thomson Reuters, Credit Suisse research Net debt to Ebitda Ex Financials Ex Financials and resources Buybacks are a popular mechanism for returning cash to shareholders in the US for a couple of reasons. Firstly, while mathematically equivalent to dividends, when a company cuts its buyback it doesn t have the negative stigma that cutting a dividend has. Secondly, in the US buybacks are more tax efficient for shareholders than dividends. The alternative to repurchasing shares is investing the cash in future growth opportunities, which is currently our preference. In this regard we believe Alphabet (GOOGL.US) is currently one of the best risk-to-reward opportunities in the US equity market. First NZ Capital Securities Ltd NZX Firm 21

22 Can Mrs May Have Her cake and Eat it Too? The British Prime Minister, Mrs May, would like the freest and most frictionless trade possible with the EU while also restricting free movement of labour. The problem is the UK holds a weak hand at the negotiating table. It is a real possibility that the UK will find itself outside the European Union and the Customs Union (refer graphic), trading with the EU like any other non-eu-member country under World Trade Organisation rules. Europes Pacts That Govern Trade, Immigration and Euro Source: Bloomberg No deal for Britain is better than a bad deal for Britain Mrs May herself, has asserted, no deal for Britain is better than a bad deal for Britain. The issue for the UK is that 44% of exports go to the EU. Sitting outside the EU would mean tariffs of 10-36% on UK exports. No deal would also end Britain s access to the EU s trade deals with 53 other countries. For those hoping for a quick bespoke trade agreement between the UK and the EU, it is worth considering that the EU-Canada free trade deal is still not fully in force even though negotiations started in The hope for the UK rests in that it imports more that it exports to a majority of European Union countries. Since the Brexit referendum, UK economic growth has exceeded expectations, as consumer spending has been resilient. However, consumption is expected to slow in response to lower real disposable income driven by imported inflation from a weaker British pound, which has benefited the UK equity market. Listed UK companies derive a large percentage of revenue from offshore and have benefitted as the British pound tumbled. However, the tailwind provided by the currency is expected to be transitory. Consequently we remain cautious on the outlook for UK equities. First NZ Capital Securities Ltd NZX Firm 22

23 Investment Outlook June 2017 Geopolitics in Asia Key Takeaways + + War with North Korea is a low probability event, but it has significant ramifications + + US China rivalry is the real issue + + What investors should watch out for Since the Soviet Union collapsed in 1991, US Presidents have struggled to deal with nuclear power, North Korea. Clinton tried negotiating, Bush threatened and Obama tried to wait North Korea out with strategic patience. During this time, China has become an economic powerhouse and is emerging as a great geopolitical power, challenging the global dominance of the United States and its alliance system and further complicating the Korean Peninsula. Some Background We expect North Korea sees nuclear weapons as its only option for its regime s survival. The country s leaders have watched the US invade Iraq because they thought Saddam Hussein had chemical weapons. Also, they saw Libya s Gaddafi negotiate with the US only to be toppled by US backed rebels. North Korea already have the capability to strike Japan, South Korea and the 60,000 odd American troops stationed there with a nuclear warhead. This prevents attacks on North Korea by both countries as both have seen the missiles that could potentially destroy their cities. North Korea, with urgency, has been trying to develop a nuclear warhead capable of reaching the US West Coast. If the US knew North Korea could strike a West Coast city, the US would be less likely to come to the aid of South Korea or Japan, thereby breaking the global alliance and gaining more leverage in the process. North Korea Ballistic Missle Launches Source: Thomson Reuters, BCA Research 10 8 Nuclear tests: 2006, 2009, 2013 and twice in 2016 Missles Launched The Question Is Is the stalemate of the last 25 years changing in a way that breaks previous cycles of transgression-and-containment and poses a real risk to the global economy and stability in the region? We think yes, as North Korea has become a proxy for the underlying (and increasing) rivalry between China and America. Hence the US s simmering conflict with North Korea could feed into a larger US-China confrontation, a low probability event that would have huge ramifications. Under President Obama, disagreements between the two super powers happened on a regular basis, but the response was always predictable, which was important. The trouble now, is that while Chinese policy has changed little, American policy has First NZ Capital Securities Ltd NZX Firm 23

24 changed a lot under Trump and has become a lot less predictable. Secretary of State, Rex Tillerson, recently said, The policy of strategic patience has ended, before Trump added, if China is not going to solve North Korea, we will. We don t believe China has a particular fondness for North Korea, but it does not want North Korea to collapse for two reasons: firstly, it could mean a flood of refugees from North Korea into China s North-eastern provinces; and secondly; it would remove the buffer China currently has between the US allies and US troops stationed there. The South China Sea Source: The Economist Exclusive Economic Zone Claims That countries believe they are entitled to under UN convention on the Law of the Sea Philipphines Vietnam Malaysia Brunei Indonesia China/Taiwan mine-dash line Ideally, we suspect that China wants to remove US influence from Asia, carving out a geographic region for themselves to achieve their super power ambitions. Without the US, China would go largely unchallenged, exerting influence over Taiwan and taking control of the South China Sea. A strategically important region as it is incredibly rich in natural resources and has 30% of the world s shipping flows. Removing US influence has the potential to destabilise Asia. The first derivative would likely be nuclear proliferation as South Korea and Japan seek a deterrent. Japan would likely take the opportunity to militarise (an agenda that Prime Minister Abe is pursuing) in an attempt to combat China s influence. This would likely be the case for other US allies like the Philippines as they seek to protect their exclusive economic zones in the South China Sea. Another ramification of a US withdrawal would be the unleashing of the China trade bully. Evidence of this is already apparent. Recently, in retaliation to South Korea building an anti-missile defence system, China s tourist flow to South Korea dried up, as did Hyundai car exports to China. Japanese carmakers, Philippine banana farmers and Taiwanese tourism workers have all previously been on the wrong end of hostile campaigns instigated by Beijing. These trade boycotts against foes may only be the tip of the iceberg if the US was to withdraw from the region. Even though China has substantial leverage over North Korea (China accounts for 85% of North Korea s trade) there have been troubling signs recently as Kim Jong Un, who is in his 30s, has publicly rebuked China. The day before Chinese President Xi Jinping was set to meet President Trump, North Korea tested a ballistic-missile. If President Trump is considered unpredictable so is Kim Jong Un. As a result the US sent naval ships towards the Korean Peninsula and China restricted North Korean coal exports. The bottom-line is While there are no immediate investment actions required as a result of these developments, there is certainly a need for ongoing monitoring. The hope is that negotiators are successful in getting North Korea to change its behaviour. In the meantime investors should be especially wary of any missile tests that reveal North Korea can reach the US. Investors should also be wary of a pull-back or isolationist language from the United States that would suggest a withdrawal of support to Asian allies. In lieu of outright war, a deterioration in Sino-American relations is the key investment risk from North Korea. Finally, if President Trump needs to boost his electoral appeal in 2020, and is having ongoing problems with North Korea, the US might attempt decisive action by itself. First NZ Capital Securities Ltd NZX Firm 24

25 Investment Outlook June 2017 Interest Rates - Sure to Rise Key Takeaways + + Having reviewed the dynamics of the US, we retain our view that US interest rates will rise. + + Reducing the size of the Fed s extremely large balance sheet. + + The RBNZ remains resolute in its monetary policy stance. What is going on in the US? The White House issued a one pager setting out its desired budget objectives. This includes reducing the corporate tax rate from 35% to 15%, a one-time repatriation tax for cash held abroad by US companies, an increase in defence spending of $15 billion and infrastructure spending totalling $1 trillion dollars over time. While this list is unlikely to be implemented in its entirety, even if only partially implemented it would result in greater debt issuance and should be stimulatory. As the US economy is already at full capacity this economic stimulus is expected to be inflationary. Consequently the US Federal Reserve is expected to increase the Fed Funds Rate when it meets on June Long term interest rates should reflect this normalisation of the Fed Funds rate as well as higher inflation. Higher longer term US interest rates are expected to drag NZ long term interest rates higher. So why have long term US interest rates fallen recently? The answer lies in the level of confidence that President Trump s policies will be implemented. Speculation of impeachment, even though remote at this stage, has reduced confidence. However, even if this additional stimulus is side lined wages are rising as unemployment is below the non-accelerating inflation rate of unemployment (NAIRU). Low US Unemployment Should Spark Wage Graph Source: FNZC, BCA Research Wage Growth (%) Unemployment Rate (%) Weakness in March quarter economic growth is believed to have been adversely affected by inclement weather and technical measurement issues. One issue that we will follow with interest is who President Trump will appointment as the next Fed Chairman in eight months time. In conclusion while the strength of the argument for higher long term interest rates has weakened it has not been negated. While some commentators are speculating on the next increase in the Fed Funds Rate, others are thinking ahead to when the Fed starts to reduce the size of its balance sheet from post war highs. We note that the Fed has said not to expect balance sheet shrinkage until normalisation of the level of the federal funds rate is well underway. We believe that this means a Fed Funds Rate of %. First off the blocks will be shrinking the amount invested in Agency bonds and Mortgage Backed Securities in First NZ Capital Securities Ltd NZX Firm 25

26 Consequently the impact on US Treasury interest rates will not be felt for some time. We note that when the Bank of Japan reduced its investment in Japanese Government bonds in there was no detectable impact on Japanese Government bond interest rates. Largest Balance Sheet Since WW2 Source: Federal Reserve 25 % 25 Fed Assets / GDP (%) A Resolute RBNZ Shifting gear to New Zealand the focus falls on the Reserve Bank of NZ (RBNZ). Despite various factors suggesting that the RBNZ might bring forward the date that it would start increasing the Official Cash Rate (OCR), including annual inflation hitting 2.2% in March, the RBNZ noted Developments since the February Monetary Policy Statement on balance are considered to be neutral for the stance of monetary policy. No doubt part of the reason for this comment is that the RBNZ s preferred measure of inflation, the sectoral factoral model of core inflation, was 1.5%, which is at the bottom of the 1-3% target inflation band. Furthermore, the RBNZ stated, we ve seen very little impact or sign of wage inflation. This has been interrpreted as meaning that the RBNZ wants to see inflation before it raises the OCR. Two other factors cloud RBNZ decisions currently: 1. There is a review of the RBNZ s monetary policy framework and; 2. The current RBNZ governor retires in five months. We conclude that short term interest rates in NZ are likely to remain at current levels well into Debt Security Preferences Most Higher Credit Quality Lower AA rated AA- rated AA- rated (term deposit) A rated BBB rated Unrated (indicative BBB rated) Unrated (indicative BB rated) < 2 years years N/a Least N/a years 5-6 years > 6 years Source: FNZC NZ Debt Portfolio Structure Since the last edition of the Investment Outlook short term interest rates are generally unchanged across all securities regardless of credit quality. However, long term interest rates are generally down 0.25%, with the exception of AA- rated securities which are around 0.65% lower. Despite our preference for shorter term securities in the expected rising interest rate environment, we previously noted that the higher interest rates offered by longer term securities went a long way to offset the associated risk of a fall in security prices. Due to the reduced difference between long and short term interest rates, especially for AA- rated securities, our enthusiasm for long term securities is reduced. The interest rates offered on bank term deposits for terms up to three years are higher than they were three months ago making them even more attractive for investors. As always investors need to consider the total structure of their debt security portfolios when deciding which securities to add. There is a significant amount of debt securities maturing in the next 12 months, the proceeds of which will need reinvesting so as to retain a well-structured portfolio of debt securities. First NZ Capital Securities Ltd NZX Firm 26

27 Investment Outlook June 2017 NZ Dollar Side Lined Key Takeaways + + The RBNZ wants the NZ dollar to stay at its lower value. + + However, further weakness in the NZ dollar appears modest. + + The euro and pound regain some of their value as undervaluation narrows. What Drives the NZ dollar? Source: FNZC, Bloomberg Reserve Bank of NZ Approves of a Lower NZ Dollar The Reserve Bank of NZ surprised financial markets at its last Official Cash Rate (OCR) review. The market had expected that, due to recent economic developments, the RBNZ would bring forward the time when it expected to increase the OCR. This would have warranted a higher NZ dollar. However, it didn t. In addition it noted that the recent fall in the NZ dollar, is encouraging and, if sustained, will help to rebalance the growth outlook towards the tradeable sector. In other words the RBNZ is happy with the recent fall in the NZ dollar and doesn t want to do anything to reverse the fall. We don t expect the NZ dollar to change in value much going forward. While the prices of dairy products and economic growth supports the dollar, a flat interest rate outlook does not. While we are not positive on the NZ dollar neither are we overly negative. The NZ dollar appears to have been tarred with the same brush as the Australian dollar. The Australian dollar has weakened as weakness in the Chinese economy, has resulted in lower iron ore prices, and a weaker outlook for Australia s trade balance. On the other hand the key commodity for the NZ dollar is dairy, which has experienced firm pricing. Hence, in the absence of the RBNZ s comments, the recent weakness in the NZ dollar is somewhat surprising. A more neutral outlook for the NZ dollar reduces our enthusiasm for global equities US Dollars /16 12/16 01/17 2/17 03/17 4/17 Iron Ore Price Dairy Price NZD (rhs) A Few Months is a Long Time in Currency Markets Our last Investment Outlook highlighted how cheap the Japanese yen, euro and in particular the British pound were relative to the US dollar, in purchasing power parity terms. Three months on the euro and pound are trading at higher levels. While the euro is rapidly closing in on fair value, the pound still appears to be materially undervalued on this long term measure. In the case of the pound the rise reflects a significant improvement in the UK trade deficit, a reduction in the quantity of trades betting on a decline in the value of the pound and the initial reaction to the decision by the ruling Conservative party to hold a general election three years earlier than required. The triggers for the euro s rise include improved economic fundamentals at a time when the outlook for the US economy is softer than expected, and US political developments have called into question the extent to which President Trump will be able to implement his reflationary economic policies. Taking politics out of the equation we expect that the US dollar should show some strength in the immediate future despite continuing to look overvalued on a long term basis. First NZ Capital Securities Ltd NZX Firm 27

28 Time in the Market is More Important than Timing the Market Key Takeaways + + Buy low, sell high, makes investing sound easy. + + Buy-and-hold along with strategic asset allocation provide the best long-term results. + + Investment ideas should correlate with investment horizon. While market timing is intuitively appealing, it is difficult to execute as cognitive bias s, lead many investors to sell out and head for the hills when equity markets slide. Investors are prone to panic and overconfidence, so are affected by unexpected events and emotions. The result is that even though investors know the old adage, buy low, sell high, they often end up doing the opposite. It is very hard when surrounded by widespread gloom and falling equity prices with no end in sight, to pick the bottom of an equity market cycle and start buying equities. This leads to a very simple reason why market timing is very difficult. Investors have to be right twice, selling at market highs, and buying back at market lows. Since 1970, there have been five bear markets in the US, with each lasting an average of 18.5 months. The most dramatic bear market was in 1987, where in a 3 month period the S&P 500 dropped 33.5%. It recovered, and then rose through to the dot com crash in By staying invested when equity markets tumble, investors should benefit in full from the subsequent recovery. Said another way, time in the market is more important than timing the market. Investors should stay focused on their long-term investment goals, staying calm and sticking with their strategic asset allocation. Growth of $100, Source: Thomson Reuters, Credit Suisse Another important consideration for staying invested, is that a substantial amount of investment returns have been generated by a very small number of days. Consider the chart below which shows $100 invested in the S&P 500 in 1970 through 2017 would be worth $2,526. However, if the 25 days with the best returns were missed your $100 would only be worth $593. Conversely, if the 25 days with the worst returns were missed your $100 would be worth $15,264. In that period there were circa 12,000 trading days, which makes trying to pick the best and worst days of equity market performance akin to trying to find a needle in a haystack. $15,264 $2,526 $ Missing 25 Worst Days All Days Missing 25 Best Days A study by Cass Business School, found that compared to a buy-and-hold strategy, the typical investor lost 1.2% a year moving in and out of funds. From December 2006 through December 2016 the S&P 500 index returned a 6.87% per year on average, which would imply a typical investor gained 5.67%. Compounding this gap yearly over 10-years, the difference between each approach widens to 20.8%. First NZ Capital Securities Ltd NZX Firm 28

29 Investment Outlook June 2017 Why Do Investors Try and Time the Market Investors who believe they can beat the market through timing peaks and troughs usually focus their attention on fundamentals such as, valuation metrics like the price-to-earnings ratios or technical indicators based on price action patterns. Shiller Cydically Adjusted Price to Earnings Source: Robert Shiller Black Monday Black Tuesday Fundamentals are very useful in determining value, but high valuations typically do not precipitate a correction. Extreme valuation can inform us that there is a higher probability that a market might underperform over the following 5-10 year period. The Shiller US cyclically adjusted price-to-earnings multiple (which historically been a good indicator of the average investment return over the following 10 years, but not the next year) has only crossed 30x two times in history. If an investor had sold equities in 1997, the second time the multiple crossed 30x, the investor would have missed the subsequent 80% rally in stocks. Trying to profit by watching technical patterns is incredibly hard due to the dynamic nature of the markets as correlations are consistently changing so what worked yesterday might not work today. The difficulty profiting from technical analysis is further complicated by competition from computer-generated trading using advanced algorithms. Solution The best approach to avoid missing out on long term gains is to implement a buy-andhold strategy. In this context, the best defence against volatility is maintaining a diversified portfolio, spread across different asset classes with varying correlations. The practise of strategic asset allocation will help you achieve an appropriate balance between risk and return and is crucial in achieving long-term investment goals. We observe shares have tended to perform better than other asset classes over the long-term, but with significant volatility, particularly over short time periods. In comparison, bonds tend to perform better than equities in financial market downturns, and have more consistant returns, but produce lower returns over the long term. It is important to review investment portfolios at regular intervals to ensure asset allocations remain consistent with the amount of overall risk investors are both willing and able to tolerate, including being appropriate for the investor s investment horizon. If some assets have risen considerably, and others have fallen, the proportion held in each asset class will have changed from the initial asset allocation. As a result, investors will typically rebalance investment portfolios by selling assets that have done well and buying those that have fallen. If you are interested in discussing any of the topics covered above in more detail, please contact your FNZC adviser. First NZ Capital Securities Ltd NZX Firm 29

30 FNZC Investment Portfolio Series Key Takeaways + + Model portfolios cover four key asset classes. + + Each portfolio has a clearly defined investment objective, investment parameters and investment process, resulting in a sound investment track record. + + Low turnover equals low transaction costs. The FNZC Investment Portfolio Series Model Portfolios provide a useful tool for clients to assist them in managing their investment portfolios. Let us explain why. The model portfolios cover four key asset classes: NZ equities (NZ Income portfolios), Australasian equities, global equities and NZ debt securities. The portfolios are managed by the Investment Committee which comprises a team of five investment professionals. In addition, the committee draws on the expertise of an additional three specialist experts. The committee meets monthly to review the portfolios and amend as necessary. Each portfolio has a clearly defined investment objective, investment parameters and investment process, which govern how the portfolios are managed. The portfolios are designed with the needs of wealth clients in mind, rather than for large institutional clients. We believe that the resulting portfolios are well structured diversified portfolios (although clients should note there are two small portfolios designed for clients with smaller amounts to invest which are not sufficiently diversified to be used in isolation). Portfolio turnover is monitored to ensure that it remains low, thus keeping transaction costs low. At the start of every month we outline any changes to the model portfolios, with a clear rationale as to why the change to the portfolio has been implemented. In addition, we provide a monthly update for each of the model portfolios which includes investment performance, notes on the key contributors to the investment performance, notes on how to use the portfolios, notes on taxation and a description of each of the securities in the model portfolios. As a result of clearly defined investment objectives, investment parameters and investment process the model portfolios have a solid performance track record, although we note that past performance is no guarantee of future performance. NZ Income Portfolios Source: FNZC, Bloomberg *The benchmark is the S&P/NZX 50 Gross Index with Imputation Credits Mar-12 Sep-12 Mar-13 Sep-13 Mar-14 Sep-14 Mar-15 Sep-15 Mar-16 Sep-16 Mar-17 Core Core Plus Diversified Benchmark * First NZ Capital Securities Ltd NZX Firm 30

31 Investment Outlook June 2017 Australasian Equities Portfolios Source: FNZC, Bloomberg * Benchmark is 33% the S&P/NZX50 Index Gross with Imputation and 67% the S&P/ASX 200 Accumulation Index expressed in NZ dollars Apr-12 Oct-12 Apr-13 Oct-13 Apr-14 Oct-14 Apr-15 Oct-15 Apr-16 Oct-16 Apr-17 Core Plus Diversified Benchmark * Global Equities Portfolios Source: FNZC, Bloomberg * Benchmark is MSCI All Country World Index expressed in NZD Apr-12 Oct-12 Apr-13 Oct-13 Apr-14 Oct-14 Apr-15 Oct-15 Apr-16 Oct-16 Apr-17 Oct-17 Global Global Plus Benchmark * NZ Debt Security Portfolios Source: FNZC, Bloomberg, Reserve Bank of NZ * Investment objective is the 6 month bank term deposit rate. **Reference point is the S&P NZX Investment Grade Index Dec-13 Jun-13 Dec-14 Jun-14 Dec-15 Jun-15 Dec-16 Medium Risk Portfolio High Yield Portfolio Reference Point** Investment Objective * Clients use the model portfolios in various ways. Some use them as an indicator of investment opportunities (focusing mainly on the monthly changes, if any, made to the model portfolios). Others use them as a starting point for construction of an investment portfolio, and incorporate specific changes to reflect particular investment objectives. Finally, others replicate the model portfolios. Please contact your adviser if you wish to find out more about the FNZC Investment Portfolio Series Model Portfolios or to be added to the distribution list in order to receive the monthly portfolio updates and review notes. First NZ Capital Securities Ltd NZX Firm 31

32 A Useful Lesson When Investing in Offshore Securities In previous editions of the Investment Outlook we have talked about the benefits of holding offshore (non-australasian) securities in custody on the FNZC custodial platform. Buying and selling offshore securities is straight forward and efficient, if the assets are held in custody, as the delivery and/or receipt of stock is automated. However, if they are held in your own name, rather than being held on the custodial platform, transacting these securities can be time consuming and costly. This is due to our offshore counterparties needing to receive the share certificate, shareholder identification and transfer form prior to the sale transaction taking place. This process can take up to six weeks. Consequently there is a real risk that investors don t achieve the sale price they were anticipating. On sale the US Inland Revenue Service deducted a death duty tax of around 35% It can also prove expensive, in other ways, as the following example shows. We are aware of a case, where in winding up the financial affairs of a recently deceased New Zealander, a New Zealand solicitor instructed securities held in a number of US listed companies be sold. On sale the US Inland Revenue Service deducted a death duty tax of around 35%. This death duty would not have been deducted if the US shares had been held in custody. We note that in the UK a death duty tax of 40% applies (above a minimum threshold). In addition to being encumbered with a death duty tax there is also likely to be a material legal cost (including the process of having the local provincial or territorial court confirm a Grant of Probate from another jurisdiction) and time delays which can be avoided if the securities are held in custody. However, in the case where the offshore assets are held in custody, once probate has been issued (and all other requirements have been met), the shares can be sold directly out of their custody account and funds paid to the estate generally within 2 5 days. Please contact your FNZC adviser if you wish to discuss this in more detail. First NZ Capital Securities Ltd NZX Firm 32