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Responsiblity, global economy to drive NZ markets

11 February 2008

Media Information

Responsible investment and the global economy to drive NZ investment markets in 2008 – Mercer Investment Trends and Industry Outlook

Following the widespread uptake of KiwiSaver, and the recent rollercoaster of stockmarket volatility, the investment markets and industry in New Zealand will be keenly watched - perhaps even more closely than usual - throughout 2008.

Releasing its Investment Trends and Industry Outlook for 2008, Mercer’s investment managers and consultants, predict that in 2008 global pressures will continue to reshape the investment landscape and that emerging markets and responsible investing will take centre stage. Meanwhile, closer to home pressures such as PIEs, rising property prices and skills shortages will play their role in influencing the investment markets and the nation’s retirement saving industry.

Mercer has identified eight key issues that it believes will have the greatest impact on New Zealand’s investment markets and industry in 2008:

1. Global Economy to come back on track, but how quickly?
2. Commodity fundamentals favourable to NZ and Australia
3. China to drive Asia Pacific and global growth in a more interdependent world economy
4. Responsible investment will become increasingly important
5. Residential property no longer the retirement fund of choice
6. KiwiSaver will prevail as our preferred model for retirement savings
7. PIE Dividend – higher returns, lower taxes and lower costs
8. An increasingly complex investment environment will drive growth in outsourcing across superannuation industry

Martin Lewington, Head of Mercer’s investment businesses in New Zealand discusses these issues in detail:

1. Global Economy to come back on track, but how quickly?

Against the generally positive background of global economic developments for the medium term, the immediate future is clouded by a weakening US economy and the threat of the US slowdown to growth in other countries and regions.

But major longer term features of the global economy have included:

- Meaningful policy moves to lower barriers to trade and investment
- Faster integration of economies and regions
- A sizable step-up in the scale of the size of countries starting to integrate with the rest of the world (e.g. China and India)[1]
- A higher trend rate of sustainable global economic growth, climate change notwithstanding

As an example of the momentum which has built up, the annual rate of change in the world trade ratio has risen from 0.2%pa (average for 1974 to 1995 period) to 0.6%pa (average for ten years ended 2006). Comparing the same two periods annual growth in global living standards has accelerated from 1.2%pa to 2.7%pa.

There remains considerable scope before full integration could be said to have been completed and each country, whether developed or developing, is under pressure to facilitate better resource use and structural economic reforms.

In the short term the developed economies are reacting to a number of interrelated shocks: financial turmoil, cooling housing markets, and higher prices of energy and other industrial and agricultural commodities. Policy agencies have been alerted to the dangers and taken the first steps towards stability and growth.

US economic slowdowns are generally associated with volatility in financial markets and pressures on corporate profitability. The questions for investors are how long and how deep is the US slowdown going to be and partially related to those questions, how serious is the US slowdown going to be for other regions?

2. Commodity fundamentals favourable to NZ and Australia

Structural change in the global economy is generally favouring countries which produce industrial and agricultural commodities. The pattern of excess demand by commodity is neither uniform nor stable, and the supply responses vary considerably across the spectrum. But in aggregate the world is going through a sustained phase of pressure on resources, as part of the sustained growth in material living standards already mentioned.

From the perception of commodity producing countries the marked increase in export commodity prices in world markets may be viewed as a ‘positive shock’ and one which occurred in these countries at a time when pressures on labour and resources were already high. The Reserve Bank of New Zealand has been tightening monetary policy for over four years yet the Official Cash Rate remains at 8.25% relative to an inflation target centring on 2%pa.

High relative interest rates and booming exports prices are providing comfort to investors in commodity currencies. Despite pressures from global monetary developments, financial flows to commodity currencies from investors are expected to continue provided the markets’ perception of the global economic outlook coming back on track is strong.

3. China to drive Asia Pacific and global growth in a more interdependent world economy

One of the key themes for 2008 will be China. There has been much speculation in the investment world about whether, or to what extent, China (and indeed other developing markets) are now deep enough to be able to ‘de-couple’ from the US economy. If the Chinese economy was to be de-coupled from the US, then this would have significant implications for global growth in the event of a US recession/consumption slow down.

However, China has been swift to play down such independence, with Zhang Tao, deputy head of the international department of the People's Bank of China stating that, “If US consumption really comes down, that's bad news for us. That will have a pretty severe impact on our exports”. This message is not only coming out of China - "Decoupling is yesterday's story," stated Stuart Schweitzer, a global strategist at JP Morgan Private Bank.

So how will China impact the world economy in 2008? In recent times, cheap production costs in China have helped lower global inflation, and Chinese purchases of foreign government bonds have helped keep down global bond yields. However, at some stage, as wage pressure and raw material prices go up, China may turn into an inflation exporter. Similarly, if economic growth slows down tremendously in China, that will have repercussions on the Asian Pacific economy. For example, most of the recent resource price boom has been demand driven, while there has been relatively less ability to increase supply. In terms of the effect in New Zealand, China is an increasingly important market for agricultural exports and a weakening of this market would hit exporters’ profits.

4. Responsible investment will become increasingly important

In 2008, responsible investment (RI) will continue to engage the minds (and hearts) of the mum and dad investor, Trustees of super funds and superannuation members and, increasingly, global companies and investment managers.

Responsible investment has typically focused on environmental, social and governance factors, with recent studies concluding that they are material to investment performance. We expect to see new investigations into the social aspects of responsible investment come under the spotlight. Major research studies that examine the relationship between good workforce practice and productivity with better investment performance, as well as global supply chain management issues such as labour and human rights, particularly in developing countries, are already underway.

Expect corporate governance to continue its focus on issues of remuneration, accountability and transparency, while company engagement will become more focused on how to reform the market rather than tackling a particular company on governance. Coalitions of institutional investors and investment governance specialists will strategically influence reform and will work more selectively with industry bodies regionally and globally. In Australia, the recent Telstra and Macquarie Bank AGMs are examples of the way in which fiduciaries are exercising their ownership rights on behalf of members, particularly in regard to proxy voting.

Funds and companies with USD 41 trillion who have signed up to the Carbon Disclosure Project have begun to report on their carbon emissions. This trend of voluntary reporting is set to continue for the big players until targets are confirmed by those countries not signed up to the Kyoto protocol and not until 2010/2011 in Australia.

We expect to see green rated property to become a desirable asset class for investors wishing to invest for good performance and responsibly.

Signatories to the United Nations Principles of Responsible Investment (PRI) representing USD 10 trillion will begin to undertake a range of new initiatives, ranging from requiring their investment managers to report on their integration of ESG in their investment process and assessing alternatives, clean technologies and RI overlays in asset classes such as bonds and private equity.

5. Residential property no longer the retirement fund of choice

In recent times, New Zealander’s have placed a lot of faith in residential property as their main way of saving for retirement: they expect to trade down, realising capital or generating rental income.

This faith may be misplaced and could be revised during 2008 / 2009. There are a number of factors driving this change:

- The IRD are now taking a closer look at the tax status of people owning more than one property or those who regularly buy and sell houses.
- There is an increased awareness – or recovered memory - that property can fall in value. There was a period in the late 1970s and early 80s where property fell 40% in real terms. During the early 1990s property values remained flat in real terms. New Zealanders can look to the US housing market for further evidence, that the property market may not be ‘safe as houses’ after all.
- Housing affordability in New Zealand has us placed as the most costly country in the world to buy a home both in terms of household income to house prices (low median income high median house price) and household income required to service debt (high interest rates).
- KiwiSaver as an alternative vehicle for retirement savings was sweetened by the Government and in 2008 matched employer contributions will make it even more attractive to join.

6. KiwiSaver will prevail as our preferred model for retirement savings

Since its introduction in 1 July 2007, the number of KiwiSaver members has continued to exceed Government forecasts. As such, the success of New Zealand’s ‘soft compulsion’regime will keep any notion of compulsory superannuation off the agenda in the short term.

We are also likely to see many existing superannuation funds close to new members (especially defined benefit funds, which is consistent with global trends) and in many cases wind-up – anecdotal evidence suggests that in the seven months post 1 July 2007 this is an emerging practice in both the public and private sectors.

However, as companies seek to stand out in the current tight labour market, the widespread uptake of KiwiSaver will be a driver for innovation in corporate superannuation, with many companies seeking advice on how to structure their superannuation offerings and what they can offer over and above KiwiSaver to differentiate themselves.

The area of crediting rates and how superannuation funds credit investment returns is one of tremendous risk for trustees and given the significant tax changes in the past 12 months, the new PIE regime and the increasing sophistication of superannuation investment structures - we see the area of crediting rates as a hot topic for 2008.

Compliance and risk management will be pivotal and we are likely to see growth in this area - again this is consistent with global trends both in superannuation and within investment markets.

7. PIE Dividend – higher returns, lower taxes and lower costs

The introduction of PIE and FDR taxation in 2007 has brought about a multitude of changes for investors.

From an investment viewpoint the biggest impact is for actively managed share investments, where the tax changes have led to a move from a risk sharing approach to tax (tax on income and realised gains and losses) to one where only the actual (PIE) or notional (FDR) dividend income is taxable.

The attraction of the new taxation arrangements to many pooled investors are the higher expected levels of after tax returns as capital gains are tax free. With investors now facing non deductible capital losses on local and overseas share investments the new system has not had the best start.

Mercer expects the convergence of tax exempt and tax paying investors into single vehicles and the general consolidation of existing products by managers to continue. This clearly has benefits for all involved as investor monies can be better pooled, thus reducing cost and duplication as well as deepening specialist market segments (such as Responsible Investment).

We expect that these benefits and ultimately higher long term after tax returns to emerge as the dividends of the new PIE regime.

8. An increasingly complex investment environment will drive growth in outsourcing across superannuation industry

The pressure on trustees to manage risk more actively is rising. This has been heightened by the increase in market volatility over the past year, and January’s sharp fall in asset values across the board.

Trustees also have to deal with more complex investment decisions; we’ve had tax changes and PIEs, KiwiSaver and ‘new’ asset classes such as alternatives. There is an expectation on funds to adopt best practice governance and investment strategies, and at the same time focus on member or community interests. With limited time at their disposal trustees, and a crippling skills shortage across the industry, trustees are finding these growing demands are an increasingly delicate juggling act.

A solution that more and more trustees are turning to is outsourcing some functions to a partner. The functions can range from unit pricing and tax calculation through to asset allocation, decisions and manager selection. An increasingly popular option is the use of multi-managers or implemented consulting – or a combination of both. This frees trustees to focus on their member of community interests (their core business) and higher impact decisions (such as asset allocation), depending on the scope of outsourcing.


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