KEY POINTS:
Three major issues are dominating the business media in most developed countries. These are house prices, the prospects of an economic recession, particularly in the United States, and falling sharemarkets.
The first two subjects are having a negative impact on equity markets, including the NZX which has had a dreadful start to the year.
Residential housing and the US economy, with the latter representing approximately 25 per cent of world economic activity, will continue to have a major impact on investment markets in the year ahead.
The poor performance of most sharemarkets is mainly due to the worldwide housing price bubble over the past decade.
Figures compiled by the Economist show that residential property prices rose strongly throughout the 1997 to 2007 period. South Africa performed the best, with the average price rising a staggering 393 per cent, while New Zealand was in 10th place with an average 123 per cent house price increase over the same period.
As the accompanying table shows house prices rose an average 189 per cent in the top 10 performing countries compared with a 195 per cent increase in their sharemarkets.
But these house price and sharemarket figures don't tell the full story.
Gearing has helped generate far higher returns from residential property than the figures shown in the accompanying table. For example, an individual who purchased a house in New Zealand in 1997, and borrowed 80 per cent of the purchase price, would have achieved a 615 per cent return on equity instead of the 123 per cent average house price rise.
As the worldwide housing boom expanded financial institutions became more aggressive and lent higher and higher percentages of purchase prices. They also lent against the increased value of residential property with this money used for general consumption purposes.
The wealth effect of the global housing boom has had a positive impact on the world economy in a number of areas including:
* It has lead to a massive increase in consumer confidence. * A huge uplift in retail spending, which represents between 60 per cent and 70 per cent of economic activity in most western economies.
* A significant boost to developing countries, particularly China, as they experienced a sharp increase in demand for their exports.
The housing boom first started to unwind in the United States towards the end of 2006. The downturn accelerated throughout most of 2007 with the average sale price of an existing home in the US falling from US$225,000 in November 2005 to US$210,200 two years later.
Sales volume declined by 28.9 per cent between November 2005 and November 2007 with US housing starts, on a seasonally adjusted annual rate basis, falling from two million to one million in the two years to December 2007.
The downturn in the US housing market was the catalyst for the sub-prime credit crisis, which began to unfold in mid-2007. This crisis, which is due to too much money being lent to poor quality borrowers to purchase overpriced residential property, has spread throughout the world and has had a major impact on sharemarkets.
Housing markets have also started to decline in most other countries, particularly Ireland, Britain and Spain. South Africa, the best performing market since 1997, is holding up but its rate of house price growth has slowed from 4.1 per cent in the March 2007 quarter to just 1.3 per cent in the last three months of 2007.
The New Zealand housing market has also slowed in recent months. According to Real Estate Institute of New Zealand figures released this week the average sales price has fallen from $347,500 in June 2007 to $345,000 in December and sales volume for the second half of the 2007 year is 25.8 per cent down on the first half. This indicates further price weakness as prices usually follow volumes down.
The downturn in housing markets has created a number of concerns including:
* Residential property markets, unlike sharemarkets, tend to have long cycles and the current downturn could last a number of years.
* The huge amount of mortgage debt will have put enormous pressure on households, particularly if house prices fall by more than 5 per cent.
* Weak housing markets will have a negative wealth effect, which will impact on retail spending.
* Housing problems could spread to other areas, including credit card repayments.
Prior to Christmas most economists, particularly in the United States, believed that the housing problems could be contained. A relatively poor Christmas, as far as retail spending is concerned, has resulted in more and more economists predicting that the US will go into recession in 2008.
This is the main reason why most sharemarkets have had a dreadful start to the year.
Recessions, which are usually defined as two consecutive quarters of negative GDP growth, are a rare occurrence. There hasn't been a recession in most major economies, including the US and Australia, since the early 1990s although New Zealand had a short recession in the December 1997 quarter and March 1998 quarter when Reserve Bank Governor Don Brash maintained a tight monetary policy during the Asian economic crisis.
The RBNZ's hawkish interest rate strategy was completely out of line with most other countries at the time.
In the months ahead the financial press will be full of stories about the outlook for a US and international recession.
Investors may be best advised to think about the year ahead in terms of the Tour de France cycle race instead of worrying about the prospects of two successive quarters of negative GDP growth.
The Tour de France has two main types of stages, the flat and the huge mountain climbs. The peloton (main bunch) travels together on the flat with most riders given the same finishing time whereas mountain stages fully test the riders and there is a huge gap between the first and last place finishers.
The last few years have been a flat stage as far as most economies and investment markets are concerned. Businesses and investors have performed reasonably well, regardless of their skills, as they have been carried along by the peloton.
The year ahead will be a major mountain stage for the majority of economies and investment markets. The important point to note about mountain stages is that this is where most riders abandon the tour, the first place finishers on the flat do not normally win in the mountains and the ultimate winner of the tour is decided in the Alps and Pyrenees.
As far as New Zealand is concerned the year ahead could be difficult, particularly the first half. There could be some relief in the second half of the year as long as Reserve Bank Governor Alan Bollard doesn't take the same hawkish approach to the current international crisis as Brash did to the 1997 Asian downturn.
Bollard will have the major impact on the domestic economy in 2008 as he will determine whether it is a brutal or a more benign mountain stage.
As far as the NZX is concerned the year ahead is all about stock selection. There will be good opportunities but investors should not automatically buy into downturns as companies that have performed well during the good times may not necessarily be the best bets when conditions are more difficult.
* Disclosure of interest: Brian Gaynor is an executive director of Milford Asset Management.
