Mark Smith: Investing abroad to deliver better returns

Despite recent volatility in the sharemarket, local investors have been buoyed by its strong performance in the past two years.

This, coupled with the property boom and the poor performance of international markets for three years earlier this decade, has created an environment where, psychologically, it has become difficult for investors to look beyond New Zealand.

We can now add to this the changes in tax law announced in last month's Budget that will see gains on domestic equities no longer taxed after April 2007. In contrast, it appears that all gains on international assets will remain taxable.

So is the case for investing just in domestic securities as strong as it appears? We would that argue that perception is not reality.

First, consider the exchange rate's impact on returns.

The appreciation of the dollar has significantly altered investors' perceptions of overseas markets.

If we look at the past 20 years' returns, international shares have performed negatively in only five years.

Australian investors still favour international markets because the annual average return (converted to Australian dollars) is almost 14 per cent - better than all major asset classes except Australian shares.

On the other hand, New Zealand investors in those markets over the same 20 years would have seen a far lower return of 11 per cent if converted into kiwi dollars.

The difference is not attributable to the markets, but rather the appreciation of the dollar.

Most predictions are for the value of the kiwi to fall against the US dollar. If the dollar falls in value against a currency, New Zealanders with investments in that currency stand to make an automatic equivalent gain.

Some believe the NZ dollar is overvalued as much as 20 per cent.

A second reason to consider international markets is the slowing of the New Zealand economy.

Most predictions are for growth to halve, suggesting many local companies will not enjoy the growth rates and trading conditions of the past few years.

While the slowing economy has yet to significantly affect many investors, it is nevertheless real and the slowdown may be more pronounced than expected.

In March, the Reserve Bank was predicting that growth for the December 31 quarter would drop to 1.1 per cent. We now know it was dramatically lower at 0.4 per cent, suggesting that annual GDP growth is more likely to be about 2 per cent than the 4.8 per cent achieved in the 2004 year.

The Reserve's estimates for 2007 forecast GDP growth to be a mere 1.6 per cent by June of that year.

Worse, the current account deficit for the quarter was $3.1 billion, which, combined with the lower-than-expected GDP growth, saw the dollar tumble a few cents against the US dollar, making another interest rate rise from the Reserve Bank much less likely.

Markets are sensing this. Take a look at the shape of the yield curve. The short end is predicting no more rate rises to come, while the long end is pricing in rate cuts.

According to the yield curve, New Zealand is in for sharply slower growth, so much so that the Reserve Bank will be forced to cut rates over the medium- to long-term.

Meanwhile, key indicators show the US economy performing more strongly than expected, despite high oil prices and rising interest rates, achieving annualised growth rates of about 4 per cent.

China is expected to grow at twice that rate this year - or four times the New Zealand rate, and Europe and Japan are expected to turn in robust performances after a disappointing 2004 year.

Overall, with several major economies likely to considerably outdo New Zealand in the foreseeable future, and given the automatic value boost a falling dollar will create for some overseas investments, the case for local investors to place a share of their portfolio outside New Zealand looks compelling.

Dollar influence

* The appreciation of the dollar has significantly altered investors' perceptions of overseas markets.
* International shares have performed negatively in just five of the past 20 years.
* Australian investors' average return from international shares is almost 14 per cent.
* New Zealand investors' return has been 11 per cent.

* Mark Smith is chief executive of BT Funds Management (NZ).