KEY POINTS:
The equity return statistics for the past 12 months make for depressing reading - world stockmarkets are down by 8.2 per cent and New Zealand shares have done even worse, plummeting by 23 per cent.
Although there are several reasons for the fall, most experts agree that one of the biggest culprits is fear of that old enemy of long-term investors, inflation. After being vanquished by Paul Volcker of the US Federal Reserve in the late 70s and lying dormant for 30 years, prices are again on the march upwards.
While the most visible of these is the oil price, just about everything is going up in price except, of course, houses.
Inflation is bad news for investors, hurting the two major asset classes of bonds and shares. Investment theory says as inflation drives interest rates higher the current value of the cash-flow stream of a share portfolio, or bonds, falls in value.
For real assets such as shares and property, some of the reduction in value because of a higher discount rate is offset by higher earnings as companies raise prices. But as we shall see, the net effect of inflation on share prices has usually been negative.
If inflation is bad for real assets, it's a positively poisonous environment for nominal assets such as bonds.
Once you have bought a US 30-year government bond, that's it - the interest rate has been set for better or worse and if inflation does rise and, with it, required returns, long-term government bond prices can fall just about as violently as share prices.
Investors unlucky enough to own 30-year US government bonds from 1969 to 1979 suffered a 19 per cent capital loss on their investment (excluding income). It is possible to lose your shirt in bonds - even government-guaranteed investments. Consequently the bond market is usually the first to be spooked by an inflation scare.
We can get an idea of the local bond market's forecast for inflation by looking at the difference between the real yield on inflation index bonds and the yield on conventional long-dated government bonds. The latter currently yield 6.3 per cent and the yield on inflation indexed bonds is 3.9 per cent, suggesting that the bond market is forecasting inflation to average just 2.4 per cent a year over the next eight years.
With inflation soaring in countries from India (8.75 per cent) to the US (forecast to be 7 per cent in 12 months' time), this low rate is surprising. But in the last 10 years New Zealand's inflation rate has averaged just 2.1 per cent a year.
The low break-even inflation rate is also consistent with the lack of concern shown by other bond markets at the recent rise in inflation. US 10-year yields are just 4 per cent a year, down from 5 per cent a year ago.
The consensus seems to be that what we are seeing is a one-off spike in prices and then it will be a return to business as usual. Let's hope the financial markets are right - low-bond yields provide little margin for error.
Long-term data shows that New Zealand has generally always had much higher levels of inflation than the US - about 4.4 per cent a year in the period 1930 to 2007, versus about 3 per cent a year for the US.
A history of high inflation may be part of the reason New Zealand's interest rates are as high as they are and is almost certainly behind the long-term depreciation of the dollar against the greenback.
The worst period for local inflation was the 70s and 80s when prices rose an average of 10 per cent a year and the interest rate on long-term government bonds got as high as 18 per cent. During this period New Zealand government bonds returned -1 per cent a year in real terms, but the stockmarket rose by an average of 4 per cent a year faster than prices.
Tim Bond, head of global asset allocation at Barclays Capital in London, recently produced a research note looking at how financial assets behaved during the so-called Great Inflation in the US/UK between 1969 and 1979.
The average annualised total return for shares in that 10-year period was -2.3 per cent a year in the UK and -0.9 per cent a year in the US. While these are poor returns, they were a good deal better than low-risk bonds recorded which fell by 4.1 per cent a year in the UK and 1.6 per cent a year in the US.
Bond shows that in times of high inflation, while corporate earnings tend to rise at rates higher than consumer prices, total equity returns are negative because investors' valuations of corporate earnings fall during inflationary periods.
He notes that the S&P-500 price earnings ratio stood at around 16 times in 1970 and had fallen to just 7 times by 1979. That was the reason for the poor performance of shares, not that profits didn't keep pace with inflation.
For this reason research by Barclays Capital shows that dividends from companies generally keep pace with prices even in times of high inflation. This is good news for buy-and-hold equity investors interested in income - as long as you don't have to sell.
The current decline in world stockmarkets could be part of a transition to a lower PE ratio.
Inflation really is the bogey man for financial markets and virtually no one seems to see it coming.
Bond is cynical about the bond markets' current insouciance and warns that the commodity price-inspired inflation is likely to be more consistent than is currently priced into government bond yields.
Next time we will look at Bond's advice for investing in times of high inflation.
Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.