Brent Sheather: Slow US growth behind market turbulence

Investment rises and falls are best ridden out with patience and a diversified portfolio. Photo / Thinkstock

Markets go up and they go down. In the first quarter of 2011 the sun was out, investors were optimistic and world stock markets duly rose by 7.1 per cent in New Zealand dollar terms.

However, dark clouds gathered in early April, the mood became sombre and global equities slumped by 7.5 per cent in the second quarter to yield a small loss for the half-year of -0.9 per cent.

In the first three months of 2011, while the world seemed to be beset by one disaster after another, the stock market took no notice and cheerfully marched higher. In the second quarter Mother Nature calmed down somewhat but investors became increasingly nervous, selling risky assets and buying bonds.

Mark Twain is supposed to have famously said "sell in May and go away". The world stock market in US dollar terms reached its highest point so far in 2011 on May 2 so that was particularly apt advice from Mr Twain. But why the radical change in sentiment?

The chief reason for the markets' transition from manic to depressive seems to be that the US economy's rate of growth is disappointing investors - that is, the recovery may have stalled.

With the US Federal Reserve having pulled out all the stops to get things moving in the past couple of years, with two episodes of money printing, the worry is that if the economy does slip into a double-dip recession there is now no ammunition, nor appetite, left to revitalise animal spirits.

In the meantime US house prices continue to fall and are now more than one-third below where they were in 2006. That is apparently a bigger fall than happened in the 1930s and is significant as homes represent the biggest part of the average American individual's wealth. Lower house prices mean a lower propensity to spend, which, of course, means lower profits for American companies.

For some time Andrew Smithers of Smithers and Co, an economic consulting group in London, has been warning that sooner or later the US, UK and European governments have to address the fact that they are spending more than they raise in taxes, and the inevitability of balanced budgets will mean lower cash flow and profits for the corporate sector.

In late June the US 10-year bond yield got down as low as 2.86 per cent. It seemed as if the party was well and truly over and the day of reckoning was upon us.

However, the German Government agreed to extend its lifeline to Greece, the immediate crisis was averted and bond yields and stock markets duly rose. A cynic would argue, as Nouriel Roubini did recently in the Financial Times, that Greece's default has not been averted, just postponed.

But there is always a winner, even in the darkest scenario: the government bond market loves bad news so the second-quarter saw 10-year US government bond yields falling from 3.3 per cent to a low of 2.86 per cent before bouncing back to 3.16 per cent on the Greek news. Even so a 3.16 per cent 10-year government bond yield is hardly consistent with the inflationary consensus or a healthy economy.

This fall in bond yields is the opposite of what most pundits were forecasting at the beginning of the year and most local financial advisers seem to have been favouring shares over bonds on the basis of relative valuation.

Certainly interest rates are low and share prices look historically attractive so this is a quite rational view, unless of course the world slips back into a prolonged recession.

The very low US 10-year bond rate seems to indicate that that scenario is quite possible. In their excellent book This Time Is Different - Eight Centuries Of Financial Folly economic professors Carmen Reinhart and Kenneth Rogoff warn that recovery from a global financial crisis invariably takes much longer than people think and there are many false dawns along the way.

Lower bond yields are also in evidence locally, where we have seen the benchmark 10-year New Zealand government bond fall from 5.87 per cent in January to the current level of just under 5.0 per cent. If we look at a long-term history of New Zealand 10-year bond yields the lowest annual average level recorded since 1920 was 3.4 per cent in 1935 and the highest was 17.7 per cent in 1985.

The other notable influence on investment returns in the second quarter was the particular strength of the New Zealand dollar. In the period the kiwi appreciated in value by 8.9 per cent against the US dollar, 4.8 per cent against the Australian dollar and 6.6 per cent against the euro.

This is particularly bad news for overseas investors as when you convert prices to New Zealand dollars, returns are reduced accordingly. The NZ Super Fund has a policy of hedging its foreign exchange exposure on shares so with this tail wind may have even been able to record a small gain in the quarter.

So, putting all this together what does it mean for Mum and Dad investing with a financial adviser, contributing to a pension fund or investing in a balanced KiwiSaver fund? Assuming the typical asset allocation of 40 per cent in bonds and 60 per cent in growth assets, the average balanced fund will have fallen in value by about 1.7 per cent in the quarter.

Over the first six months of 2011 the average balanced fund is estimated to have returned 2.6 per cent pre tax, pre fees, which doesn't compare particularly favourably with an estimated 2.3 per cent from a six-month term deposit, which of course attracts no fees.

So what investment strategy makes sense for the future? So far long-dated nominal government bonds, apart from those in Greece, Spain, etc, have been the way to go - indeed global government bonds have outperformed the world stockmarket for almost 24 years now, since 1987.

Assuming this is the case and employing a 100 per cent bond strategy, thereby avoiding real assets, is very risky - the markets are volatile and while deflation is the focus today, inflation could be the problem tomorrow, potentially bringing huge losses to long-dated bond investors.

The answer, as always, has to be, in the absence of a crystal ball, a diversified portfolio of genuinely low-risk bonds, property and shares.

Perversely, financial advisers are paid to make asset allocation decisions (or if their clients are particularly deluded, pick stocks), but the biggest risk to a retired investor's savings is the adviser who has a strong view one way or the other, aggressively overweights that asset class, and gets it wrong.

In two weeks' time we will, with the help of a London Business School professor, look at the recent takeover of NZ Farming Systems Uruguay.

We will then speculate as to why so many investors sold into the offer when, what looks like, with the benefit of hindsight, a very conservative investment adviser's report told investors that at the offer price of 70 cents they could expect a 12 per cent compound return for the next 18 years.

* Brent Sheather is an Auckland-based authorised financial adviser and his adviser/disclosure statement is available on request and free of charge.