Brent Sheather: Surging kiwi dollar takes gloss off returns

Well, that was 2010, overall a bit of a disappointing year for portfolio investors. The average pension fund or balanced KiwiSaver fund will report returns before fees and tax of about 5.1 per cent for the year, in line with a bank term deposit but below NZ government bonds, which returned 7.0 per cent.

The reason for this lacklustre result? Simply that stockmarkets had a poor year in NZ dollar terms with New Zealand shares recording a 3.2 per cent gain, international shares 5.2 per cent and Australian shares 6.7 per cent.

Comparable figures for 2009 were 3.9 per cent, 19.2 per cent and 41.5 per cent respectively, so two-year results still look pretty good.

Balanced funds typically have about half their money invested in shares spread between New Zealand, Australia and international shares, with a bias to the latter, so when shares underperform, that usually brings overall portfolio returns down with it.

It is worth noting, though, that all these figures are adjusted for the impact of the NZ dollar exchange rate. This has had the effect of reducing global share returns by about 7 per cent as the NZ dollar appreciated against the greenback by that amount in the year.

In fact, over the past 10 years, the NZ dollar is up against the US dollar by an average of 5.8 per cent a year.

Currency had an even greater impact for New Zealanders who had UK and European investments, with the kiwi up by an impressive 11.6 per cent and 15.1 per cent respectively in the past 12 months. Local fund managers who routinely hedge out the currency impact of their overseas investments will no doubt be feeling pretty smug and will report much better than average returns for 2010.

So, 5.2 per cent for global equities overall wasn't great but it was possible to do a good deal better than that if you were prepared to take higher risks and concentrate your money in more esoteric areas. Everyone seems to be jumping on the emerging market bandwagon presently because in 2010 that sector returned 13.4 per cent and 10-year returns are at 10.5 per cent a year, some 13 per cent a year ahead of the developed market index.

If there is a slowdown in China, or some other catastrophe, emerging markets could quickly go out of fashion.

Other highlights in 2010 included the US smaller company sector (+17.4 per cent), US property (+19.9 per cent) and, of course, that barbarous relic, gold, which rose in value by 21.2 per cent. Gold has now averaged 11.4 per cent a year, in NZ dollar terms, over the past 10 years. However, I am not prepared to speculate whether it is a good investment or not today.

The year was also notable for the fact that, thanks to the efforts of the US Federal Reserve to promote growth and the underlying strength of the emerging markets, the global economy picked up speed and avoided the dreaded double-dip scenario.

Normally a stronger economy and the money printing strategy of the US is bad for the bond market, as both of these variables are usually associated with higher inflation rates. Despite these headwinds global bonds had a reasonable year, rising by 5.6 per cent in US dollar terms, which was a lot better than many people expected.

In 2009 global bonds returned -19 per cent and, with bond yields starting 2010 at close to generational lows, downside risk was a clear and present danger. In the event, US 10- year government bonds had a volatile year but yields finished marginally below where they started from.

The "crowd" appears today to be favouring equities over bonds and it seems apparent that US 10-year bond yields at 3.4 per cent are not consistent with a resumption of growth, whereas the pricing of the US equity market seems to assume that a return to growth is a given.

There is a danger, however, translating that view to New Zealand, where bonds haven't fallen by anything near what the US bond market has done. In New Zealand, assuming long-term inflation of 3 per cent, our 10-year bond offers a reasonable 2.5 per cent real return, pre-tax. In the US, again assuming 3 per cent inflation (that is what it has averaged since 1926), real rates are barely positive at 3.4 per cent. Similarly, the concern is that interest rates are going up and that may indeed be the case for longer-term bonds in the US and, maybe, short-term bonds in New Zealand. But is it the case locally - 10-year government bonds hit a high of 6 per cent in 2010 but are today trending lower at 5.5 per cent.

To get an idea where the "hot money" was going in late January I spoke to expatriate Ohope painter and now Gold Coast-based private wealth specialist Les Lostchild of Goldman Lostchild. Apparently Goldman Lostchild's proprietary trading models predict the imminent demise of the major Western economies and a run on the US dollar.

Its valuation models highlight the high growth rates of the emerging markets, particularly the Bric countries of China, Brazil and India. Accordingly Goldman Lostchild's clients were overweight the Brics and gold stocks. The last time I heard Les express such a confident view was back in December 2008, at the US stockmarket bottom, when he was confidently predicting a depression and had all his clients in cash.

What could 2011 hold in store: will the US Government default as per the Goldman Lostchild forecast, or will there be a slow grinding recovery which would suit investors overweight in the local bond market? Will growth surprise on the upside with associated inflation favouring real assets like shares, property and commodities?

The cynics point out that while a dive into the abyss of depression has been averted by the US strategy of quantitative easing (printing money and using it to buy government bonds), the problems of high levels of debt, low levels of saving and a chronically weak banking system haven't been addressed.

Andrew Smithers of Smithers and Co, an independent economics consulting group based in London, advises clients that there is a very real risk of another serious stock market crash and that the US government needs to balance its books sooner rather than later.

Lower government spending will inevitably reduce company profits. I'm not as confident at predicting the future as the folks at Goldman Lostchild so, faced with such an uncertain world, I'll stick with having a portfolio with a bit of everything as the safest option, while keeping operating costs as low as possible.

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