Brent Sheather: A dollar each way is best bet for growth

Halfway through 2009 and the average KiwiSaver account with a balanced portfolio mandate will be down by an estimated 1.4 per cent before fees and tax in the six-month period.

That's assuming the fund managers have an asset allocation as per the traditional 40 per cent bonds and 60 per cent shares and property and have done as well as the market in each sector.

This is disappointing but a big improvement on the first-quarter result of minus 6.6 per cent. In fact the second quarter saw a substantial bounce in sharemarkets as investors recovered their nerve and appetite for risk. Global stocks rose by 7 per cent, New Zealand stocks were up by 8.4 per cent and global property led the way with a 23.5 per cent return.

The small loss in the half-year is an estimated average return. Some providers will have done better than this if, for example, they invested their funds with clever stock pickers or got their asset allocations right.

The latter strategy meant overweighting sectors which did well in the half-year, principally emerging markets and commodities, and underweighting the losers, which were the mainstream equity markets and Government bonds - in fact, just about the mirror image of what had proven to be a winning strategy this time last year.

In New Zealand dollar terms the three biggest components of the world stockmarket index - US, Europe and Japan - have gone backwards so far this year, recording losses of 7.1 per cent, 3.5 per cent and 8 per cent respectively.

In contrast the emerging markets had a bumper first-half with the broad index up by a very useful 22 per cent, Latin America up by almost a third and Asia ahead by 24 per cent.

Australia and New Zealand's commodity exposure and proximity to Asia rubbed off on their stockmarkets, with the ASX returning 13.9 per cent and New Zealand, a little lower but still positive, at 5 per cent.

The big losers in the six months were Government bond investors who had done so well last year. The global Government bond index had one of its worst half-years on record, falling by 12.6 per cent as interest rates surged from their December low.

In the US the benchmark 30-year Treasury bond yield rose in the half year from 2.69 per cent to 4.3 per cent, giving long-dated US Government bond investors a shock with a 23 per cent fall in value.

But don't shed too many tears for bond investors: over 12 months global Government bonds still show a 23 per cent gain in kiwi dollar terms as, despite the recent rise, interest rates have fallen sharply over one year.

Indeed, even over 10 years global bonds, at 4.4 per cent a year, are well ahead of global shares at minus 2.3 per cent a year.

In the half-year lower-risk New Zealand bonds went backwards, with the Government stock index falling by almost 1 per cent.

What this fall in the local Government bond index actually means is that, despite paying a coupon of between 2.5 per cent and 3 per cent in the half-year, the effect of rising interest rates was such that the price of New Zealand Government bonds fell by an amount greater than the income received. In the half-year 10-year NZ Government bonds rose from 4.59 per cent to 5.89 per cent.

The fact that bond prices fall when interest rates rise is a source of confusion for many people, both private investors and advisers alike.

However, a simplified example will help an understanding of why it happens like this.

Take, for example, the 2021 New Zealand Government bonds. When they were originally issued they paid a 6 per cent interest rate on the value of the funds issued, which we can assume was $1000 for this example.

So, looking at the cash flows, someone who bought $1000 of 2021 Government bonds is going to receive $60 each year until 2021.

But $60 received in 2011 isn't the same as $60 received in 2010 because you could invest that money at the prevailing interest rate at the time.

So what we need to do to reflect the "time value of money" is to discount each of the cash flows by the prevailing market interest rate. In this case we divide the $60 received by 1 plus the applicable interest rate.

That is how and why bond prices fall when interest rates go up.

It works this way because as the rate at which the coupon is discounted increases, the value of the coupons fall.

Remember, too, that the longer the maturity of the bond the more sensitive the price is to changes in interest rate.

A few years back I heard of a local retail investor who was "sold" a 100-year General Motors bond by one of America's largest stockbrokers. Imagine how sensitive that bond was to changes in interest rates, especially given General Motors' shaky situation.

It looked like a blatant attempt to flog off some bonds the broker's investment banking side had been left with and was totally inappropriate for someone aged in their 70s.

As mentioned earlier the New Zealand stockmarket had a reasonable half-year, returning 5 per cent. This was despite our second largest company, Contact, falling by 17.9 per cent.

Outperforming the market was an excellent 25 per cent return from Telecom and 20.4 per cent from Fletcher Building. Telecom stocks around the world have found favour with investors as defensive investments.

Long-term Telecom investors have been badly served by the company, with 10-year returns at minus 1.6 per cent a year versus 5.7 per cent per annum for the market as a whole.

Fund managers are generally underweight in Telecom so there is every chance that most will have underperformed the index thus far this year.

Bringing up the rear in the six-month period were Nuplex and Fisher & Paykel Appliances, which fell by 66.52 per cent and 29.19 per cent respectively, according to Bloomberg.

So much for the past six months.

Predicting what happens next is more difficult. Although economic activity is picking up there are some doubts as to its sustainability and fears that falling demand is only plateauing on the basis of Government stimulus policies which are in the long run unsustainable.

Then there is the worry that companies and households have too much debt and savings rates need to rise, further depressing GDP growth.

In such an uncertain time it's tempting to favour bonds over equities. But this strategy runs the risk that runaway inflation will decimate bond portfolios as it did in the 1970s.

However uncomfortable it may be, a dollar each way still seems to be the best strategy.

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