As 2012 kicked off virtually all of the experts were suggesting that shares were the way to go and bond yields could only rise. Five months into 2012 and the world stock market is up by just 2.0 per cent in US dollar terms as weakness in continental Europe (-2.1 per cent) has been offset by strength in US shares (+6.1).
Much of the latter's outperformance has been due to the stellar rise in Apple shares which have returned 39.6 per cent in the same period. So after starting off with a rush and a roar shares have disappointed the faithful thus far in 2012 but this is just part of a bear market that has seriously eroded investors' faith in shares in the last ten years. Since the peak in 2000 the real return on global shares is - 1.71 per cent pa. But don't despair, it could be a lot worse.
The Global Investment Returns Yearbook records that since 1900 the worst 10 year period for global equities in real terms was the ten years ending September 1920 where global equities returned - 6.5 per cent pa.
The Financial Times reports that institutional investors in the UK and US are flocking to bonds at the expense of shares and that the average US pension fund now has only 50 per cent of its assets in shares, down from 70 per cent in around 2005.
With all this negativity you would think that shares might be cheap but unfortunately that doesn't look to be the case. Corporate profit margins are at a historical high profits as a share of GDP are at 50 per cent and labour's share of GDP is at a low. Mean reversion will mean lower profits in the future. This will be compounded as Governments and individuals continue to deleverage. Some critics are saying deleveraging has only just begun.
What has really confounded the critics however has been the continued bull market in long dated US, German and UK government bonds. The US ten year bond yield closed, at the end of May, at 1.56 per cent, at its all time low. Germany's 10 year bond yield is also at an all-time low at 1.2 per cent pa and UK 10 year bonds are the lowest they have been since the Bank of England started collecting data in 1703!
If that wasn't bad enough the thirty year German Government bond went under 2.0 per cent for the first time ever in late May and finished the month at 1.74 per cent.
The Financial Times interpreted this as "no confidence in European growth. Ever again". These bond yields keep me awake at night more than the prospect of Tame Iti playing war games in the Ureweras as the low interest rates forecast very dire times ahead. There is every prospect of a severe recession worldwide not to mention political and social upheaval in Europe.
Whilst NZ and Australia have lots of scope to reduce interest rates the big issue for Australasia could be a house price crash. NZ and Australian house prices have not corrected anywhere near the extent that other Western countries have. One only has to look at the current weakness in the share prices of ANZ, Westpac, CBA etc to see that the institutional market is very worried about the prospect of bad debts on residential house loans causing substantial dividend cuts.
So the implications of low long term government interest rates for the man in the street are that we are almost certainly heading for recession and individuals should be carefully considering taking on fixed term debt, starting new businesses or divorcing the wife.
The implication for retired individuals living off their savings is that there is a strong possibility that short term interest rates are not going to stay at current levels for too much longer.
In any case when structuring one's fixed interest portfolio the received wisdom amongst the experts is to acknowledge that interest rates could go up, down or stay the same and accordingly invest your funds into short, medium and longer term bonds. This is the conventional wisdom but there is always the odd adviser ready to speculate with his client's funds.
Speaking of which a highly trained financial adviser made the ridiculous comment in the Herald recently that he didn't think many retail investors would be buying 10 year government bonds at a 3.65 per cent yield when they can get 4.5 per cent in the bank on call.
He then made the reckless statement that "investors would be crazy to lock their money into any bonds for more than two or three years at the moment". Whether keeping your money on call or investing it for 10 years actually turns out to be the best strategy or not is irrelevant the point is that investing all your money short term is a risky strategy. What if interest rates fall and call rates are down to 0.1 per cent in a year's time.
What is that going to do to your income? Besides the volatility of income introduced by just focusing on short term fixed interest investments this was a dumb comment because if managing a bond portfolio was as simple as picking whichever term has the highest interest rate then 90 per cent of US bond fund managers would not underperform the index. It is probably true that looking at what interest rate you are going to get, when dealing in the secondary bond market, probably does more harm than good. People should just accept that the market is efficient and diversify accordingly.
While we are talking about interest rates the budget contained Treasury forecasts for NZ 10 year bond yields and one really has to wonder what drugs these Treasury guys are on. They are forecasting that 10 year NZ bond yields will finish 2012 at 4.0 per cent when the long and short term trend is down, down, down.
Currently 10 year NZ government bonds are yielding just 3.26 per cent so Treasury must be looking for some off the radar up-tick in either economic growth or inflation none of which look remotely likely. Indeed with global interest rates well below 2.0 per cent it is not surprising that NZ government bonds are getting the bid from overseas investors.
One bright spot for investors has been NZ shares which have outperformed international stocks over 10 years and in 2012. We have had a number of excellent profit results from NZ companies and whilst the likes of Fletcher Building and Fisher and Paykel Healthcare will be impacted by the global downturn smaller stocks like Ryman, Comvita, PharmacyBrands and Infratil are surprising the market with a resilient performance.
What all this means for investors with a balanced portfolio, either via Kiwisaver, a managed fund or through a financial adviser is that in the five months their portfolio will have returned around 4.8 per cent pre fees, pre tax. Assisting performance was a great effort from the NZ stockmarket which returned 8.7 per cent in the five months.
The main driver of this great return was Telecom shares which rose by 29.6 per cent but Telecom shareholders shouldn't get too excited as the ten year return at 3.3 per cent pa is still half what the broader market has done. Also helping performance in the period was the local listed property sector which returned 9 per cent and global equities which returned 4.7 per cent, thanks largely to a weaker NZ dollar.
With Government bond yields so low in countries with relatively strong financial positions it will be interesting to see how the stock market holds up for the rest of the year. I have a bet with a local fund manager that the S&P500 will end the year lower than it started and after a bad start I am now in the money.