Brian Fallow

The Economics Editor of the NZ Herald

Asset prices look stretched

Analyst urges investors to take cautious approach as economic cycle nears its peak.

Property markets in many countries have also benefited from a world awash with cheap money. Photo / Hagen Hopkins
Property markets in many countries have also benefited from a world awash with cheap money. Photo / Hagen Hopkins

It is a time for investor caution as asset prices look increasingly stretched, warns Bank of New Zealand economist Stephen Toplis.

The BNZ's head of research believes we are about at the peak of the economic cycle in terms of rates of growth, which is always a time when complacency sets in about investment returns.

That effect is compounded this time by the impact of massive monetary easing by the world's central banks, inflating prices of bonds, equities and property.

"Alas, one of the ironies of growth cycles is that the peak in growth, when folk are making most money, is the very time when the expected returns for investing that money start to wilt, " Toplis said. "That's because interest rates rise, slowing growth, raising corporates' input costs, creating capital losses on fixed interest investments and reducing the relative value in equities."

As the cycle peaks corporate profitability generally is reduced, as capacity constraints push up the cost of labour and other inputs at a time Caution urged as asset prices 'look stretched'

"We are trying to say just be a little bit cautious about your expectations for returns, rather than saying you are going to lose everything," Toplis said.

Global bond yields are extraordinarily low. Bond yields should reflect expectations for real growth and inflation in an economy over the period concerned. At their present historically very low levels they are either acutely pricing a pretty grim outlook for the real economy or they are seriously overpriced.

United States bond yields are pricing in real growth of not much more than 1 per cent over an extended period.

"Either you believe that is the case - and the consensus forecasts do not - or bond yields have to go substantively higher," Toplis said.

Yields on German 10-year bunds have fallen to historic lows below 1.1 per cent, which is lower than in the darkest days of the eurozone debt crisis and at a time when German inflation is around 1 per cent.

If bond yields do rise equities will come under pressure.

"At the same time that valuations come under threat from the interest rate side, it is also likely that earnings growth will be compromised as the pace of economic growth peaks and the easy gains from cost reductions, often in terms of reduced labour input, become history," Toplis said.

Almost 90 per cent of the increase in the global sharemarkets since early 2012, as reflected in the MSCI index, was a result of rising forward price/earnings multiples and only 10 per cent because of rising expectations for earnings.

Meanwhile property markets in many countries have also benefited from a world awash with cheap money.

"New Zealand is no different in this regard with property further assisted by its preferential tax treatment and the fact that overseas buyers are increasingly interested in our market," he said.

"Whether you look at New Zealand property prices compared to rental returns or wages, they still look overdone to the tune of over 30 per cent. Are they likely to correct any time soon? No, because excess demand still exists and will probably continue to do so for some time yet.

"But supply will come on stream at an ever-accelerating rate over the next few years," Toplis said.

"Eventually, excess demand will be whittled away and that's when the correction will come. New Zealand property is far from a one-way bet."

- NZ Herald

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