Brent Sheather: Interesting times - for all the wrong reasons

The world stock market fell by 16.5 per cent in the September quarter in US dollar terms.

At the same time, interest rates on government bonds in the United States, Britain and Germany are hitting record lows. In the quarter, 10-year United States Government bond yields touched 1.7 per cent and finished at 1.9 per cent.

This is getting close to their all-time low point in the 1940s. Normally people interpret low interest rates as being good news, but today nothing could be further from the truth.

Today's low yields suggest two things - low inflation or even deflation and low growth - neither of which is good news for the world. The question before the panel, therefore, is: is the bond market a credible witness?

Most historians reckon the bond market has a better track record of forecasting the future than the stock market, and it is interesting to note that on many days when the United States stock market has risen euphorically, the bond market has been unimpressed, with only small rises in interest rates.

But today, both the stock market and the bond market seem to be reading from the same script: the great contraction is coming.

These certainly are interesting times - but for all the wrong reasons.

As this column has previously reported, many of the world's top independent economists are forecasting the worst recession since the 1930s and some are even allowing for the possibility of a depression. Nothing is certain and a miracle could happen - but that looks unlikely.

With this background, it's no surprise that share prices have been falling sharply all quarter, with the world index down 9.4 per cent in NZ dollar terms in the three months.

This performance would have been a lot worse had it not been for the weaker NZ dollar - thank goodness for that downgrade.

We have to go back to the third quarter in 2008, when world stock markets lost 21.6 per cent, to find a worse three-month period for shares than the September quarter's scary 16.5 per cent fall.

Using data from the Ibbotson Yearbook, the worst-ever three-month period for the US stock market was the quarter ended June 30, 1932, when stocks fell by more than a third.

With half the assets of a typical balanced pension fund in shares, this is not good news for long-term savers. Investors with growth portfolios will have done much worse and should maybe stop reading at this point.

What does all this bad news actually 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 3.3 per cent in the quarter. Not the end of the world.

Fortunately, the depressing performance of global stocks was offset by a relatively stable performance from NZ shares, which fell by just 1.6 per cent. Furthermore, the average pension fund typically has a 10 per cent weighting in property, much of it local, and NZ property stocks actually rose by 1.6 per cent in the quarter. But the real stabilising force for balanced portfolios this quarter came from the bond sector, where global bonds returned 12.5 per cent in kiwi dollar terms and NZ Government bonds also came to the party with a 3.5 per cent return.

Unfortunately, these numbers may overstate the actual performance of the typical mum-and-dad portfolio managed by a financial adviser for two reasons; first, most global bond investments are hedged, so wouldn't have benefited from the fall in the kiwi. Second, for various reasons, financial advisers tend to advocate higher-yielding risky bonds rather than government bonds.

In bad times, like we are in now, the bond market bifurcates - low-risk bonds rise in price, higher-risk bonds fall. A couple of extreme examples will illustrate this point.

In the US, 30-year Government bond yields fell from 4.4 per cent to 2.9 per cent in the quarter. This doesn't sound like a big deal, but that movement was enough to turn the face value of 10,000 on June 30 from US$9060 to US$11,924 ($11,436-$15052) on September 30 - an extraordinary gain of 31.6 per cent. Recall that at the beginning of the year, all the experts were saying bonds were overpriced and shares were the way to go.

At the other end of the spectrum, an example of lower-quality bonds are the Goodman Fielder 16/5/2016s which are widely held by retail investors. In the quarter, the capital value of these bonds fell by 2.8 per cent as yields rose from 6.9 per cent to 7.6 per cent. During the quarter, these bonds have fallen by more than the NZ stock market at precisely the time that their diversification benefits would have been useful.

So what is happening - why are shares tanking and bonds going up? The key factor driving financial markets is not just about the prospect of Greece defaulting. The market has long assumed that is going to happen. The important factor for the financial markets is that economies are slowing fast and some are going into reverse as individuals and governments start to pay off debt rather than spend.

There is a theory called "the paradox of thrift", and that is that while saving is generally good news, if we all start saving and cut spending, economic activity plummets. The US Government, for example, has to balance its budget, which means sooner or later it will be cutting its spending by trillions of dollars.

This means less money in the economy and lower profits for companies, which means lower share prices. In this environment, inflation is unlikely but deflation is possible, and anything that promises a safe guaranteed return will be in demand - such as government bonds.

The other "elephant in the room" is Italy, which has the dubious honour of having the third-largest government bond market in the world, according to Longview Economics. At €1.9 trillion ($3.3 trillion) and with debt to GDP of 120 per cent, it is probably too big for the Western economies to bail out, according to Longview. Interesting times indeed.

So should we sell all our shares and buy bonds? Probably not, but if you just own shares, you might have a good think about things, although it may be too late - sharemarkets may be close to factoring in the dismal future and there is always the chance that, if things get worse, monetary authorities will pull out all the stops and print money like there is no tomorrow.

In this environment, bond investors might lose a lot of money. The right thing to do, of course, is to have a diversified portfolio of low-risk bonds and shares and it is never too late to do the right thing.

In two weeks' time, we will look at a financial plan prepared by the financial-planning arm of one of the major banks.

A reader emailed asking for a second opinion on the plan, particularly as regards the suitability of the fee structure and whether its return forecasts were realistic.

It is one of the first financial plans I have seen since the new regime of "putting the client's interest first" has been in operation, so it was interesting to see how things have changed, or not.

The author is a "highly trained" authorised financial adviser, so the expected standards are high. All will be revealed in a fortnight.

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