Brent Sheather: Interesting times

What is behind this dramatic reversal of fortune? Photo / iStock

Brent Sheather is an Authorised Financial Adviser and a personal finance and investments writer.

The year has got off to a bad start for portfolio investors with the world stock market having fallen by 10.8 per cent in US$ terms.

January has traditionally been a good month for share markets so that was a bit of a shock. However of potentially more relevance to mum and dad, retired and living off their savings is the continued downward pressure on interest rates. At the end of last year 10 year US Government Bonds were yielding 2.27%, the US Federal Reserve in December had raised its benchmark rate and expected to further lift short term interest rates gradually over the next three years.

The chairwoman of the Fed, Janet Yellen, said at the time "the Fed's decision today reflects our confidence in the US economy".

Barely a month later people aren't so confident - the Fed is widely expected not to be raising interest rates anytime soon and the 10 year Treasury has fallen to 1.74 per cent. In NZ our interest rates have mirrored overseas trends - five years ago 10 year NZ Government bond yields were at 5.5 per cent, today they are just 3.13 per cent which means a fall in income for investors of about 44 per cent even ignoring the impact of inflation on spending power.

Perhaps of more significance to retail investors is the fall in six month deposit rates - a year ago the banks were offering 4.2 per cent and that is down to 3.3 per cent today, a fall of almost 22 per cent. Clients of those financial advisors who recklessly declared that interest rates were too low a few years back and advised their clients to wait for higher rates and just own short dated bonds must be feeling a little upset to put it mildly. Best practice is clearly to own a range of maturities as this minimises income volatility.

The Chinese have one "get out of jail free card" that they could play and that is to devalue their currency and thus export their problems to the rest of the world.

What we can learn from this experience is that nothing is certain in matters financial and we need to position portfolios to accommodate this uncertainty, ie have a dollar each way. Incidentally a proven strategy for many investors who feel the need to speculate and forsake the safety of diversification is to spend an hour or two considering the market, formulate a strategy and then do the opposite to what they think they should do.

So what is behind this dramatic reversal of fortune?

Anatole Kaletsky, Chief Economist of Gavekal Dragonomics, reckons there are three things preoccupying share market investors at present. They are China, oil and the fear of a global recession. For the last ten years or so China's growth has supported commodity prices and in particular Australia and the emerging markets.

Investors worry that the 55 per cent fall in the Chinese stockmarket since its peak in October 2007 signals major issues in the "middle kingdom". The Chinese have one "get out of jail free card" that they could play and that is to devalue their currency and thus export their problems to the rest of the world perhaps setting off a round of competitive devaluations like we have seen in earlier crises.

The other big issue is the falling oil price.

Whilst lower oil costs might be thought to stimulate an economy the current mind-set of investors is to focus on the negative and that is that low oil prices indicate collapsing demand and thus hint at recession which brings us onto Mr Kaletsky's third point.

Certainly one can reconcile ultra-low interest rates like 1.74 per cent on US 10 year Treasuries or close to zero on 10 year Japanese bonds with a dire outlook for the world economy.

Mr Kaletsky notes:

If oil price movements have any relevance at all in economic forecasting it is as a contrary indicator. Every global recession since 1970 has been preceded by a big increase in oil prices whilst almost every decline greater than 30% has been followed by accelerating growth and higher share prices.

Kaletsky adds that the widespread view that low oil prices augur recession is a clear case of the belief that this time is different. He makes the point that "while markets are often wrong in predicting economic events financial expectations can sometimes influence those events and as a result reality can sometimes be forced to converge toward market expectation, not vice versa" that's why we can probably expect the US Federal Reserve to act again to improve what Lord Keynes called "animal spirits".

Either way it is interesting times and in this environment the typical private banking fee structure of 2-3 per cent pa looks even more incongruous than usual. With average yields of 3.5 per cent on a bond portfolio and maybe an average of 4.0 per cent on shares then the after-tax, after-fees cash return of a balanced portfolio is likely to be barely above zero which means that investors will be dependent upon capital gains to fund their spending.

Whilst this may be sustainable in the short term retail investors faced with declining portfolio values and little or no cash income who are advised to sell assets at a loss to fund their spending typically start to query the rationale of this investment strategy after a couple of years of pain. Retail clients are regularly chastised for throwing in the towel at the first sign of trouble but, faced with high fees, high risk and lower returns than they can earn in the bank it's not obvious that pulling the plug is an altogether dumb move.

Overlay that with the fact that their risk profile was most likely misdiagnosed in their original investment plan and its no surprise that so many people apparently walk away in down markets.

Late last year the FMA surveyed the "sales and advice markets" and in particular KiwiSaver and declared that there were no major issues locally.

Right! Let's look at the reality of the KiwiSaver market.

Most if not all of the independent financial advisors who bother to give KiwiSaver advice on any scale only recommend those products which pay commission. All of the other KiwiSaver advice is undertaken by banks and they frequently only recommend their own high cost products.

For some perspective on the suitability of this arrangement the Financial Times reported a week or so ago in a leading article that JPMorgan was fined US$307million by the SEC "to settle allegations it failed to disclose to clients that it was steering them to the banks own investment products over those offered by rivals."

In the latest enforcement action authorities said JP Morgan's preferences that benefitted the bank effected a client's asset allocation and the selection of fund managers. It's strange that that sort of activity is deemed to be illegal in the US but gets the okay from the NZ regulators.

Meanwhile in another giant step backwards the Financial Advisor Code Committee, one of whose members a couple of years back publicly stated that interest rates were too low and advised investors not to buy long bonds, is consulting with industry as to whether they should back track on a previous code amendment and again allow sales promotions of new products to count as continuing professional development. Oh dear.

Brent Sheather is an Authorised Financial Adviser. A disclosure statement is available upon request. Brent Sheather may have an interest in the companies discussed.