Brent Sheather: Not a bad 2013 for NZ investors

For those New Zealanders with a well-balanced portfolio, the last six months have been good. Photo / Richard Robinson

I seem to remember from Sunday School someone important once said words to the effect that "the first shall be last and the last shall be first".

He may have had something else in mind at the time but this remark could describe the contrasting performance of financial markets in the first six months of 2013. A number of major trends which had been in place for the long term changed direction rather abruptly. The most notable of these was the reversal in the fortunes of bond investors around the world.

Bonds have had a great run since about 1980 but nosedived towards the end of the period as the ten year government bond yield in the US, from which most other fixed interest investments are priced, rose from 1.62 per cent at the beginning of the year to finish at 2.49 per cent at the end of the period delivering a loss to holders, in US$ terms, of 6.7 per cent for the period. Nasty.

It is not hard to find critics of bonds as an asset class. In fact many local commentators have been warning that interest rates can only go up for the last five years or so and as they say if you predict a trend for long enough eventually you are going to get it right. So this is the bond bears opportunity to say "I told you so".

Coincidentally about two weeks ago this column rehearsed the argument for bonds investors not worrying too much about a rise in interest rates, just in time for interest rates to rise sharply. As discussed interest rates are up so it is interesting to look at the performance of bonds relative to other asset classes over the period. We can't consider the bond returns in isolation because in the same breath the bond bears frequently warn of inflation and argue that investors need to invest in real assets which means owning shares in developed and very often emerging markets.

The data, in the admittedly short time frame of the six months to 30th June confirms the wisdom of the "sell bonds" strategy but bond bears should not however feel too smug because the impact of rising bond yields has impacted other asset classes, in some cases more so, than it did bonds. In the six months the NZ bond market returned - 1.3 per cent and the global bond market was flat, in NZ$ terms.

Emerging markets, which have been underperforming developed markets for some time, were particularly impacted by rising US interest rates and their sharp downward trend picked up momentum as China's debt problems became more widely known. Six month returns were much worse than both NZ and global bonds at - 2.4 per cent.

One UK based economic consulting group whose research is rather unique because it is insightful and isn't free describes the current market dynamics as the "Real Great Rotation" from emerging market equities to developed market equities.

Continuing the reversal of fortune theme the Australian stockmarket, which has been a stellar performer in the last ten years (10.3 per cent pa vs 4.8 per cent pa for the world stockmarket), sharply underperformed in the six months as international investors, who had previously bought the Australia story enthusiastically, rediscovered the attractions of their home markets and brought their cash home causing the Australian dollar to fall by 5.3 per cent over the six months and thereby keeping Australian stocks almost flat at 1.2 per cent.

In contrast US shares, which this time last year had a ten year average historic return of just 0.4 per cent pa, surged ahead in the six months returning 21 per cent, helped in no small way by a stronger greenback.

Not all bonds suffered big losses in the six months. As a general rule the longer the maturity date of the bond the worse was its price performance. But it was possible to achieve excellent returns in the bond market in the six months.

Perpetual preference shares were much aligned a year or so back and in hindsight probably should not have been as highly represented in retail portfolios had a huge year. Two of the worst offenders, ASB Capital Preference Shares and Infratil Perpetual Preference Shares, returned around 20 per cent and 14 per cent respectively in the six months. These bonds, or shares if you prefer, stand to benefit if interest rates continue rising as their interest payment is reset annually. Investors should remember however that past performance means very little and higher risk bonds like this shouldn't represent much of an individual's fixed interest portfolio particularly if they also own shares.

The big event in the six months and the cause of the sharp rise in interest rates was of course Ben Bernanke's decision to signal a possible end of quantitative easing depending on whether the US economy continues to recover or not. When financial markets heard this news they went into an immediate nosedive with peripheral markets i.e. those which have benefitted most from the rush by American investors to seek yield overseas, falling the most.

As an aside isn't it perverse that when the Chairman of the Federal Reserve signals that the economy is recovering and quantitative easing may not be needed, stock markets fall. You would have thought that this was good news not bad.

This table summarises returns for the major asset classes and markets in the six months ended 30 June.

The key number for many Herald readers will be what a balanced portfolio returned and here the news is good. If we assume a balanced portfolio comprises weightings typical of the average pension fund or KiwiSaver funds i.e. about 40 per cent in bonds, 10 per cent in property and 50 per cent in shares split between NZ, Australia and international, a balanced portfolio is estimated to have returned, before fees and tax, about 6.1 per cent.

Not a bad effort in six months.

The key contributors to this good result were, as the table illustrates, international shares which returned 15.7 per cent and typically comprise two thirds of a balanced fund's portfolio, followed by NZ shares at 10.0 per cent. Prize for best performing large developed country stock market goes to Japan which returned 24.1 per cent.

The extreme weakness in emerging market equities in the six months is also a bit ironic - earlier this year at a financial advisers conference one of the "distinguished speakers" was of the view that the fundamentals of emerging markets were so good and those of developed markets so bad that "mum and dad could achieve all their equity exposure via emerging markets".

Anyone who has followed that advice will be hating life. It was nonsense then and at sharp variance with best practice but qualified for CPD credits nonetheless.

Brent Sheather is an Authorised Financial Advisor.