Brent Sheather: Different markets, different messages

The strong gains from international shares which began in the second quarter continued into the third with global equities returning 5.4 per cent in the three months.

Fortunately for New Zealand share investors who buy close to home, two of the best performers in the quarter were Australian and New Zealand shares, which rose by 19 per cent and 11.5 per cent respectively, to give very impressive year-to-date figures of 36 per cent and 17.1 per cent.

The banking stocks, which represent about a quarter of the Australian stockmarket, were especially strong, with ANZ and Westpac returning 45 per cent and 27 per cent respectively in the quarter.

Of the major equity markets, Japan had the worst performance, falling by 4.4 per cent in the quarter, despite a stronger yen. European equities shone with a 10.3 per cent gain, well ahead of US stocks, which rose by just 3.7 per cent, partly as a result of a weaker US dollar - down 11.5 per cent against the kiwi.

On the domestic stockmarket the listed property companies had a record quarter with the NZX property index returning 17.1 per cent. The AMP NZ Office Trust led the way with a 21.4 per cent rise and Kiwi Income was up by 17.8 per cent.

This follows a similarly inspired performance from the Australian property trust sector, which gained by 27.1 per cent in the three months. In the broader New Zealand market, Fletcher Building rose by 29.5 per cent, enough to give it a bigger market capitalisation than Telecom and thus become New Zealand's largest company on this measure.

Telecom itself had another bad quarter, falling by 0.5 per cent, but the booby prize for poorest performer probably goes to Pyne Gould Corporation, which is down by about 68 per cent in the quarter.

So apart from Pyne Gould Corporation, the stockmarket's view is unequivocal - good times are here again. However, a look at the fixed-interest markets in the quarter presents a less confident picture.

While headline returns from bond markets (New Zealand government bonds plus 1.7 per cent and global government bonds in US dollars plus 3.2 per cent) suggest steady to falling interest rates, the reality for many business borrowers appears to be sharply higher financing costs.

In fact, if you dig a bit deeper, the evidence is mixed as to whether interest rates are actually high or low. The case for low interest rates begins with a Herald article early in September in which ASB noted that its floating mortgage rates on residential property had fallen to 5.75 per cent, the lowest level in 40 years.

But the same report noted that if you were a business or farmer your floating rate from ASB was likely to be around 10.6 per cent and 7.6 per cent respectively. That differential - of 5 per cent between financing a house and borrowing for a business - could be part of the reason residential property investment is so popular in New Zealand and our stockmarket is so small: the cost of capital for residential property is much lower than that of investment alternatives.

A lower cost of debt capital, all other things being equal, means more investment in that sector. If rates get too low, overinvestment occurs.

At the same time mortgage rates hit a low point in New Zealand, the Financial Times in London reports that interest rates on short-term British government bonds hit an all-time low of around 0.8 per cent due to demand from commercial banks worried that the Bank of England might introduce negative interest rates.

This strange state of affairs looks quite possible. British commercial banks like Barclays and Royal Bank of Scotland frequently invest some of their short-term funds with the Bank of England if they can't find or are unwilling to lend to higher-risk customers.

These commercial banks have recently sold large amounts of government bonds back to the Government under the Quantitative Easing programme, with the Government assuming that the banks would then relend the proceeds to companies or individuals on a commercial basis.

But the banks are worried that the economy will turn down again so, rather than lend to risky entities, they are simply depositing the money with the central bank, the Bank of England. This has upset the British Government as it sees these moves as undermining the chances of recovery so it is threatening to charge the commercial banks to leave the money on deposit with the Bank of England - that is, charge a negative interest rate.

This prospect makes government bonds even yielding less than 1 per cent a relatively good bet.

So on that evidence interest rates look low but the contrary view looks equally possible.

If you are a bank trying to raise hybrid debt - bonds that aren't as risky as bank shares but more risky than bank deposits - interest rates appear sky-high.

Deutsche Bank, one of Europe's largest banks, just paid 9.5 per cent a year to raise some of this hybrid capital.

It is a strange situation where one of the world's biggest banks is paying 9.5 per cent to borrow money at the same time that small, risky New Zealand finance companies lending to customers the banks won't lend to are borrowing from the public at 6.5 per cent.

Closer to home, mortgage rates might be low here and across the Ditch but listed commercial property trusts in Australia in particular are warning of sharply lower profits due to rising interest rates.

ING Industrial (IIF), a A$6 billion ($7.3 billion) listed property fund investing in prime industrial property which got itself into trouble at the top of the property boom by, with the considerable benefit of hindsight, borrowing excessively to buy expensive property, recently published its accounts for the year ended June 30.

In those accounts it discloses that one of its major borrowing positions - a A$1.6 billion loan facility - had just been renegotiated at a cost of 10.6 per cent a year. The reason for this high interest rate was that the value of ING Industrial's property portfolio had fallen by 22 per cent over the year (due to the use of higher capitalisation rates), whereas the value of the debt, of course, remained constant.

This had the effect of increasing debt as a proportion of total assets from 47.6 per cent last year to 63 per cent this year. This high debt/equity ratio made IIF's bankers anxious, thus they required a higher interest rate.

As an aside, consider how many local property investors went into this recession with 50 per cent gearing and whose property values will be subject to the same downward pressures as those of IIF.

The Financial Times reckons that, even if property values stabilise at current levels, most property transactions done at the top of the market in 2007 with high levels of borrowing will have seen most, if not all, of their equity wiped out.

If IIf's cost of debt is any indication, many investors will face higher interest charges on their commercial property holdings in the next 12 months, if they are lucky enough to refinance.

This brings us back to the apparent contradiction of high and low interest rates. The paradox can be reconciled by considering risk - specifically, the bond market seems to be discounting the risk that the recovery is largely due to government stimulus and is unsustainable. It is for this reason that low-risk bond yields are so low and higher risk ones are so high.

All in all, it's a somewhat confused situation and, accordingly, commentators are divided on whether we should be buying bonds, stocks, gold or holding cash. With the world stockmarket having risen in US dollar terms by 64 per cent from its low point in March, the risk is that much of the good news is already embedded in stock prices.

Note: Brent Sheather may have an interest in investments mentioned in this article.

Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free.