Brent Sheather: What's working and what isn't this year

Almost three-quarters of the way through 2010, it is an appropriate time to look back and see what investment strategies have and haven't worked so far this year.

This information isn't just of relevance to big investors. If you have a KiwiSaver fund investing in a balanced portfolio of bonds, property and shares, the performance of the benchmark portfolio may help you to assess whether your fund manager has added or subtracted value through the year.

One point, though: if you do use the numbers to benchmark your fund, make sure you compare apples with apples. For instance, time periods have to be consistent - this data relates to the nine months ended September 30.

Also, make sure your asset classes are similar - most people own a balanced portfolio but some have a bias to bonds and some have a bias to equities.

The numbers shown here are before tax and fees.

So what has worked thus far in 2010? As the table shows, a balanced portfolio comprising weightings typical of the average pension fund or KiwiSaver funds - that is, about 40 per cent in bonds, 10 per cent in property and 50 per cent in shares split between NZ, Australia and international - will have returned, before fees and tax, about 3.6 per cent.

This poor return is due to lacklustre performances from international shares (2.4 per cent) and New Zealand shares (0.1 per cent) so far this year.

Where investors have made money has been in the bond sector, thanks to falling interest rates. NZ Government bonds are up by 7.8 per cent whereas global government bonds are up by 6.1 per cent. Those are excellent returns from low-risk assets in just nine months.

In the NZ bond market 10-year government stock rates have fallen from 6.1 per cent to 5.1 per cent. However, usually falling interest rates are associated with rising stock and property markets.

To see why this is so let's look at the standard present value model, which simply says that the value of an asset is the sum of all its future cashflows converted to today's dollars as per the equation:

Using this model, lower interest rates mean that the number you divide the cashflow by is smaller, so the present value figure, or share price, should get higher as interest rates fall. In other words lower interest rates equal higher share prices. Sensible enough.

But since April of this year the 10-year bond in the US has dropped from 3.85 per cent to 2.55 per cent, but the US stock market has fallen at the same time, by 1.54 per cent. What is going on?

Perhaps the answer to this apparent paradox is that the lower interest rates also reflect a likelihood of lower economic growth.

Therefore, while a lower discount rate - that is, the denominator (bottom part) - of the equation is good news for share prices, perhaps the stock market estimate of growth has also been falling and, with it, sales forecasts and profits, thus causing lower share prices. On this basis we can reconcile lower interest rates with lower share prices as the lower interest rates reflect a slowing economy.

The chairman of the US Federal Reserve summed up many people's thoughts last month when he said "things are more uncertain than usual". The big question is "are we heading for an inflationary period or deflationary period?"

In the deflationary camp, Andrew Smithers, an independent economist based in London, whose research we buy, reckons that shares in the US are overvalued because profits are going to fall. In the other corner, Jeremy Grantham, a very successful fund manager from the US, is adamant that shares are cheap and that bonds are expensive.

Markets seem to agree with Smithers one day and Grantham the next.

A commonsense view might be that we seem to have got off very lightly from the worst financial crash since the 1930s and it seems too good to be true that the answer to too much easy credit is more easy credit and that the Government can bail out anyone who makes a bad investment without causing nasty side-effects.

On that subject the Government's $1.7 billion bailout of South Canterbury Finance seems a step too far today, although admittedly things were far worse a couple of years ago when the bailout plans were first put together.

However, since then New Zealand has managed to avoid the worst of the financial crisis, our economy is growing thanks to its proximity to Asia, and none of our major banking institutions seem to have made the same mistakes as the US and European banks.

So did we really need to bail out South Canterbury two years after the crash and given its continued enthusiastic lending practices?

No doubt the experts will debate this point in the future. But think how many hospitals, schools, etc, we could have had with even just the $600 million the Government is projected to lose on the deal. In addition, the bailout sends a very bad signal to prudent investors who avoided the high-risk alternatives like finance company debentures.

So who is going to be right in the medium term - Grantham or Smithers?

A cynic might reflect that there are no free lunches in this world and no gain without pain.

The worry therefore is that the markets are unrealistically pinning their hopes on the Federal Reserve printing more money and keeping interest rates low, meaning that the day of reckoning for highly borrowed investors and consumers is postponed rather than avoided.

The weak bond market seems to be a pretty clear sign that the economy is going to improve slowly at best as government spending will need to be reduced before too long.

The effect of these factors is that company profits will inevitably come under pressure and, with it, share prices.

A reasonable response to this possible scenario is that local investors should retain a higher than normal weighting in bonds with a decent allocation to long-dated bonds so as to reduce the impact of falling share prices just in case things turn bad again.

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