Boom in shares, bonds paradoxical

By BRENT SHEATHER*

First the good news: the past three months have been great for share investors. The world's stock markets rose by 11.4 per cent measured in New Zealand dollars, and local shares returned an impressive 14.7 per cent.

The bad news is that long-term Government bonds had a great run, too, as interest rates fell. This is a worry because bond investors love bad news - for bonds to perform so strongly, either investors see declining economic growth, or the bond market has a dose of irrational exuberance.

The second explanation is possible, but the bond market has a better track record in anticipating the future than the sharemarket.

In contrast, shares thrive on economic growth, so their rise appears to be anticipating better times. A rise in the price of both bonds and shares raises an obvious question: which group of investors is going to be disappointed?

Funds such as pension plans and "balanced" unit trusts had an excellent quarter, returning an estimated 7.7 per cent before tax and fees. However, investors who bought into a savings plan three years ago are likely to be still showing a loss of about 1 per cent a year, before fees and tax.

One reason for the sharp rebound in sharemarkets is that in several major markets, notably Britain, share prices had fallen and bond prices had risen, so the dividend income from shares was momentarily higher than the income from Government bonds.

A share analyst would see this as a good reason to buy shares, but there is always another interpretation: a bond salesman might see it as a sign that deflation is growing more likely and that dividends would probably fall in that situation.

More support for the bears comes from the behaviour of the market for US long-term Government bonds, where yields on 30-year bonds fell by about 0.3 per cent in the quarter, giving holders windfall profits of 5.1 per cent.

Long-term bonds from risk-free issuers like the US Government often rise in price in reaction to bad news. Such a big move in the benchmark US treasury market would appear to show that the market believes the chances of a prolonged deflationary period have increased.

It is difficult, if not impossible, to reconcile the bond market's view of imminent depression with a bullish stockmarket, particularly in the US, where valuations remain historically overdone, because investors expect higher corporate profits. Clearly one party is going to be proved wrong.

Obviously a prudent person has a dollar each way, which is more than can be said for local investors who have a portfolio of shares and a mix of higher yielding and higher risk junk bonds. If (when) our economy comes off the boil defaults will increase, and it will take only one high-profile blow-up to spoil the fun.

With stock, property and bond markets all booming, spare a thought for those nervous investors who switched out of shares at the bottom of the market into the apparent safety of hedge funds. Most have missed out on both the 11 per cent bounce in international shares over the past three months and the 6 per cent returns from long-term, high quality local bonds.

Experts have always maintained that the biggest threat to the hedge fund industry is a new bull market in shares; while the past three months may turn out to have been a one-quarter wonder, my guess is that it is giving a few hedge fund managers and their financial planner disciples a bit of a fright.

* Brent Sheather is a Whakatane investment adviser.