KEY POINTS:
While the Blue Chip fiasco and the finance company/CDO blow-ups have made the headlines, it has also been an extraordinarily bad three months for sensibly diversified investors.
The portfolio of the average pension fund or balanced unit trust with their funds spread over bonds, property and shares has
fallen in value by an estimated 6.4 per cent in the first three months of 2008.
For the 12 months ended March 31, the typical balanced investment portfolio will have returned -7.2 per cent.
So far this year, the conventional orthodoxy of higher risk assets producing higher returns has been turned on its head as cash outperformed every other asset class.
Shares led the way down with international equities slumping by 11.5 per cent and NZ shares down 16.1 per cent.
For some perspective on the decline in international stocks, we have to go back to the September quarter 1990 to find a down quarter of a greater magnitude.
The Financial Times reports that retail investors are withdrawing their money from share funds in record numbers. The quarter was characterised by extremes in performance and valuation.
In the Australian listed property sector, REITS invested in prime office assets were available with 12 per cent yields versus around 7 per cent a year earlier. On the NZX debt market, the best bid for the bonds of St Laurence property was a rather unflattering 30 per cent. Investment grade bonds generally don't yield 30 per cent.
BBI Networks Bonds, originally listed at around an 8.5 per cent yield, traded at 20 per cent.
While there were a number of worthy contenders, the booby prize for worst performing local security in the quarter probably goes to Kingfish warrants which started the quarter at 20c and finished trading on March 28 at 0.1c offered, a fall of 99.5 per cent.
The average "balanced" portfolio run by professional managers generally has half its money in shares split two-thirds offshore, one-third local so when shares go down they usually take the whole portfolio with them. Within the overseas shares sector, all the major markets had a torrid time with the biggest, that of the United States, falling 12.3 per cent. There wasn't a lot between Europe, the UK and Japan at -11.3 per cent, -12.3 per cent and -8 per cent respectively.
Even a strong resource sector couldn't help the Australian market which, due to a big exposure to banks and property, was among the worst of the major markets at -13.3 per cent.
Australia's performance is particularly significant as most New Zealand retail investors are overweight in "the lucky country" due to its proximity and the fact that many Australian stocks are not subject to the new Fair Dividend Rate of Tax.
Much has been made in recent times of the ability of alternative assets to perform when equities are out of fashion. Foremost among these assets is property, which in the recent past attracted a lot of attention from retail and international investors on the back of high returns and a low correlation with shares.
An overweight property strategy has worked well for about 10 years but things went seriously wrong in the March quarter, at least as far as overseas markets are concerned, as listed property prices performed far worse than shares.
In Australia, the property sector crashed by 20 per cent as a host of highly geared companies teetered on the edge of bankruptcy.
Fortunately, with the exception of Centro, these were small companies. But investor confidence in the Australian property trust sector, which had previously been seen as a low-risk way to play the stockmarket, is now badly shaken.
The central problem seems to be that gearing levels which have crept higher in the past five years are now regarded by investors as being too high. It will take some time for companies to rebuild their balance sheets.
The one area where investors could have made big money in the March quarter was the commodities sector. The Goldman Sachs commodity price index, which is heavily into oil, surged by 14 per cent in the quarter taking with it the resource sector of most sharemarkets. Unfortunately, most fund managers and retail investors have only a token 2-3 per cent weighting to this sector.
Besides commodities, the other sector to record a positive result in the March quarter were bonds - the government stock index returned 2.8 per cent in the quarter and it was interesting to see, amid all this talk of rising interest rates, 10-year government bond yields were steady at 6.38 per cent.
The obvious question is - why would institutional investors buy 10-year governments at 6.38 per cent when they can get 8 per cent-plus in the bank?
There are probably two reasons: firstly government bonds are less risky than bank bills and, secondly, the fixed interest "market" expects that interest rates will fall before too long. Perversely, higher short-term rates today can mean lower inflation and thus lower interest rates in the future.
So what is behind all this market turmoil? Companies are financed by equity and debt, with share prices representing the interests of the owners of the equity component of a company. Before equity holders can get paid, however, companies must first pay the interest bills on their debt.
What has happened during the past six months or so is that, after an extended period of low interest rates, debt holders are now demanding a higher return on money they lend to companies. This means there is less left over for shareholders.
At the same time, fears of a recession mean the profits of companies may be reduced too, which again means less cash flow for shareholders. Lower share prices thus reflect the likelihood of lower profits, higher risk and an increased return to debt holders.
Central banks like the US Federal Reserve are trying to engineer a soft landing for the economy by cutting interest rates. But the extent to which they can do this is limited by worries about inflation.
In any case, the central banks can only influence the risk-free rate on shorter dated bonds whereas a company's interest bill is made up of the risk-free rate plus a margin for risk. This latter component has skyrocketed in the past six months. Share investors are also worried that the credit crisis, bad debts and problems in the banking sector could tip the real economy into recession, which would also be bad for profits.
But equally, if interest rates are lowered too far, inflation will pick up down the track and take longer-term interest rates with it.
Share investors will suffer if the economy goes into recession while bond investors will lose if inflation picks up. The jury is out and it is not clear whether inflation, recession or a toxic combination of both will eventuate.
Mum and Dad in Remuera shouldn't try to second guess the markets and instead should retain a balanced portfolio of low-risk bonds and a highly diversified portfolio of shares so part of their portfolio should generate positive returns whatever the environment.
Owning property and shares is painful at present but we are probably closer to the end of this crisis than the beginning and, when push comes to shove, central banks would rather deal with inflation than deflation, which means that having some exposure to real assets which cope better with inflation is a sensible move.
Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.
