Markets giving you that sinking feeling?

By BRENT SHEATHER

Despite all the bullish noises from stockbrokers earlier in the year - and one bright-spark adviser who pointed to the historic low probability of a record third down-year in a row - 2002 is shaping up as another bad one for international share investors, particularly those operating in New Zealand dollars.

In the first half of the year, world sharemarkets were down 22.2 per cent in New Zealand dollar terms, as measured by the MSCI index. On that basis, share prices are now at levels not seen since October 1998.

At the start of the year there were hopeful signs that economic growth would recommence. It was assumed that this recovery would be sustainable and translate into rising sharemarkets.

A recovery of sorts has eventuated, but the profitability of key sectors of the market has continued to disappoint.

Even some brokers are now turning bearish - Morgan Stanley believes a number of factors, notably a squeeze on profits at American corporations and the potential capitulation of the American consumer, in addition to lingering structural imbalances, make a compelling case for another slowdown in economic growth.

They note that five of the past six recessions have contained a "double dip", all of which were triggered by a relapse in demand just as businesses started to lift production to replenish stocks.

However, it's not all bad news for holders of balanced portfolios; because as international shares are going backwards, longer term bonds and property are on track for record years, in US dollar terms anyway.

As the table shows, the place to be in the first half of this year was New Zealand shares and bonds - up by 4.8 per cent and 3.1 per cent respectively. Most overseas sharemarkets recorded losses in the first half of the year once you take the rising kiwi dollar into account.

Even international bonds, which rose by 10.8 per cent in US dollar terms, succumbed to the strong kiwi, falling 6.7 per cent when measured in local currency.

In some ways the decline in international share prices was entirely predictable, given historically high valuations and after such a period of excess.

New Zealanders may not have got carried away with internet stocks like the Americans, but financial advisers and brokers have done a roaring trade in international shares for the past two years, with WorldCom being a particular favourite.

New Zealand shares and the New Zealand dollar were definitely out in the cold - in hindsight, a great "buy" signal.

The poor performance of international shares is significant because they now represent the biggest sector in mostmanaged portfolios, and are thereforea real drag on performance.

One of the favoured vehicles for investing in international shares was the AMP Winz fund, which had everything going for it, until the market crashed. The Winz price is down by 47 per cent from its high and there isn't even a dividend for consolation.

The incredible performance of the kiwi dollar dominated investment returns in the first half of the year.

Where does the New Zealand dollar go from here?

If you find yourself worrying that your overseas investments are depreciating, it may help to look at the problem in terms of minimising risk rather than maximising returns.

If you think of an investment portfolio as being designed to insure, or "hedge", against certain risks, then the big risk we all face is that for the rest of our lives we need regular cash inflows to pay for food, petrol, travel and clothes, etc.

But these living expenses are not just priced in New Zealand dollars. Many of the goods we consume are imported, and even if they are not imported they are often priced in US dollars, so we face a foreign currency risk even though we live in New Zealand.

Given that we have a need for regular inflows of foreign currency for the rest of our lives, as low-risk investors we should hedge this risk now by buying assets that produce foreign currency dividends - overseas bonds, shares and property - rather than delay buying the currency until we actually need it, because there is a risk the exchange rate could get worse.

So rather than incurring foreign exchange risk when we buy overseas shares, really we incur the risk if we do not.

Right now, many New Zealanders who have bought overseas assets with (what turned out to be) undervalued New Zealand dollars over the past couple of years are scratching their heads and wondering if they have done the right thing.

It is the nature of a diversified portfolio that you get the good with the bad, so, provided you haven't got all your money overseas, you should probably grit your teeth, stay the course and secretly hope one of the political parties says something silly to scare off international investors.

If it's any consolation, you should note that in the first 12-month period since 1986 that the local sharemarket has beaten world shares by more than 10 per cent, New Zealand institutional investors have a record high exposure to overseas markets (39 per cent) and a record low domestic equity exposure (16 per cent). The experts regularly get it wrong, too.

Over the past 20 years returns on global shares have trounced bonds, but so far 2002 is a different story. Could the ultimate heresy occur and bonds outperform in the longer term?

Even over five years, international bonds, at 11.6 per cent a year, are well ahead of international shares at 7.8 per cent.

Bonds have another important attraction: in times of negative inflation they are unbeatable. Some economists are again privately worried about deflation, that the current resurgence in world growth might be short lived, that the wealth effect in the US and Britain of rising house prices could turn to a bust.

All the above suggests that the average NZ pension fund's 40 per cent weighting in bonds is justifiably prudent, and that makes sense for a good number of private investors too. A return of 7 per cent a year for 10 years from long-term Government stock may yet prove a hard act to follow.

* Brent Sheather is a Whakatane investment adviser.