Spectre of downward spiral looms

By BRENT SHEATHER

Despite all the bullish predictions from brokers, financial planners and even fund managers, 2002 was a record third year in a row of capital punishment for portfolio investors.

Weak overseas markets and a strong New Zealand dollar (up 26.5 per cent against the US dollar) combined to give local investors a total loss of 36.4 per cent on international shares in the 12 months.

Since their peak in March 2000, international shares are down by 42 per cent in US dollar terms. This compares with declines of 83 per cent in 1929-32 and 42 per cent in 1972-74.

That's the bad news; the good news is that many independent experts reckon that shares, particularly in Europe and Britain, have fallen to levels at which some genuine value is apparent, especially if the US, as some suggest, makes dividends from shares tax-free.

It is worth noting, too, that if the US was able to broker some sort of a peace deal between Israel and the Palestinians, this would probably encourage financial markets significantly more than any monetary stimulus. There is, of course, no guarantee that share indexes will level off at fair value, given the market's tendency to overshoot on the way down as well as on the way up.

Nevertheless, the opportunity cost of investing in shares, in terms of income forgone, is now low or even negative in Europe, Britain and much of Asia (excluding Japan).

While the plunge in international shares has received the headlines, of potentially more significance to the man or woman in the street has been the consistently poor performance of balanced portfolios, particularly pension funds, after deducting fees.

Not only has performance suffered because of a high exposure to international shares, but the returns from other asset classes, apart from property, have been in the mid single-digit range for some time now.

The era of low inflation, low returns is upon us. A diversified portfolio, as used by the average New Zealand balanced fund (unhedged) - comprising bonds (40 per cent), property (10 per cent), shares (50 per cent) - is estimated to be down 11 per cent in 2002, before fees, and has been negative over three years after fees.

Even over five years most pension funds would have struggled to return 3 per cent a year after fees and tax. Balanced funds would have been better having some residential property in Auckland; we calculate that last year, residential property in Auckland returned 16.8 per cent before tax, including rent and after all costs, and has averaged 7.8 per cent a year for three years.

Poor investment returns mean we all have to save more, whatever our pension arrangements.



The single biggest worry in the minds of international investors, besides war and terrorism, is the spectre of a deflationary spiral - a sustained period of declining demand and prices.

Before World War II, intermittent deflation was as common as inflation.

In 1922, for example, consumer prices in Britain fell by 18 per cent. The rate of inflation in the US has dropped by nearly half in the last two years with some economists forecasting a negative rate, deflation, by next year.

Economists have been warning of the risks of deflation since 1998 and the prospect of falling prices likely keeps Alan Greenspan awake at night; when inflation is positive, say 3 or 4 per cent a year, a central bank can, by forcing short-term interest rates near to zero, give the private sector a good reason to invest its cash balances.

But once inflation goes negative, even if interest rates are zero the real value of cash rises each year, giving both consumers and industry good reasons to defer spending and investment.

The prospect of deflation is the reason interest rates are as low as they are in the US and why short-term rates in New Zealand will probably go lower.

Investing successfully in an environment of zero or negative inflation requires quite a different strategy to what has worked in the past 20 years. For a start, inflation rewards borrowers whereas deflation raises the real cost of borrowing. What is the sense in borrowing to buy the house next door when its value is declining and the value of the debt is rising?

Four lessons for investing in a deflationary environment are as follows:

* High-quality bonds outperform. In the 1930s, one of the best investments were long-dated US Government bonds paying 3 per cent. Locally, 2011 Government Bonds returned 11.9 per cent in 2002. The average NZ pension fund has 40 per cent of its assets in bonds and overseas fund managers are raising their weightings in a hurry. Deflation is likely to be associated with low demand and shares would face tough times from lower production volumes and a squeeze on margins.

* In a deflationary period, debt is bad news. Avoid it if possible and if it is unavoidable, make sure it is floating rate debt so your interest bill falls as the value of your house does.

* Stick to high-quality investments - property and shares with low levels of debt. Low-risk bonds love a deflationary environment but the key attribute is quality. Bond markets diverge with spreads on risky bonds rising and those on high-quality issues dropping; locally, over the year, five-year Government stock yields are down by 0.35 percentage points whereas those for higher risk bonds of a similar maturity are up by 0.6 percentage points.

A feature of the corporate bond markets in the US and Europe in 2002 was the large number of investment grade companies being downgraded to junk ratings, so-called "fallen angels". If our economy catches the flu like the rest of the world a few of the many corporate bonds floated in 2002 could join our two local fallen angels, Brierley and Tower.

* Perhaps the best defensive strategy to prepare for a possible period of deflation is that old standard, diversification. If deflation does become a reality, some countries will be affected more seriously, and some will take steps to inflate their economies more quickly than others.

If you are worried about the effect of a deflationary environment on your business, spare a thought for the managers of international share funds. Following the go-go years of 1996-2000, new business has slowed to a trickle and because fund management fees are charged as a percentage of the funds under management. The effect of weak international sharemarkets and a strong New Zealand dollar has been to slash the price at which managers sell their services by around half over the past two years.

At the same time there is an increasing recognition from retail investors all over the world that with long-term returns from shares likely to be in the 6 to 8 per cent per annum range, losing 2 per cent of that in annual fees doesn't make much sense.

Although the glamour and high margins of hedge funds may provide some temporary respite for investment managers, one suspects that this dalliance, too, will end unhappily and employee numbers within the industry, both locally and globally, will continue to fall.

What, then, is the retail investor to do? It may be easier to answer the question by focusing on what not to do, which by definition is what everyone is doing at present, given that whatever is fashionable is often wrong.

Right now, deflation is the bogey man and appetites for risk are low, so bonds are in fashion, especially new issues of corporate bonds sold by NZ corporates.

That, or leaving the money in the bank, seems to be the flavour of the month. What most people aren't doing is buying international shares, yet overseas markets are down and our currency is up.

Back in September 2000 we noted the then love affair with shares and suggested contrarians should buy bonds. Well, right now New Zealand dollar bonds appear to have everything going for them and international shares are friendless. Financial advisers and stockbrokers are recommending lots of fixed interest in portfolios to the small numbers of clients still coming through their doors.

Unfortunately, though, a love affair with bonds could potentially have a traumatic ending too, particularly if the US Federal Reserve engineers an economic recovery, a rise in inflation and an increase in the investor's appetite for risk.

Bond aficionados should note that within six months of hitting its lows in 1932 and 1974, the US stockmarket had risen by around 90 per cent and 45 per cent respectively. As at year end the US market in US dollar terms is up 14 per cent from its October lows.

* Brent Sheather is a Whakatane financial adviser.