What a year it’s been! The roller coaster to beat all roller coasters - and right now, many in Financial Markets are congratulating themselves on their relatively good performance. These last twelve months, most investors have done well - be they Share, Property or Bond investors. Of course, there’s still some sectors reeling from Covid-19. So, where to next? What do we anticipate for tomorrow?
Perfect hindsight doesn’t really help with tomorrow. In that regard, it never ceases to amaze how many experts predict with absolute authority the direction of markets (and get it totally wrong). To be fair, we’re talking about the future and the best of us will struggle to be perfectly positioned for tomorrow.
Dwight Eisenhower famously said, “Plans are nothing, but planning is everything”.
As specialists, we spend a lot of time trying to be right, but even with the best laid plans, we can still get it wrong (though not too often, we hope). The thing is, Financial Markets are constantly adjusting and so too are the investors for whom we work (injecting or withdrawing capital). So, plotting an efficient course can be complicated. That said, there are fairly reliable lessons in history that can help guide us.
Back in 2017, I was of the view that a prudent adviser seeking an absolutely “safe” outcome in the short-term would be better to look increasingly at using simple Term Deposits (TDs offered a lower risk than Bonds). At that time, we could all see the global economy was heating up and with that, there was an escalating risk that interest rates would soon push higher. Escalating interest rates hurt Bonds*.
*Central Bankers will adjust interest rates higher to dull the enthusiasm of people and business for spending, because it requires that we then all pay more interest. Accordingly, our collective borrowing across the economy moderates and this dampens demand. Fundamentally, borrowing simply brings forward tomorrow’s consumption. Pushing rates higher today, pushes spending temptation out to a later time (a time when we can afford it better, maybe without borrowing so much). And prices stabilise…
“Planning” that interest rates would rise, I had started to favour shorter-term deposits, over longer dated bonds. By positioning in this way, I’d avoid the Bond Market carnage when interest rates rose. The only problem being - I was right, right up until the point that I was wrong. My “planning” didn’t predict Covid19, nor that interest rates would collapse and consequently, bonds would rally to even higher returns.
With perfect hindsight, the Term Deposits we held did no harm, but neither did they participate in the “extra” gains that have since presented in many multi-sector Conservative, Balanced & Growth strategies that held longer dated bonds (and Bond funds themselves) as interest rates fell to near zero.
However, conditions have continued to shift and since the announcement of vaccines (November 2020), New Zealand ten-year Government stock yields have risen from their low of 0.50% to now 1.93% (as at mid-March 2021). It’s a dramatic rise and no one is entirely sure how much higher they may yet track…
One of the world’s most famous investors recently commented: “Gov’t bonds no longer offer a ‘risk free rate of return’. They’re now, return free risk!” Charlie Munger (Warren Buffett’s business partner). So, I question, if the lowest risk asset in the market now offers a “return free risk”, how should we proceed?
Here’s a word you’re going to hear a lot more - Inflation. It had a massive impact to asset prices, wages and economic policy through the 1960’s, 70’s, 80’s and 90’s. Not so much these last twenty years, though looking at the returns from Share and Real Estate Markets we’d concede, asset price inflation has been alive and well (the rich got richer), whereas wage and consumer price inflation has been muted by the forces of Globalisation (the poor, got poorer).
Can the past lead us to some forward conclusions and if so, how far back should we look? My own living memory extends to the early 70’s and gosh, a lot has happened in those fifty years (1971 to 2021).
Back in April 1971, Apollo 13 lifted off. It was the third mission to take a crew all the way to the moon. Fifty years on and it has been the global share markets that have been lifting off - fighting initially to recover the massive ground that was lost to a pandemic that mostly shut down the world’s economy.
“Houston, we have a problem…” This was the infamous line (from the Apollo 13 movie), and a true statement at the time. On that occasion, the minds of many and the computing power of NASA (by comparison, now less in its processing ability than the latest iPhone) managed to resolve the problem on board Apollo 13 and the crew was returned to the earth unscathed.
With my iPhone firmly in hand; tracking markets, Hatch, Sharesies and all number of applications and news feeds, I wonder if now someone, somewhere is calling out: “Wall Street, we have a problem...”
For most of the last forty years, interest rates in the USA (and here in NZ) have been tracking in one direction. Down! As interest rates drifted lower, borrowing costs have got cheaper. In turn, more capital has been raised. More fuel for the economy and momentum has continued. Working in lock step with this has been globalisation and consequently inflation (consumer price & wage) has been held amazingly low.
Observe below the trajectory of interest rates (reflecting the manipulations of Central Bankers, to stimulate the economy, as to avoid the really hard times). And it’s worked, every time.
10 Year US Treasury Bond Rates
When Share Markets fell, Bond values rose (as rates fell). The rise in Bonds offset the loss in Shares and as we saw above, lower interest rates then meant “easier money” for capital markets. But this effect was not just in the long-end of the market, short term interest rates also fell. For a NZ flavour, observe below six-month Term Deposit rates and their trajectory since 1965…
Observe every dip? Pretty much, each one of these is in response to some economic crisis. Interest rates push lower and soon after, there is an economic recovery. The key message here is; No matter what happens, when there’s a problem - Governments change things up and there is a subsequent recovery.
For the first time in forty years, Bonds are now an expensive insurance against Share Market declines. We’re not saying to preclude bonds or defensive term deposit assets from a strategy, but we are cautiously warning to constantly test the intention of the asset allocation and the purpose behind that strategy. Bonds may no-longer offer the diversifying properties we’ve come to know and certainly, some will begin to present more equity type risk. If interest rates overall are again on the rise (i.e. 1970’s style), then certain shares will also start to underperform (as higher interest rates begin to draw defensive investors away).
We know the so-called “growth stocks” have been major beneficiaries of near zero interest rates, because investors have been prepared to “give it a go” (when the alternative is to see their capital sitting idle earning near zero interest rates). Should interest rates push higher and if “growth shares” don’t produce enough reward in sufficient time, then higher interest rates may begin to look again like a “bird in the hand”, enticing capital markets to rotate out of growth stocks and this in turn leads to share prices falling.
Be assured that none of this is absolute. It’s in constant motion and there are many competing forces at play in this technologically advanced world fighting more successfully a Covid foe. And aiding the advance of share markets is the largest non-wartime fiscal stimulus (more than ten times that which we say for the Global Financial Crisis). Underwriting that stimulus are the Central Banks (having cut short term rates and embarked on large-scale asset purchases). They’re now signalling a tolerance for higher inflation.
In the USA alone, $2.0tn of fiscal stimulus was pushed into the economy mid-2020, then a further $900bn was released in December 2020. Just this month, approval has been given for a further $1.9tn to be pumped into the US tax payer. Here’s a recent metaphor I saw on the subject of a billion vs a trillion:
Give or take a few seconds - a billon seconds ago, it was 1990 and the Hon Bob Hawke was Australian’s Prime Minister. A trillion seconds ago, the first aboriginal was colonising Australia…
The US Federal Reserve has gone on record targeting full employment in priority to everything. They’ve said they’ll abandoned a ‘balanced’ approach to policy; meaning the Fed will no longer pre-emptively raise interest rates but rather, let inflation in the short-term push higher, relative to their long-term target.
With a cautionary smile, there are some wonderful opportunities coming. Certainly, long-term interest rates rising substantially from here is a very real risk for current bond holders as well as the broader share and property markets as investors rotate in or out. By the same token, rising mortgage rates are likely an even greater risk to the economy, as so many home owners are leveraged to the hilt.
Some markets are priced near peak, so much caution is needed. Even so, many sectors are still just recovering and interest rates overall must remain lower than their pre-covid levels for some time.
So, with the wave of stimulus money imminent and the united policies of Central Bankers, there is plenty of upside… but remember, no one can perfectly predict the future. If things change dramatically, then what we can predict is that Governments will react, things will change and there will again be a recovery.
In summary – bonds aren’t dead, but they carry more risk now than we’ve seen in forty years; simply because, for not a lot of interest rate increase, there could now be a disproportionate amount of asset price decreases (in particular, within the bond market itself).
Prudent advisers will constantly discuss an investor’s tolerance (need) for short, medium and long-term assets (it’s an exercise in determining when is the most risk best to be taken – now, later or much later).
An experienced or sophisticated investor has more tolerance for volatility and will more easily push up the risk curve when the alternative is to earn very little. But no matter how experienced or sophisticated, “safe” accessible money, is still best kept simple. In turn, it will be a drag on performance (except for when markets are falling, at that time the bird in the hand could well buy three in the bush at sale prices). While we do not encourage a lot of cash to be held, don’t ignore the importance of cash as a stabiliser.
For investors who may have conservative or balanced type portfolio strategies, in these intriguing times we may need to push prudently deeper into other investment sectors - to at least offer their capital the opportunity for protection from the rising inflation that inevitably impacts value in the medium/long term. Others will be comfortable with the engagement of equity, property, infrastructure and alternative assets.
As we navigate forward, it is best to think about investment strategies as “buckets of intention”: For capital needed in the short-term, we should still invest for the short-term, despite such low interest rates (keep it simple - in this bucket, it’s more about the “return of” capital, than the “return on” capital).
For the medium to long-term, we have to take short-term risk (no-one ever intends to take long-term risk).
We know that in the medium to long-term it’s actually quite difficult to lose (providing we buy quality and diversify prudently). Values will inevitably rise and decline and rise and decline and …. You get the idea.
By being diversified, owning quality and not being forced sellers at the wrong time, we will always be tomorrow’s winner.
Tony Munro | CFPCM, Post Grad Dip. Bus.Studies (PFP), FSP 5501
The views and opinions expressed in this article are intended to be of a general nature and do not constitute personalised advice for an individual client. A disclosure statement is available on request and free of charge.