Is this the end of a sharemarket boom or is the next crash on the way?

by Paul McBeth / 28 August, 2018
RelatedArticlesModule - Sharemarket crash

Illustration/Getty Images/Listener

Trade wars, sagging business confidence, an end to rising house prices. What does the less-certain economic outlook mean for you?

For most of the decade since the so-called global financial crisis, both the world economy and the New Zealand economy have been growing.

The focus of much political debate during that period was about worsening income inequalities and the blow-out in housing affordability. But investors have had a great 10 years, both here and internationally.

Wall Street’s bull run has been so entrenched that the occasional correction – July’s US$100 billion ($148 billion) tumble in the value of Facebook stock, for example – automatically attracts a round of speculation that the boom is finally over.

In New Zealand, the last sharemarket bust was in 2007, ending a six-year run during which the benchmark stock-market measure – the S&P/NZX 50 index – rose 153% before falling off a cliff with the rest of the world in the financial crisis. That wiped 44% from the value of the local market, hitting rock bottom in March 2009.

Since then, however, the market has soared 269%, and stripping out the financial-crisis slump, is still up 106%, beating even the 93% increase in Auckland property values over the same period.

But in recent months, the shine has been coming off. With US President Donald Trump flirting with destabilising trade wars, signs the Chinese economy is much weaker than its pumped-up official statistics suggest, and a slump in business confidence in New Zealand from the third-highest in the OECD two years ago to second-lowest, caused, in part, by a new Government, the question is increasingly being put: are we heading into an economic downturn?

Earlier this month, financial commentator Bernard Hickey noted the “worst week of 2018” included a rise in unemployment, a national decline in property values, the failure of two building companies and the most pessimistic business sector in a decade. Indeed, former ANZ chief economist Cameron Bagrie commented that the low business confidence “is a sign that the economy is dangerously close to what we call the ‘stall speed’.” Whereas growth 12 months ago was about 3.5%, at the moment Bagrie believes it is alarmingly close to 1.5%, “and we’re decelerating as opposed to accelerating”. In theory, he adds, “we should be able to transition the growth back”. However, this week the run of weak data  – including retail spending falling in the June quarter – led the Treasury to highlight the risk that “growth over the coming fiscal year may be weaker than forecast in the Budget”.

Source: ANZ

Source: ANZ

Peters saw it coming

Early out of the blocks with such gloomy talk was NZ First leader Winston Peters, who predicted after the coalition Government was formed last October that the world economy was about to worsen and that it would be unfair to blame the new Government for any of that. Former Prime Minister John Key chimed in at the National Party annual conference. “We’re at the end of what I’d say is the economic cycle at the moment. There’s no question that when I look around the world and the things I’m now involved in internationally, you can start to see the pressure in the system,” he said on the conference sidelines.

Key’s reason for raising it was to suggest a weaker economy would hurt the new Government, given its shaky early relationship with the business community. However, Finance Minister Grant Robertson was quick to bank those comments. Although forecasts for world economic growth were robust at about 3.9%, the current environment was “not without risk”, he said, quoting Key’s analysis.

“New Zealand always remains vulnerable to change in the international outlook,” Robertson told Parliament. “That’s why we need to remain fiscally careful but also to diversify our export markets and shift to new sources of growth.”

If “there was a shock to the financial system”, the Government could also relax its debt-constraining Budget Responsibility Rules.

In other words, the Government considers itself well placed to absorb the impact of a downturn by spending a bit more, just as the Key administration did after the 2008 crisis.

BNZ’s Stephen Toplis. Photo/Hagen Hopkins

BNZ’s Stephen Toplis. Photo/Hagen Hopkins

Peters, meanwhile, has changed his tune and is talking up the ongoing strength of the NZX50 as evidence that all is well, which will only work politically if the index continues to rise. And in a conversation he had with US Secretary of State Mike Pompeo in Singapore last week, the Foreign Affairs Minister says Pompeo was “acutely aware” of New Zealand’s need to trade steel and aluminium with America.

Make no mistake, the stoush between the US and China is reverberating through financial markets, pushing volatile assets such as stocks and currencies up one day and down the next. The kiwi dollar has dropped 6.4% since protectionist US President Trump officially took office last year – a windfall for exporters, but hiking prices for consumers of imports such as petrol. And a chorus of bank economists is picking tougher times internationally and, at the very least, a pause in the long domestic growth spurt in New Zealand.

ANZ chief economist Sharon Zollner says the economy is “delicately placed”, with firms in a “funk” as confidence sank to its lowest level since May 2008. More worryingly, the ANZ business survey showed a net 17% of firms expect to see lower profits in the coming year as they grapple with rising labour costs, particularly in industries that have low-skilled workforces typically on the minimum wage and that lack the ability to pass those costs on to consumers. “It’s fair to say that the road ahead is looking less assured, and risks of a stall have increased,” Zollner says.

What’s more, the “very mature” run of expansion means “it increasingly feels as if a tipping point is not far away”, according to BNZ research head Stephen Toplis. That’s not to say he’s pessimistic about the local economy. Rather, it’s an acknowledgement that “businesses have to be prepared for a more difficult and variable operating environment as cost pressures increase and uncertainty rises”.

NZ Superannuation Fund’s Mike Frith.

Battening down

But even if the economic cycle is on the turn, does that mean New Zealand’s sharemarket might head south too? Professional investors have begun limiting some of their riskier bets, but by and large they don’t seem to think a sharp downturn is around the corner. If anything, it may be a couple of years before markets start entering the “red zone” where prices fall.

New Zealand Superannuation Fund acting investment chief Mike Frith says cheap credit has given momentum to the major economies of the US, Europe and China for some time, pushing markets higher. Even so, all good things come to an end and Frith says prices look “particularly high” and returns won’t be as strong.

“We’ve been saying for the past year or two that returns were getting overdone beyond what we anticipate,” Frith says. That caution is enough to spur headlines speculating about a market crash, which in turn can send small investors into overreaction mode. That’s when wise heads are needed.

Bernard Doyle, New Zealand strategist at JBWere, says investors need to be careful whenever financial markets start chalking up new records. That’s little comfort when stock markets are on the cusp of the longest bull run in post-war history. “We are mindful that this is not something – hand on heart – that’s going to last years and years longer,” Doyle says. “It’s already lasted a very long time.”

After almost a decade of the world’s major central banks running ultra-loose monetary policies to take the hard edges off the global financial crisis and its subsequent recession, policymakers are starting to tighten up. Central bankers are moving their benchmark interest rates away from the near-zero levels they’d been running and ending quantitative easing programmes, where they’d in effect printed money to buy government bonds as a means to keep funds circulating in financial markets to encourage activity.

JBWere’s Bernard Doyle.

Such central-bank actions would in theory spur inflation, as an expanding money supply in the hands of financial institutions, and ultimately consumers, encourages spending and drives up prices. That has taken a little longer than expected and inflation is only now starting to emerge in some of the larger economies.

Doyle says that’s a good thing for investors because it opens up a new option in bonds. “We are pretty happy to see rising interest rates around the world, but you don’t want too much of a good thing,” he says. “If they rise too quickly, we will see a tougher time for shares.”

What the professionals agree on is that a knee-jerk dumping of shares in a changing economic cycle is a rookie mistake. Unfortunately it’s something that happens all too often.

Michael Lang, investment boss at NZ Funds, says people are hardwired to make poor investment decisions, typically buying when things look great and selling when everything turns to custard. The end result is that they pay too much and sell for too little.

The problem with selling in a downturn is that people don’t tend to notice a slide until it’s already fallen 10-20%. Another common foible is exiting at every little blip, and being hit with transaction fees on every sale and purchase. “If you aren’t used to the market wriggling, it can be pretty worrying,” Lang says. “I’m pretty nervous when it fluctuates.”

Without having somewhere to turn to for advice, people commonly make bad investment decisions if they have all their eggs in one basket and those assets start tanking. “It’s a lonely and dangerous frame of mind,” Lang says.

Source: ANZ

Source: ANZ

Bargain-hunting

If anything, a slump can be seen as a time to go shopping, often referred to as bottom-trawling. Institutional investors try to anticipate such opportunities by building up a war chest. “I regard a market downturn as being like a sale sign has been put up,” Lang says. “If a stock is 20-50% cheaper, you should buy it.”

NZ Funds urges people to talk to a financial adviser, but tools such as the Commission for Financial Capability’s website, sorted.org.nz, will give you an understanding of your investor profile before going down the adviser path.

Poor financial literacy comes up time and again as a cause of investor apathy and successive governments have been at pains to address the knowledge gap.

The latest investor confidence survey by the Financial Markets Authority (FMA)shows a big knowledge gap between people engaged in financial markets and those on the sidelines. And although the introduction of KiwiSaver has helped lift interest among the previously non-investing public, those whose only exposure is through the state-sponsored savings scheme are still less likely to understand the importance of spreading their investments and that bigger returns come with greater risks.

FMA chief Rob Everett says many KiwiSaver members remain apathetic about financial markets and a big challenge is engaging people who feel like they don’t have enough money to invest. He also worries that older people with a little knowledge and bulging pockets may struggle to recover from a downturn, especially when there’s been an extended run of above-average returns.

“We’re trying to make sure people understand that when the market actually turns and goes the other way, people don’t think the sky’s falling in, and [understand] that things are cyclical,” Everett says. “Deadening the fall when things get iffy is incredibly important.”

A problem that crops up as a bull run nears its end is that investors used to above-average returns take on too much risk relative to the returns on offer. That happened during  the mid-2000s, when people invested in finance companies offering a couple of percentage points above what they’d get in a term deposit. Many were mistaken that the “secured debentures” they were buying were relatively safe, when in reality they were funding highly speculative property developments and were down the pecking order when it came to being repaid.

In much the same way, investors have been drawn to dividend-paying stocks in the likes of listed real-estate investors and utilities to supplement their cash returns, using funds they might have previously allocated to bonds when interest rates were a little bit higher. Although the dividend payments may be relatively stable, their total return will fluctuate with the share price.

Those are the types of holdings investors will probably ditch as interest rates start to rise. And despite New Zealand’s official cash rate being nowhere near the stimulatory levels seen in Japan, Europe and the US, it is likely to start increasing in coming years.

Mike Warrington: don’t look back. Photo/victoria Birkinshaw

Mike Warrington: don’t look back. Photo/Victoria Birkinshaw

Kiwisaver to the rescue

Mike Warrington, a financial adviser at Kapiti brokerage Chris Lee & Partners, has a long history in fixed-interest markets. He says investors seem confident local inflation will rise to 2% in the interest rates they’re willing to accept, with three- to five-year term deposits paying 2% above inflation, known as the real return, “which doesn’t feel too bad to me”.

One of the difficulties for advisers such as Warrington is getting investors to look forward rather than back. Investment statements typically carry the rider that past performance is no indicator of future returns, and yet the returns an investor is used to getting will cloud the judgment of the canniest people.

“It definitely colours their thoughts,” Warrington says. “In 2008, we saw people terrified of risk – they didn’t want a bar of it. In 2018, they’re saying how fabulous KiwiSaver is going, and they’re asking ‘why buy bonds?’.”

And after a spell of stock markets delivering double-digit annual returns, the single-digit returns on offer in other asset classes seem less appealing.

Warrington likes to draw on the advice of veteran broker David Wales, of Jarden & Co, who used to opine that anyone would take an assured 4% real return (after inflation) for 50 years every time. Put another way, for every dollar invested you’d have an inflation-adjusted $7.11 after five decades. “The wisdom is if you’re generating a 4% real return, you’re doing a good job.”

The switch from applying a formula that’s worked once to adapting to a changing environment can lead investors into mistakes. After 30 years in the industry and six downturns, Warrington says he can rebut most misguided notions, but ultimately investors decide what to do with their money.

When he first sits down with a client, he figures out the overall structure of their investment, what they want to achieve and gives them a set of rules to invest by. Once that framework is in place, investors can respond to changing market conditions.

Like other market watchers, Warrington says sharemarkets are “optimistically priced”. But a big no-no is to simply dump all shares, which cuts investors out of higher cash flows when things inevitably recover.

NZ Funds’ Michael Lang.

Warrington cites the example of Vector. In the 2008/09 rout, its share price almost halved to $1.80, but the dividend payment stayed at about 13c a share. Since then, its shares have hit $3.33 and the dividend has increased to 16.25c. “It’s gone from hot to cold to hot, but it’s still the same business – a quietly expanding, evolving monopoly generally drifting higher on inflation and population growth.”

Vector’s trajectory illustrates that investing is never black and white; that investors need to adapt to changing circumstances rather than throw in the towel.

NZ Funds’ Lang points out that the best returns typically come at the end of a bull run, so if investors jump out too early, they’ll miss out on the biggest gains.

The hard part is anticipating when to scale back, and whether the market is heading for a soft landing, dipping, say, 20%, or a hard one, with a slump as big as 40%.

“For there to be a crisis, normally you need to have excesses in the system, such as finance company excesses,” Lang says. “In the US, we aren’t seeing any area of excess.”

He’s relatively optimistic about our ability to cope with a downturn, pointing to the big inflows of money from KiwiSaver funds, which in the past would have probably gone into residential housing. That leaves us in better shape to weather a storm if and when it arrives, with long-term investment able to insulate the country from shocks, he says.

“I’m more positive about economic growth than I’ve ever been because of the effect KiwiSaver will have slowly and surely on the amount of money available in New Zealand for growth.”

When a bear is on the loose  …

  • Don’t panic and move your KiwiSaver funds from a higher-risk to a conservative fund. In an upcoming book, financial writer Mary Holm estimates someone with total KiwiSaver contributions of $400 a month for 40 years could miss out on $600,000 in retirement if they switch from a growth to a low-risk fund.
  • Don’t constantly check your KiwiSaver balance unless you have a strong stomach for risk. Holm worries that people used to peeking at their banking app and seeing a steadily rising KiwiSaver balance will panic when the numbers go down and will switch to a conservative fund. Bad move (see above).
  • Don’t look in the rear-view mirror. Those double-digit gains were specific to that time. Financial adviser Mike Warrington says investors often stay with something that’s been successful “believing it’s a winning horse rather than a horse back in the stable”.
  • Do get some advice. It might be time to shuffle around your asset allocations depending on your cash requirements.
  • Do … nothing. If you are putting money away regularly, financial advisers suggest you keep doing just that. When the market starts falling, instead of worrying about the short-term value of your investments, think of it as everything you buy being on sale. Bargain! 30% off!

This article was first published in the August 18, 2018 issue of the New Zealand Listener.

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