Market Review: Moving from one “bubble” to another?

February was a repeat of a familiar pattern, with bond markets performing strongly and sharemarkets continuing to be weak. For example, the New Zealand Bond Index was up 1.3% for the month while the New Zealand sharemarket was down over 4%.

The past month has seen New Zealand bond rates fall to levels not too far from their lowest of the past 15 years. For example, the New Zealand 10-year bond yield at the end of February of 5.7% compares with a yield of 5.6% in January 1994 – just before rates rose to be 8.6% a year later in early 1995.

The rally in United States bond yields has been even more marked with their bond rates at forty-year lows. For example, the US 10-year yield was down to 3.7%, a level last reached in mid-1961!

Given this, a key question for many investors is: how low can bond yields go?

Just as you hear convincing arguments about why the trend will continue when sharemarkets or currencies hit new highs, sensible reasons are now being given why bond rates are at such low historic levels.

Clearly, an unusual combination of geo-political and economic uncertainties is behind the dramatic fall in bond yields. The world is a very uncertain place at present!

However, one can’t help but get the feeling that, in the rush to exit equity markets and find some more stable returns, investors could be laying the foundations for a speculative “bubble” in bonds. Any resurfacing of global economic growth and/or any positive outcome to the potential Iraqi conflict could see a significant lift in bond yields. This would result in lower than expected returns from the bond sector over the next few years and even (possibly) losses.

Thus, there is the potential for some investors to be “whip-sawed”; exiting their share investments because of negative returns and then finding they are in the same situation with their bond investments.

This, in turn, could cause some retail investors to give up on investment markets and go to cash in the bank or to residential property investment. This is already happening anyway, helping drive cash rates lower and boosting property prices around the world. However, this does mean there is a greater risk of a residential property investment “bubble” in many developed countries (including New Zealand).

What is the lesson from this? While it may be regarded as unfashionable by some, diversification of investments still remains the best strategy for most investors.

Looking back on February most major equity markets were down for the month with Continental Europe and the United States particularly hard hit. For the month, Germany (DAX) was down another 7.3% (making it down almost 50% over the past 12 months) and France (CAC 40) fell 6.3% for the month and 38% for the year. The US sharemarket (S&P 500) was down 1.7% for the month and 24% for the year.

After being the worst performer in January the UK market (FTSE 100) lifted 2.5% while the Japanese market (Nikkei 225) kept its reputation of being different, by being flat. With a loss of “only” 21% Japan is the best performer of the major global equity markets over the past year.

The New Zealand dollar continued to appreciate against most of our trading partners, apart from the Australian dollar, against which the kiwi was down 1.2% for the month.

For the first time in a while the New Zealand sharemarket actually under performed its global counterparts. This is despite a very good earnings season in this country, with few companies disappointing in terms of their reported results and with the average growth in earnings being double-digit. What the United States sharemarket wouldn’t give for such an outcome in its earnings reports over the coming year!

However, the current nervousness in equity markets was illustrated by the savage price markdown of companies that, in any way, disappointed in terms of their results or outlook.

But that is in the past and the market is always trying to look to the future. Unfortunately for many New Zealand companies there are some black clouds on the horizon. Obviously the potential Iraqi war hangs over most companies with tourism related stocks most at risk. For exporters the relatively strong New Zealand dollar is starting to impact. For domestically oriented companies, the very strong retail and building sectors cannot carry on indefinitely in the face of the slow western economies.

Thus, we may be seeing the “end of the golden weather” for the New Zealand sharemarket, at least in the short-term.

Moving to bonds, February saw domestic and global bonds producing strong monthly respective returns of 1.3% (CSFB Government Stock Index) and 1.4% (Lehman Global Aggregate Hedged Index) respectively. This means high returns for the past 12 months from global (+12.5%) and domestic (+9.7%) bonds. But as covered in the preceding commentary there are some real questions about whether these rates of return will continue. Instead, returns around coupon levels may be the best bond investors can hope for over the next twelve months. Low bond returns could then prompt investors to once again look at equity markets in the hunt for higher returns.

To see how the numbers stacked up for various markets around the world in the past month and over the year, visit our Monthly Market Reveiw here

Anthony Quirk is the managing director of Guardian Trust Funds Management

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