In this three-part series we look at the strategic and material changes occurring to investment returns and the implications for investors, investment advice and the businesses of investment advisers and fund managers.
Another rate cut
The recent announcement by the RBNZ that their Official Cash Rate was reducing from 1.5% to 1.0% to me was just another nail in the coffin marked ‘FUTURE RETURNS’.
Either way, New Zealand investors and their financial advisers are in territory none will have experienced in our clients’ investing or our own professional lives. It is however familiar territory for other countries like Japan, Europe, UK and the US that have been in a low interest rate, low inflation environment for a decade or more.
I’m hoping its not like the late ‘60s, as this was followed by a decade plus of ‘stagflation’ and insipid returns.
Since 1985, New Zealand has seen a seemingly relentless decline in inflation, interest rates and investment yields. The initial fall in inflation and interest rates in the 1980s and 1990s was very necessary. But over the course of the 21st century this trend has continued globally and in New Zealand. Stability of inflation at lower levels is typically an important precurser to sustainability of economic growth .
Taking stock since 2009
To better understand the future implications for investors and their advisers let’s take a start point of mid 2009 just after the worst of the GFC had passed.
In the 10 years since that time, NZ Corporate bonds have delivered an annual average return to investors of 6.0% pre-tax (1), NZ shares have returned 14.7% pre-tax (2) and International shares have returned 10.6% (3) pre-tax PER ANNUM (to 30 August 2019).
Over this period 10 year New Zealand Government bond yields have declined from 5.5% to only 1.0%.
At the same time the Reserve Bank’s OCR (Official Cash Rate), which heavily influences the rate of return investors get on bank deposits, has declined from 5.5% to 1.0%.
And the New Zealand sharemarket valuation is, outside the bubble period of 1986/87, at a post financial deregulation high with a projected PER of 24x (4) for the S&P/NZX 50 index.
Having done a quick tour of the current yield or valuation of the mainstream financial markets asset classes, it would seem that investors in the future are GUARANTEED to achieve below average and, in many instances, pitiful returns, relative to the past decade.
And for those looking for salvation in residential property investment just be aware that New Zealand’s average house price to income multiple has expanded from 3.5x to 6.3x between 2003 and 2019. (9x+ in Auckland).
So, it is fair to say that the years of the golden returns weather for investors, especially for lower risk assets, could well be behind us.
In contrast to the decent returns in the last decade, future returns on low risk assets after tax appear likely to be close to nil which is hugely lower than what has occurred over the past 30 and 15 years.
Where is this unpleasant financial future most pronounced or most likely to materially impact investors?
Using KiwiSaver funds as an indicator;
- The $2-3 billion invested in ‘Defensive’ KiwiSaver funds. This fund group has 90-100% of their investments in cash and bonds. The average return in this fund sector for calendar 2018 post fees and tax was 1.22%. The yield on these assets pre-tax and fees is c1.5%.
- The $15-18 billion invested in ‘Conservative’ KiwiSaver funds including default funds. Their average return in calendar 2018 post fees and tax equalled only 0.46%.
Over the same period CPI inflation index for 2018 rose 1.9%.
With these rates of returns, such KiwiSavers funds are REDUCING their future spending power not increasing it.
Which is the antithesis of why people should save and invest – that is to achieve a return above the rate of inflation and in doing so increase their future purchasing power.
With interest rates falling even further in 2019, I expect returns from defensive assets like cash and bonds plus defensive and conservative funds (read investment strategies), to be materially lower on average in the future than they have been in recent times.
Is there ‘life’ after the death of future returns?
Yes there is life, but its clear low risk doesn’t equal no risk.
To avoid the death (long term demise) of portfolio returns requires a material change in investment thinking…clients hopefully being led by their adviser.
To help avoid the unpleasant financial fate of their investment portfolio returning below the rate of inflation for an extended period-of-time, investors will have to:
- Consider accepting more investment risk.
- Consider accepting greater variation in capital values/short term returns.
- Better understand how to mitigate the negative impact of intermediary costs like brokerage, advice fees, investment fees etc on their future returns.
Painful as it might be, a progressive shift to higher yielding and riskier assets be it:
- At an asset allocation level such as a shift to a higher weighting in shares from cash and bonds PLUS
- At a security level such as switching to corporate bonds from Government bonds appears absolutely necessary.
That’s not an easy discussion for an adviser to have with retired or conservative clients. I expect a fair bit of handholding will be required for many such clients who will be fearful of the increased propensity for capital loss albeit of a temporary nature.
To avoid an advice ‘car crash’, crafting a well thought through, rational and understandable case for change is a start point.
My approach is to take clients through the rationale, my recommended changes in their strategy, and the potential consequences of this though still providing them with options.
These options should include a ‘no change’ scenario as clients may still prefer capital stability over higher returns. The consequence of such an option will likely be a lower return, less accumulation of retirement wealth and quicker dissipation of their financial assets when in drawdown.
Less desirable to many but likely acceptable to some.
Next in this series is the challenge that a lower future returns world creates for the financial advice business and whether fund managers can survive the inevitable crunch in their management fee levels.
This article was originally published on Good Returns.