22 August 2012
John Carran, Senior Economist at Gareth Morgan Investments
Judging by the news headlines over the past few months you could be forgiven for believing that the end of the world is upon us. There has been a proliferation of pessimist predictions ranging from Greece crashing out of the eurozone, Spain nearing a full-scale financial bailout, sickly US economic growth, and a hard landing for China’s economy.
If mainstream news has been your only source of information, you might be surprised to learn that share markets are actually in positive territory for the year. Even with the rising New Zealand dollar dampening returns somewhat, the MSCI All Countries Index is up around 6% and up around 14% from last October’s lows (in NZ dollars, as at 15 August 2012).
Understandably many investors, including ourselves, are concerned about the current state of share markets, despite these positive returns. How will the European crisis unfold from here? What will happen to economic growth in China? What about the US elections and the fiscal cliff?
As serious as the situation is, the underlying picture is perhaps not as dire as the media and some commentators make out:
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The US economy is growing, albeit slowly, at around 2% p.a. Even the housing market (which has fallen 33% since July 2006) appears to have bottomed. That’s a good sign, because when house prices are rising, consumers are tempted to spend more.
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China’s economy does not look like it is in for a hard landing, especially given the monetary easing we’ve seen to date. We expect to see signs of a reacceleration in Chinese growth over the next couple of months.
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The eurozone policymakers have made some major decisions to support troubled member countries. There has been a subtle but important shift in recent weeks, which suggests the European Central Bank (ECB) will ultimately be the final backstop to European governments. This is another important step in preventing this crisis spiralling out of control.
Many investors are also wary about the long-term prospects for shares given their under-performance, particularly relative to bonds, over the past five years.
However, the factors that have depressed share returns relative to bond returns over the past decade may be coming to an end. In our view shares are likely to produce higher returns over the next decade than bonds for the following reasons:
Long-term profit growth
We acknowledge that continuing debt reduction in developed countries is likely to inhibit profit growth for at least the next two to three years. However, there are encouraging signs that US households – which are the world’s biggest consumers – are making good progress in getting their finances in order. Emerging countries are not so encumbered by high debt and have brighter prospects. Global economic growth, therefore, is not likely to be as dire as some expect, helping to support company profits in the longer term.
The euro is unlikely to collapse
We don’t think the euro will collapse. The eurozone as a whole has a current account surplus and therefore has the fundamental ability to finance its liabilities if there is the political will to collectivise member country debts. We consider that in recent months eurozone politicians and the European Central Bank have given important signals that they have the will to protect the euro through member government bond purchases and structural reforms.
Government bond rates are at historically low levels
Anxiety about the global financial system and economic growth has been driving investors to safe havens such as US and German bonds. New Zealand bonds have also been gaining from these safe haven flows. But, in our view, there is limited upside to bond values at such low rates. Given the unprecedented fall in yields it is likely that bond prices are now over-inflated and will fall as yields eventually rise. That has a consequent impact on returns.
Corporate finances are robust
Corporates in the US and Europe currently have low debt levels and high levels of cash holdings. When the global outlook becomes more certain companies have the capacity to increase investment spending as they seek to replace aged assets. This could help generate cost reductions and revenue growth further down the track.
Even though the outlook for shares may be better than it has been in the past decade, we doubt the average returns will be as high as those experienced over the 1990s. This is largely because expectations back then were based on debt-fuelled economic growth, and there remains a lot of work to do to reduce high debt levels in most economies.
In addition, shares will always remain inherently volatile. Large holdings of share investments are not likely to suit investors with a low tolerance for risk and short investment horizons. Nevertheless, some exposure to shares is likely to be necessary to achieve a rate of return that at least beats inflation after tax over the longer term (10 to 15 years).
Any opinions in this article are the author's own. They are of a general nature and should not be treated as a recommendation or guidance to any individual. Everyone's financial circumstances are different, and readers should seek specific financial advice appropriate for their circumstances before making an investment decision.