October Market Commentary

The joy of low interest rates

As we finish another month, we have further historical events occurring. This time it is closer to home, with 2-year & 5-year government bond yields falling into negative territory for the first time in history. In September, the 5-year NZ government bond rate went as low as -0.06%.
This is down from the not so attractive 0.66% six months ago.

NZ Yield Curve – 18th Sept 2020


Source: The Daily Shot

This has also led to mortgage rates in New Zealand dropping, which in turn is throwing further fuel on an already overpriced NZ property market. This is great news for borrowers who can now re-fix their debt at lower interest rates, giving them some short-term breathing room.

NZ Mortgage Rate Forecasts NZ Annual Property Price Forecast


Source: ANZ Research Source: Westpac NZ

ANZ is currently forecasting mortgage rates to drop further, with the short end below 2% in 2021, as the RBNZ potentially moves our Official Cash Rate (OCR) into negative territory for the first time ever. The RBNZ is also likely to commence the Funding for Lending Programme (FLP). This is where the RBNZ lends funds to the NZ banks directly to reduce their reliance on term deposits for their funding. This will also likely lead to the banks being able to reduce mortgage rates further. As shown above, this has led Westpac to update their NZ residential price forecasts from a loss of -7% in 2021 to now only -1%.

Spare a thought for those about to retire

Falling interest rates are good for borrowers but not so good for savers. Below is a chart showing the capital needed by someone who is retiring over different periods from 2007 to 2020. We are assuming a rate of return equal to the 6-month term deposit rate at the start date of their retirement plus 50%, and a personal tax rate of 28%.

We have asked how much would a person need in capital to produce $100,000 net p.a. for a period of 20-years, assuming they are comfortable to consume all their capital? If we go back to January 2007, the 6-month term deposit rate was an incredible 7.24% gross p.a. Using the assumptions above, someone retiring in 2007 would require $995k in starting capital to achieve this goal.

Now fast forward to 2020. The 6-month term deposit rate is now a miserable 1.49% gross p.a. and someone retiring with the same goals would require $1.7 million or almost double the sum required back in 2007 to achieve the same goal.

Capital required to generate $100k p.a. – consuming capital


Source: RBNZ, PWA

Below we have a second example using the same assumptions except this time the retiree wants to retain their capital value (i.e. not consume any capital). In this scenario, someone starting retirement in 2007 would need $1.2 million in starting capital to fund their income for 20-years and retain their investment capital. Fast forward to today and someone with the same stated goals would require $6.2 million or five-times more capital than someone in 2007 to achieve the same outcome.

Capital required to generate $100k p.a. – retaining the capital value


Source: RBNZ, PWA

So, as we all high five each other for the free lunch we are getting on lower mortgage rates, do spare a thought for those coming into retirement who may have thought they had enough saved to stop work, only to find out that the sum required has doubled or tripled.

The K-shaped recovery

There has been much debate about the shape of the global recovery. The US and NZ share markets have already priced in a V-shaped recovery. Europe & Australian share markets are more likely pricing in a U-shaped recovery, and the European Bank index is pricing in an L-shaped recovery, or maybe a “Nike swoosh” recovery.

As noted in the table below, economists surveyed in the Oxford Economics Global Risk Survey are forecasting a c.38% chance of a U-shaped (lower for longer before a steep recovery back to normal growth) and a c.27% chance of a W-shaped recovery (double dip in growth). Most disturbing in this table is the rise in economists forecasting an L-shaped recovery since the last poll.

Percentage forecast shape of global recovery


Source: Oxford Economics Global Risk Survey, The Daily Shot

One of the most interesting, and we think accurate, descriptions of this recovery is the K-shaped recovery described in JP Morgan’s Quantitative and Derivative Strategy. This example suggests that we all experienced the negative impact of the global lockdowns from Covid-19, and we all experienced a partial recovery as central banks stepped in with unprecedented money printing to support the markets. However, from there we have seen a divergence with those that hold assets/investments experiencing a full recovery due to central bank & government stimulus and those without assets/investments or in “blue collar” jobs seeing their wealth fall compared to society averages.

What is the K-shaped recovery?


Source: JP Morgan Quantitative & Derivative Strategy, The Daily Shot

This has led to the wealth gap in developed societies blowing out to record levels post Covid-19. In democracies like we live in, this is likely to lead to the rise of further populist political parties as dissatisfied citizens vote for change, and a better future for them and their children.

The impact of central bank intervention

When the global economy went into lockdown on the back of the Covid-19 virus, bond markets initially froze. As everyone was watching the share markets fall, the bond market was where the truly scary action happened. Yields on junk (high yield) and investment grade bonds were rising as their prices fell. This was a good signal that this was not a normal market correction. Bonds are supposed to be the safe part of investors’ portfolios and rise in value when share markets fall.

Central banks around the world watched the bond market liquidity dry up, remembered their lessons from the 2008 Global Financial Crisis (GFC) and stepped in to provide much-needed liquidity via quantitative easing (QE) and support to the bond market. Currently, the 12-month rolling global QE is at US$4 trillion p.a. and is forecast to increase to US$6 trillion p.a. in 2021.

Total Central Bank QE (USD trillion, 12-month rolling)


Source: Citi Research, July 2020

This had the same effect we saw in the 2008 GFC, with global bond yields pushing to new record low levels and bond values pushing to the highest price levels we have seen in the last 150 years (in most of the developed world) as shown below. As central banks hoover up the existing bonds, we have also seen corporations and governments around the world come to market with longer dated low interest rate bonds, which has also pushed out the average maturity (duration) of global bond indices.

This is increasing the risk in index aware bond fund managers as the longer the maturity date of a bond, the greater the impact on any changes in interest rates (positive and negative). At the end of August 2020, the Bloomberg Global Aggregate Index (NZ Hedged) had an
average maturity term of 9.29 years and a yield to maturity of 0.84% gross p.a.

Bond yields vs. Bond Valuations – 1870 to 2020


Source: Quill Intelligence

As interest rates have dropped, US corporations have taken the opportunity given by the US Fed’s QE to avail themselves of some longer dated debt at record low levels. As shown below, the level of US corporate debt as a percentage of US GDP is now almost 160%, and well above the long run trend for debt growth in the US.

What does all this mean? It means that corporations are well funded with cheap debt for the foreseeable future. If interest rates stay at these record low levels, this level of debt will not be too difficult for the corporation to fund, but if we see credit spreads push higher (borrowing costs rise) as investors finally start to demand a positive real return on their bond investments, then the debt levels could be a major drag on profits.

Total US Corporate Debt as % of GDP – 1970 – 2020


Source: Deutsche Bank Research, The Daily Shot

Summary

We are living through uncertain times, and the end of this year is likely to see increased uncertainty, especially with the US election in early November and the likely challenge from Trump on any negative result for him.

Share and bond markets are trading at record high valuations. Both these markets have been positively impacted by central banks’ record levels of QE. If this continues, and investors continue to be okay with low or negative yielding bonds, this party should continue. The US Fed has already confirmed that they intend to do everything they can to keep interest rates at these low levels for the next few years.

When interest rates are 0% or negative around the world, investors have subscribed to the “TINA” theory (There Is No Alternative) and are investing into anything that has a ‘reasonable’ yield. Shares therefore remain attractive in this environment, even at record high valuations.

There are always “unknown unknowns” that can topple this market (such as the Covid-19 crisis), however, there are also “known unknowns” such as the risk of inflation, a volatile outcome to the US elections, or a military conflict between the US and China. It is for these reasons that PWA continues to proceed with caution within portfolios.

In conclusion, we live in uncertain times, however economic indicators are improving, and some data is coming in ahead of economists’ expectations. This is leading to analysts and economists having to upgrade their forecasts. The cost of funding around the world is at record low levels allowing governments and corporations to borrow their way through the Covid slowdown. This is great news and we truly hope this continues however, we will continue to manage our clients’ portfolios cautiously until we have a clearer view on how markets and economies will manage post Covid and post the end of government stimulus.