April Market Update

“The Intelligent Investor is one who sells to optimists and buys from pessimists.”

Benjamin Graham

NZ Property Update

House price inflation is rampant in NZ with +22% y.o.y. for the period ending February 2021. This sort of growth increases the risk of a major disruption to the wider NZ economy when the $1.5 trillion property bubble finally bursts. How could we address this rising risk? Enter Prime Minister Jacinda Ardern!

The biggest news in the past month for NZ investors has to be the changes to property investing announced as part of Labour’s Housing Package by PM Ardern on the 23rd of March. The major changes were:

1. The extension of the bright-line test to 10-years

Previously, if you purchased an investment property after October 2015 and sold it within 2-years, you may have to pay income tax on the change in property value. This was then increased to 5-years in March 2018 and has now been extended to 10-years from the 27th of March.

Bright-Line Test evolution

Source: KPMG Housing tax changes – March 2021

To keep things complicated (and accountants employed):

  • The bright-line test will remain at 5-years for “new builds” acquired after the 29th of March. This is designed to encourage support of new property builds.
  • If you purchased a residential owner-occupied property before the 29th of March and occupied it for more than 50% of the bright-line period, it was exempt from capital gains tax.
  • Under the new rules, owner-occupied properties that are purchased after the 29th of March, then sold prior to the 10-year bright-line period will have their capital gains taxed for the percentage of time that the property may have been a rental property; i.e. a property that was owner-occupied for 60% of the time and a rental property for 40% of the time will have to pay personal income tax on 40% of the gains in the property value if sold within 10-years of the purchase date.

These changes by themselves would be unlikely to dissuade individuals to invest into residential property in NZ. The change in the bright-line term to 10-years would simply mean that investors would now aim to hold properties longer than this period.

2. The cessation of interest costs being deductible

For residential investment properties purchased after the 29th of March, the interest on the mortgage used for the purchase will no longer be deductible against the property’s rental income from the 1st of October.

Investment Property Tax Deductible table

Source: KPMG Housing tax changes – March 2021

For residential investment properties purchased before 29th of March, interest deductibility will remain but will reduce over the next four-years. From the 1st of October, 75% of interest costs will be deductible. For the tax year ending 2024, this reduces to 50% and then 25% for the tax year ending 2025. All interest deductions will be completely removed from 1st April 2025.


This will have a meaningful impact on property investors that relied heavily on borrowings to fund their property purchases. According to early forecasting by ANZ, these changes may lead to investors offering 5% – 15% less for properties to maintain their previously expected yields. Another option that has been widely publicised is for landlords to pass on this increased cost (from loss of tax credit) to tenants by putting their rents up. It is most likely that it will be a mixture of both.

3. The new Kainga Ora Fund & Homes and Communities Land Fund

The government will now offer $3.9 billion to councils to fund infrastructure costs that will allow for faster growth in subdivisions. This is designed to help purchasers by increasing the supply of residential properties and deal with the supply shortfall in NZ.

According to latest government figures, there are more than 22,000 people on the housing waitlist. This is 7,000 more than prior to the pandemic. The government has offered $2 billion to be used for the purchase of land for social housing needs. This is designed to help reduce the level of homelessness in NZ.

According to economist Shamubeel Eaqub, these two initiatives have the potential to produce 80,000 serviced sections over the next decade. This will go some way to address the shortfall of 60,000 – 90,000 properties that Shamubeel estimates exists today.

4. Apprenticeship Funding

The government has extended the Apprenticeship Boost payment until 2022. The payments are $1,000 per month for first year apprentices, and $500 per month for second year apprentices. This is designed to support trade companies grow their apprenticeship programs and to ensure that NZ has a larger number of qualified trades people to meet the construction demands.

It was never going to be possible to please 100% of New Zealanders with these changes, but some of these initiatives have received wide support. Unsurprisingly, the removal of interest costs being deductible has met with much criticism from property investors and some commentators in the wider market.

ANZ has produced the below table to show their forecasted impact from all the Housing Package initiatives. As shown, they are forecasting a minimal impact to NZ house price inflation, with the heat taken out of the current cycle slightly earlier than previously forecast.

The message received by the market from these changes is that the government no longer wishes to support people who pursue a property investment business. Property investors make up c.30% of all property purchases.

It is expected that those most affected by these changes will unfortunately be the tenants who will see their rents increase. This in turn may impact the poorest in the community who can now only just afford rent. Potentially, one of the negative outcomes of these changes could be a rise in homelessness.

House price forecast – post Housing Package changes

Source: REINZ, ANZ Research

Global Market Views

Below we have included a table showing the current views of a pool of fund managers around where different parts of the US economy are currently at.

The question around the US economic cycle produced the most division, with 25% of respondents stating we were at the start of an economic recovery, followed closely by 22% of respondents who felt we were at the start of a decline.

Across the remainder of the questions, most respondents believe share markets are approaching the current peak of this cycle, debt markets are starting to decline, and commodity markets are now in a rising market.

Fund managers’ view on where we are in current cycles

Source: Pregin, The Daily Shot
Post lockdown inflation

The Bank of America recently completed a survey of global fund managers’ views. Managers were asked what they thought the biggest risks for a major “tail-end” share market correction were. Thirty-six percent of respondents put higher than expected inflation as the largest risk. Within the survey, over 70% of respondents were expecting higher global inflation. The last time inflation expectations were this high was May 2004.

What are the biggest global risks facing investors?

Source: Bank of America Global Fund Manager Survey, The Daily Shot

The high expectation of rising inflation is mainly due to economies starting to come out of lockdown as they vaccinate their citizens. This is leading to an increase in demand for goods as consumers look to spend some of their savings. The lower level of supply to meet this demand is the main reason most economists are forecasting a spike in inflation in late 2021.

So, what is happening with inflation expectations?

In the RBNZ February Monetary Policy Statement (MPS), they provided updated guidance on their forecast for expected inflation over the coming years. They, like all developed economy central banks, are forecasting a rise in inflation in 2021 to a possible high of 2.50%.

NZ Consumer Price Inflation (CPI) forecasts

Source: RBNZ, Statistics NZ, ANZ Research

Again, like most central banks, they are forecasting that this spike will be a temporary anomaly with inflation reducing back down to 1.50% in 2022. This means the RBNZ will not feel pressure to increase interest rates until they are certain that our economy has achieved ‘escape velocity’ to confirm any economic recovery is sustainable.

The rise of long dated bond yields

As the risk of higher inflation increases, global bond investors have started demanding a higher return on their longer dated bond investments. As shown below, when bond yields rise, the capital value reduces. The US 10-year bond yield has risen by just over 1% since its low in mid-2020. This has led to the resale value of the 10-year bonds purchased mid-2020 to drop by over 10% in value.

US Government 10-year bond yield

Source: PWA, www.investing.com

Investors had been expecting a rise in interest rates due to rising inflationary pressures, but it is the speed of the rise that has caught most investors unawares. This has led to the MOVE index (bond volatility) increasing vs. the VIX indices (share volatility) which remains low. Remember, bonds are supposed to be the safe part of a diversified portfolio!

The US 10-year bond rate is used as the “risk free rate” for investments with an expected duration of 10-years or more. Investors then demand extra interest above the risk-free rate to compensate them for the perceived higher risk of other investments. As an example, if we were trying to determine the yield we needed from a share, we would start with the risk-free rate (1.66%) and may require an extra 3% (spread) to justify the higher risk of the share. This would equate to a required yield of 4.66%.

Both the risk-free rate and the spread can move, hence the yield required can change. If the risk-free rate increases, then the required yield from the share investment would increase as well. The share yield can increase either from a higher dividend being paid, or the capital value of the share declining.

Why do rising interest rates matter?

We have seen share markets around the world dip on the back of the rise in longer dated interest rates. This is due to the increase in the risk-free rate causing a squeeze in the share/bond yield spread, which is the percentage difference between the yield being offered by shares vs. that being offered on the risk-free rate (government debt).

Historically, each time we have seen a meaningful rise in the US 10-year bond rate share markets decline. The difference that we may see this time if interest rates continue to rise is not only a falling share market but falling bond prices as well.

Share capital values are not likely to drop by the same level as bond values should yield increases continue because most companies are producing earnings and announcing profit upgrades. Therefore, the yield is supported by a higher dividend which means the share price does not have to drop as much to retain the historical spread.

US 10-year yield – 1985 to 2021

Source: Bloomberg Finance, The Pain Report

Over the page is a table showing a survey of global fund managers and economists. They were asked to predict what level the US 10-year government bond rate would have to rise by to trigger a 10% or more decline in the US share markets. As shown in the table, the majority felt 2.00% on the US 10-year government bond could be the trigger level. This is only 0.34% above the current US 10-year bond yield.

What level on the US 10-yr. will cause +10% market correction?

Source: Bank of America Global Fund Manager Survey, The Daily Shot

Will the US 10-year reach the dreaded 2.00%? Will this be the trigger for a wider share market sell-off? All this is unknown, but what we do know with a higher level of certainty is that the US Fed is not planning to raise interest rates anytime soon.

The US Federal Reserve can also act to drive the longer dated interest rates/bond yields lower as well. They can easily do this by moving their quantitative easing (QE) programme from short-dated bonds to longer dated bonds. If they did this the yields curve would flatten, and markets would likely rally due to a stronger belief in lower interest rates.

When will this period of low interest rates end?

The question on all investors’ minds right now should be, “when will interest rates normalise?” To qualify what normalise means, there is “normalise” back to pre-Covid-19 stimulus levels, and “normalise” back to before Central Banks pumped QE into the markets.

As shown below, the current yield for the US 10-year government bond is now 1.66% and the pre-Covid-19 “normal” yields for the US 10-year bond were about 2% p.a., so interest rates only need to move a bit higher to reach these levels. If we look back to the start of 2008 for “Pre-Quantitative Easing” levels, the interest rate then was 3.60%, which is 1.20% higher (or over double) than the current US 10-year yield.

We do not see any end to the QE from central banks in the next 2-years. Indeed, governments cannot afford for interest rates to move higher as this would end up costing them more in interest than they could maybe afford, due to the record high levels of debt most central banks carry. So, when might this stimulus end?

US Debt to GDP & Interest Costs to GDP

Source: Mizuho Securities USA, Dept of Treasury, @SoberLook, The Daily Shot

The US Federal Reserve has confirmed that they do not plan to raise rates in the next 12-24 months and are primarily focused on ensuring their unemployment rate comes down. In the latest reading in mid-February, the number of Americans filing for unemployment benefits unexpectedly increased.

US Fed Dot-chart – Feb 2021

Source: CME, Federal Reserve, Oxford Economics, Bloomberg Finance, The Daily Shot

While it could be argued sharemarkets are ‘expensive’, low interest rates are leading to ‘TINA’ (There Is No Alternative) and supporting continued funds into shares in a hunt for yield. Fund flow into US shares is now at record levels of just under US$75 billion per month. This supports share markets at current levels and could well push share markets higher in 2021.

The only question is when will this reverse? To answer that we need to first know when interest rates will move higher, and to answer that we need to know what inflation is going to do. These are all unknown factors currently. We (and all investors) will be watching these indicators with great interest, and we can expect that as the picture becomes clearer markets will move quickly to price in new information, both positive and negative.

US share monthly fund flow at record levels

What does “downside risk” mean?

If you are talking to any investment adviser, at some point during your conversation the term “downside risk” will be used. What does this actually mean to you and how big is the risk? The answer is (as always) it depends. If you are new to investing and have only been invested for the past 5-years, then downside risk likely means between a 20% – 30% fall in share markets, with full recovery of capital in the next 2-3 months. As shown below, the Covid-19 crash and recovery only shows as a small blip on the table. So small in fact that they must expand the section out to highlight the correction.

US share market crash timeline – $1 invested in US stock market – Real Peak values

Source: Morningstar, The Daily Shot

Looking further back in history, the more likely drawdowns are 50%+, and it can take as long as 10-years to recover your capital value from any drawdown. Most investors, and even some investment advisers, are not aware of the mental fortitude required to navigate through such periods.

Drawdowns have a meaningful impact of longer-term compounding returns and are more difficult to recover from than most investors are aware. As an example, if you had $100 invested and this dropped by 50% to $50, you would now need to secure a return of 100% just to get the capital value back to break-even.

For investors that do not draw income from their investment portfolios, major share market corrections are difficult to navigate, but for those that draw income in retirement, it is much more unbearable and any major fall can have a meaningful impact on an individual’s ability to fund their retirement.

Why are we telling you this? Because we want our investors to be informed around what real downside risk looks and feels like as this will better prepare you for the difficult decisions that need to be made during such times.

Are we forecasting a major market correction? As shown in the table above, a major market correction is inevitable according to history. The only issue is we have no idea when it will occur, or what might be the catalyst for the end of the current share market rally. The best we can do is plan for the worst and hope for the best.

Summary

We have seen differing outcomes with vaccination programs globally. The US has managed to secure an exceptionally high number of vaccine shots, and equally have had a solid vaccination program operating since President Biden took office. The progression of vaccinations around the rest of the world is less successful, but as more vaccination shots are made available, we can expect this to accelerate.

This can be expected to lead to a rapid rise in consumerism, which could see the forecast spike in inflation. What happens from there is still anyone’s guess, but at present, most economists are forecasting only a temporary spike in inflation meaning there will be little pressure on central banks to raise rates.

No. of vaccinations administered per 100 people

Source: Our World in Data, WSJ, The Daily Shot

Warren Buffet famously said, “Be fearful when others are greedy and greedy when others are fearful.” We are certainly in a “greed” period in most markets with asset prices in the US testing new highs. However, as discussed above, bubbles can last a lot longer than a sensible investor would think possible, so we continue to proceed with caution.

 

Private Wealth Advisers believes the information in this publication is correct, and it has reasonable grounds for any opinion or recommendation found within this publication on the date of this publication. However, no liability is accepted for any loss or damage incurred by any person as a result of any error in any information, opinion or recommendation in this publication. Nothing in this publication is, or should be taken as, an offer, invitation or recommendation to buy, sell or retain any investment in or make any deposit with any person. The information contained in this publication is general in nature. It may not be relevant to individual circumstances. Before making any investment, insurance or other financial decisions, you should consult a professional financial adviser. This publication is for the use of persons in New Zealand only.