"Property’s not looking so flash, so where should I put my cash?"
For decades many
Kiwis have relied on term deposits and residential property for their
investment portfolios.
The share market
has been comparatively ignored. Personal finance expert, Mary Holm, attributes
this to the damage caused by the stock market crash of 1987.
That crash was certainly
brutal, and more so here than anywhere else in the world.
The late Brian
Gaynor provided an excellent summary of the excesses that led to this crash, in
an article
in 2017.
While the world’s
major stock markets fully recovered within twelve months, he states that the
New Zealand’s market has never reached that height again. I would suggest that
that is hard to conclude this with certainty as the calculation of the index
has changed
a few times since the crash.
None the less it is unsurprising that this crash, coupled with the abject performance of the New Zealand market through the 1990s and 2000s, has made property investment much more attractive for the majority of Kiwis.
In addition of
course you have the power of leverage.
In no other area is
it normal for a retail investor to borrow almost all of the money that they
invest. If you want to invest $10,000 in the stock market then you typically
have at least $10,000 in the bank first. Whereas if you want to buy a house for
$100,000, you might only need to have $15,000 personally.
While on the face
of it borrowing to invest seems extremely reckless, with property it has proven
a shrewd move time and again.
The graph above
shows that house prices have more than tripled since 1992 (the year that the
Reserve bank began collating data).
Whereas the New Zealand stock market has risen eight-fold and the average World market has risen by a
multiple of eleven.
However as property
investors would typically use leverage then their net result is often more impressive.
If you invested
$10,000 to buy a $100,000 house in 1992, it would now be worth $320,000. At 5%
interest your loan over that period would have cost $174,000.
So your original $10,000
would have netted you a profit of over $134,000. A thirteen-fold increase.
Almost double the
$70,000 profit from investing the same in the NZ market and comfortably exceeding
the $100,000 profit from investing in the World index.
What was even
better was that the cost of the mortgage reduced the tax that you paid on the
rent and there was no tax to pay on the sale of the property.
At this point it
has to be said that New Zealand is almost unique in enjoying this picture of
property investment benefits.
Most other
developed countries have been taxing property investment for decades and the result
here is certainly enhanced by the lack of data pre-1992.
One would be
forgiven for concluding that property investment must be a one-way bet.
However the data
only covers a period that has been exceptionally kind to investors in all
areas.
In the UK and
America, the housing
price crash of the late 1980s for example led not just to “negative equity”
(mortgages worth more than the property) but tens of thousands of repossessions
due to rising interest rates.
Imagine losing your
home or investment property and still owing the bank many thousands of
dollars.
The situation today
For investors in New
Zealand property the environment has changed dramatically.
The “Brightline”
rules could lead to many being taxed on any profits that they make.
The gradual removal
of mortgage interest relief radically changes the overall return made from
holding the asset each year.
Add to that rising
interest rates, rising inflation and a looming recession.
Suddenly, investing
in property is far less attractive.
So if not property,
then where?
Obviously the
rising interest rates, rising inflation and a looming recession are detrimental
to all investment assets. The best that can be said is that they are likely to
produce an attractive buying opportunity for the long term at least.
“Diversification
is the only free lunch” in investing [i]
However when the
environment becomes more challenging, diversification becomes a particularly powerful
aid.
The implication
being that you are hedging your bets, and so have a greater chance of avoiding an
overall loss.
If you had $50,000
to invest and opted for property, then the whole lot would have to go into one
house. No diversification would be possible.
Conversely in the
stock market, you could spread this amount across a wide variety of areas.
You could also
invest some in the stock market and some in, say, gold or more esoteric areas
such as fine wine or financing opportunities.
Some investments
will go up, some down. Even if all go down, some will go down less!
So the main purpose
of diversification is to help preserve your capital. It is not necessarily a
recipe for riches. By definition if one holding gains in value while another
falls, then the net effect to cancel one another out.
This is why the
legendary investor, Warren Buffet, said:
I would suggest, however, that with so many factors working against investors it is harder to “know what you’re doing” now than it has been for many years.
Assuming that we
agree diversification can help prevent significant loss, then where should one
diversify to?
Of all the threats
that investors face right now, inflation is the most ominous. Certainly from a
long term perspective at any rate.
While it’s a friend
to borrowers it is the ultimate destroyer of wealth.
By some estimates,
New Zealand property values effectively fell by 40%
between 1974 and 1980. Over the course of the 1970s, net property values
actually stagnated. This was due to inflation.
I would therefore
argue that investors need to ensure they hold assets with a decent chance of
rising by at least the same rate as inflation.
Most alarming for investors
unnerved by the sudden change to this new environment is that this therefore
excludes cash from the options.
While right now it
may prove a prudent place to be in the short term – though one should bear in
mind the danger of the Open
Bank Resolution here of course – in the long term interest rates are
extremely unlikely to come close to matching the inflation rate.
So cash in the bank
is falling in value day by day right now.
Infrastructure and
farmland
An insightful
article by The Economist[ii] assessed a number of assets
that may be assumed to do well during times of inflation.
The writer agreed that in the past both infrastructure and farmland
have performed well during inflationary periods. Leases are often linked to
inflation, tenants are responsible for most costs, and debt used to purchase
them is eroded by inflation.
JP Morgan Asset
Management calculated that when inflation exceeds 2.5% then these assets beat
the stock market.
However as the
article states:
Gold
The most famous retainer
of purchasing power.
There are countless
examples of how the metal has retained its worth. Frankly I find some hard to
believe and the evidence provided is often less than conclusive.
One of the best reasoned
that I have found is as follows:
“In the era of
Emperor Augustus (27 B.C. to 14 A.D.), a Roman centurion was paid 15,000
sestertii. Given that one gold aureus equalled 1,000 sestertii and given there
was eight grams of gold in an aureus, the pay comes to 38.58 ounces of gold. At
current prices (2013), this is about $54,000 per year.
The centurion who
commanded 80 legionaries is roughly equivalent to a U.S. Army captain.
The current wage for
a captain is $46,000 – which is fairly close.” [iii]
Over shorter
periods there seems to be a far weaker correlation between inflation and the
price of gold. Certainly in my experience gold experts predictions prove to be
among the most inaccurate of any in the investment industry.
Therefore I do not
view it as an asset from which you are likely to profit significantly.
But as a retention
of purchasing power – over the very long term at least – it appears to be hard
to dismiss.
Commodities
Metals used in
construction, oil and gas used for power (and manufacturing), agriculture producing
food.
Commodity prices often
drive inflation. As these are all part of the supply required for modern
life, this is referred to by economists as “supply-side inflation”[iv].
Therefore investing
in this area can prove to be an effective way of dealing with inflation.
Inflation-linked
Bonds
These are typically
issued by Governments rather than companies.
Where bonds offer a
fixed interest payment, and so will fall in value when inflation rises (and this level of income becomes less attractive), an inflation-linked treasury or gilt (bond)
will provide an income that increases with inflation.
Problem solved? Well,
not quite.
Bonds, unlike
shares, typically only exist for a set period of time. Say ten years. At the
end of this period the issuer repays the debt to the holder of the bond. A bond
is issued for $100 and repays $100. During times of inflation, inflation-linked
bonds become much more attractive and so their price rises.
Looking at a range
of “index-linked” Treasuries, we find the following current prices:
1.
Index-linked,
maturing in 2024: $110
2. Index-linked, maturing in 2044: $147
When these
treasuries mature, the holder will receive $100.
So the purchaser of
the first one will receive $10 less than they paid (a loss of 9%). The
purchaser of the second one will receive $47 less than they paid (a loss of
32%).
Buying them now is
betting that you will receive more in interest (coupon) than you’ll lose on the
sale/redemption. In other words betting that inflation will stay elevated for a
significant part of the remaining term.
Hedge Funds
Where most
investment is focused on buy-low-sell-high, at it’s most basic a hedge fund
seeks to profit from market falls as well via sell-high-buy-low.
That is selling a stock
it doesn’t own at a high price, and borrowing the stock from a bank to complete
the sale. Then once the price has fallen, buy the stock and repay the bank.
This action was
immortalised in the fantastic book by Michael Lewis (and the film of the same
name) called The Big Short.
During the Global
Financial Crisis a small number of investors correctly predicted that the
market was going to crash. Their bet meant selling without owning (known as “shorting”)
in the hope that the crash would make them rich.
One investor not
mentioned in the book was a hedge fund manager named John Paulson. His bet against
the market before the GFC meant his firm made a profit in 2009 of $15 Billion.
Under normal hedge fund rules, 20% of that would be paid to the manager. Paulson took home several billion dollars that year....
Hedge funds are typically
successful when there is a trend to exploit or a sudden big move in the direction
that they are predicting.
When markets are simply
fluctuating up a little, down a little, hedge funds find it very hard to be profitable.
Many lost money
over the past decade as they continued to bet against a rising market. Many
more were exposed as mirroring traditional fund strategies (but just
charging higher fees) as they failed to protect investors in previous down
turns.
A few, however, are
doing rather well now.
The S&P500 is
down 18% so far this year. I know of hedge funds that are up by that same
amount. Out performing the market by over 35% is impressive.
It has to be said
that these assets are not suitable to all. This is sophisticated investing typically
involving a lot of leverage. The managers can get it spectacularly right, like
Paulson did in the GFC, or spectacularly wrong as with LTCM
which almost brought down the world’s financial system in 1998 - yes, just one fund almost did that!
Conclusion
We are now in truly
uncertain times. There are no longer any one-way bets.
At the same time, sitting
it out in cash only guarantees loss (of purchasing power).
Some of the assets
discussed may be suitable for most people.
Some of the assets
are only suitable for certain kinds of investors and strategies.
Diversification is
key as is taking proper advice.
[i] Nobel Prize laureate, economist Harry
Markowitz, is reported to have said
[ii] Do
physical assets offer investors refuge from inflation, September 11th
2021
[iii] https://www.hurriyetdailynews.com/roman-centurions-and-the-price-of-gold-today-46042
[iv] Where people drive up prices by buying more,
this is termed “Demand-side” inflation.
Disclaimer: This communication is purely meant as information for general interest. It is in no way to be taken as financial advice or relied upon in any way for investment decisions.
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