17 October 2019

    October quarterly update

    From your Chief Investment Officer

    Interest rates continued to fall in the third quarter of 2019. While they can always go lower — we have learnt that 0% is not the boundary that many of us once thought it was — the thirty-year trend of falling rates is inexorably drawing to a close. This will mean we need to rethink how we build and manage long-term wealth. Being clear on long-term investment objectives, accepting and profiting from the variable returns that accompany taking more investment risk and creating excess returns from active management are key elements needed to deliver future investment success.

    Sometimes I sound like a broken record. So excuse me if you have heard this before but falling interest rates, particularly in New Zealand, were, once again, a dominant theme for the quarter. After years of falling rates that starts to sound repetitive.

    The game is ending.

    The ten-year New Zealand government bond stands at 0.99% as I write this. While interest rates can go lower — we have ample evidence of that happening in Europe and Japan — the arithmetic for long-term investors gets even worse if they do.

    It’s the end of an era. For as long as most of us can remember, we have been able to invest in low risk assets yet earn a healthy real return. That is extremely unusual. I believe the last thirty years will prove to be an anomaly. Low interest rates offering a meagre real return will likely come to be seen as the norm. It would require a significant increase in economic growth or inflation for that not to be the case (and if its higher inflation we should be careful what we hope for!!)

    An environment with low interest rates and low real returns from fixed income will require a major shift in mindset and approach if we are to achieve our investment goals. 

    Don’t forget fixed income!

    This may seem like a strange place to start given the preamble. Fixed income still has an important role in portfolios even if it generates a lower return. Fixed Income dampens overall portfolio variability — it makes portfolio returns more stable year by year. Think of it as an insurance policy. Fixed Income tends to perform best when risky markets are performing worst. Any asset that generates a different return profile, and hence provides diversification, is very valuable when we build portfolios.

    It is important that investors don’t forget the role that fixed income can play when considering the right long term strategy for growing and managing their wealth. It is there for a reason.

    Manage true long term risk

    The risk that too many investors, in my view, focus their energy on is the risk of the here and now. There are always things to worry about so I can see the allure of this. Will there be a recession in the United States? How much is the New Zealand economy slowing down? How will the trade war affect the global economy? While these are genuine concerns, they are not the most material risk we face. The risk we should concentrate our energy on is the risk that we don’t accumulate enough savings or the risk that we don’t manage our wealth appropriately, given the low interest rate environment, to achieve ourlong-term goals.

    For most of us that means saving enough money to fund our retirement although there any other objectives that investors may have with their money. Our primary focus should be managing the risk of not meeting those objectives, not on what the Fed’s next interest rate move will be, as an example. If we focus too much on the near term, particularly if this leads us to get too defensive, we could miss meeting our long run objective. That is by far and away the most risky thing we can do. Reducing short-term risk too much in response to the “crisis of the day” can be much more risky in the long run, as counter intuitive as that may seem.

    Accept more variable returns

    With the demise of “free” money — high risk adjusted real returns in the fixed income market — many investors will need to accept more short-term risk, through investing more in shares and property, to meet long-term objectives. This can be uncomfortable. More risk means more years where portfolios perform poorly — of course this will be more than balanced out by the bumper years. This is where a mind set shift needs to happen. With more investment risk we need to train ourselves to think and act long-term. If we undermine strategies by responding to short-term negative news, long run objectives will be jeopardised. As highlighted earlier this is the definition of real risk. To manage this risk we all need to learn to get comfortable about sometimes feeling uncomfortable.

    Embrace volatility

    I would go one step further. Much of the financial advice that has been handed out in the past is based on a set and forget approach — decide your risk tolerance, set your objective, determine an asset mix and stick with it through thick and thin. We can be smarter than this. With the modest returns on offer in markets, we have to be.

    Market variability gives us choices that we can use to our advantage. This is common sense.

    Lets say my objective is to save $100,000. I invest in a portfolio of shares that do well and I now have in excess of my $100,000. Why would I not pivot to a lower risk strategy? I have achieved my objective. I should now focus on staying wealthy not getting wealthy. Similarly, if things go poorly I may need to consider a change to my approach either buying more risky assets, at what are hopefully great prices, or by saving more.

    Either way volatility can be an ally, helping to achieve long term investment objectives if we take a more dynamic approach and vary our risk exposure over time.

    This does need to be done in a thoughtful way and in response to major market moves, not just normal variability, but it can be an important tool in our arsenal for achieving investment success.

    Active management is more important than ever

    Interest rates are sending a message. The message is clear. Expect low inflation and low economic growth over the foreseeable future, for much of the World.

    While current interest rates might be overly pessimistic, and could go a little higher if data improves, the broad signal is not wildly wrong in my view. With a tepid growth backdrop and with company pricing power remaining weak there will be clear winners and losers.

    Companies with wide competitive moats, with pricing power and a secular growth tail wind will be big winners. Companies offering me-too products in highly competitive, low growth industries will struggle.

    For active managers an environment where company fortunes are clearly differentiated is a fertile ground for generating excess returns. In a low return environment, these excess returns become even more valuable to investors and an important contributor to help achieve long-term investment objectives.The thirty-year trend of falling interest rates is drawing to a close. This means we need to think carefully about how we build and manage long-term wealth.

    We believe being clear about our long-term investment objectives and adopt a true long term perspective on getting there, being prepared to take on more investment risk and making the most of the opportunities in active management will be important in achieving success in tomorrow’s investment environment.