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Recessions, Stagflation - What Next?

After a brief respite of strong gains in late May, further market falls have dominated media headlines.  This has been precipitated by fears of a recession, fears of inflation and the potential for "stagflation" to reappear. The concept of recession is a familiar one – causing high unemployment, business failures, and bankruptcies as a result of diminished demand from consumers and businesses. While recessions are ideally avoided; they are a necessary by-product of excessive risk taking, money printing and a general disregard for Investing 101 basics. Markets have experienced periods of slowdowns before; however, a younger generation has largely managed to avoid this pain in their lifetime, in part due to the general desire of politicians and governments nowadays to avoid financial pain at all costs. Their investment experience has been periods of continued growth without significant volatility. Many are now feeling the heat of the concentrated risk they’ve perhaps unknowingly taken by investing in a limited number of securities, such as on share trading platforms or in cryptocurrencies. Economic slowdowns are a normal part of economic contraction following periods of expansion and therefore there is no need to panic. However, extra care and attention to spending and avoidance of unnecessary risks during these periods becomes more important. Even during a significant economic downturn, there are many positive steps that can be taken to improve financial situations and measures that can be put in place to ‘recession-proof’ assets. The key, of course, planning for the longer term.  Others include measures to ensure job security, taking care in business expansion, borrowing funds, and reviewing cash flow forecasts. From an investment perspective, it’s a good opportunity for asset accumulation at lower prices and certainly not the time to be selling out. Stagflation (Stagnating growth, and high inflation) on the other hand is another matter. This is when there is an environment of slowing or stagnant economic growth, jobs losses, plus inflation. Stagflation is rare but can be persistent with devastating effects; in the U.S. it occurred from the 1970s to the early 1980s. Important to note however, that it normally comes with high unemployment which is not the current market scenario. Stagflation is not setting in at this stage and reserve banks around the world are raising interest rates with the goal of countering inflationary pressures. In other words, they are increasing the cost of money reduces your spending power (what you can afford to buy) and therefore effectively making you spend less. In saying this, similar principles apply to your financial affairs as for a recession; establish a strategic plan, review cash flow forecasts, hold emergency funds where possible, pay down debt, and ensure diversification of investments to weather the storm. Both scenarios are far more complex than we have discussed, and economists/experts vary widely in their opinions on when, if and how long these economic circumstances may arise.  As always, accurate predictions are difficult. In these circumstances, wisdom is not expressed in panic-selling of investments. While the markets are experiencing some liquidation panic, the reassuring news is that, while these times are uncomfortable, such panics usually don’t last long. History shows that stock gains can add up after big declines as illustrated below. Investors who make continued contributions will benefit from the eventual upside. With any personal investment strategy, it needs to be fit for the specific purpose and situation of the individual. Long term planning and executing assists in being in the right position when markets recovery to take advantage of the opportunities this presents. Wealth managers are critical in establishing these strategies and assisting in the delivery over a longer-term.   By Glenn Read Principal Adviser, Director Date first published: 14 June 2022   Image source: Dimensional Fund Advisors This article is intended as general information purposes only and is not, nor should be considered, financial advice or recommendations.  Where the author expresses opinions, this should not be taken as financial advice for any individual. It should not be used as a substitute for seeking professional financial advice which takes into account your personal financial goals and circumstances. 

Inflation, interest rates and investing: Part 3

This is the final in a series of three blogs on inflation, interest rates and investing.   In our previous post, we introduced the idea that asset values in a diversified portfolio are largely determined by three factors: an exposure to growth, an ability to protect against inflation (or deflation) and a sensitivity to changes in real interest rates.  But each asset class in a portfolio has a different sensitivity to each factor and no single asset class is usually capable of achieving all investment objectives as economic settings change. In this final episode we explain the relationships between growth, inflation and interest rates and how they combine together in certain economic settings with historical examples.   We then pull it all together - what asset classes might behave best in each of these settings?   Let us first look at what normally drives inflation.  As the economy grows and business profits and consumer confidence grow along with it, the demand for resources, materials, finished goods and labour services increases.  Accordingly, these goods and skilled labour become harder to find. Capacity constraints and inefficiencies emerge.   Meanwhile, buyers are more willing to endure price rises in a growing economy.  Thus, inflationary pressures naturally rise in a growing economy.  Conversely when the economy is weak and the consumer and businesses are less confident, demand falls and capacity is freed up, meaning inflation usually subsides or there is even deflation.   The real interest rate is determined by how much supply and demand there is for capital to borrow, invest or spend which in turn, is determined by all manner of factors.  All else being equal, as an economy grows, there is a greater demand for capital.  Capital is required to fund expansion of infrastructure, to buy new plant and equipment or to fund consumer spending as people feel more confident about their prospects.  Growth in the economy therefore causes the price of money/capital i.e., the real interest rate, to rise.  Likewise, if there is a decline in business and consumer confidence as the economy weakens, this reduces the demand for capital and generally causes real interest rates to fall.   Central banks are also tasked with keeping inflation low, dampen inflationary pressure by manipulating the real interest rate, tightening bank lending standards and reducing the money supply.  Raising the real interest rate above those natural forces of supply and demand will cool the economy and release pent up steam as capital becomes more expensive to use.  Higher real interest rates focus borrowers on whether they really want to spend money on that new piece of machinery or borrow money to build that new house, invest in riskier investments or instead save at lower risk at relatively more attractive rates after inflation.  Likewise, real interest rates will be reduced to stimulate demand in an economy when in a recession to reduce the chance of damaging deflation.   Accordingly, owing to the influence on economic growth on both inflation and real interest rates and the presence of central bank inflation-fighting mandates, there is usually a strong positive relationship between inflation, economic growth and real interest rates.   That is, inflation and higher real interest rates are usually synonymous with a growing or an even booming economy.  And low inflation, deflation and low real interest rates are typically associated with a low growth economy or one in recession.  This is depicted in the diagram below: real interest rates and inflation tend to move up and down at the same time, because they are related to the typical boom or bust growth cycle of the economy.     There are times however, when real interest rates and inflation rates move in opposite directions.  The first of these less usual scenarios is a ‘deflationary growth’ scenario.  Here, usually owing to a what economists call a “positive supply side shock”, such as a new technology, a new abundant source of energy, mass migration, working population growth or trade liberalisation, economies can grow without serious capacity constraints and avoid the boom-bust cycle.  The UK Industrial Revolution is the classic example of an overall period of deflationary growth.    With advances in technology, a young and growing population and trade, goods became mass produced and cheap. Meanwhile, the demand to build new factories, railways and shipping led to high real interest rates as demand for capital was also very high.    The second, less usual scenario is where high inflation exists alongside low growth and low real interest rates, i.e. ‘stagflation’.  Stagflation often occurs after a period of high growth and debt accumulation that leads to overheating or a “negative supply-side shock”, such as a trade war, over-regulation or energy price hike.  Central banks may choose not to fight the emerging inflation, prioritising other policies instead or fearing a recession and the opprobrium of their political masters.  Without the central bank providing a necessary handbrake, high wage and inflation expectations then become ingrained but growth eventually becomes constrained as private sector investment decisions, already weighed down by excessive debt and discouraged by high inflation uncertainty, are often crowded-out by high government spending. Bottle necks continue to emerge, companies fail, unemployment increases and productivity collapses.  Private sector demand for capital declines and real interest rates fall further. This rather gloomy scenario is New Zealand and the UK during the 1970’s and early 1980’s.  Stagflation also readily emerges through unconstrained money printing and profligate government spending off the back of it.  Venezuela is a recent extreme example of this in a long list of South American economic woes.   In summary, the framework of inflation and real interest rates can be roughly divided into four quadrants with historical examples in the diagram below.   So how do these economic environments translate into appropriate asset allocation strategies?  As per our discussion in Part 2, in an inflationary boom with growth causing rising real yields and inflation, your portfolio benefits from being overweight asset classes that are more responsive to growth than the negating impact of rising real yields has on valuations, but which also have the ability to protect the investor against inflation.  Growth oriented infrastructure e.g. airports, power generation, toll roads along with blue chip companies, commercial property with short or inflation adjusted leases and banks who are able to pass on and even profit from inflationary pressures, should all do well.  Commodities/energy and cyclical equities are likely to also perform, as might property development.  Equally these asset classes will not perform well in a deflationary bust.  Here, high quality government bonds, long term commercial property leases to high quality tenants, certain investment grade corporate bonds and defensive and counter cyclical equities (e.g. supermarkets, discount stores) are likely to perform as their stable cashflows are made relatively more valuable when real interest rates fall and if inflation falls below expectations.   In less usual deflationary growth periods, smaller growth orientated companies understandably perform as these periods create space for new entrants and disruptors, outweighing the drag of higher real rates on their future cash flows.   Riskier, high yielding credit with short maturities e.g.  leveraged loans also perform as leveraged companies do well in growth environments whilst the exposure to rising real rates is relatively muted in comparison.   In stagflationary environments there are few asset classes which do well.  High quality inflation-indexed bonds are an obvious contender as are more defensive infrastructure assets which offer good inflation protection and stable cash flows.    The diagram below summarises some of the above mentioned asset classes which might tend to perform best in these four general scenarios. But these preferences are all relative to other available asset classes – returns might still be disappointing but just better than the alternatives.  Importantly, outcomes also depend on whether the asset class already incorporates that particular scenario into its current price.  Nor does it suggest that portfolios should abandon asset classes altogether for more favoured ones as no one can reliably predict where the economy will be over any reasonable investment horizon.      The overarching message here is that in an uncertain world, the case for a diversified and liquid portfolio that offers flexibility and protection, against not only inflation but also the ups and downs of the economic and interest rate cycle, is crucial.   Investors need to be especially aware that focusing on just one aspect of an asset class’s attributes without considering its other characteristics may lead to disappointing outcomes overall, particularly when you consider the returns after inflation.   To read part two in this series on inflation, interest rates and investing,  click here .   This article is intended as general information purposes only and is not, nor should be considered, financial advice or recommendations.  Where the author expresses opinions, this should not be taken as financial advice for any individual. It should not be used as a substitute for seeking professional financial advice which takes into account your personal financial goals and circumstances.    By  Andrew Bartlett Independent Member of the Quartz Investment Committee   Date published: 10 December 2021

Inflation, interest rates and investing: Part 2

  This is part two is a series of three blogs on inflation, interest rates and investing.   In part one of this series we have told the story of how, over a decade ago, central banks turned their attention away from fighting corrosive inflation towards confronting the spectre of a deflationary spiral.  They printed vast sums of money and suppressed interest rates to very low levels – often below that of inflation.  Yet this so called ‘financial repression’ has also encouraged asset prices and debt levels inexorably higher without, arguably, spurring significant inflation, let alone growth.     Owing to the economic damage of the global pandemic response, central banks doubled down with even more money printing.  This time however, their actions have been accompanied by massive government borrowing and spending.  At the same time, pent-up consumer demand and supply-chain disruption has stoked inflation expectations; perhaps sustained higher inflation might make a comeback.  And with inflation fears, interest rates appear to be on the rise.  If this scenario eventuates, what does this mean for investors? As with all things investments, the answer is not straightforward.  To see why, we first need to appreciate that each asset class has an exposure to essentially three fundamental and related factors.   Growth and Recession It should be no surprise that the current state of, and outlook for, the economy should have a direct impact on the value of an asset class.  Yet its significance may vary greatly. Does Vector, a regulated gas and electricity distributor get harmed by weak economic conditions?  The answer is ‘yes, but not much”.  Vector has a relatively low exposure to a recession because it is a “defensive” infrastructure asset which tends to have a stable, bond-like earnings stream.  Economic growth simply means there are usually some more customers to connect to Vector’s grid and pay fixed line charges.  A gas producer or electricity wholesaler/retailer such as Genesis Energy, would tend to be more sensitive because energy consumption, particularly from large industrial users, fluctuates with economic growth.   Genesis’ assets therefore exhibit more “cyclical” qualities than Vector even though it is also core, essential infrastructure.  Of course, Genesis is much less cyclical than say, a fashion retailer – given clothing is generally a discretionary spend that will often be the first budget to be cut in tough times! At the other end of the spectrum, government bond valuations are usually not affected at all by economic growth or recession per se , unless they materially change the credit quality of the government or its bond supply i.e.  in a recession, government finances are under pressure and will tend to issue more bonds to fund a larger deficit, lowering the bond price.  There are even some assets which are ‘counter-cyclical’, which do well in bad times.  These are admittedly relatively few but may include discount retailers and debt collection agencies.    Real interest rates The interest rate you see on your mortgage or on your term deposit is called the nominal interest rate.  But what you should really care about is the real interest rate since this is your return after inflation.  That is:   real interest rate = nominal interest rate - inflation rate   The impact of changing real interest rates is felt in different ways.  Obviously if Vector has debt, its interest expense burden will rise as real interest rates rise (unlike banks, it cannot easily pass interest costs on to consumers), lowering forecast profits and its valuation. But as we discussed in Part 1, all assets are valued relative to real interest rates.   That is, as the attractiveness of low risk fixed interest assets increases when rates rise, the required return on riskier substitutes such as commercial property and shares must also rise.   All else being equal, the value of those assets will have to fall to then achieve the now higher rate of return.  Less obviously, this effect applies to existing fixed interest investments too, even government bonds and term deposits.  This is because their underlying value will immediately decline to allow their expected return to match the now higher real rate of interest. To the extent that the asset in question has a greater proportion of its returns further into the future than in the near term, the greater the negative impact from rising real interest rates on its valuation.  For instance, commercial property has a lower sensitivity to real interest rates than bare land, since with commercial property there is an ongoing rental stream to earn whereas bare land has holding costs such as rates.  It is only truly valuable in the future sometime when it is sold or developed.  A 1-year to maturity bond has less sensitivity to changes in real interest rates than a 5-year to maturity bond.  Similarly, ‘growth’ companies, where a greater reliance is placed on uncertain future projected earnings (e.g. Tesla) will tend to suffer from rising real interest rates than the likes of a mature, “value” shares such as defensive Vector or cyclical Genesis Energy. The steady decline in real interest rates over the past three decades has worked in favour of asset valuations for all the reasons described above, but in the opposite direction.   Inflation Protection Inflation protection is the ability of an asset class to protect itself from unexpected inflation diluting its true value or purchasing power over time. Real assets are things you can touch and see, such as hard commodities, land and precious metals.  Intuitively, real assets are fully protected from inflationary rust.  Even Venezuelan-style hyper-inflation does not diminish the true value of a piece of bare land in downtown Caracas but is probably worth a lot less because of the accompanying economic collapse!  Certain liquid financial assets such as inflation-indexed government bonds can also typically provide strong inflation protection.  Shares in essential, regulated infrastructure assets such as Vector, Chorus or other companies that have market power (e.g. Woolworths) where inflation can be fully passed on and commercial property with long term inflation-indexed leases, are all examples of financial assets that should also get the inflation-protection tick.   Conversely, smaller, growth-oriented companies with little market power or industries with inflexible cost and revenue structures, bonds and cash itself are examples of assets that may lose value because of inflation.  Short term bank deposits or corporate debt, where there is an ability to reset the interest rate frequently (e.g. “floating rate notes”) have some modest protection from inflation. Be aware however that although some of these asset classes lose value in an inflationary period, they equally might add value in periods of deflation.  Nominal bonds are a good example of an asset which does well in periods of unexpected deflation.  The reality is that although we need to isolate and measure an asset class’s sensitivity to each factor individually, we must take into account that asset class returns are a combination of all three factors.  Accordingly, their behaviours in response to different economic conditions can also be quite different from each other.   In our highly stylised diagrams below, we give examples of asset class sensitivity to all three factors together.    To explain, government inflation indexed bonds and commercial property are considered to have high levels of inflation protection and exposure to real interest rates, but commercial property has a material exposure to growth and recession too.  Does it matter if commercial property protects you from inflation if the economy is in recession or real interest rates are rising? Hard commodities, as real assets also offer good inflation protection but have a much higher sensitivity to growth and recession (soft commodities less so). Shorter term, fixed rate high yield credit, “junk” corporate bonds offer no inflation protection but have a moderate exposure to real interest rates and to economic growth.  Falling real interest rates might benefit high yield bonds but if the economy is in recession, then those bonds might have a greater risk of defaulting. We can easily see that each asset class has a different relative and absolute exposure to each of these factors and when compared to other asset classes.  And the characteristics are more valuable in certain scenarios and in extreme scenarios than others. The case for careful diversification of your investment portfolio in an always uncertain future is already evident.  In our final episode we highlight how these factors may tie together in certain economic settings and what implications this has for such asset classes.   To read part one in this series on inflation, interest rates and investing, click here .   This article is intended as general information purposes only and is not, nor should be considered, financial advice or recommendations.  Where the author expresses opinions, this should not be taken as financial advice for any individual. It should not be used as a substitute for seeking professional financial advice which takes into account your personal financial goals and circumstances.     By Andrew Bartlett Independent Member of the Quartz Investment Committee   Date published: 26 October 2021

The Case for Wealth Management

Why don’t we seek personal financial advice? While the evidence shows a strong relationship between seeking professional financial advice and achieving increased financial prosperity [1] , many are still hesitant to take the first step. We see several reasons for this hesitancy. For starters, it’s fair to say that financial advice services, and more broadly the financial sector, have endured a relatively mixed recent history which has resulted in a decline in public trust. As a result, the wider public have typically waited for a significant ‘life moment’ such as the sale of a major asset, an inheritance or retirement before engaging a financial adviser. More common however is that many of us don’t perceive that we have genuine wealth to manage, that the collection of assets we have accumulated in our lifetimes don’t call for a sophisticated or professional approach to properly manage.   What’s changed? 1. Legislation and Regulations Following major events such as the 2008 financial crisis we have seen the introduction of new legislation and regulations in Financial Services, both internationally and domestically.  These have been designed with the intention of providing consumer protection and increasing trust and participation in financial markets.   2. Organic Wealth Creation Many of our client base are in the wider Auckland area and almost by virtue of owning property have built up sizeable wealth through the equity in their family home. This awareness of equity is beginning to lead many to consider their next step in assessing their financial future. Homeowners begin to understand that indeed they have a balance of wealth that does require qualified expertise and guidance.   3. Access The introduction of KiwiSaver saw many New Zealanders become participants in the financial markets for the first time. While in the early years balances were moderate and participation was largely passive, many New Zealanders are now faced with healthier and ever-growing balances.  With this people are starting to consider the options that this creates. In fact, many KiwiSaver balances are now significant and New Zealanders are beginning to become more actively engaged and ask important questions about what they’re invested in, fees, returns, and ultimately – are they in the right fund for them? Additionally, the inception of online investing platforms has opened up financial markets to a wider audience.  These platforms have helped remove or reduce traditional barriers such as minimum account size and have made market participation far more accessible to average New Zealanders.  With recent Covid-19 lockdowns around the world these platforms saw a surge in popularity as new investors opened accounts.   These changes are all important elements of increasing trust, opportunity, awareness and participation in financial markets, but the missing piece of the puzzle is investors having confidence that their investments are right for them in the long-term and that they’re taking a comprehensive approach to the creation and management of their wealth.   What to expect with wealth management? When engaging the services of wealth advisers, there are a number of obvious tangible benefits to expect. These include access to professionally managed globally diversified portfolios, disciplined rebalancing practices and as research shows, investors who seek financial advice achieve better financial outcomes.   However, the intangible benefits are equally or even more important. 1. Dealing with complexity and ambiguity The role of a financial adviser is also to provide clients guidance in managing the complexities of their investments.  Often clients' assets will include a mix of liquid assets (such as cash, term deposits, shares) and illiquid assets (such as property, KiwiSaver and other superannuation schemes, and business interests). Some will be lifestyle assets, while others will be investments assets to help fund their financial needs in the future. An adviser will take a comprehensive view to develop an overall plan and ensure that all elements are working in harmony to help the client meet their lifestyle needs and objectives now and in the long-term.   2. Help you manage your emotions Emotionally based decisions often end up being bad financial decisions.  Whether it be investors buying high in the ‘fear of missing out’ or selling low because panic set in as markets dipped (even if the level of volatility was still within expected ranges).  Part of an adviser’s job is to help clients manage these emotions and maintain discipline.  Firstly, before investing in anything they will help clients make sure that the investments they choose are suitable for the level of risk that they are prepared to take, and they are comfortable with the range of possible outcomes.  By working with clients on an on-going basis advisers coach clients through the market’s ups and downs and make sure they are still on-track to achieve their long-term goals and prevent them from making emotionally based, and potentially bad, financial decisions.   3. Focus on what you can control While neither the financial adviser nor the client can control what the markets do or plan for every possible change in personal circumstances, by engaging with an adviser clients will build a robust strategy that allows the client the means to deal with change.  By developing a strategic plan advisers help clients focus on what they can control and make informed investment decisions as their life changes.  This gives clients confidence about their financial future and helps them feel less stressed about the elements that are outside their control.   We want our clients to live the lifestyle they want today, while keeping one eye on their financial future. A financial adviser helps you understand how you can make that happen, so you make informed decisions, changes or compromises to help you achieve both goals.   Date published: 18 October 2021 [1]   Money and you - Financial Services Council consumer research report, August 2020

Inflation, interest rates and investing: Part 1

Inflation is like rust; it silently but steadily erodes your hard-earned savings.  Over the years, even modest inflation adds up to a material reduction in the spending power of your cash.  It is a secret tax on savers paid to borrowers and governments.  Protecting your investments from inflation is therefore an important objective.  Thankfully, reducing inflation has been the primary focus of central bankers, such as the Reserve Bank of New Zealand, for the past 30 years.  To date, central bank actions have generally tamed inflation but have been assisted by the favourable tailwinds of trade globalisation and digital technology.   Yet central bankers fear deflation more.  Deflation is where the price of goods and services fall and so the spending power of cash increases.  This phenomenon causes people to hold back on investment and spending because they believe things will become cheaper in the future, creating a vicious cycle of lower prices and lower growth.  Following the property bust in 1989, weak growth and bouts of deflation has been a feature of the Japanese economy.  Following the Global Financial Crisis in 2008-2009, central banks feared a similar Japanification of the Western economies or even a 1930’s-style deflationary depression.  In response, central banks pumped the banking system with cash.  In some cases, they opted to print that cash - more euphemistically called quantitative easing - in vast quantities.  Central banks also pushed interest rates down to historically low levels to stimulate the global economy.  So much so that the returns of low-risk assets like term deposits and bonds have fallen to levels that fail to compensate investors for even modest inflation, and that is before tax.  This so-called financial repression means savers are being deliberately penalised for not spending their savings or taking on greater risk.  To escape financial repression, many investors have borrowed money and invested in riskier asset classes, such as residential property and shares at ever higher valuations and ultimately lower returns or yields.  Interest rates, the price of money, are a key foundation of all asset valuations.  All else being equal, if interest rates fall, asset prices will rise and vice versa.  This spectacular asset price growth witnessed since 2009 was admittedly also an intended outcome of the central bank measures.  The psychological impact of people feeling wealthier means that they are likely to spend more and stimulate the economy.  Whether this wealth effect has worked much is hotly debated, however central bankers have become obsessed with its importance and relatively unconcerned about potential financial excesses, including ever growing debt levels, because of it.   Moreover, at the first sign of share or property market reversal, central banks have comforted the markets by further money printing, lowering interest rates, relaxing lending standards or assuring investors that interest rates will stay low for a long time.   The unintended consequence of this support has led many investors to believe there is no risk to asset prices seriously falling, in turn leading to more borrowing and ever higher asset prices.  The “irrational exuberance” that many people consider to feature heavily in current asset prices, from residential property, Tesla shares and Bitcoin, is therefore being sustained on the belief that inflation and interest rates will stay low forever. In some cases, asset valuations have escalated to certain levels that are hard to reconcile to any sensible fundamental basis, earning a “bubble” moniker.  So what can upset this delicate balance between maintaining high asset prices, some of which are in bubble territory, and keeping interest rates low to avoid deflation?  The obvious answer is a belief by central bankers and markets in general that inflation is more of a risk than deflation and that continuing to keep interest rates low and money-printing will cause a damaging inflationary spiral.   If central banks are true to their inflation targeting credentials, they would then allow interest rates to rise.  This in turn would make all manner of riskier investments relatively less attractive and potentially lead to a correction across many of those asset classes.   Are we now at the point where inflation is a concern and interest rates might rise?  In response to the 2020 global pandemic measures, not only have central banks continued to print more money and lower interest rates, but governments have abandoned fiscal restraint and started to spend that money.  The size of government borrowing and spending is on a scale, in some cases, not seen since World War II.  This government spending is likely to be mistimed as economies emerge quickly from post-Covid hibernation and often wasteful.   The ingredients for a return of inflation, even relatively modest inflation, are more readily recognised.  And in New Zealand, barring a return to Covid lockdown measures, inflationary pressures are already apparent.  Yes logistical challenges and closed borders because of the pandemic response have caused price pressures for a number of goods and services but many economists believe the Reserve Bank of New Zealand will begin, after already halting its money printing programme, to steadily raise interest rates.  Next blog we will discuss what rising interest rates and inflation may mean for different asset classes but also what other scenarios may await our future.     This article is intended as general information purposes only and is not, nor should be considered, financial advice or recommendations.  Where the author expresses opinions, this should not be taken as financial advice for any individual. It should not be used as a substitute for seeking professional financial advice which takes into account your personal financial goals and circumstances.    By Andrew Bartlett Independent Member of the Quartz Investment Committee   Date published: 26 August 2021

What now for Residential Property Investing in New Zealand?

What now for Residential Property Investing in New Zealand? The Government’s recent announcement of changes to the treatment of residential property has been well documented. The likely impacts however have been less publicised. In this blog, we are going to look at what it all means for existing property investors. Before we do that we should back up to look at what was happening in the market and why we believe they may have stepped in.   Let’s start with the charts that tell us the price change over time of NZ property over time. Source: REINZ April 2021. Not inflation adjusted.   As you can see, there have been significant rises over time but little evidence that there have been any significant decreases. We see periods of flat line growth with growth rates resuming in the long run.   Why has this been the case? Consensus on the reason for growth vary but there are several contributing factors. A growing population with limited housing supply has certainly been a factor in driving demand and in turn putting pressure on prices. With the addition of low interest rates and somewhat generous tax systems that supported negative gearing this created a strong environment for investment. With these ‘incentives’ to invest in place, for many it made sense to invest in the market. While investors continued to enter the market it exacerbated the issue of higher prices and made the environment more challenging for first home buyers. First time buyers’ savings could not keep up with the deposits required to make their first home purchase. In this blog I will not debate the issue of whether residential housing is a social right or can be simply treated as a business investment, the reality was, prior to the change, it made perfect investment sense to purchase property in this fashion (concentrated risk not withstanding). As we know, politicians have short life cycles and are very rarely bold in their strategic outlook, however they are certainly incentivised to make moves if there are grumblings on the ground amongst their voters. These grumblings have been accumulating for quite some time, and the Government appears to have just “snapped” and implement significant change. And these changes are significant.   The Changes The key change in our view was to remove mortgage interest rate deductions progressively over four years from existing homes. Our initial modelling suggests that for an existing property investor on a top marginal or trust tax rate, with a moderate to high LVR (loan to value ratio), will move from potentially receiving a cheque from the IRD each year to paying a significant cheque each year. We calculated for a property investor with four or more “average” homes in Auckland or Wellington the difference could get into six figures. While this impact on most investors will be small for the next 12 months it does become significantly larger over time.  We’ve modelled that for an owner of a $1m rental property on a 60% LVR interest only arrangement, it will cost them a further $1,000 in year one, progressively increasing to further $7,700 by year five. A figure not insignificant on a current rental yield of 2.5%. And if an investor buys an existing home for rental usage, then there is no interest deductibility at all from 1 October of this year. Another change is the Brightline test extension to 10 years (from five), which applies to any unconditional made sales after 27 March 2021.  Additional changes have been made to the main home exemption, which matters for clients who may rent out their properties for parts of the year; some of any future gain on sale may be taxed.   So all in all, not favourable. But what are potential impacts going forward?   Macro Impacts The difference in cash flows will be very material for some investors, particularly those who have multiple properties and don’t have a spare free cash flow from other sources to make up the difference.  So we can expect to see some potential selling pressures (compounded by the tenancy act changes), which on balance may lead to outright house price declines. It should be kept in mind a 20% fall just re-winds the clock to where things were a year or so ago!   At the very least, the tax shifts should remove perception that residential property investment is a “sure bet.”     We may see some investors look to sell older houses to replace them with new builds. The Government has effectively retained the incentives for investors who look to finance new builds via the proposed approach of allowing them to continue to claim the interest expense deductibility. The moves should also help accelerate new building activity given they have a much more favoured tax position now compared to existing homes. More new homes equates to greater supply to match demand, which may slow price rises. Investors may also look elsewhere for investment opportunities. Smart investments are all about setting a strategic financial plan based on your personal circumstances and lifestyle ambitions and  then deciding what is the best implementation approach required to achieve it. As the “family home” is not subject to capital gains, people may choose to upgrade their homes instead of investing in a rental property. That is, instead of owning a $2m home, instead purchase a $3m home and, while you are unable to deduct the interest expense for tax purpose if you are borrowing, at least any increase in value will not be subject to capital gains should your circumstances change and need to sell within the 10 years Brightline test. It may still make sense for those with cash on hand to buy residential investment property outright and appreciate a 3% return (currently). But one still needs to consider concentration risk as opposed to asset diversification, illiquidity of the asset purchased, and any likely future capital spending requirements (new roof, government requirements regarding rental standards). Additionally, while commercial property may now be a better alternative it is not without its own challenges…and a blog for another time.   Clearly there are significant challenges ahead. Our recommendation is to take a holistic view of your ambitions from both a lifestyle and financial perspective and seek advice and expertise wherever possible.     Date Published: 30 April 2021

The issue of low interest rates

As we come out of the holiday period and life resumes, one of the many questions we are now pondering is where to invest during this period of low interest rates. The answer, of course, greatly depends on whether you’re a borrower or an investor.  The impact of low interest rates on borrowers Obviously, the conditions are much better if you’re a borrower in these times of low interest. This is especially true for consumers, governments, and businesses with strong credit ratings. As the government works its way through the pandemic, low interest rates make taking on additional debt for stimulus purposes and servicing this debt much more manageable. For us as consumers, interest payments on mortgages decrease and we are in a position to either pay down more principle on our loans or have access to more funds for discretionary spending. Consumers may also choose to build their investments through an investment property or other assets. Businesses too have options in these periods of lower interest rates including the ability to access cheaper capital that could see them fund innovation or make upgrades to plant, machinery, and equipment. Impact of low interest rates on investors Depending on what type of investments you hold, prolonged periods of low interest rates generally have weaker results. Cash accounts and term deposits have low rates and bonds have only marginally better returns. With that being said, share markets and private equity firms can fare well in these periods as they deliver greater returns for their clients than cash holdings would achieve. Businesses with greater access to cheaper finance are in a better position to grow while remaining profitable and some continue to pay dividends during these times. Over the past year we’ve even seen companies that are not yet profitable or that are not paying dividends experience share price growth. While many investors focus on dividend payments as a measure of the success of their shareholding, the capital growth of an equity is also an important consideration. It is possible for investors to create a revenue stream from capital growth by selling down some of their shareholdings as total value grows. This too can be a method for creating more free cash during a period of lower interest rates. The plan As always, our advice is to have a plan established so that you are prepared prior to any economic changes. This plan needs to consider more than your short term cashflow goals, it must also consider where you are in your life stage and your desired view of the future. In short; what’s right for you. Our view is that this is the best way to significantly reduce the stress of ‘I’m getting nothing at the bank, what should I do with it?”   Date published 29/01/2021

Explaining Wealth Advice – who is it for?

Most of us understand the concept of wealth – but do you have a full grasp of what wealth advice is? You’ve probably seen the phrase pop up in articles on investing, in retirement literature or even thrown around by family and friends. One of the myths pervading wealth advice is that only the rich or those with money to invest can benefit from it. However, that’s not entirely accurate. Our clients often tell us that they wish they had come to see us earlier in their lives – before they had money to invest.  Many young ambitious New Zealanders can gain advantages from a wealth advisory programme before they’re ready to invest.  In fact, the earlier you start planning your future lifestyle, the more opportunity you have to create better financial outcomes throughout your life. What is wealth? Most people have some degree of wealth, but not everyone has a clear understanding of what their true wealth is. If you are younger, you may not feel “wealthy” – especially if you have children or mortgage repayments draining your income. Yet if you were to look closely at your current assets, what you have tied up in KiwiSaver, and other pockets of savings, you may be surprised about how “wealthy” you really are. Once you understand your current financial situation and where you need to get to, there’s a raft of things you can do to make your money work harder for you. This can range from behavioural changes, developing cash, debt and investment strategies, looking at your insurance, managing your taxes better and much more. If this sounds overwhelming, don’t worry – this is exactly where wealth management comes into play. What does a wealth adviser do? Wealth management is about looking holistically at your current financial position and putting into place a strategy to help you achieve your lifestyle goals. It’s about understanding what is important to you and building a plan to make that happen.  A well thought out wealth management programme will help you become financially resilient. Everyone has ups and downs in life, and the same goes for money – but with a good wealth management strategy you’ll have a roadmap to weather any situation, from job loss to retirement. Research shows that there is a direct relationship between money and wellbeing [1] .  Having a plan in place will help you stay in control of your wealth, reduce worry and help you feel reassured should the worst happen – something the recent global pandemic has certainly shown us the value of having! Why are there so many misconceptions about wealth advice? There’s a lot of misunderstanding about who wealth advice is for, when to use it and where to find the right advice. Often wealth advisory services are only sought when there has been a life or financial event, such as the sale or purchase of a business or property, or an inheritance.  This misperception about wealth creates a barrier to people seeking advice. While a wealth adviser can certainly help you if you’ve sold your business or the family home, many are unaware that you can actually start planning your wealth much earlier than that.    Should I consider working with a wealth adviser? We think everybody should consider wealth management services, because research shows that those who seek professional financial advice achieve better financial outcomes. They are “more able to live within their means, have more savings and are able to pay down debts quicker, and tend to have more investments.” 2 As wealth compounds over time, a young person with 30 years left in the workforce has a real advantage. By putting the right strategy in place early, they have the opportunity of living the life they want by growing their wealth to its full potential. The key thing to remember is that wealth management isn’t just the domain of the uber rich or those ready to invest. It’s a journey to a better lifestyle, enabled through the best possible plan to manage your personal financial situation. Whether it’s making work optional earlier in life, buying your dream house or financial security for your family, creating a plan today to manage your wealth will help you reach your financial goals tomorrow.   Quartz Wealth has developed new services and has a new wealth portal to help people start their wealth management journey earlier in life. Contact us to find out how you can start planning for your future.   [1] Money and You - Financial Services Council consumer research report, June 2020 [2] Money and You - Financial Services Council consumer research report, August 2020    Date published 29/10/2020