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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.     By Andrew Bartlett Independent Member of the Quartz Investment Committee

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.  

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 202   Date published 29/10/2020