Investors need to adjust to changing market conditions but not fear them, Nikko Asset Management NZ head of bonds and currency, Fergus McDonald, said last week.
McDonald told the Nikko 2018 Investment Summit audience that “certainty has become a very rare commodity” in markets this year.
He said a raft of issues had conspired to raise investors fears early in 2018, including: the end of central bank extraordinary monetary measures; rising rates; concerns about the effect of aging populations on demand for assets; ‘twin deficits’ in the US; looming trade wars; and technological disruption.
“Investors need a greater return for that uncertainty,” McDonald said, which has been reflected in the higher bond yields and rising equity market volatility.
“But there’s always a tipping point with interest rates,” he said. “Lower equity prices will limit how high bond yields can go: that connection isn’t broken and I don’t believe it ever will be.”
Historically, rising rates have only had a “transitory” effect on investment grade securities, McDonald said, citing the last significant bond market crash in 1994. He said while the bond market took a hit in 1994 it was “bookended” by high annual returns.
The Barclays Aggregate bond benchmark was off -2.92 per cent in 1994 compared to returns of 9.75 per cent the previous year and 18.46 per cent in 1995.
In the current hiking cycle the NZ official cash rate would probably peak at 3.75 per cent, McDonald said, equating to mortgage rates of up to 6.5 per cent.
While NZ mortgages at the peak rate might suck about $5 billion out of the economy (or 1 per cent of GDP), he said the approximately $230 billion on term deposit would uplift income on the other side of the ledger.
Of the current NZ housing stock valued at about $1 trillion just $260 billion – or just over a quarter – was mortgaged, McDonald said.
He said default risk was also low in NZ’s corporate bond sector, which was arguably of better quality, albeit much narrower, than global credit markets.
And while NZ short-term bond rates were now lagging the US (and about par for 10-year securities) that disparity would “only matter if NZ can’t fund itself”.
McDonald said of the roughly $62 billion of outstanding NZ government debt about 60 per cent is owned overseas.
“The latest $2 billion [NZ government bond] issue was three-to-four-times over-subscribed with 60 per cent of buyers offshore,” he said.
Low and stable rates were “overwhelmingly” positive for the NZ economy as a whole, although the short-end shortfall versus US rates could stymie the popular ‘forward points’ trade.
Reversing a long-term trend where NZ short-term rates have been higher than the US could see fixed income investors lose the forward points benefit for owning US dollar-denominated assets.
“We could see a switch back to domestic asset classes,” McDonald said.
