Is a Recession a Bad Time to Invest?
Is there light at the end of the tunnel during a recession?
In the wake of Covid-19 and the responses of governments worldwide, investors have been concerned about inflation and higher interest rates.
Higher interest rates make it more expensive to borrow money, reducing the amount people are willing to pay for assets, such as shares, bonds and real estate. This can lead to declines in asset prices.
The good news is that higher interest rates are working and inflation is being brought under control. Investor confidence also seems to be returning.
Higher interest rates do slow down economic activity – it’s the medicine we need to swallow to tame inflation – which can lead to a recession, as we’re now seeing in New Zealand.
Businesses and employees tend to see slowdowns as threats, whereas investors know there are opportunities to find attractive longer-term investments.
This difference in mindset restarts the business cycle and enables asset values to begin to move upwards again, often long before any slowdown is said to have ended.
In fact, by the time an economy has reached the end of a recession, the share market has on average already risen 25% from its low. Why? Because investors are forward-looking and economic data is historic
The benefits of longer-term investing through a recession
Investors also know that investing in growth assets, such as shares, has paid off over the long run.
The chart below shows the returns of some of the main asset classes since 1969 (pre-fees and pre-taxes). The chart highlights some big events, but there were others, such as two oil crises in the ‘70s, the Gulf War, 9-11 and Brexit.
In spite of these events (or perhaps partly because of them), economies kept growing, business profits kept increasing and the share market moved higher.
When you zoom out, the compound returns of shares over that period ended up six to eight times greater than those from investing in cash or bonds.
Of course, there were significant challenges along the way and every investor experienced the journey differently, depending on factors like the particular assets they held, the timing of their investments and taxation. Yet, while no guarantee of future returns, it is clear patience and a willingness to accept risk are rewarded.
Right now, we are focused on helping clients position their portfolios to benefit from the next phase of the business cycle and identifying assets with compelling risk-return profiles. We believe this should be your focus too.
Our job as financial advisers is to help clients find the right balance between investing in shares and other growth assets, for the potential of higher returns, and investing in more stable assets, such as cash, for lower but more consistent returns.
Are you a genuine longer-term investor?
This is an excellent question that we heard recently. It highlights the importance of always remembering that most client portfolios (or at least a subset of their portfolios) are designed and managed for the longer term – 10 years, if not much more.
When markets go through a volatile period and the value of a portfolio is impacted, there is a tendency to lose sight of the bigger picture.
My focus is on helping my clients achieve their longer-term goals by ensuring they ride out any volatility. In other words, building a plan, sticking to the plan and being genuine longer-term investors.
What to make of higher interest rates during this recession?
With the Official Cash Rate in New Zealand now at 5.5%, the interest rates offered by banks have risen to attractive levels for shorter-term investors, particularly for wholesale investors like Fund Managers.
This is where ‘unlocked’ PIE Cash Portfolios come to the fore because we can access investments in 3-month securities (bank bills) issued by major banks. These bank bills currently offer around 5.65% pa. After fees, this means our clients receive a running yield of around 5.25% pa (at the time of writing).
In addition to the attractive interest rate, Cash Portfolios like this offer other benefits:
- Tax efficiency: As the Cash Portfolio is a PIE, tax is capped at 28%, which is a sizeable advantage for anyone on a higher marginal tax rate. The benefit of paying less tax can be seen as an increased effective interest rate. So, for example, if you’re on 39%, a term deposit has to pay 6.2% p.a. to achieve the same after-tax return.
- Liquid and simple to administer: Unlike term deposits and term PIEs, which are locked in, investments in a Cash Portfolio like this can be withdrawn within four days without incurring any costs. You also avoid the hassle of calling a call centre to roll over your term deposit (we know how painful hold music can be! That leads me to another topic for another time: Why do NZ banks owned by Australian banks play NZ music instead of Australian music when customers are on hold? Maybe they think some Cold Chisel may infuriate us Kiwis on hold even more? He he he…).
- Diversified and not volatile: the Cash Portfolio is invested across multiple banks (e.g., ASB, BNZ, Kiwibank and Westpac) and 3-month bank bills do not change in value like shares and bonds.
A Cash Portfolio like this can be a great option for shorter-term funds, such as excess cash or cash earmarked for a near-term purchase.
But as the goal for most investors is to obtain a return that exceeds what you can get with cash, as the chart above shows, it’s important to have the right allocation to shares and other higher-returning assets.
For some, they simply want to sit out the volatility of the markets, and I get that. Whilst I wouldn’t recommend investing in cash, unless those funds are intended to be spent in the next two years, investors on the more conservative end of the spectrum may want to sit things out for now but still get a good return, pay less tax than their income tax rate, and have accessibility to their funds within days, and without breaking a term deposit. I get that….
Where there’s a will, there’s a way. Remember this: Don’t save, invest!
Daniel Carney
Financial Adviser
Goodlife Financial Advice