INSIGHTS

IS THE PRE-GFC RISKY BEHAVIOUR RETURNING?

Mark Lister, 18 January 2016

The protagonists in the film "The Big Short" were insightful (and brave) enough to bet big on a crash and make tonnes of money, but most people would probably settle for simply avoiding getting caught up in the aftermath.

It's easy (and probably quite fair) to condemn the bankers, authorities and rating agencies, but investors aren't blameless either. Many were greedy, complacent and too accustomed to the big returns of the preceding few years to question whether it was all sustainable.

In New Zealand, there weren’t too many of the risky securities portrayed in the movie on offer, thankfully. However, we saw similar behaviour in those years to some offshore. Investors demanded higher returns, so were tempted into finance companies offering higher interest rates. Shares and property were booming, so many ignored diversification principles and piled in.

A year like 2008 could happen again, and unfortunately some of this risk-taking behaviour has crept back into the mind-set of some investors.

Some have relaxed their standards for fixed interest credit quality to get better returns, others have abandoned fixed interest altogether for shares in the search for yield, and plenty are assuming that capital gains from houses continue forever.

The building blocks of investment returns are economic growth and inflation, which drive interest rates, earnings and prices. When growth is strong, inflation tends to be high and this usually sees interest rates at above average levels. Periods like this usually go hand-in-hand with strong performances from share and house prices.

This was the case in the 1970s and 1980s, when inflation was averaging 11-12 per cent a year. The six-month deposit rate was 12.4 per cent in the late 1970s, and it averaged 13.7 per cent through the 1980s.

But times have changed. Global growth is subdued, and likely to stay that way as the world gradually recovers from its indebtedness, changing demographics and other issues. There is little sign of inflation anywhere, as well as ongoing loose monetary policy from central banks. Consequently, at 3.3 per cent the six-month deposit rate is the lowest we have seen since 1966.

People expecting (or being promised) high returns against this backdrop should ask themselves what sort of risks they need to take to generate such a premium over government bonds or low risk deposits, which offer little more than 3 per cent.