August Wrap Up - The only way is up (for now)

August was another solid month for growth assets like shares, supported by the increasing possibility of cuts to short-term interest rates in the United States. In many ways the most interesting story of the month happened to longer term interest rates. 

Around the world in countries like the US, UK, Japan and Europe, long run interest rates have been under pressure and rising - the culprit being burgeoning fiscal deficits. In short, governments are borrowing too much, and investors are fretting about how this will be funded. This is a trend we have been aware of for some time and have positioned portfolios away from these long-term rates towards shorter maturity bonds. 

Being active in how we manage your money and positioning portfolios to protect and profit from long term economic trends is an important way we help build your wealth. 

August was another solid month with share prices hitting all-time highs in Europe and the United States, propelling the overall world share market to record levels. The New Zealand market (NZX50), which has lagged global markets for the year, posted a near 1.0% gain boosted by a cut in the official cash rate by the RBNZ and a dovish outlook pointing to further rate cuts. Absent a return to recession, lower interest rates should buoy the New Zealand share market.

While the news for share investors has been good, for fixed income investors it is more mixed. Overall fixed income performed well in August, but that hides real pressure in the long end of the yield curve (that's financial market speak for longer maturity bonds). 

This is an important consideration as we build portfolios. 

While receding into the past, thankfully, the COVID-19 pandemic continues to create echoes through the global economy. John Cochrane, a well-known economist, wrote on this issue recently, noting: "In the COVID-19 pandemic, the US spent nearly $5 trillion, mostly in the form of checks to people and businesses." He added that: "fiscal policy did not return to normal, or normal levels of dysfunction, after the pandemic waned. The Biden administration passed an additional $2 trillion stimulus in February 2021, quickly followed by the CHIPS Act, the hilariously named Inflation Reduction Act, and more. Unprecedented deficits continued."

While fiscal deficits can be a good thing if the money is spent wisely and governments have a credible plan to return to surplus, trouble brews if either of these tests are not met. 

Burgeoning fiscal deficits raise the risk of inflation. Cochrane has some good thinking on this, and they also need to be financed. Think of it as having to go to your bank to keep borrowing ever-increasing amounts. Eventually the bank will say no.

While bond markets aren't saying no to governments' insatiable desire to borrow, they are increasingly asking for higher interest rates to make it worth their while and to compensate for risk. This has meant ever rising long-term interest rates.

The numbers paint a grim picture. Over the past three years, US 30-year bond yields have risen 1.6%, UK 30-year bonds 1.9% and Japanese long-dated bonds 1.9%. While understanding exactly what drives market pricing can be a dark art, the Financial Times opines: "The market is not saying countries will inflate their way out of debt, but rather sovereign borrowing requirements will be so high that higher interest rates will be needed to entice an adequate amount of money out of savers' pockets."

Higher interest costs can then compound the problem given that governments must borrow even more just to cover interest costs. As an example, US interest costs already exceed the country's spending on defence and are approaching the spending on Medicare. It does not look sustainable. This is, somewhat obviously, a problem!

As an active manager we have choices about where we invest your hard-earned money. Persistent fiscal deficits and the risk of higher inflation is a key consideration as we build portfolios. 

That means we are positioned away from owning longer term government bonds, preferring shorter maturity issuances and corporate bonds which also tend to have shorter duration. This positioning has meant that we have been able to help protect portfolios from rising long-term interest rates and, with our investment in inflation linked bonds, position the portfolio should inflation continue to be persistent.   

Allied with this we continue to hold a small allocation to gold in portfolios. This performed strongly in August, rising to new all-time highs, and is a good hedge for both inflation risk but also from any instability should bond markets grow increasingly nervous about the levels of government indebtedness.