A bad weather warning on the horizon?
The ‘ZIRP’, acronym for zero interest rate policy, that has been applied by many of the large global economies since the financial crisis, projects some bad weather warnings on the screen of pension investors the consequences of which are not all that clear.
More directly it has been eroding the social security systems of these countries as these systems are to a large extent dependent on fixed interest instruments delivering real returns. Those that are still actively contributing towards their social security systems will be on the losing end of this equation and will either have to pay in ever more or will experience ever declining old age provision and will have to make supplementary provision. Those that are already receiving benefits will be faced with a steadily declining standard of living as the result of the systems not earning real returns anymore.
More indirectly, savers have been turning their backs on fixed interest bearing assets in favour of equities, property and other assets that generate real returns. As the result global equity markets, property and a number of other markets are bloated. At some point in time this imbalance has to correct as no one can afford to invest in an asset returning negative yields in the long-term while flows into such assets will eventually dry up.
When the inevitable turning point comes, any investor who has placed his reliance on capital appreciation of his investments – caused by the search for yield in areas other than fixed interest assets – will experience disappointment from a decline in the valuation of equities, property and other bloated assets.
An analogy to a decline in market value of equities that the man in the street is probably more familiar with is a decline in the property market. If you own a property and you live in that property, a decline in its market value is unlikely to be of concern to you, unless you leveraged on the increasing value of the property to incur debt. The value of any debt will not change of course, no matter what happens to the value of your property and debt typically must be repaid. If you wanted to sell your property in order to purchase shares or other assets, a general decline in bloated asset values will mean that you will now get less for your property, but at the same time you will probably be able to purchase another asset that has also declined in value.
Similarly, if you bought the property to generate an income for you to live off, a decline in the market value will not impact immediately on your rental income but as tenants find alternative shelter whose rent is now calculated on a lower capital value, you will eventually be forced to reduce the rental on your property as well.
So why should your share investment be different? If you are not required to sell you shares, a change in their value will not affect you, alternatively you will be able to exchange value for value, be it at a lower level. But why does a pension fund investor invest in equities at the end of the day? You require an income to live off when you retire. If you have to sell to survive, you will have a problem because you will get less than what you had bargained on. What you will be left with is the dividends generated by your shares. And of course we are aware of inflation so your dividends should not remain constant but grow with or above inflation.
In summary, if we are facing declining markets, selling lower without simultaneously buying lower will realise investment losses that would otherwise not have been a problem for the investor. A pensioner who needs to live of his pension investment will be selling if he draws at a rate higher than the dividends and other income generated by the pension investment and will be realizing losses as he continues to sell down his investment into declining markets. This should be avoided at all cost. Furthermore when choosing his investments, he should look out for investment generating high and growing income.
Unlike property, where your income is a function of the market values in the long-term, dividends are not a function of the underlying market value of the share but are a function of the turnover generated by the company and the expenditure incurred by the company to generate the turnover.
In view of our expectation of a continued sluggishness of the global economy and the risk of rebalancing between fixed interest assets and equities, primarily, yield will be hard to get by. The basic principles are to spread risk and to look for value in assets that generate high yields with superior growth prospects. The pension fund investor should continue to focus on achieving real returns of inflation plus 4% to 5%, i.e. be content with returns of between 10% and 12% for the next 12 months. Ideally this yield should be generated by your dividend to avoid being dependant on selling assets to realise capital gains.