When the Reserve Bank announced a new official interest rate of 0.1% on Melbourne Cup day, they were presiding over the lowest official interest rate in Australian history. As part of the announcement the RBA also confirmed they will be purchasing $100 billion worth of government bonds over the next six months. Their intention is to stimulate the economy with an expectation of lower interest rates for the next three years. With the economic environment uncertain the RBA governor also suggested that further stimulus may be needed, leaving open the very real prospect of negative interest rates.
Central banks have historically managed their interest rate targets in line with maintaining “healthy” and sustainable levels of price inflation – generally around 2-3% per annum. When the economy is booming and inflationary pressures emerge, the RBA will raise interest rates making the supply of money more expensive and dampening demand for new goods and services. The economy slows as a result.
Conversely, when economic growth is poor and demand needs to be stimulated, the RBA lowers interest rates, making the supply of money cheaper. With the official interest rate at 0.1% there isn’t far to go before we are in negative territory.
Negative interest rates were first seen in Europe post GFC when drastic measures were needed to kickstart growth. In Switzerland the official rate in January 2015 was -0.75% meaning depositors effectively paid the banks to keep their money safe.
In the initial stages of falling interest rates, most growth asset classes respond well and that has certainly been the case in 2020 with shares and residential property defying the underlying weakness of the economy. Many investors are seeing the opportunity to borrow money at historically low interest rates to invest in growth assets.
As this recession and low rate environment continues, we will likely see an adjustment in the expected returns on most assets.
On the right we can see that when the risk-free rate falls, so should the expected returns on all asset classes. Higher risk still equals higher returns but if the starting point is a return of zero, the expected returns on all other asset classes will also be lower.
Now none of this information is intended to unsettle investors although it is a transparent reality check of the economic environment we are in. We do see several traps for investors driven by low interest rates, and we want to share our thoughts on how you can avoid these traps.
Seeking higher returns by taking higher risk
Increasing exposure to shares – Low interest rates on cash are hard to swallow. What was a 3% return on cash three years ago, fell to 1% last year and with current interest rates so low, returns are negligible.
Most investors have a natural urge to do something about low returns as the idea of lazy money isn’t attractive.
One of the trends we are seeing in the market is investors taking money from their cash reserves and investing in shares. This is fine if you can afford to take the risk. The big but is that most investors hold cash for a reason – to fund immediate expenses and to provide a buffer against the inevitable volatility of the markets.
When markets do head south, this search for higher returns will end badly for some investors.
Seeking higher credit returns – Another alternative to get higher returns is to take more risk on other defensive assets. This keeps money in the defensive allocation but seeks higher returns through assets like hybrid securities, non-investment grade bonds and other riskier lines of debt often found in credit funds.
We have recently seen the collapse of the Mayfair Group which offered high yielding deposits marketed to be the equivalent in security to a term deposit. Many investors took the bait only to find the promise of higher returns was a hollow one. The current low-interest environment is an ideal time for promoters of credit products offering higher returns and we expect to see a proliferation of these offers in the months ahead.
Investors always need to remember the adage, that there’s no such thing as a free lunch when it comes to investment risk.
So, what to do?
The interesting observation we make about the current environment is that despite all temptation, the best strategy is almost certainly to maintain the investment plan you set out with. When we design an investment plan we do so with extreme economic and market events in mind.
Let’s say you commenced your investment plan five years ago. If it was done properly you will have considered three critical things:
- How much risk do you need to achieve the desired return;
- How much risk can you afford to take if markets or the economy turn bad; and
- How much risk do you feel comfortable taking?
If the portfolio is properly constructed around these parameters, the current market environment should not be a concern to you. While returns on defensive assets are low at the moment, growth assets are performing well. When markets turn – as is inevitable – the defensive assets will be there to cushion the impact and will continue to fund your lifestyle during the recovery.
This is undoubtedly a testing time for all investors. The stock market seems too good to be true while returns on cash are testing every expectation we have ever had. However, we do know that an economic recovery will follow in time and with that will come a return to more normal conditions.
Until then, hold on tight and while you should review all your plans, be mindful that this is a very unusual time and patience will be rewarded.