As discussed in our last commentary, these are extraordinary times for the Australian investor and even more so for the global investor. We have, these days, ridiculously low cash rates and bizarrely low bond rates, with several countries actually having negative yields. Cash rates and bond yields have fallen even further in the last couple of months.
And all this is while equity and property markets remain strong despite having ‘bouts of volatility’ about the same thing, aka the China/US trade war. Cheap cash and lower interest rates should help boost markets and activity. That is what central banks are hoping for, with fingers crossed! Yet, it is more complicated than that, and more needs to be done.
The weird concept of negative interest rates/yields has many rational people confused. What are negative interest rates really, and why are they becoming more prevalent now around the globe? Why on earth would people buy a guaranteed negative returning asset, particularly when there are other asset classes that will or at least have a far greater chance of a good positive return to the investor?
Turning directly to the negative interest rate situation. I consider there are two types of ‘negative returns’. In the first case, and one that is now an actuality here in Australia, is where you earn a positive nominal interest rate return on your cash, term deposit or bond however, now, when the interest or bond coupon is less than the prevailing CPI i.e. level of inflation in real terms you will lose money. If you earn less than inflation (which is currently at an annualised rate of 1.6%), your investment is effectively losing money. For example, if you, an investor, bought an Australian Government Bond (AGB) today and held it to maturity, you would yield 0.68% p/a for a 2yr AGB; 0.70% for a 5yr AGB; and a paltry 1.01% for a 10yr AGB! And should you pay tax on your meagre interest earnings then that loss in real terms will sadly be accentuated!
In the second case, you will also actually lose money; meaning lose it in two forms in terms of the money eventually returned to an investor in nominal terms as well as in real terms! Europe is a clear case where this is now occurring. The German Government Bund (GGB) is a good example to illustrate this such scenario. If you, say a German investor, bought an GGB today and held it to maturity, you would simply lose money, full stop! You would get a negative yield of -0.74% for a 2yr GGB; -0.70% for a 5yr GGB; and -0.45% for a 10yr GGB! To explain this scary outcome using the 5yr Bund as a current example. You are offered 0.00% coupon (interest) on the bund, which you can buy now for $103.57. Then, when it matures in five years’ time, the government gives you back $100.00 being the face value of the bund. So, the loss locked in, both in actual cash terms and even more so in real terms! Go figure!
So, why are such securities being bought? There are several reasons. I think, out of habit of people just buying good old bonds; out of a belief that it is still good to always own bonds in a portfolio for diversification; and also because, other than high growth investors, all other portfolio profiles will include bonds, to varying degrees, in a portfolio. When bond prices are rising (and thereby yields falling), as has typically been the case for several years now, bond returns have been good – but only if you offloaded the bonds and have not held/hold them to maturity when the revert back to the lower face value on the designated maturity.
Bonds are generally considered defensive, low risk investments. However, the whole question of investors owning bonds now is becoming very questionable. Yes, we do need diversification in investment portfolios, but buying more bonds now when bouts of market volatility occur, is probably not the answer! Certainly, being overweight bonds in these times does question logic especially where investors require income from their investments.
There is a lot of talk by local economists and the like about activity and growth being quite stagnant, and even of a recession here being imminent. I do struggle to see ‘this’ recession happening here soon, especially with the recent tax cuts still to kick in and our relatively strong employment rate. Have you tried to find staff in recent times? It is very hard! I speak with clients from many areas of business and, like financial services, finding the right staff is probably the biggest challenge facing many firms here.
Yes, a recession may mean tougher times are prevalent, but recessions are part of economic cycles. They do not happen often, and supposedly, very rarely in Australia, but they do and will happen, as do expansionary and boom periods to which we are more accustomed too! Economic cycles happen. Of course, Australia is part of the world of economies, so we are prone to overseas events and economic cycles as well as to how things are going here.
Certain business sectors, such as retail, are definitely feeling the pinch and the grip of global competition and of online purchases being so readily available in these times. The impact, speed and development of the internet and similar technology combined have changed our world (especially retail) forever. People and businesses have to adapt and evolve so quickly now. We live in this world that is faster and faster with even more and more information available. It is a challenge for all especially handling and manoeuvring with this continual pace of change. It is all this rapid change that I consider is what does create discomfort and uncertainty, at various stages, for businesses and for people alike.
One outcome of all this increased visibility, globalisation and increased competition via access to more markets to access more and cheaper goods, etc. is that inflationary pressures have reduced globally. However, speaking of inflation, I remain perplexed at how the Bureau of Stats comes up with continually low annualised inflation numbers. Other than some food items being possibly unchanged in prices, virtually everything else seems to be rising at rates well faster than official weighted inflation figures. Any services, insurances, education, health, council rates, fuel and travel costs just keep going up. And there is little wage growth to combat these rises to the consumer and their families. At least mortgage rates are coming down, so this is a cash flow boost to many households. There is ‘talk’ that inflation will fall even further, but this could well change if stimulatory monetary and fiscal measures do gain traction.
I do think that consumer and business confidence has waned. So why is there this ‘flattish’ sentiment supposedly around. The sheer pace of change, discussed above, brings with it fatigue and uncertainty. What also cannot be underestimated is the negative impact that the Labor election campaign had on investors and businesses for the many months leading up the Federal Election held a few months ago. Fortunately, Labor failed to get elected because of the recognition by voters of Labor’s regressive and class segregation policies. Nor can we underestimate just how damaging has been the Banking Royal Commission for the country. Yes, there have been the remediation benefits to impacted consumers, however, the sheer financial cost, reputational damage and the pulling out of, or the reduction to, many banking and financial services, and to lending by the banks,’ as a consequence of the Commission has, I fear, outweighed the intended benefits. It was a political football. Labor had said it would undertake a full banking enquiry when it came to power, so Turnbull jumped in beforehand to say that ‘we’ will do it. A country must have a strong banking sector (and ideally one with very strong ethics) to underpin a strong economy. We are all paying for the Commission’s outcomes. Ignoring the argued benefits of the Commission for a moment, further regulation and compliance has slowed down the economy and raised business operational costs. Many businesses are having to push their wheels of motion through more ‘wet mud’.
So, to also help move things along and to encourage growth activities, with official cash rates already squeezed down to such low levels, increased fiscal measures and more investment by governments must occur, together with pro-business and more stable policies needed. Maybe also seeing a pull back on some of the constant and often questionable regulatory framework we are being tied up in. We all can only hope that this will all occur!
Certainly, global events such as the ongoing China/US trade dispute and the Brexit saga have fuelled market concerns and volatility on many occasions during the past couple of years. It has become quite tiring but, if these such issues can be resolved favourably, then the growth market sectors of equities, property and infrastructure are primed to advance further ahead, especially in the US. This would be a good result for investors with sensibly diversified portfolios but understanding that allocation to traditional defensive assets is now a far more questionable choice with such very limited income and very limited, if any, capital gain prospects in the current environment. Taking more supposed ‘risk’ by investing in more growth-oriented investment assets needs to be decided by investors based on their income needs, risk appetite and, really, logic and common sense!
As noted previously, all in all, maybe we don’t need to wear the shades but the future here still looks pretty bright!
As always, should you have any queries, please do not hesitate to contact us.