Investing in a low-interest environment

Returns on bonds and term deposits are now the lowest for a long time.

There is a world of lessons for investors coming to grips with low‑interest rates.

Look back to March 1960. Robert Menzies has another six years to serve as Australia’s prime minister, Dwight Eisenhower is in the White House and Australia’s cash rate is just under 3 per cent.

The nation’s official cash rate or its equivalent would not fall below 3 per cent again until mid-2013, 53 years later.

Now many investors, particularly those who place an emphasis on income, are asking themselves: how should I invest in a low-interest world?
During much of the past five years, extremely high bond returns shielded investors from the worst the sharemarket could deliver. Even rates on term deposits were well above inflation.

However, returns on bonds and term deposits are now the lowest for a long time, with numerous investors actually losing money once inflation and tax are taken into account.
Further, investment specialists warn that existing bond investors face potential capital losses if bond yields rise rapidly.
 
The multispeed global economy is creating opportunities and pitfalls for investors. In Australia, economic growth is slowing as the mining boom passes its peak, the Australian dollar has been falling and economists widely expect interest rates to fall further.

Overseas, much of Europe is in the doldrums, the Chinese economy is experiencing a cyclical slowdown and the US economy is picking up as its corporate profits, residential property market and share prices gather strength.

INTHEBLACK asked seven leading economists and investment specialists about where investors should now turn.

Asset allocation

Shane Oliver, head of investment strategy and chief economist at AMP Capital Investors, believes the best approach for most individual investors to deal with the shifting environment is to set an appropriate long-term or target asset allocation.

A portfolio’s target asset allocation – its planned exposure to the different asset classes of mainly Australian shares, overseas shares, bonds, property and cash – is intended to spread an investor’s risks and opportunities to deal with varying investment conditions.

This allocation should largely reflect an investor’s circumstances, including goals and tolerance to risk.

Oliver emphasises that investors should regularly rebalance their portfolios back to their long-term asset allocations as markets move.

Don Stammer, long-time investment commentator and adviser to several Australian fund managers, favours setting a long-term asset allocation within ranges.

For instance, an investor might set a target allocation of 30 per cent of a portfolio to Australian shares while allowing for that exposure to move up and down within set limits.

Investors can become overly focused on yield in a low-interest environment. David Rolleston, executive director of UBS Wealth Management Australia, says many yield-hunting investors with their holdings in a superannuation fund – which is taxed at concessional rates – do not realise that generating capital gains from their portfolios is really the equivalent of generating yield.

In other words, Rolleston says, appreciating assets can be sold with minimal tax consequences to boost an investor’s income.

"I think there is a significant chance that we are in the early days of a bear market in bonds." – Don Hammer

Bonds

“I think there is a significant chance that we are in the early days of a bear market in bonds,” Stammer warns. A bear market in bonds can be triggered if bond rates sharply rise, causing potential capital losses for bond holders – particularly those holding longer-dated bonds.

The outlook for bonds has changed significantly. Bonds provided excellent returns in recent years as yields fell, producing strong capital gains for investors in addition to income.
“The trouble is,” Oliver says, “now that bond yields are so low they can’t fall much further.”

Oliver and Stammer say that bond funds typically deal with the prevailing interest-rate environment by shortening the duration to maturity of bonds in their portfolios. The longer the duration, the greater the risk of a capital loss from a rise in yields.

Greg Davis, chief investment officer for Vanguard Asia-Pacific, says investors who invest in bonds to diversify their portfolios and receive a regular income should not be overly concerned by a rise in interest rates.

But he says those who are investing in bonds because of high performance in recent years should become realistic in their expectations of returns.

Davis warns that investors who increase their exposure to higher‑yielding bonds and high-dividend shares in an effort to maintain income will increase portfolio risk and volatility.

Property

Some property investors are becoming more optimistic about residential property prices, given low mortgage rates and high auction clearance rates.

RP Data-Rismark reports that capital city median dwelling prices increased by 2.9 per cent nationally over the 12 months to May, with Perth (up 6.4 per cent), Darwin (up 4.7 per cent) and Sydney (up 3.9 per cent) leading the way.

However, these figures don’t tell the whole story. RP Data-Rismark statistics for the three months to May show signs of weakness, with Melbourne home prices falling 1.9 per cent while Sydney prices remain static.

Oliver expects low interest rates will lead to “a bit of a bounce” in residential prices. However, he urges investors to be cautious because of the low yields for residential property – typically about 3 per cent, against 5 to 6 per cent for local shares (including the value of franking credits).
“Investors in residential property are dependent on capital growth,” Oliver says. “The problem is Australian property has had such a huge run over the past 15 years, particularly up to 2010.”

Oliver expects average residential prices to rise in line with inflation over the next five to 10 years, with rental yields remaining fairly low.
Lower interest rates are unlikely to lead to higher prices for small shops and strata offices costing less than A$1 million, warns Vanessa Rader, director of consulting and research for real estate agents Knight Frank Australia.

These properties are popular among self‑managed super funds (SMSFs). 

While Rader expects low interest rates to encourage more SMSFs to buy small commercial properties, she suspects this won’t be enough to lift values. “Commercial property values tend to reflect yields rather than interest rate movements,” Rader says.

Currently, the leasing market is tough for small offices and shops.

Australian real estate investment trusts (A-REITs) returned 33 per cent in the 2012 calendar year. “But that was after the devastation of the GFC [global financial crisis], which was far worse for listed property trusts than ordinary shares,” Stammer says.

Oliver and Stammer caution that expected returns from REITs are nothing to get excited about.

Stammer believes REITs will appeal to investors willing to put up with modest returns – below shares once franking is counted, yet higher than bonds.

Australian equities

Yield-hunting investors turning from bonds, term deposits and cash to high-dividend, fully franked Australian shares pushed the S&P/ASX 200 to a post-GFC high in mid-May.

The market then corrected before experiencing its biggest one-day rise in almost a year in June.

At the time of writing, the index was still down about 30 per cent from its pre-GFC high.

The recent higher volatility in share prices points to opportunities and pitfalls in the prevailing investment environment.

There are likely to be times when high-yield stocks in particular rise to unrealistic levels, making them vulnerable to correction, and times after corrections when buying opportunities are created.

Oliver says the search for yield had driven the price of banks, telecommunications and other high-dividend stocks to extreme levels before June’s correction.

“The hefty fall had taken their price from being overstretched to the point where they are good value again,” he adds. Oliver emphasises that bank stocks provide a yield of about 8 per cent – about twice the yield of term deposits.

Oliver also sees opportunities in “oversold” mining stocks that have really underperformed for much of the past 12 months over concerns about China. In mid-June, the resources sector was trading on low price-earnings multiples of 10 to 12 times.

With the pick-up in the US economy and the fall in the Australian dollar, Oliver suggests investors look at Australian stocks with US exposure. These include selected biopharmaceutical-medical companies and wine exporters.

Stammer describes himself as big fan of Australian banks, even though their dividend yield has fallen as their prices have risen.
He says quality stocks, paying good franked dividends that are likely to grow over time as profits increase, are highly appealing – particularly for investors who can withstand short-term volatility.

Overseas equities

The US sharemarket recently reached new highs in contrast to the Australian market. But, as Oliver says, the US market has spun its wheels for much of the past 13 years.

He believes Australian investors should be looking more to the US as its economy gathers strength and as our economy slows – and if the Australian dollar continues to fall, investors in unhedged international equities will benefit.

Benjamin Pedley, head of investments for UBS Wealth Management Australia, is also enthusiastic about the US sharemarket.

He points to the recovering US economy and housing market, and to the movement of US investors away from term deposits and cash to shares as they search for a yield higher than near-zero.

“The US equity rally has been driven in part by flows of money that would normally have gone to Europe being diverted to the US,” Pedley says.

Asian markets, excluding Japan, have risen about 20 per cent in the past year. Yet David Urquhart, portfolio manager of the Fidelity Asia Fund, says Asian markets are still trading at a significant discount to their historic values.

“There are some great companies in Asia with strong growth profiles, healthy return on equity and growing market shares,” says Urquhart, giving South Korea’s Samsung as an example.

“Samsung has had great success with smartphones, becoming the No 1 player globally after only entering the market several years ago. It is the only credible competitor to Apple globally at the moment [in smartphones] and Samsung is the No 1 player in television.”

Significantly, Urquhart believes Samsung has created a path for international success that other Asian companies can follow.

Fidelity is keeping a close watch on companies that have done well with consumer products in their domestic markets such as Korea and Taiwan, and can further their success by expanding into China and other parts of Asia.

Such companies – which make a wide range of goods, including  cosmetics, confectionery, snack foods and even milk products – can take advantage of China’s burgeoning consumer spending as personal incomes rise.

“There are good opportunities in China itself,” Urquhart says, “particularly given its low valuations.” He says much pessimism has been priced into Chinese stocks, providing buying opportunities.

Interesting companies include the makers of such competitively priced products as patient monitoring systems, which are breaking into overseas markets.
“And China is at the early stages of becoming a research centre globally for research into drugs and the raw materials going into drugs,” Urquhart says. “China has a great test market with the scale to do a lot of drug testing.”

Urquhart also says India is a big manufacturer of generic drugs for its domestic market, as well as for the European and US markets. “A lot of drugs are coming off patent and that provides a great growth opportunity.”

Elsewhere in Asia, he believes the free-trade agreement being created among ASEAN (Association of South-East Asian Nations) members will enable manufacturers to compete in much bigger markets.

Urquhart says there is more confidence among Malaysian businesses following the re-election of the ruling party by a comfortable majority.

Further Reading

  • Access these CPA Library items at cpaaustralia.com.au/wealthcreat_guide
  • Wealth: grow it, protect it, spend it and share it (eBook)
  • Escape from poverty prison, by D Burke, USA Today, 2013
  • Personal Finance for Dummies (eBook)
Contact CPA Library on 1300 737 373 or email [email protected]

July 2020
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