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Interest Cuts: Has the RBA’s Phillip Lowe made Equities the Only Game in Town?

Stuart Lucy

Stuart Lucy is an Investment Specialist at the Australian Stock Report, and has gained exposure to funds management and investment banking throughout his career. He draws on this experience to provide macroeconomic commentary and actionable investment insights to clients. Stuart is responsible for writing reports, is involved in delivering Macrovue webinars and provides general advice to our members on portfolio construction. Stuart currently holds RG146 General and Securities qualifications.

Before the GFC, most retirees with a comfortable nest egg could live well off term deposits. Interest rates exceeded 7%, and it was easy to get more than that on safe term deposits and corporate bonds. Not a bad deal when inflation was 5% at most, whilst mostly sitting within a 2-3% range.

The GFC was a game-changer for Aussie savers, and not in a good way. Rates hit a then intergenerational low of 3%, and, after a brief rebound, only headed downwards from there. The RBA sees more downside than upside at present, so if anything changes, interest rates are more likely to fall than rise from here on.

Aussie interest rates for the past 20 years

Figure 1: Aussie interest rates for the past 20 years (Credit: RBA)

To make matters worse, that 1% interest rate doesn’t even offset our 1.6% inflation, meaning the real value of your wealth declines by 0.6% even if you don’t spend a cent of your savings. Even if you spend every cent of the returns on your low-interest savings account, it still takes over $10m in the bank just to match Sydney’s average household income off bank interest.

With most analysts also believing that property will take a long time to recover and rental yields sit at record lows, equities are the only game in town.

 

What about a recession?

While equity markets are at all-time highs, many investors believe that the stock market is a risky place to do business. The important thing to keep in mind through is that more defensive stocks with stable cash flows have not corrected far in recessions and are much safer places to park cash than the broader market. Some stocks, such as gold miners, rise when the stock market goes down. This is because people look for safe havens during periods of market turbulence, driving the price of gold up and increasing the earnings of companies producing the commodity.

 

When will rates rise?

While many retirees have been holding out for higher interest rates, the unfortunate reality is that rates simply cannot rise to the levels they once were. Household debt is far higher than it ever used to be, which constrains the ability of central banks to increase debt levels.

To illustrate this example, lenders will typically lend up to 6 times someone’s income for a home loan. If mortgage rates were to rise to even 6%, implying a cash rate around 4%, all new home buyers who maximised their borrowing capacity would be paying 36% of their income on interest alone for their home loans. Most economists would consider such a high-interest bill indicative of severe mortgage stress, and it would hurt spending in the economy so much that it is highly unlikely the RBA will embark on this path.

 

Australian Household Debt Set to Keep Rates Low

Figure 2: Australian Household Debt Set to Keep Rates Low (Source: RBA)

Adding high debt levels to a slowing global economy, increased uncertainty from the US/ China trade war and low inflation all but rules out that sort of rate rise. The global economy is slowing rapidly, which is of increasing concern to both the RBA and its international counterparts.

 

What is the lowest they can go?

While interest rates are at record lows in Australia, the success of quantitative easing (QE) across the US and Europe and the possibility of a recession all combine to indicate interest rates can go a lot lower. The RBA cut interest rates by 425bps in the GFC, and they would have less than a quarter of that room today before interest rates went negative.

This makes negative rates a real possibility if there was a recession today. It would be almost unprecedented for a central bank not to cut interest rates by more than 1% in a recession where inflation was running below the central bank’s target range. This would mean that you would not only not get interest at all on bank deposits, but you would also be billed for keeping cash there.

Sounds crazy? Then check out these advanced economies which have already cut rates to negative territory, even before a recession:

 

Major advanced economies already have negative interest rates

Figure 3: Major advanced economies already have negative interest rates

With the whole of the Eurozone accepting a negative cash rate, the concept is not confined to smaller advanced economies. There are already $15tn in negative world bonds worldwide, meaning that investors accept a guaranteed loss on investment if the securities are held to maturity. Switzerland’s central bank has an interest rate of -0.75%, and individuals who keep money in Swiss banks are already suffering from negative rates.

Phillip Lowe said that is “possible” for the RBA to be forced to cut interest rates to 0%, if there is a serious downturn. He said he “hoped” to avoid negative interest rates, but coming from the RBA Governor, that is a far cry from ruling it out. If a moderate to severe recession was on the cards for Australia, negative rates are more likely than most people realise.

Should I Shoot for Dividends?

Talk of low-interest rates drives up interest in dividend stocks, a great investment alternative for investors seeking an income. In this game, however, it is important to seek out companies with a quality yield, not just stocks that pay out a high dividend yield for now.

Quality yield is about finding a stock that is unlikely to cut its dividend and can slowly increase its dividend yield over time through steady earnings growth. The payout ratio is a good proxy for a dividend cut; if a business is paying out more than 80% of profits, like Westpac (ASX:WBC) and CommBank (ASX:CBA), it often has a higher than average chance of needing to cut its dividend to get some cash to reinvest. Cyclical sectors such as banking and mining are also susceptible, since their earnings can swing more than normal in a downturn.

The importance of quality yield explains why we still recommend stocks paying a 4-5% dividend locally, despite being able to easily find stocks paying much more. We would rather a 4-5% dividend that could sustainably grow to over 10% of the initial investment over a few years, than a 10% dividend for a company in terminal decline.

If you are a bit more selective, there are numerous US companies that have not missed a dividend payment in a hundred years, have sustainable payout ratios and quality management. Given this includes two world wars, the Great Depression and the GFC, it is quite an accomplishment.

Our international high dividend Vue, a selected list of international stocks with attracts no management or performance fees, pays an 8-9% dividend yield. For investors who also want to not tie all their assets to the health of the Aussie economy, an 8-9% dividend yield beats 1% in local banks. This is one of the many options that investors have, if they want to boost their income and get out of the trap of declining interest rates that has defined term deposits over the past few years.

Which Industries to Invest in?

As monetary policy is inseparable from our position in the economic cycle, it is vital for us to consider both in order to determine where to invest. Interest rate cuts in a boom time such as ours will boost high growth companies whose cash flows a long time in the future suddenly become more valuable. In a recession, however, when market confidence is far more subdued, most capital flows into defensive industries.

Which industries outperform depends on our position in the economic cycle

Figure 4: Which industries outperform depends on our position in the economic cycle (Source: ASR)

Sectors that benefit most from falling interest rates include those with high levels of debt and ones that are dominated by growth companies with a large percentage of their cash flows in the future. Tech, Infrastructure and Utilities are generally the biggest beneficiaries, and a balance between all of them helps position us for the current market dynamic while being prepared for a downturn.

 


 

Disclaimer:

This article has been prepared by the Australian Stock Report Pty Ltd (AFSL: 301 682. ABN: 94 106 863 978) (“ASR”). ASR is part of Amalgamated Australian Investment Group Limited (AAIG) (ABN: 81 140 208 288 Level 13, 130 Pitt Street, Sydney NSW 2000).

This article is provided for informational purpose only and does not purport to contain all matters relevant to any particular investment or financial instrument. Any market commentary in this communication is not intended to constitute “research” as defined by applicable regulations. Whilst information published on or accessed via this website is believed to be reliable, as far as permitted by law we make no representations as to its ongoing availability, accuracy or completeness. Any quotes or prices used herein are current at the time of preparation. This document and its contents are proprietary information and products of our firm and may not be reproduced or otherwise disseminated in whole or in part without our written consent unless required to by judicial or administrative proceeding. The ultimate decision to proceed with any transaction rests solely with you. We are not acting as your advisor in relation to any information contained herein. Any projections are estimates only and may not be realised in the future.

ASR has no position in any of the stocks mentioned.

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