THE LOW INTEREST RATE DILEMMA
Mark Lister, 20 June 2019
Sharemarkets around the world have continued to grind higher in recent weeks, shrugging off the malaise of last month. Expectations of lower for longer interest rates continue to be a key theme, driving investors into assets that deliver anything resembling a predictable, reliable income.
Central banks have ramped up the rhetoric of late, as they try to shore up confidence amidst flagging economic activity, ongoing trade tensions, and little sign of inflation.
This week Mario Draghi of the European Central Bank and Jerome Powell of the US Federal Reserve have both reiterated that they are ready to provide support, should it be required.
It’s not only the heavyweights of central banking that are talking this way. Closer to home, their counterparts in New Zealand and Australia have been singing from the same hymn book.
This all puts the average investor in a tough spot. Term deposit rates have fallen to around three per cent, and we have to go back more than four years to find a time when they started with a four.
Around that time I recall writing a report titled “four is the new seven”, or something along those lines. I guess this year’s equivalent will be “three is the new four”, and in 2020? Well, who knows. It’s entirely possible that rates go even lower.
Three per cent is a far cry from the seven or eight that prevailed in the pre-GFC years, and it doesn’t leave much of a return after tax and inflation. Fixed income yields aren’t much better, also sitting around three per cent.
Residential property offers a slightly better yield, in some regional centres. However, it’s not as not as attractive as it used to be and policy changes have made life more difficult for amateur landlords.
Then you have the NZX 50, with an alluring average dividend yield of about 4.5 per cent. Some sectors look even more tempting. Listed property is averaging 5.5 per cent for those on the top tax rate, while the electricity companies offer yields as high as seven per cent.
We’ve even caught the attention of some overseas media agencies, with at least one story circulating about our market becoming “overstretched” on the back of the “relentless hunt for yield”. There’s more than a bit of truth in that, but at the same time it’s hard to see it changing anytime soon.
It’s also worth pointing out that contrary to popular belief, we’re not the highest yielding market in the world these days, at least not for international investors.
The dividend yields quoted earlier all include imputation tax credits, which are only available to New Zealanders. Overseas investors are looking at a much less attractive 3.5 per cent, on average.
That’s still ahead of government bonds in most places, but it’s not as high as the dividend yields available in some other markets. Australian shares are trading on 4.5 per cent, while investors can get 5.0 per cent in the UK and 3.5 per cent in Europe.
Interest rates look set to remain at low levels for the foreseeable future, and they could easily go even lower. While companies are in decent shape and the economy isn’t in recession, that should underpin our sharemarket, even if we look highly priced compared to history.
At the same time, investors replacing fixed income with shares need to be mindful of the risks. While listed property and electricity company shares are at the defensive end of the spectrum, they can still be volatile under difficult market conditions.
During the GFC, the NZX All share index peaked in May 2007 then fell 49 per cent before bottoming out in March 2009. Contact Energy and TrustPower were the only two major electricity companies listed back in those days, and they fell 43 and 27 per cent respectively at their weakest point.
That’s a much better performance than many of the more cyclical, economically sensitive companies on our market, but they’re still hefty falls. The listed property sector simply followed the market average. Precinct Properties and Kiwi Property Group both fell 48 per cent, while Goodman Property declined 51 per cent.
In contrast, the NZX investment grade corporate bond index rallied 14.4 per cent in 2008, while government bonds performed even better. That’s your true protection during a period of major market weakness, good quality fixed income.
With central banks likely to tread very carefully and inflation still missing in action, shares will probably remain the first port of call for income investors.
We just need to remember that while those yields are highly attractive, they won’t completely shield us from a really rough patch. Fixed income is still our best option for that, and that means accepting a disappointing low yield in the interim.