The Reserve Bank of Australia is widely tipped to reduce interest rates again to historic lows. Easton Wealth economist Emmanuel Calligeris explores the impact.
The Reserve Bank recently eased the official cash rate to a historic low of 1%. The RBA believes that the level of wages growth does not threaten its inflation outlook and the economy can operate at a much lower rate of unemployment. This essentially means that monetary policy (interest rates) can be lower for longer without overheating the economy. That said, the outlook is for interest rates to move even lower in late 2019 and early 2020 with some forecasters suggesting that the rate will reach just 0.50%. Term deposit rates have moved lower to reflect the low cash rate.
The real impact of low interest rates
Low rates have produced a dilemma for savers. As interest rates fall, more and more capital is required to sustain the same level of income. This is illustrated in the table below.
The table shows that at a 10% interest rate, an investor could generate income of $50,000 with a capital or investment amount of $500,000. If the interest rate falls to 6%, the capital required to generate the same $50,000 of income is approximately $833,000 and at a 2% interest rate, an investor would require $2.5 million to generate the same amount of income.
Looking at it another way, if you own an investment that is capable of generating an income of $50,000 per annum, then the lower the interest rate, the more valuable the investment becomes. This has been the case for bonds over the last 30 years and property and shares that have maintained their dividend growth in the last 10 years since the global financial crisis. An investor that has had the same $500,000 invested without capital growth (like a term deposit) will now be generating income of just $10,000 at 2%.
Investing in a low return environment
To date, investors in property and share markets have been happy about the low and declining interest rates. They have paid more attention to the market gains that have resulted from falling rates than the falling future rates of return.
We now find ourselves in a situation where future returns are likely to be low and are confronted with the question of where to invest in this low return world. The easiest way to achieve higher returns is to increase investment in those asset classes that traditionally offer them – namely domestic and international shares and property. However, in seeking higher returns, investors must assume higher risk. It is important that the overall portfolio balance is not tilted too far and investors remain disciplined from an asset allocation perspective. If fiscal spending does increase in the future, a bias towards (income generating) infrastructure may be appropriate over the near term.
In terms of stock selection, shares and property are fully priced in the short term but should remain part of a well-diversified investment portfolio. Investors should be cautious near term but look to add to exposures into market weakness. Shares and property are likely to provide moderate growth with a good level of dividends over the next few years – lower returns in a low growth, low inflation world will likely be the norm.
This information is general information only and hasn’t taken your personal circumstances into account. It is important that your personal circumstances are considered before making any financial decision and we recommend you seek detailed and specific advice from a financial adviser.
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