Tuesday 02 August 2016 by FIIG Securities crystalball Opinion

Crystal balling a 1% cash rate

As published in The Australian on 2 August 2016 

Hardly a day passes without some analyst predicting that the official cash rate will ultimately decline to 1 percent. That equates to three more cash rate cuts, almost halving the current very low 1.75 percent rate

I think it’s important to imagine what might happen to various markets and prepare now if you think a 1 percent cash rate is a possibility.

In markets where very low cash rates are already a reality, portfolio tactics have been to opt for longer dated fixed rate returns or chase high yield, but in this case investors pay with higher risk and volatility.

First, how and why might the cash rate get that low?

Top of my list would be a low inflation rate.  Assuming the Reserve Bank Board keep their inflation target of two to three percent, then persistently low inflation could force their hand. After this week’s quarterly inflation figure of 0.4 percent and the weighted average yearly mean at 1.3 percent, it’s tracking well below the target range.

Other data to watch includes the unemployment rate and growth. A relatively high currency could also influence the Board to cut rates. It lowers our global competitiveness, harming growth and employment.

Employment rates seem acceptable with unemployment at 5.8 percent, however part time employment made up about half of the new jobs created last quarter.

Assuming the cash rate is cut to 1 percent, what might happen to financial markets?

As our market often tracks the US, and while a long way from perfect, as the US market has had a cash rate below 1 percent since 2009, we can take a look at the performance of various asset classes in 2015 to help us speculate on what might happen here.

US returns across asset classes in 2105 were dismal according to Capital Spectator. It measured returns using Barclays and other indices. The best performing was US REITs at 2.5 percent, followed by marginal positive returns in corporate bonds and stocks. Most people’s ‘safe haven’ cash, showed a nil return. All other broad investment sectors showed losses, with commodities the worst at -25 percent.

The closely watched S&P 500 Index regarded as the best gauge of large cap equities, declined 0.7 percent for the year, its worst performance since the financial crisis in 2008 when it dropped by nearly 40 percent. Oil and materials sectors incurred significant falls. The broad benchmark’s total return was 1.4 percent.

Other reports on specific segments were better. Ken O’Brien, Executive Director of research and analytics company MSCI, said “The U.S. direct property market continues to deliver solid, double digit returns to investors in a domestic economy struggling with slower growth.’’ Its index of 4,848 property investments with a total capital value of USD279.8bn as at December 2015, showed a 12.41 percent increase in 2015. Not unalike pockets of real estate returns in Australia over the last few years.

High yield bonds were down 1.45 percent until December when they took a tumble to be down 5 percent for the 2015 year. It’s important to remember that many commodities companies issue high yield US bonds and there would commonalities with commodities shares down 25 percent for the year.

Returning to the domestic market, similarities already exist between us and the US. Equities were flat in both as you might expect in a low growth environment in 2015 and while the US equity market continues to surge this year, ours has improved but not to the same extent.

High yield bonds have also rebounded in the US, and according to S&P High Yield Index, the current 12 month return is 6.6 percent.

There is plenty to ponder and I haven’t even touched on currency, interest rate differentials with the rest of the world or the possibility of domestic quantitative easing.

If the cash rate drops to 1 percent, two things are certain:

  1. Investing in deposits will earn nothing, and few could afford that luxury
  2. The chase for yield will continue to drive down returns in all asset classes and increase risk

One practical suggestion is to switch poor performing equities to high yield bonds. You would have more certainty over your returns and even if high yield bond prices decline, if you hold to maturity and the company continues to operate, you will always have a positive return. If those bonds are fixed rate, and longer dated they would be more protective of lower overall interest rates.