The RBA has moved to cut interest rates to the lowest level in over 50 years.
Interest rates play a large role in determining the performance of your investments. Here we look at how interest rates and expectations about future rates have impacted 5 different assets classes: Australian shares, Global shares, Emerging market shares, Australian bonds and Gold.
First, what has caused interest rates to fall?
In order to understand how different asset classes have been impacted by Australia’s low and falling interest rates, it is first important to explain how our terms of trade (the relative price of the things we export versus the price of things we import) have impacted interest rate expectations and the Australian dollar over the past year.
Over the last 2-3 years Australia’s terms of trade have fallen drastically as the price of our major exports like iron ore have collapsed. After reaching an all time high of 118.50 in 2011, Australia’s terms of trade have plunged into the low 80s and look likely to continue falling as commodities like iron ore, copper and oil fall to levels not seen since 2008 or earlier.
A fall in the terms of trade is sometimes referred to as an unfavourable movement in the terms of trade because it means that Australia must export more goods and services to maintain the same level of imports. This is bad news for the economy, reducing inflation and tax receipts for the government, putting pressure on the budget and jobs growth, and in turn forcing the Reserve Bank (RBA) into considering interest rate cuts to encourage spending and stimulate the economy.
Since interest rate differentials (the difference between two countries interest rates) are a major driver of currencies, the increased likelihood of rate cuts in Australia to stimulate the economy has sent the Australian dollar sharply lower. Meanwhile, expectations of a rate rise in the US have been increasing, which has compounded the move of the Australian Dollar against the US Dollar. The AUD/USD pair has fallen 17% over the last 6 months from 0.9360 to 0.7760 as rate expectations for the two countries have moved in opposite directions.
What do falling interest rates mean for your investments?
The fall in Australia’s terms of trade, currency and interest rates have had a mixed impact on Australian shares.
Defensive sectors like utilities, property and telecommunications have performed strongly because their dividend yields become more attractive as interest rates fall.
In the past 12 months, Telstra has risen 30% from $5.00 to $6.50, pushing its dividend yield (before franking credit tax benefits) down from 5.6% to 4.5%. Similarly, Westfield (property) and APA Group (utilities) have risen 55% and 41% respectively since January 2014 as investors have chased stable dividend paying investments as an alternative to leaving their money in the bank.
Falling interest rate expectations also have the effect of reducing discount rates. Discount rates are the rates at which future cashflows are discounted to work out how much a company is worth today. Many analysts are still using a discount rate of 4% to 5%. Updating this assumption in their models to reflect current bond rates could increase valuations by 30% to 40%. While it’s true that interest rates are likely to be higher at some point, the longer rates stay low, the more likely analysts are to reduce their discount rates and increase valuations on defensive stocks.
Australian 10 year bond rates (a good approximation for discount rates) have fallen from 4% to 2.44% in the last 12 months. This has been one factor driving up the valuations of defensive stocks like Telstra and Westfield.
Australian banks have also performed well on the back of rising earnings and fully franked dividends. That said, banks have historically been more exposed to economic cycles so if Australia enters an economic recession, their earnings and dividends may be less defensive than other sectors like utilities and property. The banking sector also faces structural risks brought on by fast changing technology, which may impact their profitability over coming years. Nonetheless, while Australian property prices continue rising, and unemployment and bad debts stay low, banks can continue attracting investors for their perceived defensive yield.
The bad & the ugly
Resources and sectors servicing mining have been the biggest losers from the falling commodity prices which have driven interest rates lower.
Australia’s third largest iron ore producer, Fortescue Metals has fallen 56% over the last 12 months to its lowest level since the Global Financial Crisis. Over that time, iron ore prices have halved from around $120 to $60 per tonne. Energy stocks like Santos have also had a tough year, falling 42% as the oil price halved. On the other hand, Qantas has risen 137% from $1.10 to $2.61 as the lower oil price has reduced its fuel costs and improved profitability.
Some mining sectors have fared better than iron ore and energy and actually risen strongly. Australia’s largest gold producer, Newcrest Mining has risen 40% over the past 12 months as the price of its energy input costs have fallen and the plunge in the Australian dollar has meant that the export price of gold actually rose.
Macroeconomic factors like commodity prices, interest rates and currencies are notoriously difficult to predict but can have immense impact on share prices. This is one reason analysts and active fund managers struggle to consistently beat the market. At the start of 2014, Fortescue and Santos were two of analysts’ favourite stocks (most ‘buy’ recommendations vs. ‘sell’ recommendations), while Newcrest and Qantas have been hated by analysts and fund managers for years. Being ‘overweight’ Santos and Fortescue and ‘underweight’ Qantas and Newcrest in your portfolio for the last year would have been disastrous for your returns.
That’s why instead of trying to correctly predict top-down macro drivers each year, we recommend a broad exposure to all large-cap Australian shares. This removes the risk of having too much of your portfolio in ‘popular’ stocks like Fortescue and Santos, and missing out on ‘unloved’ companies like Qantas and Newcrest when the macro environment changes.
Bond prices act inversely to bond yields so as interest rates fall, the price of bonds rise.
The yield of the Australian Bond ETF is now just 2.50%, having fallen from about 4% a year ago. This has resulted in the Bond ETF (ASX:IAF) rising from 100 to 108 over the last 12 months as well as paying interest over that period.
If interest rates continue falling, Australian bonds will remain a strong asset class in 2015. However, if the Australian economy starts to improve and commodity prices stabalise, bonds may fall while cyclical and commodity stocks would likely rebound under that scenario.
Which is more likely to happen? It’s difficult to predict which is why we recommend a diversified portfolio of stocks and bonds rather than make 50/50 predictions like many analysts and fund managers will do. As always, half of them will be right and half will not.
The US stock market has benefited greatly from the zero interest rate policy which the Federal Reserve has maintained since the financial crisis. Zero interest rates has pushed Americans into buying stocks and property rather than leaving cash in the bank since 2009. This has driven up the S&P 500 (the broadest measure of US shares) from 666 to 2,000 today.
However, as this policy is unwound, there are risks that US corporate profits and valuations may be impacted and this may cause the US stock market to have a period of weak performance. While it is likely this would be coupled with a strong US dollar (which will cushion the impact on unhedged portfolios), other assets like Emerging market shares and Gold may take the lead if US stocks are weak.
Emerging Market Shares
Since 2009, central banks in the major developed economies like the US, Europe and Japan have held interest rates at very low levels to stabilise financial markets and support the recovery of their economies. One of the unintended consequences of this policy has been volatile capital flows in fast-growing emerging markets. The resulting inflationary pressure led to measures by emerging governments to try and limit foreign capital inflows.
As a result, Emerging market stocks have significantly underperformed major economies since 2009. With the US now looking nearer to increasing interest rates, some attention has returned to emerging markets in late 2014 and early 2015.
The strengthening of the US dollar and changes in the expectation around US interest rates helped the Emerging Markets ETF within the Stockspot portfolios rise 6.85% in January.
Since Emerging markets often move in the opposite direction to Global developed shares, they provide an excellent diversifier to Global developed shares in a portfolio.
Gold has been the best performing asset so far in 2015, rising 10.5% in January. Historically Gold has performed poorly in periods of rising US interest rate expectations because the opportunity cost of holding gold (what you sacrifice in interest) rises as interest rates rise, plus the demand for defensive assets fall as the US economy strengthens (and rates rise).
This hasn’t been the case in January because the gold price has risen despite a strong US dollar and rising US interest rate expectations.
Gold has instead been taking its lead from non-US factors like the Swiss National Bank’s surprise move to remove its currency ceiling against the Euro on January 16th, and the European Central Banks AU$1.4 trillion dollar stimulus package announced on Jan 23rd.
Gold has historically risen in times of global monetary expansion (money printing) which is now in full force in both Europe and Japan. More money in the system means the value of that money falls and the value of hard assets like property and gold are rebased higher.
Gold is also seen as a safe-haven asset during times of market volatility. Greece looking to exit the Euro zone and the US potentially raising interest rates in 2015 are two events that could generate market volatility and benefit gold this year. We continue to like gold as a portfolio diversifier and ‘shock absorber’ in our portfolios that can also maintain its value throughout different interest rate environments.
Interest rates can have a meaningful impact on not only your mortgage and deposit rates, but also other asset classes like shares, bonds and gold. To Stockspot clients we recommend diversifying their investments across different asset classes and geographies to ensure that their portfolios can perform well across periods of both rising and falling interest rates.
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