What historic low interest rates mean for investors

Interest rates are at historic lows. The RBA’s August decision to cut the cash rate to 1.5% means that Australian banks are now operating at their lowest official cash rate in history.

But while Australians with mortgages might be happy, the picture is very different for self-funded retirees.

Australia’s low interest rates are an attempt by the RBA to encourage growth. Inflation in Australia is running at just 1%, well below the RBA’s target inflation rate of 2-3%, providing the central bank with the room to act further to stimulate activity.

In a global context, Australia’s cash rate is actually one of the highest in the world; the US Federal Reserve is running at 0.5%, the Bank of England has just cut its official cash rate again to 0.25%, while in Japan and many European countries interest rates are actually negative.

Locally and globally, the theory behind low interest rates is to stimulate growth in the economy by providing incentives for businesses and individuals to borrow in order to invest money in capital-generating activities, in a low financing cost environment.

But whether this will actually occur as a result of the rate cutting program remains to be seen – interest rates have been low for some time.

While the official cash rate is low, the rate cut has not been fully passed on to borrowers by the banks. The four major banks have announced that they will be passing on only around half of the rate cut (0.12 – 0.14%) to home loan customers. Over the last 18 months, many of the banks have actually increased lending rates for business and investment purposes, and have increased the security requirements for borrowers.

What this means for investors

In order to stimulate growth, businesses and investors need to feel confident about the future. Business confidence fell during the federal election, and with the uncertain future of the functionality of the Senate, it may take some time for business leaders to have confidence to invest in future projects.

This global low interest rate environment has left investors desperately seeking yield, and taking on higher risk as a result. Locally and globally we’re seeing listed hybrid securities, infrastructure assets and listed real estate investment trusts (REITs) trading higher, and many equities are currently expensive when assessed against traditional valuation methods.

In this sense, low interest rates could very well be positive for share and property markets, and we wouldn’t be surprised to see some of the more unloved sectors picking up a bit more interest from investors.

In particular, we’d expect resources stocks to continue their recovery, and the share prices of the major banks could rally in the coming weeks as well. Reporting season is upon us, and that should give investors a little more guidance as to the performance of individual stocks over the last three months.

The ongoing challenge for Australian self-funded retirees is in how to balance risk and return while we remain in this low interest rate environment.

Conservative assets are generating record low returns, with government bond rates under 2%, term deposit rates returning – at best – 2.8%, and corporate bond rates around 4%. With minimum annual pension withdrawal requirements of 4-5% or above, self-funded retirees are facing a real challenge in generating sufficient income to meet their pension withdrawal rates.

Self-funded retirees and other investors are faced with some difficult challenges. Ultimately, it comes down to a choice between riding out the low rate period and accepting lower returns, or increasing the risk profile of your portfolio.

Hybrid securities, Australian equities, infrastructure, listed REITS, international equities and alternative assets may be appropriate ways to increase your risk and return profile. It’s critical to speak to your investment advisor to consider your asset allocation, and assess the effect and importance of imputation credits to your after-tax returns

Perhaps more importantly than ever before, investors should be considering the total return on investment. Don’t just focus on the income. Consider capital growth, after-tax income by utilising imputation credits and more active portfolio management to enhance your returns.

David Lane is a director in the wealth management division at Pitcher Partners in Brisbane.