Less than eight months ago, markets were all but certain global central banks (Australia included) would continue their path of progressively increasing interest rates. Fast forward to today, our Reserve Bank (RBA) has cut the official cash rate (with more to follow), the European Central Bank (ECB) has deferred any change in its policy rates until at least mid-2020 and the US Federal Reserve (the Fed) has openly communicated a willingness to reduce rates. What's led to this about face, what does it mean, and why should all investors be paying attention?
The below chart illustrates the dramatic shift in market expectations. Around October last year, US markets were pricing in at least two more Fed rate hikes totalling 0.50% over the course of 2019. The grey line in the chart is the actual US Federal Funds rate, the red and black lines clearly indicate a change in expectations. Today, markets are now expecting at least one 0.25% rate cut by the end of this year and a further one to two cuts (0.25% to 0.50%) in 2020.
By adjusting interest rates (monetary policy), central banks attempt to manage their respective nation's economy. Typically, a rising interest rate environment is commonly associated with an economy achieving solid growth and accelerating inflation. Indeed over much of 2018, central banks such as the Fed held a somewhat rosy outlook for the global and US economies.
Unfortunately, data in late 2018 began to show evidence of a global economy confronting the uncertainty created by the US/China trade tensions, a weaker Chinese economy and a slowdown in the interest rate-sensitive parts of the US economy (such as housing). Stimulus was needed. Central banks, particularly the Fed, had to reverse the direction of policy.
Why does this matter?
Firstly, lower interest rates benefit home owners and prospective property buyers through lower mortgage rates. While this is likely to support the economy's housing market (with recent auction data in Australia supporting this idea), households are unlikely to see much of a cash windfall as they continue to pay down debt: making the same mortgage repayments. In the US, housing activity is responding positively to the fall in fixed mortgage rates.
Unfortunately lower rates are not the friend of net savers (like retirees) as interest on deposits and rates of return on a number of fixed income investments will be reduced. This dynamic is evidenced by the shift in government bond yields (below), falling about 1.10% in the US and an even greater 1.30% in Australia. Thankfully for existing bondholders, they enjoyed an offsetting increase in the value of their investment.
Considering that many retirees and other investors rely on their portfolio's income to sustain their lifestyles, we expect many to invest their incremental dollars in more risky investments as they search for higher returns. We see this as a strategy fraught with danger, particularly in the context of the current long and positive market cycle (June marks 10 years of economic expansion in the United States).
Finally, cash rates and bond yields can impact the price of growth assets such as equities. Cash rates and government bond yields are commonly used as discount rates in valuation models for equities: lower interest rates can result in higher equity valuations, driving these markets higher. However, before investors load up on equities, it's prudent to remember why interest rates have been reduced in the first place…
How are we managing portfolios?
Lower global interest rates provide a headache for portfolio managers. In a world of increased geopolitical and economic uncertainty, returns from traditional defensive assets (such as bonds) continue to be squeezed. Meanwhile despite a number of risks and a soft outlook for corporate earnings growth, valuations for various growth assets have been upwardly revised.
We remain cautious and willing to retain our defensive positioning. Bouts of volatility will continue to occur, perhaps with greater frequency as the trade rhetoric between the US and China continues.
We believe now is not the time to be adding risk to portfolios.
While investors may be concerned by the reduced income being generated by the cash and fixed income parts of their portfolio, they should see value in that it's available to take advantage of bouts of volatility.