Central Bank Policy and Investing
Rise in the Influence of Central Banks
Since the global financial crisis began, we have witnessed an unprecedented rise in the influence of the world’s major central banks. The explicit goal of their intervention has been to lower borrowing costs and push asset prices higher to create a “wealth effect” that causes asset holders to feel wealthier and motivated to spend more. Risk assets have responded with each round of monetary stimulus pushing asset prices higher.
But central banks have created a much more challenging environment for investors because the yields on traditional “risk free” assets, used to balance or reduce risk in portfolios, are now at record lows. Cash returns in many countries are effectively zero while the real yields on many top-tier government bonds are either zero or negative. Investors with lower risk tolerance are still seeking to generate a return similar to what they would have historically earned in Cash and AAA government bonds to at least provide them with returns in excess of the inflation rate. Unfortunately, in the current low-interest-rate environment, this it is simply not possible without taking on extra risk, whether in the form of credit risk, duration risk, leverage, or the inclusion of other asset classes.
In the developed world, economic growth remains subdued, forcing the major central banks to continue pursuing aggressive monetary policies in an attempt to compensate for restrictive fiscal policy (austerity) and to stimulate economic growth. The US Federal Reserve has committed to keep rates near zero until unemployment falls to at least 6.5% and until the recovery is self-sustaining. With unemployment at 7.6%, it seem unlikely that the US Fed will start increasing interest rates before 2015. And, in respect of asset purchases, the US Fed has confirmed that it will also continue its purchases of Treasury and mortgage-backed securities of $85 billion per month until the outlook for the labour market has improved substantially. The European Central Bank has said it expected its key interest rates “to remain at present or lower levels for an extended period of time”. Meanwhile, the new governor of the Bank of Japan, Haruhiko Kuroda, is fully supportive of Prime Minister Shinzo Abe’s campaign to rid the country of deflation and is expected to pursue aggressive monetary policies.
Investing in a Low Interest Rate Environment
The monetary policy actions by central banks have distorted financial markets, in particular bond markets, by lowering both short- and long-term interest rates to historical lows and by maintaining these low interest rates for an extended period of time. Pinpointing the turning point in monetary policy comes down to how long it will take to work off the excesses and imbalances accumulated in the previous decade, and such an outcome appears to be some time away. The when and how central banks will exit these programs have added uncertainty to investing in the current environment.
It is understandable and also advisable that investors should review their investment portfolios and decide on an appropriate asset allocation and investment strategy to ensure they meet their return objectives. However, the worst thing for investors to do is to chase higher returns without understanding the higher risks involved. Given the higher uncertainty in financial markets, investors should give consideration to the following to maintain risks at acceptable levels:
One of the main attractions of investing in Equities in the current environment is the relative high dividend yields on offer. However, investors should ensure that the dividend yields are sustainable and have reasonable prospects of future growth. Investors should focus on investing in businesses that are market leaders, with high barriers to entry, with sound management, with conservatively geared balance sheets, and with a long history of high returns on equity and growth in earnings and dividends.
- Fixed Income
The overriding objective of investing in Fixed Income Securities should be to earn a guaranteed income return without the possibility of any capital loss on the investment.
A number of Fixed Income Securities have been listed on the ASX over the last 18 months. There are however significant differences in the credit quality of the issuers and in the terms and conditions of the securities. Even though the promised yields may be attractive, investors should avoid investing in securities issued by companies with poorer credit quality and/or in those securities with equity-like characteristics.
Long-term interest rates are at historical lows and will likely rise when central banks start unwinding their unconventional policy actions. Investors should avoid investing in securities if interest rates on the securities are fixed for a period that exceed two years.
As proven during the GFC, the risks of investing in Property are amplified through excessive leverage. Investors should invest in well-located properties with long leases to quality tenants that pays distributions out of free cash flow and with leverage limited to less than 60% of the value of the property.
The information contained herein is of a general nature and does not take into account the reader’s particular needs, circumstances, financial circumstances or preferences. It is a guide only and based on current legislation. We believe the information contained in this update has been obtained from reliable sources but we cannot be responsible for any errors, omission or inaccuracies. You should seek professional advice before acting on the information in this update.
Please contact your Intralink Wealth Management adviser, on (03) 9629 1100, if you require any clarification or further information regarding this update.