Interest rates are at 2.5%. You know that. Of course you do. They’ve been sitting at 2.5% for close to a year and a half now.
I hope you’ve been enjoying those fantastic returns. Because they’re about to go even lower.
At least that’s what Credit Suisse is telling us.
On Monday the bank argued that the RBA could cut interest rates even further. A cut to just 1.5% can be expected within the next year, it says.
Its reasoning is based on low consumer and business confidence, falling inflation expectations, and a rising unemployment rate.
And here we were, thinking the next move would be higher. Maybe it’s not time to lock in your fixed rate mortgage just yet.
A rate cut is needed to encourage investment and spending. While 2.5% is certainly a disappointing return, interest rates in Australia are much higher than in other Western economies. 2.5% is double what the European Central Bank returns. And it’s 10 times what the US Fed is paying. Plus it’s higher than the increase in the cost of living — the inflation rate. So it would appear we certainly could go lower.
Yet the RBA has a dilemma. Cutting rates will further fuel the booming Melbourne and Sydney property markets. The spectre of a property bubbles has been worrying the RBA.
However, Bank of America Merrill Lynch economist, Saul Eslake, believes that home price growth will slow significantly next year. So much so, that it would weigh on sentiment and curb construction. Construction has been one of the main sectors that has picked up the slack from the slowdown in mining.
A cooling property market would leave little reason not to cut rates. And Eslake expects the RBA to continue ‘easing monetary policy’ through 2016.
That’s another two years of lower interest rates…and lower returns.
What are your options?
Bank deposits are at record lows, and bond yields are disappointing too. Investors — especially retirees — need to get their income from somewhere.
Dividend paying stocks are the first solution that comes to mind. And Australians have been piling into them for the last few years. The problem is that these stocks are so popular that’s it’s hard to find quality, high yielding businesses, at reasonable valuations. Most of them have already been bid up, simply due to the fact they pay dividends.
Over the longer term, focussing only on high yielding, boring, low growth companies can leave you sitting on investments that fail to pay decent returns.
It also limits your options. Dividends are not the only way to make a return in this low interest rate environment.
In fact, chasing dividends is dangerous. It blinds you to a company’s poor prospects.
A company must make money
Your first requirement should always be a company’s ability to make money. Dividends aren’t sustainable if the company isn’t profitable. And dividends don’t rise if the company isn‘t growing its return on equity.
Yet, many investors are blinded by companies that pay dividends. They throw common sense out the window and buy anything with a decent looking yield, with little regard for anything else.
I wish I had a dollar for every time I heard, ‘I don’t care if the share price falls, so long as they are paying a dividend.’
The problem with this statement is that share prices often fall in line with business performance. If a company isn’t generating a quality return on equity or is no longer profitable, it’s foolish to believe that dividends will continue to be paid.
You are not ‘preserving capital’ by not selling shares to pay the bills.
If a company decides to cut its dividend, it’s likely that the share price will plunge. You saw this during the GFC, when what were considered to be reliable dividend payers — REITs and preferred stock of financial companies — collapsed along with the market.
Another risk of concentrating your investments in low growth, high yielding stocks is the threat of inflation. Investors commonly fail to account for the impact inflation has on their investments. A consistent 4% yield won’t keep its purchasing power as inflation rises year after year.
To maintain your purchasing power — simply breaking even — a $100,000 investment will need to have risen to $134,000 in 10 years, assuming inflation of 3% each year. Again, this is to simply maintain its value.
The focus should really be on total return. By ignoring the total return — dividends PLUS capital growth — you’re missing out on much better opportunities.
If you need extra cash, you can always sell down growth stocks as their share prices rise.
Earlier this week, I recommended one of these stocks to members of the Albert Park Investors Guild. It’s a small-cap stock, trading on the ASX, with loads of potential upside. Plus, it has paid steady, reliable dividends since 2008.
Investments such as this, as part of a well balanced portfolio, will see you through these ongoing cuts to interest rates.
Investment Director, Albert Park Investors Guild