An interest rates defence mechanism

This week's market rollercoaster did little for consumer confidence, but the rise in unemployment yesterday could, perversely, provide a much-needed reprieve for mortgage holders.

With the June unemployment rate coming in at 5.1 per cent, the highest since November 2010, the Reserve Bank is going to have a tough time justifying a rate rise in the near future. In the retail sector alone, four household name brands have collapsed this year and 22,000 full-time employees have lost their jobs this quarter. Few people have argued longer or harder than Yellow Brick Road that the RBA needs to pay more attention to Australia's patchwork economy.

As the financial economist and Business Spectator columnist Christopher Joye has noted, one encouraging development is that interest rates have temporarily been taken out of the RBA's hands, with de facto rate cuts delivered to struggling households and business via a range of means.

First, the 5-10 per cent depreciation in the currency is, according to the RBA's own research, tantamount to a rate cut, since it makes our exporters more competitive while increasing the price of imported goods and thus relaxing pressure on import-competing industries.

Second, the so-called inversion in the yield curve, whereby 3-year and 5-year bond rates are trading well below the RBA's short-term cash rate, has allowed lenders to reduce the cost of fixed-rate home loans. Indeed, some rates have dropped by up to 60 basis points, or more than two RBA cuts' worth.

While this is all great news for people with net debt, it is not such a heartening development for the prudent net savers out there.

Savers are getting whacked from three perspectives. Those who have money with the big banks in term deposits will get lower returns as banks drop their term rates in line with the cost of fixed-rate home loans.

These households also have to contend with the current high inflation, which can act like a tax on saving unless they can get significantly positive 'real' (or inflation-adjusted) interest rates.

There are a few short-term cash funds out there that deliver 6-7 per cent per annum returns with monthly liquidity and very low risk. If inflation does become a serious problem, the RBA will, for better or worse, continue hiking rates. And these funds will benefit since they invest in 'floating-rate' securities that rise alongside the RBA's cash rate.

The third problem many retirees confront is that they are, as Christopher Joye and we at Yellow Brick Road have regularly argued, often overweight on listed equities. The typical super fund has 60-70 per cent of all its capital in Australian and global shares. Yet when analysts like Christopher run proper 'portfolio optimisations', and account for equities' much higher probability of loss compared with cash, bonds and housing, they find that the ideal portfolio weight to shares is about half the normal allocation (ie. around 30 per cent). Of course, it does depend on what stage of the life-cycle you are in. Younger savers can bear more risk, whereas many of Australia's ageing households want the certainty and security yielded by cash and fixed-income.

In comparison to some global economies, Australia is still in pretty decent shape. The Australian economy hasn't fared nearly as badly as the US or Western Europe, but the commentary about the current turmoil in world debt and equity markets is enough to make middle Australia nervous.

The Australian economy's health probably has more to do with luck than skill. We are lucky to possess vast quantities of the crucial natural resources – iron ore and coal – that the likes of China, India, and South Korea need to power their economies and continue to urbanise and industrialise.

Arguably more skill can be attributed to the fact that Australia has a very strong bank and non-bank sector. Having said that, I remain deeply concerned by the oligopolistic powers of the four major banks, who were given the anti-competitive greenlight to take out key competitors during the GFC, like St George, BankWest, RAMS, Aussie Home Loans, Challenger's mortgage businesses, and even Wizard Home Loans (via Aussie).

Notwithstanding Australia's strengths, we are not immune to the global contagion and we all know that many households are struggling financially for a host of other reasons, including the rising cost of living (ie. inflation). Amidst the current turbulence, it would appear nearly impossible that we will see rate rises in Australia in the short term. The next best opportunity for the RBA will be in November, by which time they will have the third quarter inflation numbers. Depending on whether you are a wealth accumulator aged between 20 and 64, or a retiree de-accumulating at 65 or more years (young!), your incentives might be different.

In the first two quarters of 2011, the RBA's core inflation measures, which strip out all the effects of the floods, fruit and petrol, were running at about 40 per cent above its 2.5 per cent per annum target. The not so good news is that your actual cost of living, which is also measured by the Australian Bureau of Statistics, was growing even more quickly.

In the long run we all benefit from lower inflation and lower interest rates. The way the RBA tries to secure this outcome is via managing its official cash rate up or down.

It seems to me that the RBA may have underestimated the effects of the high currency, which was cruelling certain parts of the Australian economy. Employment growth has slumped over the last six months to the point where the unemployment rate is now rising again.

Prudent folks with large net cash savings obviously benefit from higher interest rates. But there are a greater number of people with interest-bearing debt, especially in middle Australia. So I am very much hoping that the third quarter inflation results in late November will convince the RBA to stay its hand, and even contemplate cutting rates.

The indisputably good news for mortgagors and Australia's housing market is that rates have not moved since November last year. In the absence of the rolling 2011 crises, we almost certainly would have had one or two hikes.

I can rarely recall a more uncertain or complex time for Australian households. And the banks' fixed rate cut this week posed a whole new set of questions for battlers. In today's volatile financial landscape consumers are looking for stability, which is why homeowners might be attracted to move into a fixed rate. In capricious times, people crave calm.

So, to fix or not to fix? It you take a fixed-rate loan today you might shave 40 to 60 basis points off your annual repayments. But the bond markets are forecasting up to five or six rate cuts over the next year, so it might be prudent to wait a few months to see what the RBA actually decides to do. If the unemployment rate really does start rising rapidly, the RBA could cut rates by a full one to two percentage points.

With many Western governments suffering from a toxic combination of high sovereign debt, slowing economies, and ageing populations, the bad news may not have come to an end. The US debt downgrade came as no real surprise, and with continued pressure in the eurozone it feels more like we're walking the economic plank than headed towards relief.

But history always repeats itself and market capitulations can be like hangovers; painful one day and forgotten the next. This is highlighted by the huge rally on Wall Street overnight.

We're in profit reporting season in this country, and whilst there will be some bad news, it will be the forward outlook that will be of most interest.

Let's not forget that our big four banks are still earning record profits, Woolworths is still selling groceries, and Rio Tinto and BHP Billiton are still digging iron ore out of the ground and shipping it to China.

And with the possibility that Australian interest rates could fall, we could soon see a situation where bank deposit rates are lower than the yields on ASX listed corporates, which will afford some help to the stock market.

My key message is to plan for an uncertain future. The world is getting more volatile, not less. Uncertainty is best dealt with by a well-diversified portfolio that should contain a balance of risk (or growth) and defensive asset classes.

If for some reason the RBA holds rates high, or hikes them further, growth asset classes, like shares, will continue to struggle. You will want a solid, stable income stream, and you can get that via safe cash and short-term fixed-interest securities, which also offer an inflation hedge.

If rates come off, the share and housing markets will be the chief beneficiaries, and will probably outperform cash and fixed-interest, albeit with significantly greater risk.

Your portfolio must be optimised for all these contingencies.

Mark Bouris is the chairman and co-founder of Yellow Brick Road Group. The above article is not investment advice.