It's going to be "lower for longer"

Cash returns are frustrating and now is the time for all investors to be alert to risk.

Summary: Returns from the Australian bond market indicate that interest rates are going to stay low for a long while. In this environment it’s important to balance risk - so take a step back to evaluate investments. Meanwhile, a Fair Work Commission decision against lower penalty rates arrangements at Coles has the potential to impact staffing costs at a number of big businesses.

Key take out: I believe if Labor takes the election, against bookmakers’ expectations, then the market will respond badly.

Key beneficiaries: General investors. Category: Australian economy. 

What the US can tell us about returns

If you are like me, when you look at the term deposit rates the banks are offering you feel very frustrated. This week I got a quote of 3.05 per cent from one of the big four banks for a five year term deposit, which filled me with no joy, but then I watched the ten year Australian bond rate fall to 2.16 per cent, which was an all-time low.

Assuming my big four bank deposit was less than $250,000, the rate on a government guaranteed term deposit (which is what the regular banks effectively offer) is just over 0.9 per cent above the government guaranteed bond rate for a period (five years) that is half the 10 year bond level.

The figures underline the fact that there is a game going on in bond markets in both Australian and the US, driven by the fact that big institutions don’t get government guarantees for major term deposit investment plays because they are investing too much. In addition big funds need liquidity. There is no liquidity in a five year term deposit.

To put it another way, the Australian bond market is telling us that our interest rates are going to stay low for a long time and the economy is not going to be buoyant during that time – the period will be accompanied with low inflation... And of course that is exactly the signal the American bond market – which reached 1.7 per cent for ten year securities – is also conveying.

As you all know, earlier this year and late last year many of us were suggesting that interest rates in the US might rise much more slowly than the market was expecting, but once the bond rate gets to 1.7 per cent there is almost no expectation of a meaningful rises in interest rates. For what it is worth I think there is more momentum in the US than the bond market is indicating and that one way or another Federal Reserve Chair Janet Yellen will find a way to slowly edge interest rates higher.  

But if the American bond market is right on future rates then, given our higher interest rates, our dollar will rise even further and it will once again force our central bank to lower interest rates. I think that with the Australian dollar above US74c, it is reasonable to have some US dollar exposure as part of your portfolio mix on the basis the currency will drive rates lower.

Managing risk in this climate

Back to Australia and when yields are very low it is actually a high risk time for investors because as you search for higher income almost certainly you are forced to take bigger risks – and if there is an economic downturn those risks may blow up in your face. So each time you invest in a high yield security, take a step back and think about the enterprise or interest bearing security you are about to invest in. Global institutions are so scared of getting caught that they are happy just to get their money back.

Penalty rates could hurt

During the last week or so there have been a lot of commentaries about the Australian apartment market and it is clear that the daily press are starting to pick up on the trends that I have been alerting Eureka readers to for over a month. It is the biggest threat facing the economy particularly as our second largest city, Melbourne, is in the front line.  

But rather than repeat those risks I would like to introduce you to another one that is not currently discussed in the marketplace, although the media has been giving considerable attention to the facts. One of the reasons Coles and Woolworths have done so well is that they have had an enterprise agreement which means that they don’t pay peak penalty rates over the weekend although they pay higher than standard rates during the week. This gives them considerable advantages over other operators trading over the weekends. Unfortunately the Coles arrangement for lower weekend penalty rates have been successfully challenged before the Fair Work Commission. This has created a very complex situation which could easily end up saddling Coles and Woolworths with higher weekend wage rates, although there is no certainty of that.

What makes this so important is that in Australia more and more shopping is taking place over the weekends. During the Monday to Friday period, shopping does take place in “normal” hours, particularly via retirees. But during the week, the two income family sees one person race into the supermarket for a quick shop for food for the evening meal while the big overall shopping is done on the weekends. What we are looking at is the possibility of higher costs for Coles and Woolworths at their peak shopping time – that is where they currently make their money – so their margins could be affected if a satisfactory solution cannot be worked out.  It is a space we will need to watch very carefully. The ramifications go further than simply Coles and Woolworths – this situation could extend to others, like McDonalds.

I have been through so many elections that I have learned not to make predictions, but the bookmakers say that Malcolm Turnbull is going to be returned. In other words they don’t believe the opinion polls which have the election level pegging. If the book makers are right then it is quite possible we will see in Australia a rise in our stock market similar to what occurred in Canada when Justin Trudeau was elected as prime minister. There was a surge in Canadian shares and as a result the Canadian stock market has performed much better than Australia in 2016 yet the economies are not that different, although Canada is much closer to the US. If the bookmakers are wrong about the election then rightly or wrongly I suspect the market will take the Labor win badly. Of course no matter who wins they will have to deal with a senate which is likely to have more independents than the parliament which has just closed.