Lower Interest Rates Are Coming

Why Interest Rates Are Set to Decline

Investment Strategies for a Low-Rate Environment

Marcus Padley | 22 August 2024 | Education Corner

The 10-Year Bond Yield: A Turning Point

This is the 10-year bond yield in the US and Australia. You have to ask – “What Happened Here?” – What turned interest rates around from under 1% to 4%? What date is that? It was COVID - After COVID, inflation shot off and rates followed.

The Causes of Inflation Post-COVID

Why did inflation take off? Lest we forget:

1. Supply Chain Disruptions: As factories shut down, transport routes were restricted, and labor shortages arose due to illness and lockdowns. This created a mismatch between supply and demand, driving up prices for goods and raw materials.
2. Government Stimulus and Increased Demand: Most governments responded to the economic impact of the pandemic by implementing large-scale stimulus packages. These included direct payments to individuals, unemployment benefits, and business support. This injected a significant amount of money into the economy, increasing consumer spending power and demand for goods and services. You might remember how unemployed recipients suddenly became know-it-all stock market traders punting with other people’s tax money. A lot of money also went to the wealthy, who were less inclined to suddenly ramp up discretionary spending (i.e., buy a jet ski). Rather, they invested it in assets, namely the housing market and the stock market.
3. Pent-Up Demand: During the lockdowns, consumers accumulated savings as they couldn't spend on travel, dining, or entertainment. Once restrictions were eased, their pent-up demand was released, leading to a surge in spending, particularly on electronics, home improvements, and vehicles, pushing prices higher.
4. Labor Market Changes: The pandemic caused shifts in the labor market. Some workers left the workforce permanently, others changed jobs or demanded higher wages due to increased risk and stress. This led to wage inflation, especially in sectors experiencing labor shortages, which further contributed to overall price increases.
5. Energy Prices: Energy prices jumped when economies reopened, partly due to supply chain issues and partly because of increased demand for oil, gas, and electricity. Higher energy costs fed into the prices of goods and services across the board.
6. Monetary Policy: Central banks initially kept interest rates low to support economic recovery. This made borrowing cheaper and encouraged spending and investment, thus increasing the money supply without a corresponding increase in goods and services. Central Banks got behind the curve thinking they had to keep interest rates down, and it only dawned on them in January 2023 that inflation was a problem that had to be conquered, and rates started to fly higher. We all remember the "inflation is only transitory" false reassurances from central bank heads.

What Now? Spotting Market Misjudgments

Succeeding in the stock market is about spotting what the market has got wrong. That’s what moves prices. ‘Surprise,’ not consensus. What the market is most likely to get wrong now:

• The market thinks that interest rates have moved higher permanently, but logic suggests that the further we get from the pandemic, and the further we get from the inflation and interest rate disruption it caused, the more likely it is that interest rates will return to their pre-COVID trajectory.
• The market is likely to miss that the path of interest rates was lower for longer before COVID, and now that this period of "transitory" inflation is over (yes, it was transitory after all), the path of interest rates will resume its lower-for-longer trajectory.

Everything points to rates heading back to pre-COVID levels:

• Inflation is trending lower.
• Bond yields have peaked.
• Central Banks have begun to cut rates.
• The Fed is likely to cut in a month.
• Australia will follow.
• The Chinese economy is driving a collapse in commodity prices (disinflationary).
• Short term, this process will be accelerated if a recession develops in the US.
• Interest rates are still too high. They are significantly higher than pre-COVID levels, and COVID aside, the chances are that rates would be lower now than they had been pre-COVID, had COVID not intervened.

Bottom line: One of the strongest themes for the next couple of years is likely to be lower-than-expected interest rates. The market is not expecting it, but it is obvious.

What Should You Do About It?

Lock in Those Term Deposits! In the stock market, swim with the tide. The sectors that benefit the most from lower borrowing costs and interest rates include companies that have naturally high gearing (REITs, infrastructure, utilities), those that are geared to consumer spending (consumer discretionary and housing sectors), and those that are geared to overall economic activity (cyclicals). Here are the sectors and types of stocks that typically benefit the most from lower interest rates - resorted to AI for this bit:

1. Real Estate and Property Stocks:
   • Real Estate Investment Trusts (REITs): Lower interest rates reduce borrowing costs for property developers and REITs, making it cheaper to finance property purchases and developments. This can increase property values and boost REIT earnings.
   • Property Developers: Companies involved in residential and commercial property development benefit from lower mortgage rates, which can increase demand for housing and commercial real estate.
2. Banks and Financials:
   • Banks: Although lower interest rates squeeze net interest margins (the difference between what banks earn on loans and pay on deposits), they can also lead to increased lending activity. More home loans, personal loans, and business loans are typically issued when rates are low, potentially offsetting the margin squeeze.
   • Asset Managers: Lower interest rates can drive investors to seek higher returns in equities and other financial products, benefiting asset management firms.
3. Consumer Discretionary Stocks:
   • Retailers: Lower interest rates can boost consumer spending, especially on discretionary items such as electronics, furniture, and luxury goods. This benefits companies in the retail sector.
   • Automotive Companies: Lower interest rates make car loans cheaper, which can increase vehicle sales and benefit automotive manufacturers and retailers.
4. Construction and Infrastructure:
   • Construction Companies: Lower borrowing costs can lead to increased government and private sector spending on infrastructure projects, benefiting construction and engineering companies.
   • Building Materials: Companies supplying materials for construction, such as cement, steel, and lumber, can also benefit from increased construction activity.
5. Utilities:
   • Utilities Companies: Utilities often have high capital expenditures and debt levels. Lower interest rates reduce their borrowing costs, which can improve profitability and make their high-dividend stocks more attractive to income-seeking investors.
6. Technology and Growth Stocks:
   • Tech Companies: Growth-oriented companies, particularly in the tech sector, benefit from lower interest rates because it reduces the discount rate used in valuation models, making future earnings more valuable in present terms. This can lead to higher stock prices for these companies.
   • High-Growth Stocks: Companies that rely on financing for expansion (like many startups) benefit from lower interest rates, as it becomes cheaper to borrow money for growth initiatives.

In summary: Sectors that are capital-intensive, consumer-driven, or growth-oriented tend to benefit the most from lower interest rates in Australia.

Gold: A Beneficiary of Lower Rates

Gold tends to thrive when yields drop in other asset classes.

The Stock Market: A Major Beneficiary of Lower Rates

The other beneficiary of lower rates is the stock market. With low interest rates, bond yields drop, as do risk-free returns in term deposits and fixed interest, driving people into the equity market looking for higher returns. This scenario is good for the equity markets generally, as fund managers and individuals allocate to equities over bonds and fixed interest. It's not great for those of you looking for risk-free rates of return in Term Deposits and similar. Many of you will be forced to look to the equity and take more risk for your returns (TINA). It’s also good news for high-yielding equities, including Banks and other reliable high-yielding stocks like Telstra. Maybe that’s why the banks are already “up there”. As rates drop, you can expect to see a plethora of new “High Yield” products (again), particularly, this time, from the ETF issuers. But watch out for those. Caution with ETFs for Income: I have not used ETFs for income, but that doesn’t mean they don’t work. However, most Members you will find are (understandably) wedded to direct holdings in major banks with 100% franking, with most preferring (understandably) the CBA (history of significant outperformance). You only have to worry when (1) the whole market tips over (sell to buy back) and (2) when there is a sector-specific event (GFC, banking inquiry) that upsets banks in particular (rare). Other than that, hold and take the benefit of dividends and franking. I would be wary of some of the ETFs purporting to offer high yield. They market a good story, but there is no advantage when you look at total return. There is nothing for nothing in this game, and a high yield means the price of the ETF constantly drops as it returns your own capital to you. Much better to go with a passive ETF like MVB, whose biggest holdings come from the big four plus MQG.

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