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Like it or not, we live in interesting times. More than a decade after the Global Financial Crisis, the global economy is facing fresh headwinds creating uncertainty for policy makers and investors alike.

This time around it’s not a debt crisis, although debt levels are extremely high, but geopolitical instability.

The ongoing US-China trade war and Brexit confusion in Europe have increased market uncertainty and volatility and put a spoke in the wheel of global growth. The International Monetary Fund (IMF) forecasts global economic growth to ease to 3.0 per cent over 2019. It expects Australia to grow at 1.7 per cent. ⁱ

Against this backdrop, there has even been speculation that the Reserve Bank may need to resort to ‘unconventional measures’ such as negative interest rates and quantitative easing to boost growth. These measures have been widely used overseas but are foreign concepts to most Australians. So what are they?

Why negative rates?

Negative interest rates have been a feature of the global financial landscape since the GFC, in Japan and in Europe. European central banks charged banks to hold their deposits, encouraging them to lend out cash instead to kick start economic activity.

So far, the Reserve Bank hasn’t needed to wield the negative interest rate stick, but we are edging closer. The cash rate is at a record low of 0.75 per cent with further cuts expected.

The Reserve Bank has said it is unlikely to take rates below zero, especially now that the property market is showing signs of recovery and mortgage lending is on the rise. Taking interest rates too low could run the risk of igniting another property boom.

Policy interest rates

* Main refinancing rate until the introduction of 3-year LTROs in December 2011: deposit facility rate thereafter

Source: Central Banks

If negative rates are off the table, another way to bankroll economic growth is quantitative easing.

What is quantitative easing?

In the aftermath of the GFC, central banks in the US, Japan and Europe printed money to buy government bonds and other assets. By pumping cash into the system they hoped to boost economic activity.

There has been much debate about whether quantitative easing worked as intended. What it did do was reduce currency values and push investors into higher-risk assets such as shares and property in pursuit of better returns.

It has also increased global public and private debt to $200 trillion, or 225 per cent of global GDP. Until now, high debt levels have been supported by high asset prices. But when coupled with geopolitical and trade tensions, debt adds to the downward pressure on growth.ⁱⁱ

The slowdown in economic growth in Australia and elsewhere is reflected in falling bond rates.

Bonds sound a warning

In recent times more than 10 European governments have issued bonds with negative interest rates. At first it applied to short-term bonds, but Germany, the Netherlands and Switzerland have 30-year government bonds with negative yields. ⁱⁱⁱ

A Danish bank has even offered 10-year mortgages at minus 0.5 per cent. ⁱⁱⁱ

In recent months, yields on Australian government 3-year and 10-year bonds have dipped below 1 per cent, an indication that the market expects growth to slow over the next decade.

10-year Government Bond Yields

Source: Refinitiv

Falling bond yields have fuelled speculation that the government could issue bonds and use the proceeds to fund infrastructure spending or direct payments to households. This would effectively combine quantitative easing with more conventional government stimulus.^iv

What does this mean for me?

It seems more than likely that bank deposit rates will stay low, and probably go even lower, for some time. That means investors seeking yield will continue to look to property and shares with sustainable dividends.

While the hunt for yield should support asset prices, it may not be plain sailing.

Trade wars, Brexit, high asset prices and slowing economic growth are creating a great deal of uncertainty. Each new twist and turn in trade talks sends markets up in relief or down in disappointment.

After a decade of positive returns, and average annual returns of 7 per cent from their superannuation funds, investors may need to trim their expectations.

Time to plan ahead

If retirement is still a long way off, you can afford to ride out short-term market fluctuations. Even so, it’s important to make sure you are comfortable with the level of risk and investment mix in your portfolio.

If you are close to retirement or already there, you need to have enough cash or ready income to fund your pension needs without having to sell assets during a period of market weakness. For the balance of your portfolio, you need a mix of investments that will allow you to sleep at night but still provide growth for the decades ahead. When markets recover, you want to catch the upswing.

Successful investing requires patience but also adaptability. If you would like to discuss your overall portfolio in the light of market developments, give us a call.

i https://www.imf.org/en/Publications/WEO/Issues/2019/10/01/world-economic-outlook-october-2019

ii https://www.smh.com.au/politics/federal/200-trillion-in-global-debt-at-risk-if-trust-falters-oecd-20190909-p52pdr.html

iii https://www.ricewarner.com/can-super-funds-continue-to-meet-their-investment-targets/

iv https://www.ampcapital.com/content/dam/capital/04-articles/olivers-insights/2019/august/OI-280919.pdf

What a difference a year makes. In recent months, Australian shares hit a record high, the Aussie dollar dipped to levels not seen since the GFC and interest rates were cut to historic lows.

Towards the end of 2018, shares were in the doldrums and while experts agreed the Aussie dollar would go lower most tipped the next move in interest rates would be up.

All of which goes to show that when it comes to predicting financial markets, the only sure thing is uncertainty. There’s no avoiding market risk, but it does need to be managed if you want to build enough wealth to live comfortably in retirement and achieve other life goals along the way.

Thankfully, there is a way to reduce the impact of market volatility on your overall investment portfolio. Hint: it’s not by putting all your money in the bank.

Mix it up

The best way to reduce the risk of one bad investment or a downturn in one market decimating your returns is to hold a mix of investments. This is what is referred to as diversification or, as Grandma might say, not putting all your eggs in one basket.

To smooth your returns from year to year and avoid the risks of short-term market volatility, you need a mix of investments from different asset classes.

The difficulty of predicting the market in the short-term was certainly in evidence in the year to June 2019.

At the end of 2018 global sharemarkets were gripped by the fear of an escalating US-China trade war, confusion over the final Brexit deal, rising US interest rates and falling commodity prices. Investors who panicked back then and sold their shares would have missed out on the unexpected rebound in global shares.

A year of surprises

As Table 1 shows, Australian shares returned 11 per cent in the year to June 30. Global shares returned 11.9 per cent while US shares returned 16.3 per cent, partly reflecting the fall in the Aussie dollar from US74c to US70c.

Table 1: Total returns (% p.a.) as at 30 June 2019

Source: Vanguard

Although not included in the table of returns from listed investments, the worst performing asset class in the year to 30 June was Australian residential property. According to CoreLogic, Australian home values fell 6.9 per cent over the year. But while the housing market downturn was constantly in the news, good news in other sectors of the property market went largely unnoticed.

The best performing asset class by far in the year to June was Australian listed property, up 19.3 per cent. ASX-listed real estate investment trusts (REITs) invest in a wide range of office, industrial and retail property.

The gap in performance between direct residential property and listed property highlight another important aspect of diversification. You also need to diversify within asset classes.

Look beyond your backyard

Where property is concerned, that means investing across a range of property types and geographic locations. By diversifying your property investments, you reduce the risk of short-term price fluctuations in one location which can result in a big loss if you are forced to sell at the bottom of the market.

The same holds true for shares. By investing in a range of companies, industry sectors and countries you reduce the risk of short-term losses.

Many Australians have a share portfolio dominated by the big banks and miners, attracted by their fully franked dividends in a low interest rate world. This is especially so for retirees and others who rely on income from their investments.

The danger is that investors with a portfolio heavily weighted towards local stocks are not only exposed to a downturn in the bank and resources sectors but also the opportunity cost of not being invested in some of the world’s most dynamic companies.

Time is your friend

Over the last 30 years the top performing asset class was US shares with an average annual return of 10.3 per cent. Australian shares (9.4 per cent) and listed property (9.2 per cent) were not far behind.

And then there was cash. In a time of record low interest rates cash in the bank returned 2 per cent in the year to June 30, barely ahead of inflation of 1.6 per cent. The return was better over 30 years (5.6 per cent), but still well behind the pack.

Cash in the bank provides interest but absolutely no capital growth. While it’s important to have enough cash on hand for daily living expenses and emergencies, it won’t build long-term wealth.

Table 2

*Growth of $10,000 with no acquisition costs or taxes and all income reinvested.
Source: Andex and Vanguard

As you can see from Table 2, someone who put $10,000 in the bank in 1989 and left it there earning interest would have the princely sum of $51,896 today. Whereas someone who invested the same amount in US shares would have almost $190,000.

There’s no telling what the best performing investments will be in the next 12 months, as past performance is not an indicator of future performance. What we can be confident about is that a portfolio containing a mix of investments across and within asset classes will stand the test of time.

If you would like to discuss your overall investment strategy, please give us a call.