Gauging the risks with investments
Last week's decision to leave the official cash rate at 2.5 percent despite an overheating property market, confirms industry speculation that interest rates will remain low for a considerable time.
The Reserve Bank's problem is that even a modest increase in the cash rate would put further upward pressure on the Australian dollar, which, by any comparison, is overvalued. With iron ore and other metal prices well below previous levels and unlikely to rebound quickly, our major exporters face the same financial pressures as the manufacturing sector has for several years. The only quick solution to maintain or boost profitability is for the value of the dollar to fall.
Our interest rates are still attractive for international investors seeking AAA-rated investments and until this capital inflow declines, the dollar will remain strong and continue to squeeze both our manufacturing and export sectors. The strong property market is the biggest obstacle to reducing our interest rates further and, even then, it's not certain that this action will have the desired effect of reducing the dollar's value. Until non-residents opt to take their profits and repatriate their capital and our residents increase their offshore investments, our dollar will stay uncomfortably high.
Another drawback of reducing the cash rate even further is the increased pressure for investors to take higher risks to maintain their living standards. Now the share market is at a six-year high and property prices are inflated, self-funded retirees are struggling to find suitable new income-generating investments. The new inflow of money into shares and property assets has boosted superannuation funds and managed investment returns over the past three years. This is because of the resulting capital gains in both property and share prices, as investors switched out of fixed interest and similar investments to obtain higher dividends and rental yields.
The share market has room to improve because of higher dividend payouts, and because of the value of franking credits, the yields available from new share purchases still considerably exceed fixed-interest returns. However, the downside is the risks of capital loss if earnings fall or interest rates rise.
In the meantime, the longer interest rates stay at or about current levels, the more confident share investors are likely to be. But they will need to be aware of, and evaluate, the associated risks of both the possibility of volatility and the need to be able, and willing, to sit out price declines. Investors with diversified portfolios who held their nerve during the GFC are far better off than those who sold out and switched to fixed-interest investments, which, at the time, were providing much higher yields.