With the Reserve Bank of Australia (RBA) policy rate now at 2% and Australian banks much more focused on raising capital than raising deposit funding, the “free lunch” that Australian investors quite rightly feasted on has ended. Since the global financial crisis, Australian investors have earned very healthy real returns of about 2%-4% for taking essentially no risk by holding term deposits. This kitchen is now closed ‒ permanently.
This is a massive adjustment. While our developed-world peers have faced this reality of financial repression for well over five years, the Australian investor reaction to this new reality thus far appears to be somewhat backward-looking.
The hunt for yield has certainly been turned up a notch, and the source of income for many investors is migrating down the capital structure of the Australian banks into hybrids and shares. These alternate sources of income seem reasonable as long as the risks are well understood, portfolio concentration risk is avoided and the capacity for larger mark-to-market loss can be handled. For example, in the past two months alone, two to three years of expected dividend income from all Australian bank shares has been completely offset by mark-to-market capital loss. It is also important to recognize that, in a more capital-conservative world, historical dividend levels may be just that: history.
Australian investors have shown a tendency to look in the rearview mirror when making other financial decisions as well. In a recent study, we found that households are more comfortable taking on debt when interest rates are low AND asset prices have recently been appreciating. (See “A Look at Rising Household Debt in Australia and the Implications for Policy.”)
The good news is that in PIMCO’s New Neutral outlook, rates are expected to stay lower for longer and permanent capital loss will likely be confined to the most bubble-prone asset classes; yet, mark-to-market volatility is expected to be higher across the board.
Accordingly, we suggest investors:
- explicitly acknowledge that the real risk-free rate is now negative;
- be mindful of the additional risk in the instruments they use for income generation;
- focus more on expected capital price volatility of portfolio holdings;
- ensure there is sufficient risk-factor and geographic diversification in their portfolios;
and finally, remember when it comes to investing, there is no such thing as a free lunch.