Investing in a Falling Interest Rate Environment

Inflation is currently below the mid-point of the RBA’s self-imposed target, so if the RBA is true to its word, and indeed common economic sense, we are set for a prolonged period of falling interest rates. This becomes wholly more likely as global tariff uncertainty clogs trade and the flow of goods.

Whether or not the Reserve Bank’s, in my opinion ‘too little too late’ reset of monetary policy will soften our GDP landing will only become apparent in the coming months. Whilst holding the cash rate steady in July does not bode well, it remains close to a certainty that, with two cash rate drops already in the bag, that the current cash rate of 3.85% will drop below 3.00% within the next 12 months.

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So, what should we expect in a falling rate environment and how could it impact our investment decisioning?

Economists pontificate about a disparate array of consequences. Whilst economics is never an exact science, two of the most broadly accepted repercussions that will be wrought are that firstly domestic spending will increase and secondly investment dollars will be re-allocated by investors away from bank deposits. More specifically:

Higher Household Spending: With borrowing costs such as mortgage repayments and overdrafts lower, both households and small businesses have more disposable income which tends to increase spending. Additionally, with lower borrowing/ repayment costs, decisions to “buy” that have been on hold whilst rates were high will start being activated. That new dishwasher or even a new car is now within reach. Higher household spending is exactly the economic stimulus the RBA is trying to encourage by reducing the cash rate.

Asset Switching: As rates on bank deposits dwindle, investors will re-deploy their cash into other asset categories like equities and real estate. Whilst this appears to be a switching of investment assets, it is actually a switch from ‘saving’ to ‘investment’ in economic jargon. Again, with cheapening debt costs, investments categories that can be levered/ geared such as real estate will gain a multiple benefit, in other words $250,000 withdrawn from the bank might buy a $750,000 investment property when sensibly mortgaged. This “switching” will increase demand for these asset classes and tend to push their values higher.

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It is the second of these consequences which is most pertinent to investors.

With bank deposits likely to lose appeal as interest rates fall away, we are heading back to a world where income is no longer a ‘given’ and must again be sought out. This does present a significant challenge. Whilst high dividend yielding equities are highly attractive, they are also a rarity and always come with the risk / reward of volatile values.

Add to this the uncertainty of the global economy which is driving choppy stock-markets and significant value swings across the globe and many investors, especially those in the latter stages of their investment cycle, are still reluctant to invest too heavily in shares. This is simply because to those of us in, or close to, retirement maintenance of wealth is far more important than increasing it.

At the ripe old age of 62, whilst prepared to embrace a little risk here and there, I prefer to plonk my excess cash into income producing, preferably low-capital risk investments and I know I am not alone. I don’t want to lose what I have and I am prepared to moderate my desire for increasing wealth in return for not losing it!

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There is also another very important driver for ‘asset switching’ which is of our own making.

With the likely introduction of a new wealth tax, otherwise called Division 296 - High Balance Super Tax, there is now another driver for asset switching. Under Division 296, whilst all of your superfund income will still be taxed at 15%, if, for example 30% of your superfund balance exceeds $3,000,000, then 30% of your superfund income will face an additional 15% tax. And here is the kicker, this additional 15% tax applies whether your income is realised or not. So, if your superfund balance is over $3,000,000 and your share portfolio goes up … you will get a tax bill whether or not you sell those shares.

I talked at length on this issue at a recent investor meeting for the Balmain Opportunity Trust (here). The short summary is that over $500,000,000,000 (yes that is half a trillion dollars) will be impacted to a lesser or greater degree by Division 296. That amount equates to 4% of the value of all real estate in Australia or 20% of the value of the entire Australian stock market.

Will vast sums of money leave the superfund sector as a direct result of the introduction of Division 296 and be deployed elsewhere? If, like me, you believe it will, the next question is … will the ‘departing money’ be invested in the same assets once outside of super as when inside super?

The answer must be no. Superfund rules about ‘eligible’ investments (must be arms’ length, can’t be used by superannuant, must produce income, hard to borrow, etc.) do not apply outside of the superfund environment, so it is highly likely that once freed of the superfund shackles, this money will be ‘switched’ into different asset classes that better suit the investor’s requirements. The sole advantage of investing through your superfund, the tax break, no longer exists.

It is hard to argue that geared real estate will not be a significant beneficiary of these unshackled funds which, as with the falling interest rate environment, will tend to drive up the value of real estate. I would opine that an equal but negative impact will apply to the stockmarket.

Our view is that, notwithstanding pockets of real estate weakness such as farms held in superfunds which may need to be sold to mitigate the impact of Division 296, there are positive drivers for real estate values from each of falling interest rates, the introduction of Division 296 and the ongoing under-supply of new residential dwellings.

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How does this impact on Balmain’s investment products?

Taking a look at Balmain’s investment products including Balmain Private and Balmain Opportunity Trust, the underlying strength and positive outlook for residential real estate, which provides the security for 85% of Balmain’s investments, is good news. It means the security for our loan investments is healthy.

More importantly, Balmain’s lending products are generally fixed rate. This means that if you borrow money from Balmain the rate remains the same during the term of the loan, even if the cash rate falls during the term of the loan.

In respect of Balmain Private this means that if you invest in a loan today, the rate will remain the same for the term of your investment. It will not reduce. This is a significant difference to investing in a variable rate asset where returns will fall as the cash rate falls. Similarly, with Balmain Opportunity Trust whilst new loans may be at slightly lower rates as the cash rate falls, the loans already in the Trust do not suffer any drop in pricing. As a consequence, the investor distribution rates are slow to reduce as the bulk of the portfolio reflects historical, higher lending rates.

So whether you invest in Balmain Private or Balmain Opportunity Trust, the fixed rate nature of the underlying investments will insulate you from the rapid decline in rates that would apply to all variable rate investments.

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In closing, my words of cautious advice to you are as follows:

We are all very used to investing in a low interest rate environment, we did it for over a decade before the COVID lock-ups changed the world. You would do well to try and remember your pre-COVID investment habits as they will soon be the ‘norm’ once again.

Add to that the recognition that as rates fall to those pre-COVID levels there will be opportunities to re-allocate your investments to seek optimal returns that better suit your investment objectives. There may also be opportunities to delay the reduction in your income by considering investments underpinned by fixed rate assets.

Kind Regards
Andrew Griffin
Chief Executive