What falling interest rates mean for investors

The Reserve Bank of Australia's official cash rate is at a record low of 1 per cent, with further cuts predicted as the central bank strives to offset perceived economic weakness.

In the United States, the outlook is similar. The U.S. Federal Reserve, which in January was expected to raise rates, is now on a path to lower them.

What has changed so quickly, and what does it mean for investors?

Around the world, economic uncertainty has risen on concerns that a trade war might limit growth. In addition, job-market indicators signal weakness.

In Australia, unemployment is above targeted levels, and wage growth has hovered at a relatively sluggish 2.3 per cent, In the United States, where unemployment remains near the lowest level in 50 years, strong job numbers have not generated significant wage increases. That may explain why inflation, the traditional target of central banks, has lingered below expectations. Workers can't spend money they don't have. Those are the immediate conditions that shifted the conversation from rate hikes to cuts as “economic insurance.”

Over the longer-term, the 2008 financial crisis modified central bankers' approach to monetary policy. Years of low interest rates have pumped money into the global economy but have not fueled inflation. Inflation's vanishing act, combined with persistent economic lethargy, has tilted central bankers' bias toward quick action.

Over the short term, reduced interest rates tend to boost share returns because investors believe monetary stimulus will improve economic prospects. Lower interest rates also push investors to seek the higher relative return of shares.

Those are generally short-term effects, however, and investors should focus on the long run. While interest rates may potentially represent an opportunity to refinance your house, they should not cause you to veer from a carefully planned investment strategy.

Changing rates do reinforce some long-term investing principles that can be helpful to remember to maintain discipline:

• Don't reach for return. Vanguard forecasts that share returns are likely to remain at about 4 per cent to 6 per cent, below historical averages, for the next decade. While this is a reasonable return, it may tempt some investors to increase risk in the hope of greater reward. Vanguard research suggests that strategies, such as investing in lower-quality bonds that pay higher rates of interest, rarely pay off. Instead, sticking with a low-cost, diversified portfolio that captures returns from global shares and bonds and matches your risk tolerance provides the best chance for investment success.
   
• Control what you can. You can't control financial markets, so focus on what you can control. If you are concerned about lower returns, consider saving more or working longer. Keep investment costs low to avoid eroding returns.
   
• Understand the role of bonds in your portfolio. Bond prices fluctuate with interest rates, but remember that income is only one reason to invest in bonds, and not the most important one. Bonds' bigger role is to protect against volatility in the share market. For example, in 2008, the Australian share market fell 38.9 per cent; Australian fixed interest, as measured by the UBS Australian Composite Bond Index, rose 14.9 per cent.

Interest rates will always move up and down. Don't let your investment strategy bounce around with them.

Written by Robin Bowerman
Head of Corporate Affairs at Vanguard.
30 July 2019
vanguardinvestments.com.au