And it's a cut, again!

And it's a cut, again! | Canny View: Stewart Group

by Nick Stewart. Originally published in NZ Herald Hawke’s Bay Today.

New Zealand appears to be stuck in an economic malaise. Household debt has never been higher, wage growth tends to lag, and gross domestic product per capita (everyone’s share of the economic pie) annual growth has been shrinking.

 According to Trading Economics, household debt to income in New Zealand reached an all-time high of 163.90 per cent in the fourth quarter of 2018 and remained unchanged in 2019.

And this was with interest rates already at record lows. Solution? Cut interest rates further. The Reserve Bank slashed its official cash rate this week to a new record low of 1 per cent (rather than 1.25 per cent that was predicted), sending mortgage rates down and kiwi dollar to a three-year low.

 Will it work? Well lowering interest rates isn’t likely to do much given New Zealand already has an all-time high household debt to deal with, maybe the RBNZ should also consider this before encouraging the nation to “go and spend” and easing the monetary policy that would make borrowing cheaper.

 RBNZ released a Financial Stability Report report in May 2019 in which the ‘household sector indebtedness’ section concludes:

 “At a national level, the growth of household debt and house prices has slowed, but household debt has still grown faster than income in the past year. Housing market pressures could re-emerge if there is a strong response to the recent decline in mortgage rates or reduced uncertainty about the future tax treatment of property investments.”

When a central bank lowers interest rates, it’s basically saying it won’t let you earn as high a return if your money’s sitting in “safe” investments (like a savings account or short-term government bonds). It's hoping you’ll decide to invest in a more “productive” way – by participating in the share market, for example, or by lending money to an infrastructure fund which can help grow the economy.

While lower interest rates probably won’t push any economic recovery, there is an outcome that low-interest rates almost guarantee – increased offerings of “high yield" bonds.

 High yield bonds are more volatile and carry a higher risk of default than investment-grade (low-risk) bonds. In times of economic stress, defaults may increase – making this high-yield sector more sensitive to economic shocks.

Without good financial education, there will always remain a group of people who live by the “no risk” mantra. These people most likely park their money in low-risk investment options like bonds, bank term-deposits, and as returns dwindle, they either cut back spending or eat further into their asset base.

Then comes a pain point. Panicked people without financial advice will often make bad decisions, suddenly ignoring their ‘no risk’ mantra to chase better returns with high-yield bonds.

Take this from Canada. Interest rates were slashed in 2009, hitting 0.25 per cent. They’ve never been above 2% since. It led to many investors chasing a better return.

Between 2008 and 2017, Fortress Real Developments – based in Toronto – raised a staggering $920 million from 14,000 investors who thought they were getting low-risk, steady income to fund mortgages for an array of development.

Many of these mortgage funds were sold to income desperate people who were reassured; they were doing something low risk. The result has been a wave of losses to investors.

As one lawyer representing an investor who’d lost money said: “People go to these sales meetings. They’re told they can get 8 per cent (annual interest), which is well above what’s in the share market. And it’s in real estate, so they think it’s safe,” he said.

In these mortgage funds, it’s the investor lending their money to developments the banks won’t touch. It’s not low risk, and it’s far from safe.

With such issues at hand, the best way to dodge economic malaise and avoid a panicked reach for high returns is by having a plan with a well-diversified portfolio, along with a financial adviser with an evidence-based approach. And lastly, it should all be tied together with an investment philosophy that doesn’t need a panicked readjustment every time economic or market conditions change.

It’s the best way to lower your exposure to investment calamity.

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