It amazes me that we pore over every utterance of the Reserve Bank and the US Federal Reserve, earnestly trying to distil what the central banks are going to do with interest rates next. Why do we still benchmark ourselves to these enfeebled and often ignored committees?
The reality is that market interest rates, the rates that matter, have been going up since July and while Trump's election may have accelerated the move, the penny is dropping that interest rates have now bottomed and are trending higher, possibly in the long-term.
US market interest rates, as measured by the 10-year bond yield, are now up 0.9 per cent since July and at the same time the Australian 10-year bond yield is up 0.85 per cent since August. Do we really think the Reserve Bank will be cutting rates again? Do we really think the Federal Open Market Committee (FOMC, the branch of the Federal Reserve that determines monetary policy) should be fluffing around and hedging their bets before raising rates? With US bond yields at 2.2136 per cent, the FOMC are now 1.7136 per cent behind the curve. With 10-year bond yields at 2.626 per cent, the RBA is 1.126 per cent behind the curve, which is inequitable, because what investors are paid is benchmarked to the central banks and what they paying is dictated by the market.
For the last three decades, with interest rates about 5-10 per cent, retirees have been living quite comfortably on the income from bond-like investments without having to touch their capital. But as interest rates fell over in the last decade or three, and as term deposit rates dropped below 3 per cent, we all know retirees have felt forced to look for higher income in other investments, in the equity market. And this is where this new trend in interest rates is really going to hurt them.
Being naturally very risk averse, and used to bonds, income-seeking investors have focused on companies that display bond-market-esque qualities such as safety and income, while hoping that the more traditional qualities of the equity market, risk and growth, behave themselves. As a result, a lot of previously risk-free retirees have been crowded into what are called "bond proxies"; the safe income stocks, such as Telstra, infrastructure, utilities and REITs.
And there they huddle, clinging to the possibly outdated expectation that they should still be able to live off their income, indignant that they should ever have to spend their capital.
And this is where it is all going to go wrong for retirees, because if this trend towards higher interest rates persists, these bond proxies are going to fall over. In fact, they have already started to. Retirees are sitting on a bombshell if interest rates rise from here. These stocks are not bonds, you have no right to your capital back and to add insult to injury, most of them have become overvalued compared with history. There is no "safe income" in the equity market, there never was, just "risky income" and a lot of retiree money is sitting in it, exposed.
If interest rates have bottomed then the safe income stocks, which are so indebted and so sensitive to interest rates, will be sold off. The question now is how long will retirees sit in the equity market and take the pain rather than do anything about it.
We are selling safe income and buying banks at the moment. Banks fell 31.4 per cent between February last year and February this year with all sorts of issues, like the need to raise capital, their margins being squeezed by lower interest rates, the imposition of regulatory restrictions on property lending and the risk of a royal commission into the banking sector. That left them looking remarkably good value and a lot of these sentiment issues are now improving. The royal commission has been avoided, the Basel IV capital requirements are going to make them look overcapitalised not undercapitalised, the property market is less frothy and the prospect of higher interest rates may lead to higher margins. Imagine that, a stock broker upgrading one of the banks. Unheard of in the last two years.
At the same time, while interest rates may plateau or even fall, the days of the safe income stocks demanding growth style multiples are probably gone. Think about it. With their low return on equity and lack of growth options, they have never been sexy, they were just popular.
Of course, for retirees, jumping out of safe income and into the banks could be a bit like jumping out of the frying pan and into the fire. So for some of you, the best option may be to rotate back into fixed interest instead, and while you wait for those interest rates to go up, learn to spend your capital rather than hand it on to your kids. It's surely better than losing it in interest-rate-sensitive stocks.
Marcus Padley is a director of financial services company MTIS Pty Ltd and the author of stock market newsletter Marcus Today. For a free trial see marcustoday.com.au.
Read more strategies and insights for retirees and pre-retirees in Money's retirement special on Wednesday, November 23.