Optimism is the only realism

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By Ken Howard

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12 January 2021, 12:10 PM

Optimism is the only realism, and not just because it is a more enjoyable way to live, but because it is the only conclusion that can be drawn from history.

The last century is littered with disasters, and yet somehow we moved from horse and buggy, to electric cars and mobile phones. The current century started with terrorism and wars, asset bubbles and a financial crisis and now a health crisis. But on each occasion, a combination of the right tools and resources have protected lives and livelihoods and set the foundation for the inevitable recovery.

Covid19 will be no different, a combination of; (a) testing, tracing and treating, and (b) the largest financial stimulus ever, will lay the foundation for lifestyles and living standards to 'normalise'.

Globally, the reaction to Covid19 has been an extremely expensive, costing current savers and future taxpayers in excess of $30 trillion US dollars. A big bill, but arguably cheaper than the cost of having to recover (without the stimulus) from the 20% (+) levels of unemployment & underemployment, that have been caused by border closures, quarantine and lockdowns.

Hopefully for taxpayers the costs can be spread over decades. While for the savers who are funding the Government’s spending, it will be interesting to see how they manage to survive on close to zero interest rates.

Buying a house or saving for retirement?

So what do ultra-low interest rates mean for anyone buying a house or saving for retirement?

The theory is reasonably simple;

• Lower interest rates and stable employment will translate into higher property prices, while
• Lower interest rates and higher property prices will deliver lower future investment returns.

For house prices to be sustainable there must be a relationship between; property prices, rents, interest rates and household income. And of course a household will need to way-up how much it spends on accommodation, versus; food, clothing, healthcare, lifestyle … etc.

To illustrate, using a 30-year time frame, a household may be prepared to either (a) commit 20% of their income to rent or (b) commit 30% of their income (over 30 years) to home ownership.

So if the household was going to buy a property;

• At an interest rate of 15%, they can afford to pay two times their annual income for the property,
• At an interest rate of 10%, they can afford to pay 2.8 times their annual income for the property,
• At an interest rate of 5%, they can afford to pay 4.6 times their annual income for the property, and
• At an interest rate of 2%, they can afford to pay 6.7 times their annual income for the property.

In all cases the total cost is the same, 30% of their income, every year, for 30 years (of course assuming interest rates remain low and incomes remain stable). The lower the interest rate, the lower the total interest bill and the more the household can spend on buying the property. So as a consequence, when interest rates fall, property prices rise.

But for an investor, looking to buy an investment property, higher prices mean lower returns. Using the assumptions above, that (a) house prices are priced off 30% of household income, while (b) rents are priced off 20% of household income, then;

• When interest rates are 15%, the gross rental yield (before property costs) will be 10%,
• When interest rates are 10%, the gross rental yield (before property costs) will be 7%,
• When interest rates are 5%, the gross rental yield (before property costs) will be 4%, and
• When interest rates are 2%, the gross rental yield (before property costs) will be 3%.

A relationship between; income, interest rates and asset prices exists for; public companies traded on a stock-exchange, private companies, real estate and in fact any investment. Lower interest rates will support higher asset prices.

However, while lower interest rates make it cheaper to borrow to buy an investment, lower interest rates do not change the risks of the investment. To illustrate, while lower interest rates will make it cheaper to borrow $500,000 to buy an investment property, low interest rates won’t help you find a quality tenant, nor will low interest rates help you repair any damage from a storm or compensate you for a major employer leaving the area. The cost of borrowing is only one part of the investment decision.

Borrowing is still leverage and buying today (with borrowed money) instead of saving for tomorrow, will reduce your future options. So just because you can borrow and just because it is cheaper to borrow, it doesn’t mean that you should borrow, to buy any and every investment.

Understanding the risks

It is always important to understand the risks of an investment. Which is why I have often said you should only invest in a company with;

1. a prominent, public profile,
2. a history of profitability,
3. a track record of innovation and
4. a solid balance sheet.

If a company does not have these attributes, it can become very hard to assess the risks and opportunities facing the company, which is why I tend to avoid them. I certainly believe that most, but NOT ALL, of Australia’s largest listed companies have;

1. a prominent, public profile,
2. a history of profitability,
3. a track record of innovation and
4. a solid balance sheet and are worth owning as part of a diversified portfolio.

I know that the covid risks are still impacting the local and global economy, but as I said from the outset, I believe that sufficient resources have been committed and more will be added if required, to ensure 2021 sees the end to the rolling disruptions.

Children need to be able to go to school, families need to be able to celebrate life and we all need to be able to make the most of the time we have.

I know the market is back at record highs, so I should be asking clients do they need to raise funds? It’s not such a bad time to be selling, that is if you need to.

However, with interest rates where they are, I think the best advice, if you do not need to sell, is to hang onto your good companies.

I know some of the good companies cut their dividends last year but hopefully the dividends will be substantially restored during 2021.

Stock recommendations

If you have additional funds to invest, I have been recommending to clients that they add to holdings of;

• Sonic Healthcare (SHL)
• Amcor (AMC)
• APA Group (APA)
• Scentre (SCG) (i.e. the Westfield shopping centres).

More Information

Ken Howard is a Private Client Adviser at Morgans. Ken's passion is in supporting and educating clients so they can attain and sustain financial independence.

If you have any questions about your strategy, investments or would just like to catch up, please do not hesitate to give me a call on 07 3334 4856.

General Advice warning: This article is made without consideration of any specific client’s investment objectives, financial situation or needs. It is recommended that any persons who wish to act upon this report consult with their investment adviser before doing so. Morgans does not accept any liability for the results of any actions taken or not taken on the basis of information in this report, or for any negligent misstatements, errors or omissions.