As the new year, and the new decade, takes hold, it is quite normal for individuals to look forward to this new period and make predictions about what to expect. I shall stay firmly away from this temptation. Instead I would like to put across some sobering thoughts about the world I live in. A world that has changed dramatically in recent years and which has impacted savers generally, both positively and negatively.
Following the financial crisis in 2007-8, central banks have largely been on a path of lowering interest rates in order to try and stimulate economic growth. Why is this pathway chosen?
Economic theory suggests that as interest rates are lowered, people borrow more to spend and invest, or simply take their cash away from the bank since it is earning nothing or next to nothing, and use it in the real economy. This, theoretically, has the impact of stimulating economic growth.
Sadly this has not happened as widely or forcefully as central banks expected, and hoped. Instead there have been other side effects that have impacted the daily lives of many savers in a way that perhaps was not anticipated.
Asset bubbles have potentially been created. Prices of bonds move in the opposite direction of interest rates. As interest rates have fallen, prices of government bonds have risen, substantially. This is because the fixed coupon (interest rate) attached to a bond becomes more attractive as interest rates fall, enticing investors to pay ever higher prices to lock into that coupon.
This has led to the phenomenon of negative bond yields – lenders paying borrowers instead of the other way around. The safe haven status of a bond is therefore being challenged at these price levels.
From a credit quality perspective nothing changes here. Unless the issuer of the bond defaults, the nominal amount investors bought of a bond will be the principal amount they receive at the end of the term upon maturity.
However, for the vast majority of the bonds outstanding which currently trade at a premium, the value of the bonds will be negatively impacted as their prices fall towards the redemption price (100). It is important therefore that investors are aware of this and be prepared for the possibility of reinvesting their capital at a lower level of interest when their bonds mature. Other assets with relatively fixed incomes attached to them have also benefitted. Property is one example.
The current trend in interest rates in Europe is unlikely to change anytime soon unless there is a change in policy direction
Malta is not the only country where property prices have boomed in recent years; to the extent that buyers of property are able to rent out their properties, prices have been bid ever higher.
And why not? Borrowing money has never been cheaper. Or if one has savings, these are earning next to nothing, so why not utilise these funds in such a situation?
At this point in the cycle it doesn’t look like European interest rates are going to start moving upwards any time soon; to the extent that this has been the driver of property prices then these should be stable, but there are other drivers impacting the demand and supply of property, and property is an illiquid asset.
Perhaps one of the main reasons why lower interest rates have not stimulated growth in the way expected has been the ageing nature of Europe’s population.
Older people are not prepared to go out and risk or spend their savings in the way younger people are. They understand the importance of preserving their hard-earned lifetime savings and are generally only looking for a safe home for their cash where they can earn a decent regular income to help them sustain a good quality of life.
Sadly, lower interest has many side effects for this part of society. It reduces the available income for such people through reduced returns from bank deposits or government bonds, thus impacting their spending power.
Worse, it forces some of these savers into higher risks in search of better returns; risks that perhaps at their age they should not be exposed to. It is key that such risks are weighed carefully to avoid any form of capital loss beyond that which the person is able to sustain. Diversification is not the only answer. Careful oversight of the assets held, and their valuation, should be undertaken regularly.
Lower interest rates do have some positive effects. Insofar as they translate into economic growth whilst keeping inflation contained, equities should benefit; both through the attractive dividend flow as well as through higher prices as companies achieve higher profitability.
The current trend in interest rates in Europe is unlikely to change anytime soon unless there is a change in policy direction. However, this should not make investors become complacent. As prices of assets move ever higher, risks grow. And as risks grow, investors should make greater efforts to manage the risks they are exposed to.
* And the Waltz Goes On is a superb waltz written by Sir Anthony Hopkins.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.
David Curmi is managing director of Curmi and Partners Ltd.