RBA rate cut: What falling interest rates mean for the stock market
The central bank has slashed rates in a bid to jump-start Australia's economy, so what does this mean for your investment strategy?
On Tuesday, the Reserve Bank of Australia (RBA) slashed the official cash rate by another 0.25%, taking it to a new record low of 1%, following weeks of speculation.
It marks the second consecutive rate cut in a row with the central bank pointing to risks stemming from global trade and technology tensions, low wages and declining house prices.
That all sounds like bad news, but from an investor's point of view, a low-interest-rate environment can be positive – at least, in the beginning.
As we saw from last month's rate cut and in recent weeks out of Wall Street, when interest rates are predicted to fall, share investing picks up. That's partly because lower rates encourage people and businesses to spend more and save less, thus spurring on business growth as well as the stock market.
Although this is also true in Australia, the local market faces some unique challenges that could dampen sentiment.
While there's plenty of debate among analysts about what the next 12 months will entail, here's a snapshot of what analysts expect to happen as rates continue falling:
- Stock market should rise in the short-term. Investors are generally optimistic that business profits will provide a boon to the stock market.
- Australian dollar falls. Lower rates usually pull down the lower currency as foreign investment becomes less attractive.
- Bond market to rally. When interest rates fall, bond prices rise and vice versa.
- The export sector wins. A lower dollar makes Australian goods more competitive on the global markets. Conversely, the imports sector will find it harder to make profits.
- Domestic spending increases. Lower rates should encourage households to save less and spend more, however this could be tempered by flat wages.
- Dividend-paying stocks become more attractive. As capital returns become harder to chase, dividend paying stocks become more popular.
- Bank stocks might fall. Low rate environments can make it a challenge for banks to maintain profit margins.
- Real asset stocks rise. Real assets such as property and utilities stocks are expected to become more attractive for investors.
Why low rates could be good or bad news for Australian investors
Stock markets tend to do well when interest rates fall because investors believe the rate cut will encourage more spending and borrowing in the economy. In other words, rate cuts encourage optimistic buying.
However, Australia's stock market is heavily weighted towards the financial sector, specifically the Big Four banks. While a low-rate environment presents a better opportunity to invest than to save, it's also a sign the economy is underperforming, which is ultimately bad news for the banks.
"Generally, in a falling interest rate environment, it's negative for the banks. They find it more difficult to maintain their profit margins," equities analyst Julia Lee of online brokerage Bell Direct explained.
Because Australian portfolios tend to be overweight in financial stocks, the effect on returns could be negative if bank profits continue to fall, especially as interest rates are expected to drop at least twice more before 2020.
Of course, that will all depend on how the lower interest rates affect the housing market and the economy. If the lower rates encourage more people to take out mortgages and loans, the banks should find themselves in a better position.
The Australian dollar will fall
Interest rates alone do not affect the value of a currency, however as a general rule, lower rates will result in a lower local currency.
A low Australian dollar will make imported goods more expensive and homegrown products a better deal for Aussie consumers. By that same token, Australian goods will become cheaper and more competitive in overseas markets.
As a whole, a lower Australian dollar is good news for Australia's domestic industry and bad news for companies reliant on overseas goods, such as the automobile sector and outgoing tourism sector.
However, because the Australian dollar is largely priced in relation to the US dollar, these effects partly hinge on whether the US Federal Reserve also continues cutting rates. The RBA will need to be more aggressive than the US central bank in cutting rates if the Australian dollar is to stay low and pass on those effects to the economy.
Which stocks will perform better?
With all that in mind, how should Australian share market investors take advantage of falling interest rates?
According to AMP chief economist Shane Oliver, investors that have been relying on bank interest in the form of term deposits should evaluate what they regard as most important –- security or income flow.
"If it's the latter, then there are alternatives worth considering. These include Australian shares offering decent sustainable dividend yields with high franking credits. The grossed up dividend yield on the market is just above 5.5% which is a lot more attractive than bank term deposit rates, which are around 2% or less," Oliver said.
Because capital returns can be harder to achieve during a low-rate environment, analysts expect investors to flock towards steady dividend paying stocks.
However, Lee's advice is to start being more selective about which companies to back. On the whole, she said investors should start to take a more "defensive" stance, which means looking to hard assets, such as property and utilities stocks, while being more cautious about the banks and growth stocks, such as Aussie tech stocks.
Examples of these include Auckland Airport (AIA), which is up more than 40% over the last few weeks, Transurban Group (TCL), up over 20% over the last year and the telecommunications sector, which has delivered a 35% return in the last 12 months, according to Lee.
On the other hand, if the economy does what the RBA is hoping it does (recovers), market analyst Kyle Rodda from online brokerage IG said that the low rates will be a boon to riskier sectors of the market, such as tech stocks.
"What tends to happen in these situations is that risk-taking is encouraged as liquidity is increased in the market, so it gives equities in general a bit of a boost," Rodda said.
Property stocks becomes more valuable
The idea of lower rates is to prop up economic fundamentals, especially the property market. Put simply, when interest rates are lower, owning property should become cheaper and more attractive.
Rodda explained that analysts expect a lift in property stocks in the immediate term, such as real estate investment trusts (REITs) – companies that own commercial property such as apartment buildings, warehouses, hotels and offices.
"There's a bit of confidence that the interest rate cuts will stabilise the housing market. And because REITs provide a bit of income, we have seen this part of the market performing reasonably," Rodda said.
The bond market will rally
Shares and bonds are the two fundamental building blocks of most investment portfolios. How much each asset is allocated is normally decided upon based on how the economy is performing and how much risk an investor is wanting to take on.
Because bond prices usually go up as interest rates fall, many analysts argue that now is the best time to invest in the bond market.
"It's certainly the prevailing view in the market that it's the place to be, with global central bankers cutting interest rates," Rodda explained. "Going long on Aussie government bonds is a reasonably good bet in the market at this stage."
Where shares normally return value as the stock markets rise, bonds act as a counterweight to a portfolio because they tend to do better when the economy is underperforming.
If trade tensions between the US and China continue to weigh on economic growth, then central banks may need to keep cutting rates, presenting a strong argument for the bond market.