It’s amazing how quickly market sentiment changes these days. A few months ago, the consensus was for interest-rate cuts in Australia this year.
That changed to no rate cut this year, and the view in some quarters is now for several rate rises after hotter-than-expected inflation data in April.
Remarkably, a small group of economists, market watchers and media commentators have changed their forecast to three rate rises this year.
There’s no doubt that the ‘last mile’ of the inflation battle is proving more challenging than markets here and overseas expected. Inflation is ‘stickier’ in this cycle due to the effect of big-ticket items, such as education, healthcare and rents that are harder for consumers to avoid through their spending patterns.
My base case, outlined a few weeks ago in this column, is that Australia and the US are at peak rates and that the US dollar will weaken a little this year and next. Lower rates and a lower Greenback typically aid commodities, gold, emerging markets, and US companies with a higher proportion of export sales.
My base case remains for now, despite hawkish comments from economists last week about the need for several rate hikes this year. The next move in rates in Australia is likelier to be down than up, but rates will probably remain on hold this year. That said, the risk of rate rises is increasing as inflation data, which can be volatile, disappoints. Australia’s economy needs to slow further.
I understand the hawks’ view on rates. Unemployment is lower than the Reserve Bank expected thanks to a continually tight labour market. Inflation is higher due to persistently stronger prices for services. Australia’s cash rate is below that of its major overseas peers, and possibly too low to slow the economy sufficiently.
However, consider the damage if three rate rises occur. On my math, an extra 0.75% to the standard variable rate would add over $300 to the monthly repayment for the average-sized home loan in Australia. Ouch.
In February, Roy Morgan Research estimated 1.6 million mortgage holders – almost a third of all mortgage holders – were ‘at risk’ of mortgage stress with the official cash rate at 4.35%. Heaven help us if the cash rate gets above 5%.
Consider the political damage for the Albanese Government if it goes to the Federal election next year after several further rate rises that cripple households and damage the government’s economic credibility.
So, too, the Reserve Bank, which has its own credibility problems on economic forecasting and will be reluctant to raise rates, given its approach compared to central banks in other developed nations that were more aggressive on rate hikes.
Although I respect the hawks’ view that rates need to rise, it’s worth noting that many economists still expect local rates to remain on hold this year. The biggest and boldest calls on rate rises predictably attract most media attention and publicity. For now, they are an outlier view, although gaining more credence.
As an aside, the rate debate again shows why investors should ignore market noise and focus on what matters most: asset valuations. Inaccurate macroeconomic forecasts – from central banks and market economists – are a recurring source of wealth destruction. Better to focus on bottom-up company fundamentals than top-down noise on things hard to forecast.
That said, I’m more concerned about the prospect of larger share market falls over the next few months. We are entering a traditionally seasonally weak period for Australian equities. A changing inflation narrative and its implications for the timing of interest-rate cuts will add to market volatility and uncertainty.
The equity market rally in the first quarter was predicated on expectations of rate cuts in the US, Australia, and other developed markets. With key markets still near record highs, there is little room for disappointment on the rate front.
Add in geopolitical uncertainty from the Israel/Hamas war and the potential for a wider Middle East conflict, as well as Russia’s ongoing war with Ukraine, and the so-called ‘wall of worry’ for equity markets is getting steeper.
Trimming portfolio exposure to equities by taking profits, or exiting loss-making positions before June 30, makes sense. So, too, does increasing cash allocations within portfolios and having a more defensive posture over the next few months.
To be clear, I’m not suggesting investors aggressively sell positions and take cover. I’m still bullish on the market on a medium-term (1-3 years) basis as interest-rate cuts provide a tailwind for company earnings.
Rather, my view is that the market could have heightened volatility over the next few months as investors seek clarity on the inflation battle and the timing of rate cuts.
As I have written previously, capitalising on volatility from short-term market sentiment is the key to producing attractive real returns this decade. Having more cash on the sidelines now will enable investors to pick up assets at cheaper prices during an equity market correction or pullback over the next few months.
Moreover, if the cash rate rises, the yield on cash instruments will appeal even more. A 6% introductory rate on term deposits (assuming rates rise three times) would look even more interesting, not only for retirees but for equity investors who will watch the gap between risk-free cash and franked dividends narrow further.
Cash Exchange Traded Funds (ETFs) are a convenient way to add cash exposure to portfolios. They typically pay a little less than term deposits, but their main advantage is liquidity as the capital is not locked away for months or years.
Here are two cash ETFs to consider:
- iShares Enhanced Cash ETF (ASX: ISEC)
With $254 million of assets at end-March 2024, ISEC uses a passive strategy to provide a net return above the S&P/ASX Bank Bill Index.
ISEC’s goal is capital preservation and to maximise regular monthly income through a diversified portfolio of higher-yielding, short-term money-market instruments and floating-rate notes.
ISEC is a slightly riskier version of iShares’ larger cash ETF, the iShares Core Cash ETF (ASX: BILL). BILL seeks to replicate the performance of the S&P/ASX Bank Bill Index, whereas ISEC seeks to beat it through the use of floating-rate notes.
Over 1 year to end-March 2024, ISEC returned 4.37%, while BILL returned 4.21%. There’s not much between them and both iShares cash ETFs have a lower return than investors can get from bank term deposits.
However, if global equity markets have heightened volatility over the next few months, as I expect, the ability to deploy cash quickly to pounce on irrationally oversold assets will be even more valuable. Locking money away in term deposits helps conservative investors but works against active investors.
Chart 1: iShares Enhanced Cash ETF (ASX: ISEC)
Source: Google Finance
- Betashares Australian High Interest Cash ETF (ASX: AAA)
AAA is easily the largest cash ETF with $3.34 billion in assets under management at end-March 2024, ASX data shows.
The ETF provides exposure to Australian cash deposits by investing in deposits held in select Australian banks. Interest from AAA is paid monthly at a rate competitive with ‘at call’ term deposits and bank deposits.
Like term deposits, AAA’s return should rise as the cash rate rises and banks pass some of that on through higher deposit rates. Also, AAA has only cash deposits with major banks, meaning it provides capital security and stability, like cash.
AAA returned 4.26% over one year to end-March 2024. Unlike bonds or bond ETFs, AAA’s capital value will not deteriorate in a rising rate environment, should the hawks correctly forecast that rates in Australia will rise a few times this year.
The main drawback with AAA is its annual fee of 0.18%, which is a touch higher than competing cash ETFs.
Chart 2: Betashares High Interest Cash ETF
Source: Google Finance
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation, or needs. Before acting on information in this article consider its appropriateness and accuracy, regarding your objectives, financial situation, and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at 30 April 2024.
