At a recent roundtable event I touched on the concept of ‘financial repression’. A key characteristic of financial repression is that interest rates are lower than the rate of inflation, and this is a distinguishing feature of global fixed income markets presently. In this post I discuss the re emergence of financial repression and its impact on income generation.
The yield on a six-month term deposit in New Zealand is currently just over 1%1 . Generating retirement income in this environment of ultra-low interest rates is very challenging. During periods of financial repression retirees overly reliant on fixed income and static asset allocations are at risk of earning returns below the rate of inflation for an extended period.
Financial repression played an important role in the US after World War II (WWII) in reducing government debt-to-GDP ratios. Similar central bank policies enacted after WWII were implemented following the Global Financial Crisis (GFC) and more recently given the devastating impact of the Covid-19 pandemic on the global economy last year.
In an environment of financial repression, central banks will tolerate higher levels of inflation before acting and there is evidence of this occurring today. The US Federal Reserve recently changed their inflation policy away from targeting 2% to a policy of targeting average inflation. Therefore, they are likely to tolerate a period when inflation is above 2%. The European Central Bank has also adjusted their inflation targeting.
During times of financial repression ‘real’ interest rates (interest rates after inflation) are kept low so governments can reflate away their large debt obligations. Such an environment benefits those with debt and real assets because the real value of debt declines over time and the value of assets generally increase. Arguably, there is a transfer of wealth from savers to debtors.
Those overly reliant on bank deposits or fixed income securities are disadvantaged during periods of financial repression given interest rates are kept artificially low. As a result, income fails to keep up with the rate of inflation (purchasing power decreases) and real capital values are also eroded by inflation.
Current investment environment
A feature of the current global investment climate is that dividend yields on many sharemarket indices are higher or in line with interest rates. As can be seen in the graph below, this has not always been the case for the US sharemarket.
Interest rates were below dividend yields in the years following WWII (1945 through to the late 1950s). Although there are several reasons for this, financial repression polices by the government and central bank is one.
Another observation from the graph below is that both interest rates and dividend yields have fallen dramatically over the last 20-30 years in the US. The fall in interest rates has boosted returns from fixed income, which is highly unlikely to be repeated in the years ahead.
Except for New Zealand, this phenomenon is evident around the world, with dividend yields higher than interest rates in Australia, the UK, and across most countries throughout Europe.
New Zealand dividend yields
As shown in the graph below the dividend yield on New Zealand shares is higher than fixed income yields. In 2015 the dividend yield on the New Zealand sharemarket was 3.0% higher than the New Zealand five-year government bond yield.What is most interesting in this graph is that the dividend yield on the New Zealand sharemarket has steadily declined over the last five years. In addition, the dividend yield ‘premium’ above fixed income has steadily eroded and is currently 1.5% higher than the five-year government yield, half of what it was in 2015.
The decline in the New Zealand sharemarket’s dividend yield partly reflects the changing nature of the market. Many of the larger New Zealand companies are relatively low dividend paying investments, eg Fisher and Paykel Healthcare, Mainfreight, Auckland International Airport and Ryman Healthcare.
Maximising income in a period of financial repression
In the current environment, diversification of income is paramount. This involves seeking a diversified source of income and not being overly reliant on any one market or market segment. In addition, broad portfolio diversification assists in reducing volatility of capital invested.
Diversification of income can be pursued on several levels:
Income assets versus growth assets – which is key to driving investment outcomes.
Within income assets, diversification of income from multiple sources may include:
- domestic and international fixed income allocations
- shorter duration and longer duration investment strategies
- allocations to government bonds, investment grade credit, emerging markets and high yield
- total and absolute return fixed income strategies
- inflation linked bonds.
Within growth assets:
- domestic and global sharemarket allocations
- subsectors of the global equity markets such as listed property and infrastructure
- within asset classes
- dynamically positioning a portfolio over the business and financial market cycle.
Investment portfolios should include broad diversification and be dynamically managed to assist in delivering a sustainable and stable level of income. From this perspective, a goal orientated investment approach may also be better suited to managing a portfolio that focuses on generating a sustainable and stable level of income through the ups and downs of the interest rates and sharemarket cycles.
1 Source: Reserve Bank of New Zealand
This blog post has been prepared to provide general information and does not constitute financial advice in accordance with the Financial Markets Conduct Act 2013. An individual investor should, before making any investment decisions, consider the information available in the relevant Product Disclosure Statement and seek professional advice. While every care has been taken in the preparation of this document, AMP Capital Investors (New Zealand) Limited and the AMP Group (together, 'AMP') make no guarantee that the information supplied is accurate, complete or timely and do not make any warranties or representations in respect of results gained from its use. The information is not intended to infer that current or past returns are indicative of future returns. The views expressed are those of the author and do not necessarily reflect those of AMP. These views are subject to change depending on market conditions and other factors.