Tag Archives: Financial Planning
Some recent questions on Australian inflation
By Robert Wright /August 21,2023/
Key points
- The Australian inflation rate peaked in the December quarter but has been slower to decline than some global peers. While interest rate rises are helping to reduce inflation (especially as discretionary consumer spending slows), rises in domestic energy prices, a tight rental market and a lagged pick up in wages have contributed to higher than expected inflation outcomes.
- The main policy available in the RBA’s toolkit to manage inflation is interest rates, which is a blunt tool because of its unequal impact on households with debt.
- The burden of interest rate increases falls on households with mortgage debt. Businesses and investors are also impacted but the deductibility of interest provides some offset.
- Some countries in Europe have opted to use price controls for essential items to reduce inflation, with mixed results. Price controls tend to add distortions to the market and rent controls are not helpful while housing supply is limited (like in Australia).
- But the government still has a role to play in helping the RBA achieve its 2-3% inflation target through keeping fiscal policy neutral/contractionary if inflation is high, ensuring a well functioning energy market, maintaining sustainable wage increases, regulating businesses to discourage price gouging and monopolistic behaviour and calibrating appropriate migration targets to match housing supply.
Introduction
Australian inflation is very high. Consumer prices were up by 7% over the year to March, around a 33-year high but this was a decline from a cyclical peak of 7.8% in December 2022. The Reserve Bank of Australia (RBA) has been focusing on reducing inflation through the main policy tool available in the central bank’s toolkit – interest rates. The cash rate has risen from 0.1% in April 2022 to 4.1% in June – a 4% lift in just over a year. But, the impact on inflation so far has been lower than expected. As a result, we are often asked whether interest rates are actually having an impact on inflation or whether there are better tools available to policymakers, especially as interest rate hikes are having an unequal impact across household groups. We go through some of these issues in this article.
Are interest rate hikes working to reduce inflation?
Interest rate hikes have led to a slowing in consumer demand which is helping to reduce inflation. Discretionary spending fell in the March quarter and the volumes of retail spending was negative over the December-March quarter. Without the lift in interest rates, inflation may have increased further and consumer and market-based medium-long term inflation expectations could have kept rising well above the RBA’s 2-3% inflation target.
Some might say that rate hikes should have worked faster or better by now to reduce inflation. The problem has been that there have been numerous supply driven elements of the inflation story that have been less sensitive to interest rate changes. COVID driven supply chain disruptions led to big increases in shipping costs, commodity prices like energy, metals and agriculture increased significantly in 2021-22 (mostly from supply disruptions), domestic energy supply issues led to an Australian energy crisis and multiple domestic floods led to higher food prices. While these issues may not be directly influenced by the level of change in interest rates, it is the responsibility of the RBA to ensure that supply driven price changes do not leak into consumer prices. A lot of these supply related issues are now resolved but it takes time for it to be reflected in the final inflation figures.
Evidence of excessive price gouging by businesses is not obvious. Profit margins have expanded (increasing from 10% in 2020 to a recent high of ~16%) but have generally moved in proportion to the rise in inflation (see the chart below) and are now declining. The profit share (ex mining) of GDP has also been fairly stable. And slowing consumer discretionary spending means that continued profit margin expansion will be unlikely.
Source: Bloomberg, AMP
The peak of Australian inflation (in December 2022) also occurred later compared to some global peers which means that the slowing in inflation appears like it’s taking longer. US inflation peaked at 9.1% in June 2022 and in the Eurozone at 10.6% in October 2022 (see the next chart).
Source: Macrobond, AMP
Australia’s energy crisis occurred later relative to the Northern hemisphere, because of a raft of our own domestic issues like supply challenges with coal, a poor national plan for the energy transition and higher global prices. This meant that both the US and Europe were more impacted by an energy price surge in early 2022 from the war in Ukraine and the winter weather. Australia’s rental market also tightened significantly over the past year as net migration rebounded to record highs after the pandemic, pushing vacancy rates to ultra low levels in the capital cities and lifted rents, although recent vacancy rates across the capital cities have ticked up and newly advertised rental growth is slowing. Australia’s wage setting system also seems to have more “inertia”, with the minimum wage decision occurring once a year and many other wages like awards also based off this annual decision or driven by changes to headline inflation, which only peaked in December 2022.
While these factors all suggest that inflation in Australia could remain higher for longer for now, the good news is that our Pipeline Inflation Indicator still suggests significant downside to Australian inflation over the next six months and we expect headline consumer prices to be at the top end of the RBA’s target band by early 2024 (on a 6-month annualised basis).
Source: Bloomberg, AMP
Are interest rate hikes increasing inequality?
The impact of monetary policy works primarily through the lending channel because borrowing rates are priced off the cash rate. Households with a mortgage are the most impacted by interest rate changes. Businesses and individual investors are arguably less impacted because they can deduct the debt interest expenses. There are also other financial market channels that monetary policy works through, mostly through the exchange rate.
The high level of household debt now means that mortgage holders will bear the brunt of monetary policy changes. Renters can also be affected from higher interest rates if landlords are able to pass on the higher cost of debt servicing through higher rents. This is only usually an option in a tight rental market (which the current situation is allowing for).
In Australia, 37% of households have a mortgage (using data from 2019-20), 29% rent and 30% own their own outright. Detailed ABS data on housing costs shows that households with a mortgage spend close to 16% of their gross household income on “housing costs” (mortgage or rent and rate payments) as at 2019-20, owners without a mortgage spend 3% of their income on housing costs and the average renter spends close to 20% of their income on housing. And there are divergences across income quintiles (see the chart below) with the lowest income quintiles spending a very large share of income on housing costs.
Source: Bloomberg, AMP
Are there other options to combat high inflation?
The high degree of supply related factors that have increased inflation, the slow reduction in prices despite aggressive interest rate hikes and the high burden placed on households with a mortgage has led to questions about whether there are other options available to reduce the level of inflation.
The RBA has been tasked with the responsibility for the 2-3% inflation target but the only tool at its disposal is monetary policy. While the range of options within the toolkit has expanded beyond interest rates (including yield targets and quantitative easing) all of these measures ultimately influence the money supply and therefore the cost of borrowing.
The government has more tools at its disposal compared to the RBA through its spending and taxation decisions as well as regulation. However, these tools are slow moving and do not have as much of a direct impact on inflation. Some have argued that price controls need to be considered in Australia. Food price caps have recently been tried in Europe for some essential items, including in France, Croatia and Hungary with mixed impacts as measured inflation went down but there were reports of some food shortages.
Usually, economists do not advocate for price controls or caps because it’s a distortion in the market and leads to problems like supply shortages. However, the Federal government did impose energy price caps domestically, so it is already being utilised in some capacity. Talk of rent controls would likely add to supply constraints across Australia at a time when housing supply needs to lift.
But, the government does have a role to play in many components that impact inflation, such as by ensuring a well regulated electricity market, sustainable outcomes for minimum award and public sector wages which set the tone for the rest of the market, ensuring that fiscal policy (both state and federal) is appropriate for the state of the economy (we think the impact of the May Federal budget is more or less neutral but with the addition of some state cost of living benefits it could be marginally inflationary and the government could consider raising taxes to help get inflation down), regulation of retailers to ensure adequate competition and ensuring adequate housing for the migration targets.
Implications for investors
For investors, the good news is that inflation is expected to decline through the rest of the year which should mean that central banks are close to the top of their tightening cycles. This is generally positive for sharemarkets however, the further interest rates increase, the higher the risk of recession which is a risk for sharemarkets. The RBA’s recent hawkish stance means that further increases to the cash rate are likely in Australia. We expect another two interest rate increases from here, taking the cash rate to 4.6% which risks a recession in the next 12 months because of the heightened sensitivity of households to interest rate hikes in Australia.
Source: AMP
Your guide to gearing
By Robert Wright /August 21,2023/
There are a number of considerations when it comes to gearing, the investment assets you may choose to gear and the way you structure your debt.
A gearing strategy can be set at three levels:
- Positive gearing – where income from the investment exceeds the interest payable on the loan.
- Neutral gearing – where income from the investment is equal to the interest payable on the loan.
- Negative gearing – where the income from the investment is less than the interest payable on the loan. The excess interest expense is an allowable deduction against other assessable income, which for a taxpayer on the top marginal rate is currently worth 47% (inclusive of the Medicare levy).
Investing in growth assets such as shares or property using borrowed funds can be one of the most effective ways to accumulate wealth over the long term.
Investors are solely relying on a future capital gain when undertaking a negative or neutral gearing strategy. Negative gearing is tax effective in that the interest expense is fully deductible against the income generated by the geared investment and other assessable income. There are also other tax breaks such as the deductibility of depreciation (for property) and franking credits (for shares) to help subsidise the cost of the investment. In addition, for individuals, 50% of any capital gain is exempt from tax where the investment is held for at least 12 months.
Examples
Positive gearing strategy
If $100,000 were invested for a year in assets that produced a return on investment of 10% per annum, the total return on investment would be $10,000.
If the investor had also used a gearing strategy and borrowed $50,000 (at a cost of 7% per annum) and invested this in the same assets producing the same 10% per annum return, the return on investment would be 10%, less the cost of finance (7%) – that is, a net additional return of $1,500 using someone else’s money.
The net return can be greater than this when the tax deductibility of interest is taken into consideration.
The below examples of negative gearing illustrate how the negative cash flow from the investment can be offset by the deductibility of interest plus other tax breaks.
Negative gearing an investment property
Sarah earns a salary of $200,000 and borrows $400,000 to buy an investment property. The property generates rental income of $20,000 per annum while interest expense on the loan (interest only with no principal repayments) is 7% or $28,000 per annum. In addition to the deductible interest expense, there are the following ‘non-cash’ deductions:
- $2,500 depreciation
- $4,500 building amortisation (2.5% based on a construction cost of $180,000)
| Financial position | Without negative gearing strategy | With negative gearing strategy |
| Salary | $200,000 | $200,000 |
| Rental income | – | $20,000 |
| Non-cash property deductions | – | $7,000 |
| Interest expense | – | $28,000 |
| Taxable income | $200,000 | $185,000 |
| Tax payable (incl. Medicare levy) | $64,667 | $57,617 |
| Net cash | $135,333 | $134,383 |
The difference in cash flow of only $950 has been assisted by the $7,000 tax deduction for the non-cash depreciation and building amortisation expenses.
These examples demonstrate the worth of tax deductions to an individual on the top marginal tax rate in the first year of a negative gearing strategy. Over time, negatively geared investments can become positively geared – especially when rental income or dividends are reinvested.
Couples with one person on a higher marginal tax rate than the other, should carefully consider who should be the borrower and owner of investments over the long term. While initially it may be tax effective to have a negatively geared investment in the name of the person with the highest tax rate, if it’s expected to become positively geared in the future, it may be more effective to have the loan and investment in the name of the person with the lower marginal tax rate from the outset. Especially when you consider the potential capital gains tax, stamp duty and loans fees that might be incurred in transferring the investment and loan.
Trusts and companies can also negatively gear investments, however the following should be considered:
- Trusts and companies cannot distribute losses, they need to be carried forward and offset against future assessable income.
- While the company tax rate is 30% for companies that are not base-rate entities which have a tax rate of 25%, companies are fully assessed on capital gains as opposed to the 50% discount applied to assets held for 12 months or more by individuals and trusts.
Negative gearing a share portfolio
Sarah earns a salary of $200,000 and borrows $400,000 to invest in a share portfolio. The share portfolio generates a dividend yield of 4% fully franked, while the interest expense on the loan (interest only loan) is 7% per annum under a line of credit secured against her home.
The below table illustrates the impact the negative gearing strategy has on Sarah’s cash flow.
| Financial position | Without negative gearing strategy | With negative gearing strategy |
| Salary | $200,000 | $200,000 |
| Dividend | – | $16,000 |
| Imputation gross up | – | $6,857 |
| Interest expense | – | $28,000 |
| Taxable income | $200,000 | $194,857 |
| Tax payable (incl. Medicare levy) | $64,667 | $62,250 |
| Franking credit | – | $6,857 |
| Tax payable (incl. Medicare levy) and after franking credit | $64,667 | $55,393 |
| Net cash | $135,333 | $132,607 |
The difference in cash flow is $2,726 which is approximately 0.7% of the investment portfolio. Sarah hopes that her after-tax capital gain will be greater than this cash flow loss.
Source: BT
How to help grow your money through compound interest
By Robert Wright /August 21,2023/
Earning interest on interest: learn how the power of compounding can send your savings rocketing.
Key takeaways
- Compound interest enables you to earn interest on interest which is accumulated over time.
- The effect of compound interest becomes extremely powerful over a long timeframe as the amount of interest earned grows.
- Investing in your super is one of the most effective ways to potentially maximise the benefits of compound interest.
Einstein has repeatedly said that compound interest is the eighth wonder of the world. While it may appear complicated, it’s actually a relatively simple concept that can accomplish extraordinary things over time.
What is compound interest?
Compound interest enables you to earn interest on interest which is accumulated over time.
Metaphorically speaking, it’s like planting a tree. When that tree grows, it produces seeds that allows you to plant other trees. Those trees will also grow and produce seeds of their own. So with enough time, you could turn one tree into an entire forest.
The difference between compound and simple interest
When it comes to earning interest, or a return on your money there are two types of interest you could earn.
Compound interest enables you to earn interest when you invest a sum of money; but in addition to this interest, you’ll also earn interest on the interest you’ve earned.
With simple interest however, you’ll only earn interest on your original sum of money invested. For instance, if you invest $10,000 into a savings account and earn 5% interest compounded annually, in the first year your interest earnings will be $500 (5% x $10,000).
However, in the second year, your interest will be calculated based on the original amount you invested, plus the interest you earned in the first year – $10,500. In total over 3 years, you would have earned $1,576.25 in interest.
With simple interest, your interest earnings won’t increase year on year so you’ll continue earning just $500 over the 3 year period leaving you with $1500 in interest earnings.
Compound interest is a long term investing strategy
The effect of compound interest becomes extremely powerful over a long timeframe as the amount of interest earned grows.
Warren Buffett is the epitome of someone who values long term investing. He attributes the majority of his success to identifying good businesses and companies with strong fundamentals to buy and hold for the long-term.[1] He then let the magic of compound interest work for him.
One thing that is important to remember is that investing in the beginning doesn’t reap many rewards. It isn’t until years later that you feel the true power of compound interest working for you.
Get started early
Because compound interest is generally most effective over a long timeframe, in order to truly see its potential, the earlier you start investing your money, the better. So it’s generally really not about how much you’re investing but more about how much time you’re allowing your money to grow.
How you can earn compound interest
Bank account
One way to earn compound interest is through a bank account. While this approach carries very little risk, it’s generally unlikely that your returns will be enough to outpace inflation so this is something to keep in mind.
Super
Investing in your super is one of the most effective ways to potentially maximise the benefits of compound interest.
Why? Time is on your side. The more you contribute to your super early on in life, the higher potential for that money to grow by the time you need it as a result of compound interest.
Of course though, you need to bear in mind that you cannot access your super until you meet a condition of release. This includes reaching the legal age for retirement, among other things.
Dividends
When you’re paid dividends from shares, you can withdraw that dividend as cash or you can reinvest it back into the issuing stock. This means you’re earning dividends on dividends, also known as compound interest.
The bottom line: When it comes to investing, compound interest and time are truly your best friends.
Source: MLC
[1] http://www.arborinvestmentplanner.com/warren-buffett-strategy-long-term-value-investing/
Understanding your investment options
By Robert Wright /August 21,2023/
Investing is full of jargon and technical terms that can make getting started or managing your investments seem intimidating. Here are some of the key terms to help you better understand the different options available to you.
Common investing terms
There are a few terms that you’ll see repeated when we’re talking about investing.
Bonds – Bonds are a way for corporations or governments to receive a loan from investors for a promised rate of return over a specific period. Bonds can be issued to pay debts, build new facilities or raise funds for future growth.
Cash – Cash investments are savings accounts and other easy to access funds like cash management trusts and money market funds. Cash investments are stable and low risk, generally growing slower than inflation or the increase in prices of goods and services over time.
Diversification – Having a diverse group of investments means that you spread your investments across different companies or sectors (for example, shares or fixed interest). This way, if one sector underperforms or has a loss, you have other investments that may perform better and help balance out any losses.
Another way we diversify our investment options and portfolios is by using different investment managers, with different approaches to investing. In some cases we use multiple investment managers in the same option. These are called multi-manager portfolios.
Dividends – Dividends are a portion of profits or earnings paid to shareholders. They are paid on a regular basis and in some cases can be reinvested into the business in the form of more shares. This can provide shareholders with ongoing income.
Domestic Markets – Domestic markets, shares or companies refers to the variety of investments that are connected to that country, either through where they operate or the investment exchanges on which they reside. In Australia, we would refer to Australian bonds as domestic bonds. Likewise, a US-based fund would refer to the US stock market as the domestic market.
Environmental, Social and Corporate Governance (ESG) – ESG is the consideration of an investment beyond its financial performance. It often includes social and environmental factors, like its impact on the climate, the gender or cultural diversity of staff and leadership or general benefit to society. Investors are increasingly applying these considerations as part of their investing decisions.
Equities – Equities are another name for shares. Equities can be bought directly on the share market or through an investment option.
Fees – A fee is the amount charged by a fund to manage your investments. Fees may vary based on factors including the cost to manage an option, the size of the investment and the management style.
Geared Investments – Geared or ‘leveraged investing’ is a way to borrow money in order to increase the size of an investor’s original investment. Geared investments are often made with higher risk assets like shares and property.
International and Emerging Markets – International markets can give investors access to a variety of investments including shares, securities, property or bonds from nations other than their own.
International markets can be volatile because of international trade relations or fluctuations in currency value. There is more risk with less stable countries, like those in economic or political turmoil, and less risk in more stable countries.
Emerging markets are international markets that focus specifically on growing and developing economies like China, Brazil or India.
Investment Manager – An investment manager is a professional person or organisation who has been appointed to manage money in an investment option on behalf of investors. One or multiple investment managers may be appointed to an investment option. They generally have specialised expertise in the area they represent, like property, bonds or shares.
Investment managers are selected for their strengths in certain areas as well as organisational stability, solid investment process and a history of strong performance. We also use a specialist investment consulting and research firm when selecting managers.
Managed Fund – A managed fund pools your money together with other investors to buy a variety of assets like shares, bonds or property. Managed funds can be invested in single or multiple asset classes and have single or multiple investment managers.
Risk – Risk in investing is about understanding, anticipating and accepting the potential for financial loss in an investment. All investing has an inherent level of risk.
Risk can be seen as an option underperforming against expectation. Investors can spread their risk by diversifying their investments.
Securities – A security is a way to purchase a portion of an asset such as infrastructure, a property, loan or business. For example, shares are type of security that makes it easy to purchase a portion of a business.
Securities can be bought, sold or traded. The value can change based on market conditions, the value of the asset, expected income or general market conditions.
Share – A share or stock represents the purchase of a portion of a business. The value can increase or decrease based on a variety of factors including general market conditions as well as industry and company performance and challenges.
Some shares have lower volatility and provide strong regular dividends without necessarily increasing in value.
Short Selling – Short selling, or shorting, takes place when an investor believes the price of an equity (like a share) will go down. They arrange to sell shares on the market with intention of repurchasing them for a lower price later on. A short position is generally very high risk and can result in large losses if the price of the equity increases.
Mandate – A mandate is an agreement with an investment manager that sets out how money will be invested. It includes performance benchmarks and expectations, acceptable investments and investment ranges.
A mandate’s structure means that the investments are managed in a unique way for our investors, different from the investment manager’s options with other organisations. This gives CFS greater flexibility around the option including administration and reporting to investors.
Product Disclosure Statement – A Product Disclosure Statement (PDS) is a review of all relevant product information for an investment option. You should always read the PDS before making any decisions about the relevant products. It offers information including the investment managers, risk measures, objectives and minimum suggested timeframe.
Units and Unit Pricing – The unit price tells you the value of the package of investments it contains. Investments are packaged in units that are made up of a variety of assets, like shares, bonds and property. Investing this way gives you the ability to invest in ways that you may not otherwise be able to access as an individual investor.
Reading an investment option
We use a standard description to quickly review and compare different investment options. Here’s what you should look for:
Objective
A sentence or two on what the investment option is designed to achieve and the timeframe to achieve it.
Minimum suggested timeframe
How long an investment professional suggests you hold, or remain invested in, an option in order to achieve the stated investment objective.
This is only a suggestion and should not be considered personal financial advice. Because financial markets can be volatile and unpredictable, it’s good to regularly review your investments with a financial adviser to ensure they meet your needs.
Risk
A snapshot of the expectation that an investment option will deliver a similar number of negative annual returns over a 20-year period.
Generally, the higher the level of risk an option has, the higher its return is expected to be. You should review the associated risks to see if the option is suitable for your needs.
Strategy
A description of the way the investment option is structured with some details about its contents and the reasons why those investments were chosen.
Investment category
A quick way to organise different options by their typical range. These categories are not standardised across the investment industry, so what is considered ‘growth’ in one organisation might be considered ‘moderate’ by another. You should read the full details of an option before making an investing decision. We’ll break down the different investment categories a bit later.
Allocation
A quick view of the different assets, or types of investments, contained in an investment option. In some cases, the assets are given a range, (i.e. between 15-25%), which indicates the minimum and maximum ranges that may be held in the option at any time. The investment manager may make changes within that range for different reasons including market volatility. Not all investments offer an allocation benchmark.
Underlying investment managers
These are the professional investment managers and organisations that have been appointed to manage the money in the investment option. There may be one or more, which is known as a multi-manager fund.
Investment categories and asset classes
There are a few different ways we organise and categorise investments to make it easy to understand how they are structured.
Cash and deposits
Cash is invested in reasonably stable domestic currency, like bank bills. Cash is liquid, making it easier to quickly access funds as required. It also includes term deposits (money invested for a set period) and money market securities. Cash and deposits are generally low risk and provide a low, stable return.
Less liquid than cash and deposits, enhanced cash is invested in money market securities and some fixed interest securities.
Fixed interest
Fixed interest investments are investments made with a guaranteed rate of return. These are usually issued by corporations, governments or financial institutions to raise funds. They have a set rate of return, which is usually higher than cash but lower than higher-risk options like shares. The return comes from interest payments from the bond issuer. The amount of that return can change based on interest rate repayments.
Alternatives
Alternative funds may include a diverse mixture of investments including hedge funds or commodity trading like oil or livestock. Basically, anything that falls outside of the traditional shares, property, infrastructure, cash or fixed interest categories are called alternatives.
Property
Property investing generally involves buying a property or buying a stake in a building through a property security. These properties can be office spaces, industrial properties or retail. A company or trust (a group acting on behalf of the investors) generally hold, manage and develop these properties.
Infrastructure
Infrastructure is a broad term that refers to physical assets. It may include public transportation, toll roads or utilities like water desalination. It may also include social infrastructure investments in public housing, hospitals or prisons.
Infrastructure investments or securities (a portion of the investment purchased on a public market) are generally expensive and have high upfront capital requirements. They also feature low ongoing operating costs and have a reasonably stable return.
Shares
The most recognised method of investing, shares are part ownership of a company. They are generally bought and sold on a public stock exchange. Because of the general volatility of the share markets, shares are considered a high risk asset.
Over time, however, they tend to outperform other asset classes. The amount of risk can depend on the particular company invested in or the industry or region they come from.
Risk measures and categories
Risk is broken down into some general categories in order to help organise different investment options.
Because there is no industry standard around the naming of the categories, the level of risk may vary between funds. What is a conservative investment with one fund may be considered a moderate investment with another.
Risk is generally broken down into the following categories:
| Risk band | Risk Label | Estimated number of negative annual returns over any 20-year period |
| 1 | Very low | Less than 0.5 |
| 2 | Low | 0.5 to less than 1 |
| 3 | Low to medium | 1 to less than 2 |
| 4 | Medium | 2 to less than 3 |
| 5 | Medium to high | 3 to less than 4 |
| 6 | High | 4 to less than 6 |
| 7 | Very high | 6 or greater |
Source: Colonia First State