Interest Rates - where to from here?

This month mortgage holders breathed a sigh of relief after the Reserve Bank decided to leave interest rates on hold. Although the decision was widely anticipated, it's far from certain that the central bank will continue to leave rates steady in the coming months.

The challenge facing the Reserve at the moment is to somehow reign in inflation, while at the same time not causing the economy to slow too significantly. And that's no easy task.

Higher rates act to dampen spending, which places downward pressure on spending and in-turn prices. But if you reduce spending, you slow the economy, and while that's desirable to a point, you run the risk of slowing things to much. Maybe even to the point where we enter a recession.

Finding the "goldilocks zone" - that level at which rates are just right - is particularly tricky for a number of reasons. Firstly, it takes time for a change in monetary policy to filter through the economy and have an effect. It could take up to six months before the recent hikes in February and March are seen to have the full impact. Given that the official rate has climbed from 6.25% to 7.25% since last August, the RBA will be careful not to over-react.

As far as retail borrowers are concerned, interest rates have increased by more than the official hikes, as the major banks have independently raised their lending rates in an effort to off-set the increased credit costs which have resulted from the global credit crisis. Many analysts have predicted that we could see at least one other move this year outside of any official change. The RBA will certainly factor this in, and that at least will lower the need for an official move.

Fine tuning rates is also made difficult due to the fact that economic data, by its nature, is backward looking. It tells us how things stacked up last month, last quarter or last year. So relying on historical data to judge the effectiveness of current rates is akin to driving a car while looking in the rear vision mirror!

The situation is made even more difficult by the fact that the economy is not only influenced by lending rates. Indeed, the economy is continually being affected by a myriad of forces most of which are difficult to predict in terms of influence and degree.

The Australian economy represents around 2% of the global economy, so we are a very small fish on the world stage. Because most of the world is highly integrated through trade and investment, what happens in other economies can have big effects here at home. This is why so much attention is paid to the giant US economy - which represents about 25% of global economic activity. A collapse in the US housing market, a deteriorating credit market and a struggling corporate sector paint a very gloomy picture for this titan of economic activity. Already we are starting to see how these events are starting to be felt around the world, and things are likely to remain difficult for some time to come. And that too argues in favour of keeping rates on hold.

Again though, its not just a matter of managing growth - the RBA has to monitor inflation. The Reserve has a target rate of inflation between 2-3%. Currently we are well above this at around 4.2%, the highest rate in around 17 years.

Higher prices reduce the purchasing power of businesses and individuals. It acts to reduce the worth of our money and lower returns in real terms. This is the main reason why we have seen rates increasing, and it's why we can't discount the chance of further rate hikes. This week the Reserve stated that it did expect inflation to ease back over the medium term, but this was dependant on the view that economic growth would moderate. Given that Australia has a big focus on commodities, and considering that developing nations such as India and China have a seemingly insatiable appetite for our raw materials, it's quite possible that growth does not moderate as anticipated.

The best case scenario is that the recent interest rate rises and a slowing global economy will be enough to slow demand, reduce pressure on prices and bring inflation back towards the target band. If that happens the RBA will have no justification for further lifting rates. If however prices continue to rise, the Reserve will be left with little option but to increase rates.

A dangerous situation could develop where prices continue to rise at the same time as economic growth falters - a situation referred to as stagflation. We will be forced in to paying more for our goods and services, in an environment of deteriorating economic conditions.

If this were to occur it really puts the Reserve Bank between a rock and a hard place. If it lowers rates it will help stimulate the economy, but inflation will continue to eat into our purchasing power and investment returns. If it raises rates, it will help bring inflation under control, but the economic environment will become even more difficult.

So what's the take home message? Don't be surprised if we see another interest rate rise - at this point the RBA is still more likely to tighten monetary policy than relax it. And of course, even if the RBA does keep rates on hold we could well see the banks lift their variable rates independently.

Given the current environment, it's more important than ever that we are careful to monitor our debt situation. Essentially we need to ensure that we don't borrow more than we can afford. In trying to work out what's sensible, it would be wise to factor in interest rates that are above current levels - so as to provide a buffer against any future increases. This is particularly important for longer term borrowings, such as mortgages. These days lenders are too eager to provide credit, so it's up us as individuals to ensure that we don't put ourselves in a difficult situation.

Ultimately we are responsible for our own financial situation. Don't be lured into buying things you don't need with money you don't have.

In an era of easy finance and high material aspirations this is easier said than done, but unless you want to find yourself in a very difficult situation down the track - it's better to play it safe.

Andrew Page - Hubb Financial
To download HUBB's free scanning & charting software visit www.hubbinvestor.com

A Quarterly Review of the Major Sectors of the Market is set against a backdrop of volatility on the Global Sharemarkets in 2008.

We summarise our quarterly review of the major sectors of the market ended 31 March 2008 and update for the significant correction and ongoing volatility of global sharemarkets since January 2008 to date.

Cash and fixed interest

The old saying still holds true - "cash is king", and even more so in these volatile times in capital markets, with lower risk fixed interest investments anchoring portfolios. All portfolios will be generating cash following the distribution of six month and quarterly (where applicable) dividends, interest, rental income and other distributions from investment funds.

Typically 5% of a portfolio is held in liquid cash reserves and up to 25% held in fixed interest, bonds and hybrid investments for the lower risk element of a portfolio to meet income needs and to take opportunities in the market weakness and rising interest rates.

We continue to recommend that fixed interest portfolios should invest in direct fixed term deposits and debentures spread across one to four or five years evenly balanced maturities. Locking in attractive medium term maturities will defend the portfolio from anticipated slower economic growth and an expected fall in interest rates, designed to stimulate the economy.

We would recommend an unwinding of managed bond funds and moving to direct investments given the overall lack of transparency of such products following the global and domestic sub-prime crisis including such products as collateralised debt obligations (CDOs).

A one year Esanda debenture AA rated with a yield of 8.05% (interest paid at maturity) for 12 months looks pretty attractive in the current market. We traditionally have recommended further diversification in this asset class be allocated to floating rate hybrid securities as a yield enhancement strategy.

However, the hybrid securities market has been substantially hit as the market is demanding a higher risk premium to buy these securities. With fixed margins, and as credit spreads widen, such securities have had to trade at a discount to face value in order to increase the yield demanded by the market. This sector has somewhat recovered in recent weeks however they will not recover their full face value until the credit crisis subsides.

On balance, and after assessing the underlying credit position of the issuer, investors seeking yield could currently increase their exposure to maximum levels.

There is a short term bias for the Reserve Bank to continue to raise interest rates until the growth and capacity constraints in the economy are in sync and the inflation bogy is tamed. It may take a while and the risk is the Reserve Bank may over-react and send the economy into recession - but let's hope not.

With increasing interest rates and a large differential to most global major economies interest rate levels, the Australian dollar will continue to rise, particularly while the resources boom continues.

The major issue for cash and fixed interest returns is to fully understand the concept that it is real returns in a high inflation cycle that really matter, and this is why the Reserve Bank is very keen to control inflation within its stated range of 2% - 3%. The current inflation rate is expected to increase to levels above 4% during the balance of 2008.

International bonds

Yields in the international bond sector continue to show low returns, compounded by investors switching out of equities due to concerns that a potential US recession could spread globally. This sector could be boosted in the short term if the US and other major economies continue to reduce interest rates. The flow-on impact will be potential for capital gains on longer dated securities. Until the global credit position improves, we would not recommend any new allocation of funds to this sector and existing portfolios should hold investments at a maximum of 3% - 4% of the total portfolio, particularly as we also prefer direct portfolios where possible.

Australian shares

In January 2008, markets corrected and decreased by 11.3% primarily as a result of the state of the US economy and fears that it is heading for a sustained recession. It is a global crisis of confidence in the financial sector coupled with volatile commodity price outlook and real inflation risk in Australia that has led to a larger correction in the Australian sharemarket. The financial crisis is working its way through the system with the usual surprises and even shocks. The figures have been staggering and difficult for individual investors to comprehend and swallow. There will be more.

The Australian sharemarket has essentially given back most of its 2007 returns, and most investors have understood that markets do correct from time to time, particularly after the recent four years of exceptional returns.

We recommended that investors take profits during the recent bull market and peg back their portfolios to benchmark allocations following those stellar returns. This is prudent portfolio management because, as we have seen, markets can move very quickly as recently seen in January when the market corrected by over 7% in just one day.

The outlook for 2008 is now extremely difficult to predict and extreme caution is warranted as there is a tail in this financial crisis. There will undoubtedly be further volatility particularly if it is confirmed that the US has been in a recession in 2008 which will not be announced until the fourth quarter of 2008 following minor positive growth in the US for the quarter ended 31st March 2008.

Remember, a recession in the US is defined as two consecutive quarters of decline in real GNP. The current consensus is that the US is in recession, and whether it is confirmed will depend on the impact of the recent reduction in the US dollar, interest rates and fiscal stimulus saving the day.

Australian corporate earnings are likely to be weaker and most corporates will be very cautious in predicting the next period. However, it must be remembered that corporate balance sheets in Australia are what they call healthy with relatively low debt. No corporate will cut dividends so the income will keep coming. What will probably change will be special dividends and capital buybacks. Corporate actions will continue such as the continuing proposed merger of BHP and RIO, British Gas (BG) bid for Origin Energy, and Westpac and St George proposed merger. It is more likely that new capital raising and new listings will probably be deferred.

On balance, the markets are likely to move sideways in ongoing volatile conditions reacting to events and looking for signs of an end to the financial crisis and increased economic growth. There are many risks going forward and one can certainly build a negative scenario case, however to put things in balance, the Australian economy is predicted to have strong economic growth, high employment, potential for a lower interest rate cycle in 2009, prudent fiscal spending by the Federal Government and large cash reserves ready to invest.

When confidence returns it is likely markets will rebound quite quickly as the economy is still awash with funds seeking a place to invest.

Listed property trusts (LPTs)

The market darling has come a cropper with the sector (ASX 200 Property Trust) posting a negative total return of -17.86% for the 3 months ended 31 March 2008.

The sentiment for the sector changed dramatically in December 2007 following the debacle of Centro and an across the board reassessment of risk inherent in this sector. Its defensive nature has been called into question, however it must be remembered that this sector is backed by property that is leased for on average 3 to 4 years which is usually inflation adjusted. The issue is not the asset side of the balance sheet, but the levels of debt and management of debt. This sector will have to increase the level of transparency and disclosure to regain investor confidence and any further shocks or bad news on refinancing will lead to further volatility.

Portfolios should maintain their levels of exposure of up to 10% in a well balanced portfolio. We continue to remain underweight in international property due to the state of market outlook in the US.

One of the main drivers of returns for the LPT sector will be the outlook for interest rates which at the moment are biased to short term tightening however the yield curve is still currently inverted with the short term rates above longer dated securities indicating that in the medium term interest rates will fall.

International assets - shares

The international MSCI World (ex Australia) global share index unhedged fell 14.26% compared to 9.67% for the equivalent hedged version, highlighting the impact that currency movements have on returns. International equity returns were impacted by slowing global economic growth and in 2007 returns were also impacted by the so-called x-factor of the sub-prime crisis and the emerging potential for a US recession.

Despite this global markets continue to show a good growth outlook at levels close to a range of 3.5% to 4% with a shift in focus to the major economies of China and India. Their stand out performances are unlikely to significantly be impacted by the US position due to their double digit growth levels and internal domestic demand. So it is not all bad news.

The global economies will be driven by some fairly big issues in 2008 and beyond such as climate change, oil price outlook, the rise of gold, inflation risks, commodity prices and volatility. All these issues will dominate the news and the US will always be there as it elects a new president in November 2008.

Nine ways to slash your interest rate - Matthew Liddy

Intense competition between lenders means you don't have to feel the full pinch of recent interest rate rises. There are at least nine techniques you can use to secure a lower rate.

1. Just ask

Securing a lower rate can be as simple as asking if you're getting the best deal, says mortgage broker Glen Spratt. If your total borrowings are greater than $250,000, there's a good chance you can get a discount off the standard variable rate.

"The discounts are generally tiered," says Spratt, director of Mortgageport. "The bigger the loan, the larger the discount. Generally speaking on any loan these days over $250,000 you can negotiate a discount of anywhere from 0.5 per cent off the bank's standard variable rate. I've seen discounts as high as 1.2 per cent."

The loans attracting discounts at the upper end of that range would total well over $1 million, he adds.

Usually these discounts come under the guise of a professional package, which will roll in other services, such as free transaction banking accounts, gold credit cards and mortgage facilities such as offset accounts. For the package, borrowers pay an annual fee in the order of $300 to $400. Despite this approach of giving with one hand and taking with the other, Spratt says borrowers can save thousands of dollars a year.

"If you've got a $500,000 loan and you're getting a 0.7 per cent discount that's $3500 a year. If they're charging you $300 in fees, you're still $3200 a year better off."

David Johnston of Property Planning Australia says a few lenders will even negotiate on the package's annual fee as well the interest rate.

If you don't like the look of the professional packages, don't despair. CANNEX mortgage expert Harry Senlitonga says that's not the end of the negotiation. "With the lender's discretion, they may offer you a special deal, especially if you borrow above $500,000," he advises.

2. Shop around

If your current lender doesn't appear too keen to negotiate, look elsewhere. Competitors may be only too willing to offer a discount to win your business. You need to watch out for the extra costs associated with refinancing, though there are ways to beat those as well. For instance, some mortgage brokers will pay the costs associated with switching loans in certain circumstances. Or just use the better offer as a negotiating tool, suggests Johnston.

He advises, "If you prefer to stay with your existing lender but just want to try to get a sharper interest rate, you can just talk to your existing lender and say, 'here's this offer over here and you're only giving me this -  can you match that?' ".

3. Consolidate your loans

Since interest rate discounts are largely determined by your total borrowings, shifting all your loans to one lender could help.

"The more facilities or more borrowings you have with them, the more negotiating power you have," says Johnston. "If it's someone who might have loans spread across two or three different lenders, by bringing all those loans together with one lender, it'll certainly allow them to negotiate more fiercely with the lender to get the best interest rate for themselves."

4. Establish a line of credit

Borrowers who are comfortable with doing so can essentially beat the banks at their own game by setting up a line of credit, a type of personal overdraft, says Johnston. In the lender's eyes, even if you don't use the money, your total borrowing facilities are at a higher level.

"Even if you don't plan to use it in the future, you can set it up (and it) can help you to get onto a better professional package and negotiate better interest rates," Johnston reveals.

He says an LOC, as it's commonly known, doesn't necessarily involve higher fees either, since many professional packages allow for a number of different borrowing facilities.

5. Fix your rates

A lot of borrowers have switched their loans to fixed-rate products in recent months, Spratt says.

"There are products available today where the fixed rates have a lot of flexibility, such as having an offset account attached to a fixed rate loan," he says. "Three-year fixed rates now are lower than even the discounted variable rates and when you can have something like a 100 per cent offset account attached to it, it still gives a client the flexibility of making additional payments to the loan."

However, Senlitonga notes there's no guarantee you'll save money on a fixed rate since you'll be tied to it even if variable rates come down. Johnston adds that lenders aren't as negotiable on their advertised fixed rates as they are on their variable rates.

"Most lenders with fixed rates, you can negotiate a discount but it's more around 0.15 per cent or 0.25 per cent at the higher end," he says.

6. Accept fewer features

Johnston says borrowers who don't qualify for a professional package could opt for a discounted variable rate.

"The discounted variable loans are the ones that don't have quite as many bells and whistles, so they don't have the 100 per cent offset account but they give you a lower interest rate," he explains.

The difference between standard variable and discounted variable rates is often around the 0.7 per cent mark. Senlitonga says a recent CANNEX study found more than 60 per cent of offset accounts had a balance of less than $5000, meaning borrowers were paying to have access to a feature they weren't really using.

However, Spratt warns borrowers to think twice before giving up certain extras, such as redraw facilities. "(It) can have consequences that might not be apparent now but may come to a head down the track," he says.

7. Try a non-bank lender

Non-bank lenders can often help borrowers save, Spratt says.

"My experience is you can get the same sort of discounts you'd get from the banks but you don't generally have to pay the ongoing fee that you'd pay with the bank," he explains.

"You might get the equivalent of a 0.5 or a 0.7 per cent discount off the standard variable rate but you then don't have to pay the $300 a year fee."

Senlitonga warns, however, that simply switching to a certain type of lender won't guarantee you get the best loan. He says it's important to match the right product to an individual borrower's needs.

8. Go online

Lenders with online-only products often offer very good interest rates, though borrowers will sacrifice any loan extras and access to in-branch service, Johnston says. He says online loans are probably best suited to borrowers who have a good understanding of the mortgage industry and who only need straightforward loans.

"They're probably not set up for more complex loan structures for people with a number of investment properties etc.," he says. "But if you know what you're doing and you're happy to spend the time on it yourself then they can be a good option and the rates can be quite low."

9. Use a broker

If you don't feel comfortable negotiating with various lenders, a mortgage broker can do this for you - usually at no cost to you. In addition, brokers' inside knowledge and access to 30-plus lenders can help secure a discount.

"Mortgage brokers are often able to find special deals or special offers that aren't generally published to the market," Spratt says.

Johnston adds, "A good quality broker can shop around on your behalf and can know which lenders are offering the best pricing at a particular time. Different lenders are offering different levels of pricing at any given time relative to what sort of profit margins they're trying to make on their loans. Today lender 'x' might be the most aggressive in terms of trying to get market share but in six months' time it might be lender 'y'. That's something that is constantly evolving and moving and changing."

Matthew Liddy - Australian Property Investor magazine

© Australian Property Investor magazine - www.apimagazine.com.au

End of the Financial Year Tips for your Self-Managed Super Fund

As the end of the financial year approaches, it it worthwhile to consider what should be done within your self-managed super fund (SMSF) to enhance your position going forward.

Many ideas are also relevant to superannuation and tax planning in general, but they are well worth a mention and/or reminder.

1. Ensure that your trust deed is up to date and that the rules allow you to maximise your situation.
   
   
2. Enhance your contributions as much as allowable.
   
   
   1. A tax deduction is available whenever a fund member makes a concessional contribution where 10% or less of their assessable income is obtained from employment activities (including directorships). This means that if you are under 65 years of age, even if retired, you may be able to make a tax deductible contribution that can be used to offset other income that is assessible, such as rents, interest, dividends and capital gains.
      
      
   2. Salary sacrifice where possible.
      
      
   3. Make non-concessional contributions of up to $150,000 per annum (or $450,000 if bringing forward 2 years and eligible) will allow you funds to grow in your tax effective SMSF.
      
      
   4. If a member of the SMSF is a low income earner (< $58,890), they should consider making a co-contribution of $1,000, whereby the Government will co-contribute up to $1,500.
      
      
3. Defer income within your SMSF with a 60 or 90 day bank bill. Those funds sitting on cash, that may not be required to purchase investments, pay expenses (such as insurance premiums) or to pay out pensions at a later date, should think about investing in bank bills that pay interest into the following year. This way the income is assessable in the 2009 financial year.
   
   
4. If holding personal shares that you wished were in your SMSF, it may be time for you to make an in specie transfer of them into the fund as a contribution. If your transfer triggers a capital loss now, it would allow future capital gains to be in a favourable SMSF tax environment. Also, any capital losses incurred can be used to offset personal capital gains.
   
   
5. If your SMSF has accumulation and pension accounts operating with a pooled asset strategy, consider segregating those assets with large gains or high income to the pension account as no tax is payable. Otherwise, the accumulation account will be liable for tax on its proportion.
   
   
6. Realise capital losses within the fund from poorly performing assets to offset capital gains already in the SMSF.
   
   
7. Pre-pay any of the fund's expenses (accounting fees, insurance premiums, etc.) before the end of June to help reduce any SMSF tax liability this financial year.
   
   
8. SMSF's should consider imputation funds as the distributions for 30th June can be beneficial. SMSF's with tax-free pension assets will receive the full 30% rebate and may have a tax refund made to the fund, while those in the accumulation stage can use these credits to offset contributions tax and/or tax on fund earnings.
   
   
9. If more than the minimum pension has been targeted but some or all of the surplus above the minimum is not required before 30th June, consider not taking any more pension. If the member is unable to make future contributions (over age 65 and no longer working) the money may be best left within the SMSF.
   
   
10. If appropriate, consider splitting super contributions. The rules will change from 1/7/08 when it will only be possible to split 85% of the concessional contributions received.
    
    
11. Ensure that your SMSF has all members' Tax File Numbers recorded, as failure to do so will mean that contributions are taxed at the top marginal tax rate of 45% as opposed to 15%.
    
    

As always, seek professional advice if you are unsure of any strategy or issue, especially to ensure that your SMSF is compliant and efficient.

Laura Menschik
Director and Authorised Representative
WLM Financial Services Pty Ltd.
CERTIFIED FINANCIAL PLANNER TM - SMSF SPECIALIST ADVISER TM
Visit the WLM Financial Group online wlm.com.au

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