Author: Richard Webb, Senior Manager, Financial Planning and Superannuation Policy
The Reserve Bank board surprised financial markets in September. How? It only pushed the cash rate up a quarter of a per cent, after several months of steady half per cent increases. This signalled a new approach to cash rate increases: a slower rise. The shift resulted in one of the strongest weeks on the ASX this year as investors responded positively to the change.
The cash rate has been progressively increasing since April, when the Reserve Bank identified that there were pressures on inflation. These upwards pressures include a supply chain crunch, the war in Ukraine and strong demand globally for goods. The increase to the CPI in Australia from the Bank’s August Statement on Monetary Policy shows a rate of 6.1 per cent over the year – the highest year-ended rate since the early 1990s. This is likely to worsen. The Bank is forecasting inflation to be around 7.75 per cent for 2022, and not to come back down to three per cent until 2024.
Due to this high rate of inflation the cash rate will possibly continue to rise in the short term. It should be noted that high interest rates will persist for a little longer than inflation, as the Bank has affirmed their commitment to get inflation down to their target band of two to three per cent.
For some investors this is a foreign investment environment. Until this year, interest rates had been trending downwards since 2011. Inflation had not been higher than five per cent since the global financial crisis in 2008. In fact, inflation had mostly kept below two per cent since 2014. The fact that inflation – and as a result, interest rates – are up means that SMSF trustees suddenly find themselves needing to consider the impacts of each of these factors more carefully.
The impact of higher interest rates on equities markets will not have gone unnoticed by trustees. Listed equities are, of course, still the major asset class used in SMSFs. Market movements are historically felt in equities very early due to their liquidity and exposure to credit. Other listed asset classes such as listed property and infrastructure respond similarly.
Fixed interest yields are also highly sensitive to interest rate movements and have risen sharply this year. This sounds great until you remember that this means that a fixed interest portfolio is now worth less than it was. Fixed interest products are of course more traditionally found in APRA-regulated funds than SMSFs.
Cash appears to be an oasis of calm amid a cycle such as this. When interest rates are on the rise, depositors can benefit directly. However, even if the bank where a fund holds its money is passing the interest rate increase on in full, it’s still unlikely to outpace inflation after tax. Further, trustees considering switching to cash at this point run the risk of locking in investment losses on other assets.
This leaves unlisted assets, and it is these for which the most uncertainty arises. Property, regardless of whether it is residential, commercial or another type, is often directly held within an SMSF. This is due to the unique ability for such funds to hold these assets where APRA-regulated funds find it difficult to do so. But these assets are not immune to market movements themselves. One would expect, for example, that investment values would need to be revised down in this environment, particularly where similar properties in the neighbourhood are selling for reduced values.
Other unlisted assets such as collectables may possibly also rely on valuations which use interest rates or inflation rates as discount factors. They could also see reducing valuations due to this.
But most importantly, the impact of inflation may have not been considered as part of trustees’ current investment strategies beyond a cursory mention. In the past this has been reasonable, since inflation has been consistently low for some time. However, there will now be a heightened need to reconsider how a fund’s investment strategy is impacted by rising inflation. Additionally, the asset mix will have been affected by movements in asset values, which may require a fund to be rebalanced. Close attention is required by trustees.
Finally, questions will also be raised for trustees about how sustainable their present investment strategy is. If their objective is to have a portfolio which outpaces inflation after tax, and inflation is on the rise, it therefore becomes harder to achieve this goal. It’s time for trustees to get to work.