Paltry returns for savers and investors unlikely to improve
It's your money
Savers and investors face an uphill challenge in the aftermath of the financial crisis – where yields from traditional sources such as cash deposits and government bonds are paltry and unlikely to improve any time soon.
According to the Central Bank, Irish households have managed to squirrel away over €92bn in savings. In recent years these savers have been cushioned by deposit rates as high as 3-4 per cent as Irish banks scrambled for deposits to improve their loan-to-deposit ratios. However, that period has begun to unwind, resulting in a classic middle-class squeeze of falling deposit rates and rising mortgage rates.
Banks squeeze households
What compounds the issue is that the financial crisis appears to have altered investors' behaviour to certain assets irrevocably.
The typical response to the turmoil has been to park cash on deposit or put money overseas in the likes of short-dated German bonds. This is entirely understandable. Holding cash in times of duress provides a sense of security and liquidity – but history tells us that holding too much is one of the biggest mistakes investors can make.
With the world's major central banks committed to a zero interest rate policy international bond yields are at historically low levels, and with the Irish banking system now trying to get back to profitability, banks are slashing deposit rates, and raising mortgage rates, squeezing households up and down the country.
Even using simple arithmetic, a 1 per cent decrease in interest rates on €92bn reduces interest income by almost €1bn per annum. Needless to say, this is a serious loss of income to the economy and the reality is it is probably going to get worse.
ECB will not raise rates for 2-3 years
Given the weakness of economic data right across Europe, it is almost impossible to envisage the ECB raising interest rates anytime in the next two to three years.
In the near term, it is more likely that Mario Draghi will cut rates before raising them. In fact, increasingly we find ourselves asking, is Europe at risk of becoming Japan after its property implosion in the Eighties?
There are many similarities – a woefully inadequate policy response from policymakers, an unwillingness to address the restructuring of financial sector balance sheets which has left a zombie banking sector unwilling to lend to individuals and SMEs.
So, with interest rates set to remain at historically low levels for the foreseeable future, the search for yield (income) will require looking beyond cash and sovereign bonds. Unfortunately, there is no easy answer to this conundrum and to generate a higher level of return, investors will need to accept a higher level of risk.
All is not lost, however. Looking across the investment spectrum two assets with higher yields stand out. In particular, those options include equities and commercial real estate.
Equities as a source of income
We are now more than four years into the latest bull market in equities and although several stock markets reached all-time highs earlier this year, investors continue to shy away from equities.
But increasingly attractive dividend yields on offer from global blue-chip companies are tempting some back into equities as a source of income.
In order to increase yield, investors can often boost their income by holding a selection of high quality, high-yielding multinational stocks. Buying into the defensive – and safer – segments of the market often offers yields in excess of 4 per cent, which is substantially higher than cash deposit rates.
There are four main reasons investors should consider this route. Valuation levels are attractive, with forward price-to-earnings (PE) multiples remaining at reasonable levels, indicating good value in equity investments still exists.
Real returns are possible as equities possess the ability to grow earnings and dividends to offset inflationary pressures on final returns. Company balance sheets are in rude health as CEOs have been reluctant to spend despite an increase in profits.
Payout ratios, the amount of profits given back to shareholders in the form of dividends, are at historical lows as companies resist the temptation to increase dividends as profits have risen. We expect the payout ratios to rise in time.
Some high dividend-paying blue-chip stocks that Davy analysts believe offer good value include: Microsoft, the world's largest software manufacturer with over $60bn in cash on its balance sheet, paying a yield of over 3 per cent and trading on just 11 times' price-to-earnings; or Siemens, the German-based global industrial & engineering business that pays a 4 per cent dividend yield; or HSBC, one of the few truly global banks, where the wide spread of businesses between mature and emerging markets is boosting growth and enabling the company to pay an attractive 5 per cent dividend yield.
Commercial Real Estate
Outside of equities, the highest yields available can be found in the commercial property market.
Property across the US, UK and Europe pay yields of 5-6 per cent on average and in a low interest rate world, investors are once again becoming interested in property as a source of income. Indeed, the primary reason foreign institutional investors are trawling through the Irish property market is that the yields are unparalleled globally.
High-profile deals such as US private equity group Blackstone's €67m purchase of the Burlington Hotel are taking place for two reasons – firstly, prices remain two-thirds below their peak levels; secondly, and more importantly, with yields as high as 8 per cent, Irish property is extremely attractive compared with international alternatives
Although it will be a long time before property fully recovers, we believe we are still in the embryonic stage of a global recovery. It typically takes at least a decade for property prices to recover, but it may take longer this time given the additional supply expected to emerge as Nama gradually unwinds its property portfolio.
However, in time we expect property prices to gradually recover with the bulk of returns coming from income rather than capital appreciation.
In summary, the issue of low interest rates is a challenge that won't go away any time soon. With rates on deposits falling and mortgage rates rising, households may need to consider changing their strategy if they want to generate any income from their savings.
Brian O'Reilly is global investment strategist at Davy Private Clients