Self-funded retirees are being squeezed by negative returns and a rising cost of living

There is palpable angst amongst bond investors right now, particularly amongst those who are of a mature age and nearer-to or already in retirement.  Investors have gone from reading about the well-covered macro-economic risk factors in the media, since at least the beginning of this year, to actually now feeling the real impact of the said risks in their investment portfolios and their hip pocket as consumers.  Specifically, we are referring to inflation and its financial consequences for bond investors who also happen to be consumers and maybe even borrowers.

Since May, Mortgage holders (owner occupiers and property investors) on variable interest rates have started to feel the impact of interest rate increases through higher monthly repayments. Most investors would have filled up their fuel tanks with petrol at least twice in the past month at prices well above $2 per litre for common fuel variants- this is after the excise tax relief from the government. Their regular grocery bill now feels much higher than in the past and, all of a sudden, the money left in the bank after paying all the month’s expenses seems a lot lower than what it used to be. In some cases, they may be chipping down their savings to balance the monthly household budget. They are wondering which areas of their regular household expenses they will have to cut fast as they are told the energy bills are set to soar and further increases in interest rates remain in the offing.  To add to their woes, particularly the conservative investors, they are seeing parts of their investment portfolio in the red. The self-funded retirees are feeling the double impact of negative investment returns in the income parts of their portfolios vis-à-vis the rising cost of living.

What words of financial wisdom can we offer bond investors who are rightfully concerned about the direction and thus returns from this asset class? 

We divide investors in terms of two broad groups; accumulators and those in transition-to or already in retirement.  The former we consider as having a genuine 10-year outlook if not more, and the latter we refer to those who need to draw down their investment portfolio to fund the living expenses now and in the next 1, 2, 3 years.  Beyond that, such investors expect to capture some growth on the invested principle together with the income return to fund expenses (ideally). For such investors, the way big macro shifts are playing out right now and the uncertainty they bring with them, we recommend prioritising capital preservation out to 3 years for the part of their investment funds they need to cover the living costs.  And for other parts of their portfolio with a 3+ year outlook we would consider longer dated bonds at these levels and other income options such as hybrids, AREITs, and infrastructure.

Lately, we have heard from many conservative investors asking the question that have bonds been sold off far enough? Should they hold on to their negative positions or bail out for more safer substitutes of cash equivalents? Our usual response to that is, as a conservative investor seeking to place bonds in the income part of your portfolio, you should be looking to minimise the risk, as much as possible, of making a directional call on government bond yields. If bond yields (or income returns) change materially then that will also affect your invested principle in bonds (positively or negatively).   Ideally, bonds should deliver consistent income with not much movement in their price.  Right now though, we can make a convincing case for a further sell off in bonds and equally we can make a case for bond sell off as being overdone in the near-term and could even rally if our economy enters a recession.

Our belief is that for conservative investors with 1-3year cash requirements, to consider bonds right now, they would need inflation numbers to settle down over the coming quarters before adding punchy weights to bonds and duration in the portfolio.  Until bond prices and yields settle down we would keep the 1,2,3-year allocation of capital reserved for bonds in bank term deposits and or annuities.  This may apply to investors who have held on to duration through the recent bond market sell-off as much as those looking to deploy new money.

For accumulators or younger investors, time is on their side as they can afford to take the long-term view by being in bonds right now for diversification and have higher income returns (over the long range) provide offset to any prospects of a near term sell off in bond prices.

Economic News

Australian RBA decision. RBA raised interest rates by +50bps to 0.85% and Governor Philip Lowe reiterated that Australians should be prepared for further interest-rate increases and expects the board to discuss 0.25%-0.5% hike in July, as the bank expects inflation to accelerate to 7% in December quarter 2022 and only begin to ease back early in 2023. Consumer sentiment dropped in June to lowest since August 2020, amid accelerating inflation.

Global growth outlook. The World Bank further cut its forecast for global economic expansion in 2022, downgrading by -1.2% from January estimate to +2.9% with growth in advanced economies decelerating -2.50% p.a. to 2.6%p.a. (U.S. expanding +2.5%, down -1.20% from prior forecast in January and Euro area growing +2.5%, down – 1.70%) before further moderating to 2.2% in 2023. Economic growth in emerging economies is seen decelerating -3.2% p.a. to 3.4% (China growing +4.3%, down -0.8% and India expanding +7.5%, down -1.2%), well below annual average of 4.8% from 2011-2019. World bank warned that several years of above- average inflation and below-average growth lie ahead with potentially destabilizing consequences for low-and middle-income economies with real income per capita remaining below pre-Covid-19 levels in about 40% of developing economies in 2023.

U.S. Fed raised interest rate by +0.75%, the biggest increase since 1994, to 1.5%-1.75% and signalled to keep hiking aggressively this year, as it downgraded outlook for the economy from the soft-landing scenario of March to a bumpier touchdown. The Fed upgraded 2022 inflation forecast by +0.9% to 5.2% while downgrading 2022 GDP forecast by -1.1% to 1.7%. Fed Chair Jerome Powell warned that steep rate hikes could tip the US economy into recession.

U.S. Business activity took a decisive step back in June with a measure of services registering the slowest pace of expansion since the start of the year as rapid inflation reduced demand for services and manufacturing growth slowing abruptly, marking one of the largest monthly declines in data back to 2007. High prices, weaker demand, and materials shortages pushed the Manufacturing index to a two-year low. US consumer confidence dropped in June to the lowest in more than a year and a measure of expectations, which reflects consumers’ six-month outlook, dropped to the lowest in nearly a decade.

China Economy showed further signs of improvement in June with official manufacturing PMI rising above 50-mark for the first time since February, indicating an expansion in output compared with May and non-manufacturing PMI, which measures activity in the construction and services sectors, climbing to highest in more than a year.

Euro-area inflation surged to a fresh record in June with CPI jumping +8.6% p.a., with France, Italy and Spain reporting new all-time highs and consumer confidence approached its lowest level since the early months of the pandemic. Germany’s Inflation eased in June with CPI increasing +7.6% p.a. vs 7.9% p.a. in prior month, amid temporary government relief measures.

U.K.’s Bank of England raised interest rates for a fifth straight meeting, increasing the benchmark lending rate by +0.25% to 1.25%, while raising its forecast for the peak of inflation this year to “slightly above” 11% p.a., and announcing it expects the economy to contract in the current quarter.

India’s central bank (RBI) raised the key interest rate by +0.50% to 4.9% and pledged to withdraw the pandemic-era accommodation, while raising its inflation forecast for 2022 by +1.0% to 6.7%, inflation is outside the RBI’s mandated target range of 2-6%.

Japan’s central bank (BOJ) kept its policy settings for yield curve control and asset purchases unchanged and downgraded its assessment on production, exports and overseas economies, while taking an improved view of consumer spending.

Global Markets Update

US markets declined, with the Dow Jones down -6.7% and S&P500 down -8.4%, amid worries the Fed will plunge the economy into a recession as recession-signalling indicators jumped the most since 2020.

The ASX200 declined -8.9%.

In commodities, WTI oil price declined -5.5% to US$105.8/bbl, as OPEC+ ratified an oil-production increase that completes the return of supplies halted during the pandemic, rubber-stamping plans to add 648k barrels a day in August.