Mainstream economists are now predicting that interest rates in the US and UK will fall to zero in the next 6 months. This is bound to have profound effects on financial markets.
When they say ‘Interest rates will go to zero’, what the economists mean is the central banks will cut their base rates to zero. That doesn’t mean High Street deposit rates will go to zero, or that borrowers will pay nothing for their mortgages. It does mean that savings rates will probably fall to as little as 2% in 2009 while mortgage rates will move to 3-4%.
As we’ve seen with the closure of fixed rate savings offers in recent weeks, once savers get the idea that interest rates are plunging, they will buy up every high-interest opportunity they can. At present, they’re going for zero-risk options like the fixed rate bonds from banks and building societies. But as rates on new bond offers fall, savers will start to look for alternatives.
The two most likely to attract their attention are corporate bonds and shares paying high dividends.
Corporate bonds - loans issued by companies – currently offer very high yields. Companies with credit ratings only two notches down from the top AAA rating are paying as much as 9% to raise loans with a term of 10 years. Such high yields are unprecedented, and most analysts say they are far higher than is needed to compensate investors for the risk of default. Even if we have a 1930s style depression, only a very few A-rated companies are likely to actually default on their debts.
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Tremendous opportunities
I’ve previously featured corporate bond funds where the managers believe they have tremendous opportunities to buy at hefty discounts while delivering a 7% income.
The other area that stands out is equity income funds, share-investing funds where managers aim for big dividend cheques rather than capital gains. Here the story is more complicated, for while many of these funds offer yields of over 6%, nobody knows how many companies will cut their dividends if the recession gets really nasty. Last year, nobody would have expected BT Group – which with its vast heritage landline telephony business is sure to survive a recession better than most - to cut its dividend. Yet BT shares have slumped and investors have been softened up to expect a dividend cut.
Over the long term, equity income funds do well because dividends tend to rise far more in the good times than they fall in the bad times. Over a 10-year period dividends have almost always risen at a faster rate than inflation, making equity income funds an obvious choice for retired investors seeking an inflation-proof income. That’s still the case today, even though it looks inevitable that most equity income funds will pay out lower dividends in 2009 than in 2008. But they could still prove a good investment, because a 5% income will attract more buyers as interest rates fall.
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What other effects can we expect from the move to zero interest rates?
• Property: commercial property values are affected by interest rates. The lower the interest rate, the higher the value. The downturn in the economy is so severe, though, that commercial property fund prices could continue to decline well into 2009.
• Overseas markets. The weakness of sterling is likely to continue, making overseas investments more attractive. Investors in Japan and Europe have done relatively well in the past few months, because the fall in the pound has boosted the sterling value of their investments.
• Resources. Zero interest rates only happen when the economic outlook is dire, so expect prices of oil, energy, commodity and resource companies to keep on falling.
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Long term buys: resources and emerging markets
Investors have to distinguish between short-term and long-term trends. Despite the global recession, the long-term uptrend in resources is probably still intact, and so is the upward trajectory of emerging markets, which will keep on growing at much faster rates than Western economies in coming decades.
These are the most promising areas for regular savings, since the current slump means you can buy into what are still growth sectors at very low valuations.
With a fund supermarket such as FundsNetwork or Hargreaves Lansdown, you can set up a regular savings plan putting as little as £50 per month into several funds. Here’s a suggested mini savings portfolio for £200 per month, which you can set up as an ISA if you’re not already using your annual ISA allowance.
| Fund | Investment | Amount per month |
| JPM Natural Resources | Worldwide spread of energy and mining shares | £50 |
| Aberdeen Emerging Markets | Worldwide spread of shares in faster-growing markets like India and Brazil | £50 |
| JPM Global Equity Income | Mainly large overseas companies paying good dividends | £50 |
| Threadneedle UK Equity Income | Mainly large UK companies paying good dividends | £50 |
| Total | | £200 |
The mini-portfolio combines two ‘steamers’ with two ‘steadies’. Resources and emerging markets can be expected to go on behaving like rollercoasters. Putting equal amounts into these two ‘steamers’ means there’s a good chance that in ten years’ time you could bank substantial profits on at least one of them, while your two ‘steadies’ chug along with less volatile cash-in values.
Important risk warning - please read
The value of your investment and the income from it can go down as well as up and you may not get back a significant proportion of your investment. Past performance is not an indication of future performance. If you are in any doubt as to the suitability of an investment, you should seek independent financial advice.
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