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What do Investors or Savers do when Interest Rates are Near Zero?

Zero Interest Rates

We live in a world of low interest rates and it is difficult to get a return on one's savings or pension monies from bank deposits.

This is unlikely to change anytime soon for the simple reason that the developed world has too much debt and cannot afford higher interest rates. In addition, authorities need higher inflation to assist their economies to grow their way out of the debt problem.

The combination of low interest rates and likely upside inflationary pressures is not exactly what the saver wants, or indeed deserves.

In the Eurozone, the ECB has now provided €1 trillion to the banking system with the explicit aim of driving down the cost of medium- and long-term funding for banks and government. Banks have borrowed from the EBC at 1% and can use those monies to invest in their own country's higher yielding government bonds if they wish. They can pocket the difference and the gains they make will help repair their balance sheets to more easily absorb further loan write-offs. If the thought of the borrowers, banks and governments being silently bailed out at the expense of the saver was fully understood by everyone in society, Greece might not be the only Eurozone country witnessing riots.

In Ireland, we still have the teaser bank deposit interest rates of 2.5-3.0% from the banks. But with the ECB overnight rate at 1% sooner or later our short-term interest rates will gravitate back to the ECB rate, and it makes sense to plan on that assumption.

In the US and UK, short-term interest rates have been negative after inflation for a few years now. And that is the way the central banks in both economies want it. In addition, with central banks in both these economies buying their own government debt (quantitative easing), both economies have also been able to keep long-term interest rates low, as well as fund government spending to boost growth.

With increasing pressure from a new leader in France to ease up on austerity, the pressure to spend a little more in support of growth is building in the Eurozone. But who will provide the finance for extra government spending in the Eurozone? If Germany wants the Euro saved, and in the absence of an alternative, then it will fall to the ECB to copy the US and UK and start funding Eurozone governments by buying the bonds they issue (quantitative easing - money printing). This is not a good backdrop for the saver in non-risk assets be they bank deposits or short-dated government bonds.

Stock markets, while volatile, offer much better value and far higher income if you know where to look. A reasonably safe area of risk-asset investment in the current climate has been what I have often described as the defensive global consumer franchise stocks. These are companies that are relatively immune to the economic cycle, have strong business franchises and finances, exposure to the growth areas of the world and decent initial dividend yields. In the US, this label might include Coca Cola, Johnson & Johnson, McDonalds, Colgate, Kraft and Proctor & Gamble among many others. In Europe, it might include Unilever, Reckitt Benckiser, Nestle and Diageo among others. Collectively, these stocks offer a defensive dividend yield of circa 3% and the prospects of reliable growth in that income stream in the years ahead.

Yes, to obtain those higher dividend yields you must put up with the higher volatility that is, and always has been, associated with stock market investing. But it must also be pointed out that volatility is not the same thing as risk.

Perhaps an example will help explain!

At the peak of the equity markets in the developed world in late 1999, Johnson & Johnson's share price reached a high of $53 in that year. The share was offering a dividend of 55c at that time for a dividend yield of 1%. Today, J&J's share price ($64) is modestly ahead of the late 1999 level but its 2012 dividend of $2.40 a share is over four times the 1999 level. Today, J&J offers an initial dividend yield of 3.8%, miles ahead of US short-term interest rates and almost double the US 10-year government bond yield of under 2%. My point is that J&J's shares contained considerable valuation risk in 1999. But not so today! Volatility in the stock market does not alter the obvious value on offer in J&J's shares.

For those who prefer to eschew individual companies, there are many well diversified funds - either exchange traded funds (ETFs) listed on the global stock markets or investment companies listed on the London Stock Exchange - that provide initial dividend yields in excess of 4%. Such funds also offer currency, company and geographic diversification. Unlike Irish unit-linked funds, stock market listed funds have no entry or exit costs and no set holding periods. A well supported initial dividend yield of 4% plus is compelling compared to the returns that are available to savers in non-risk assets.

By way of example,

The WisdomTree International Dividend ETF (ticker code: DOO), which excludes the dreaded financial stocks, paid out a dividend of $1.75 on average over the past three years. This represents an initial dividend yield of 4.4% against the current fund price of $39. Indeed, it is relatively easy to put together a diversified basket of such funds with an average dividend yield of over 4%.

Whatever way you look at it today, the value and income lies in risk assets. There are some who say that you can only make returns by trading markets. This is plain nonsense. You must own assets in order to obtain the returns on offer. Equally, trying to circumvent the volatility in markets by buying guaranteed products is fruitless. All you achieve is to hand the vital dividends over to the product seller.

Ardle Culleton
17th May 2012