Don’t bet on rates staying lower for longer
Australians are getting used to super-low interest rates, and eye-watering loan amounts, particularly for property purchases. Along the way, the household debt burden as a percentage of disposable income has ballooned out from 170% to 185% since 2008. This is nosebleed territory. Is it time to be concerned? We think so.
When the sun is shining, and its sparkle shimmering off the water, a view of Sydney Harbour is one of the best in the world. The grungy cafes and laneways of other cities look like dank, grimy metal-recycling facilities by comparison. The Sydney views are so covetable that prices for Sydney harbourfront homes will hit $100 million at some stage in the not too distant future. Had Sydney Harbour been located any closer to the US or Europe, prices would have hit $100 million many years ago.
Despite its desirability, many residents literally draw their shades on the view – as any cruise around the harbour will reveal. Residents quickly become used to the world-class view despite its beauty and its price.
Low interest rates are a bit like that. We get used to them and acclimatise to the environment, operating as if it’s normal. Financial commentators have labelled this low-return environment the new normal but it’s anything but normal. And getting used to it is a very dangerous plan and a hazard to your wealth.
Getting used to it, and even settling-in has, however, been exactly what Australian households have done. While household debt in the US, UK and Germany has fallen materially since the GFC – and in the US, debt as a percentage of disposable income has declined from 138 per cent to 108 per cent – the reverse is true in Australia.
Aussie battlers have leveraged-up to chase asset prices higher, particularly property, increasing their debt burden to 185 per cent from 170 per cent of disposable income since 2008. As a nation, we are ill-prepared for any reversal of the global bond market rally that is now in its third decade.
The inverse relationship between bond prices and yields means that as bond markets decline, long-term interest rates will rise.
The value of any asset is simply the present value of all its future cash flows discounted back to today. Intuitively, receiving $100 immediately is worth much more than receiving $100 in ten years time. In order to work out how much more valuable the $100 is today, we need to discount the future $100 back to today to be able to compare them. If we use a 7 per cent rate to discount the future $100 back to today, we arrive at $50.83. If interest rates fall and we start using a 3 per cent discount rate, the present value of the future $100 becomes $74.40.
In other words, the value of the asset has risen 50 per cent simply because the discount rate we use to value the asset has declined from 7 per cent to 3 per cent. Global sovereign 10-year bond rates have been in decline now for 30 years and the declines experienced over the most recent decade are not the result of the normal buying and selling activity by rational and sensible long-term investors.
The most recent declines in bond interest rates – particularly the move to negative interest rates for 30% of the world’s sovereign bonds – is the work of central banks. Their collective activity has produced rates that no longer, even reasonably, reflect risk.
When Italy can borrow money at negative rates despite non-performing loans in their banking system amounting to 25% of GDP the bond market has ceased properly signalling risk.
And yet these low rates are what professional investors are using to inform the discount rates they use to value assets. And the greater the proportion of cheap debt a company has, compared to relatively more expensive equity, the lower the discount rate that can be adopted. Think about that for a minute; a company’s shares are more valuable because it has more debt.
Of course all this will unwind and we will look back with astonishment that investors were, for example, willing to lend money to the Swiss government for thirty years to receive 96 per cent of their capital back. It is such an environment that prompted Bill Gross to state the $10tn pile of negative-yielding government bonds is a “supernova that will explode one day”.
The question we should then be asking is how long will the party continue before the punchbowl is taken away? Or perhaps a better question is, should I simply go home early and not hang around to see the stampede for the narrow exit?
Investors in shares, property and other high priced assets can, at best, expect only low returns. At worst, violent volatility will accompany those low returns.
Low interest rates aren’t normal and they aren’t permanent so don’t get used to them. Awareness of that fact should have you beginning to behave very carefully.
Roger Montgomery is the founder and Chief Investment Officer of Montgomery Investment Management. To invest with Montgomery, find out more.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Eliza
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Jimbo I have been waiting for years for someone to mention the Japanese experience. You are right on the ball here.
Roger could we have an article looking at the mid 1980s to 1990s in Japan in relation to the last 10 yrs here. I was too young at the time to fully comprehend what was happening but knew it to be a lesson for our future. My understanding their problems started with a property bust and the banks being left with huge debts not being paid back, recession and unemployment. The beginning of the end to “a job for life” with one company. I think the government bailed the banks out, the view being to help just for a while but as the banks did not take the haircut the government had to continue propping up. The public moved savings from the troubled banks to the Post Office (a structure different to ours) giving the banks a bigger head ache. I think all this happened to coincide with the dramatic fall off in population growth and other demographic changes. Very little economic improvement since including very low interest rates.
Are we in a parallel universe now?
Rajneesh
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Hi Roger
Another interesting issue for me would be to find some data on Residential Mortgage Backed Securities (RMBS). I was wondering how much of RMBS are in demand and whether RMBS are the motivation behind Australian Banks’ lending to apartment developers to fund an oversupply in the housing market.
Cheers
Nick Laird
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What happens if QE expands further from the current $180 billion per month & then inflation comes back on line.
What are IR expectations if inflation heads up strongly – say above 5%?
Roger Montgomery
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That sounds like an outcome few are anticipating. As Mark Twain once observed, “when you find yourself on the side of the majority, it’s time to pause and reflect.”
John Boardman
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A point missed by commentators is although household debt as a percentage of income has hit an all time high, a lot of that debt has gone into investments whether it be an investment property or a share portfolio. It’s not like all that debt has gone into consumer goods. If households need to deleverage they sell those assets. For example if I were to borrow against my home to buy shares the income from the shares would more than cover the interest. However, for statistic purposes they would say I have a lot of debt, even though it is covered by investment assets that can be sold at any time.
Roger Montgomery
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Thanks for taking the time to share that observation John.
jimbo james
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The point is though John, in a rapidly falling market, who do they sell to? This is boom/bust stuff we’re talking about here. That wealth you speak of is all paper.
John Boardman
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They will always be a buyer when the price falls enough. But if the investment income is covering the interest bill there is no need to sell. For shares the market is yielding around 4.5%. Add in franking credits takes it up to 6%+. Interest on home loans are around 3.75%. Rates have to go up a lot before the shares are “negatively geared”.
Sam Goh
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Hi John,
That idea is sound provided the companies you hold are in great financial position & don’t suddenly have to ceased dividends indefinitely.
Andrew Ronan
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Hi Rodger, it seems that central banks are in to deep to do anything else but print money and buy bonds etc, We have also seen the start of the helicopter money in Japan it seems this can only continue and will be exported around the globe as low interest rates were and only when inflation targets are met when asset prices rise enough so as to reduce the debt owed on them as a proportion of there value will interest rates be allowed to normalise ,I can’t see what will stop governments from printing money until the cows come home they will use it for infestructure projects etc etc ,I can’t see them letting things implode after all this time and if they do there will be nowhere to hide.
BK
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Hi Roger
Can you flesh out what the possible triggers might be for a reversal? I agree in theory with you but in reality not so much. If central banks keep interfering, they could keep long rates low indefinitely. The ability to undertake to QE is endless if you are a central bank. If growth and inflation stay low, bond yields are not going to rise just on their own therefore.
Furthermore, a sharp rise in long-term IRs would probably cause a huge downturn in the global economy and in that scenario it doesn’t matter what equities you own – you would want to be 100% in cash.
Roger Montgomery
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everyone believes that corrections are always precipitated by at catalyst that can be seen in advance. Black swans by definition cannot. It could be record CCC rated credit refinancing in 2019/20. It could be China devaluing the Yuan. It could be Trump winning the election (or losing it and Hillary winning and pushing for a massive increase to minimum wages). It could be any number of triggers or, like 1987 where investors still debate what the catalyst was, it could be nothing specific at all.
Richard
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Hi Roger,
Probably wont get a simple answer here… but would love one!
If tomorrow the market was to close for 5 years, would you be comfortable with the current structure of your portfolio of companies? Given where we are in the world today with asset values, would you be more inclined to increase your cash holdings for this period?
Thanks
Roger Montgomery
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Hi Richard, We cannot say what prices will do but we know the businesses would increase in intrinsic value during that time and some of them substantially.
Greg McLennan
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Perfect answer!
Peter Todd
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Roger
Sitting on the sidelines in cash is going to be very painful if we are still talking about this in 5 years time and a complete disaster if it takes 10.
Roger Montgomery
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No disagreement there peter. Neither lots of cash nor holding it for a long time are desirable outcomes. We much prefer the shares of outstanding businesses. But cash is also an option, over lower prices, with no expiry date and no strike price.
Mark Egan
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Hi Roger,
I must be missing something. Isn’t this article at odds with your previous article about Buffett and business as usual? What is the logic of buying companies at a discount to intrinsic value now when there is the potential is for all stocks (including the ones you’ve bought) to fall when the bond market corrects? I understand the issue of timing, but the risk reward equation would surely be that such behaviour is risky. Another risk is that investors begin to see the risk of high equity market valuations and begin to cash out and the process becomes self perpetuating. There doesn’t need to be a “trigger” and besides this will happen anyway as retirees can’t live on share returns. Did I miss something in your previous article?
Cheers,
Mark
Roger Montgomery
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It is business as usual for us. That means staying invested in the high quality growth companies we have purchased in the funds, as well as having the cash to take advantage of any opportunities that are presented. In summary the message is this:
1) Low interest rates have corrupted the signal for risk and pushed asset prices up (which has been the central banks aim)
2) US 10 year bond rates below 1930’s Depression levels, 30% of sovereign bonds at negative yields and 80% below 1%, is not the result of the buying and selling of rational, risk averse and profit motivated investors but by the action of central banks.
3) The implication is that people are paying high prices for assets believing these low rates are the ‘new normal’ but this is anything but normal!
4) Investors will look back on this time aghast that institutions and investors committed themselves to long duration investments at at high prices and therefore at such absurdly low rates of return
5) High asset prices are however justified if there is solid growth but the twin forces of rising payout ratios and exceedingly high debt means growth cannot come from either retained earnings nor from leveraging balance sheet. So high prices are arguably not justified.
Some possible scenarios
5) Pay high prices now get a low return with low volatility, if rates stay low.
6) Pay high prices now and if bonds fall and long rates rise, there will be a violent reaction in asset prices. Still a low return but much more painful.
7) under the (5) lower for longer scenario, we can win again because we are seventy percent invested in very high growth companies.
8) under a (6) rising bond rate/correction scenario we have a growing cash balance to take advantage of lower prices.
9) Specifically our warning to investors is to those who believe they are safe in REITS, conventional high yielding Blue-chips and higher yielding infrastructure stocks.
Warren muor
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I disagree. Look around the rest of the world , we are in a new paradyme and cannot pretend the past is any indication of the future. Low interest rates are her to stay. Just be careful with buying depreciating assets and borrow what you can afford. Voila
Roger Montgomery
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If we didn’t have different views Warren there’d be nobody to buy the securities we are selling.
Nir Halevi
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A question not specifically to this article, that quite a few of your followers have:: Why would one, or a compny buy bonds with negative yield, lets say in Switzerland, instead of just leaving the cash for 10 yrs time in a normal saving acc with zero interest?
Thanks in advance
Roger Montgomery
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The market for deposits is not big enough. One reason for buying bonds at negative yields is the expectation that rates could be even worse in the future.
Bazza
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Can any government afford higher interest rates? Can their citizens? I personally can’t think of any country that could raise rates without causing harm to its government debt, households incomes and also the currency.
With low growth as developed economies reach their ‘steady state’, there is no trigger for inflation. In addition, there is no example of ZIRP (zero interest rate policy) being reversed. America has been able to only increase rate once in 10 years, to 0.50%.
Roger Montgomery
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Bazza,
We are talking about long bond rates rising. This can happen independently of central banks raising short term cash rates.
Bruce Gleeson
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Great article – just a pity that more economic commentators aren’t focused on what appears to be a major train wreck waiting ahead. I do find that their thinking is very short term focused and the very real distinction I take from your insights is that you are taking a more realistic / mid term view. I also think and perhaps it is just the cynic in me, that certain economists and commentators would rather go with the populist opinion as opposed to being pragmatic. The future train wreck has similar hallmarks of a Ponzi scheme and we all know how they end up!!
Dean Bourke
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I have seen the writing on the wall and have left the party; standing out the front with some popcorn waiting for the stampede. Then when the party is over and the building is empty I might pop my head in and pick up some cheap furniture.
Rajneesh
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Hi Roger,
Thanks for the insight, as always a very sober article amongst contemporary media’s “property always goes up” daily articles. I get a little worried about the economy when contemplating how many jobs/industries are linked to the property market at the moment. I always thought higher unemployment/rate rises might be the pin in the property bubble, however the recent inability of Off the Plan apartment buyers to settle is a little worrisome.
An example of this scenario can be seen unfolding in Sydney’s suburb of Wolli Creek. A lot of apartments are coming into the market and the Chinese/overseas buyers are unable to settle, the banks have said no to them further some of the valuations for 2 bed apartments have come back at 675K. The OTP purchase price was 750K. Having said that the rental is still amazingly high. These two bedroom apartments are going for $650 per week. So if local investors can buy them, there won’t be a fire-sale of the apartments, at-least not yet. I wonder how the banks are calculating APRA’s 10 percent lending limit to investors imposed upon the banks.
Anyhow, let’s see how how big the problem. One thing I am sure about is that the capital gains now won’t be as spectacular as the past three years if anything.
Cheers
Roger Montgomery
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Hi Rajneesh, thats a useful insight from the coalface. I am not worried about a fire-sale of apartments by investors or owner occupiers. I am more concerned about developers being forced to discount as oversupplied unsold apartments come to market.
Chris page
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I actually think we are only just entering the first stages of a 75 year low interest rate environment. I think they cannot go much lower but I think they will stay low for a long time
I think the big risk to property is unemployment and I see automation replacing jobs as shareholders demand more efficiency out of their businesses
Roger Montgomery
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I hope you are right Chris. Unemployment could also rise as the construction industry slows when all the current apartment developments are complete and oversupply is with us.
jimbo james
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The property bulls would agree and then promptly use Japan to justify their argument. All well and good, but they tend to squirm when they discover Japanese property values are still down 70%+ in NOMINAL terms from where they were in the early 1990s. That’s deflation for you.