Technically Speaking: Kiwis yet to learn low inflation won't ease borrowing burden

Friday 22nd June 2001

Chart 1: Telecom New Zealand

It was reported recently that net wealth - assets minus debts - of New Zealand households has declined for the fifth quarter to the end of the March quarter 2001.

The period corresponds to that of the Labour-Alliance government, elected in late 1999. New Zealanders are collectively poorer under socialist administration.

The effect would look even more dramatic if the net wealth figures were converted into US dollars to measure their international buying power in the world's principal currency of trade.

A large fall in the exchange rate value of the kiwi has coincided with the regime of the present government.

The survey was carried out by Morningstar and the Institute of Economic Research for WestpacTrust.

On the credit side, bank deposit savings and investment in managed funds were up, indicating a rising trend for thrift and retirement provision.

On the debit side, house values were down and household borrowings had increased.

The fall in house values may in part reflect a shift to income-related rents in state housing, which in turn would put pressure on private rental property values.

It may also indicate some homeowners with mortgages now have negative equity in their houses.

The increase in household debt, largely due to credit card debt expansion, is of concern considering the low- inflation economy we have achieved.

In his book The Death of Inflation, HSBC Group chief economist Professor Roger Bootle argues it is necessary for households and investors to factor lower inflation into their calculations concerning debt and investment.

The key point he makes is that high levels of inflation will not be present to erode the nominal value of debt at a rapid rate. As a result, the real cost of debt will be higher.

For example, a householder with a mortgage will no longer be able to assume that inflation will cut the cost of principal and interest or that the house will rise in value significantly above the original mortgaged amount.

The asset will improve in worth - if at all - due to real influences on the desirability of owning property, while the debt will need to be serviced with little erosion in the value of money along the way.

Strong appetite for debt among New Zealand households may indicate that people have yet to learn the lesson that low inflation will not ease their borrowing burden to any large degree.

Dr Bootle maintains that from the point of view of investors in the sharemarket - including those who use managed funds - shares will lose their inflation-proofing characteristic of rising rapidly in nominal value during bouts of high general increase in prices.

Just think back to the run-up to the 1987 sharemarket crash to recollect how a high-inflation environment ramped the value of shares.

This sort of behaviour is not likely to be observed so frequently in the future, although as the bull market in the Nasdaq composite index, terminated in April 2000, reveals, it is still possible to have asset inflation at a time of comparatively low price inflation for goods and services.

Asset bubbles are not ruled out by a low inflation environment, but they do not represent sustainable sources of wealth accumulation.

Another effect of the relationship between debt and low inflation will be that company profits will rise more slowly in nominal terms. This effect will be felt in listed company share- price performance.

Lower future profit increases reflecting modest levels of inflation will change the outlook for share price increase.

As shares tend to be priced at least in part from profit expectations, prices should rise more slowly in a low-inflation environment, reducing nominal capital gains.

A benefit will be that companies producing poor real returns to investors will not be able to hide behind inflation and will have to produce efficiencies in the way they operate to do better.

However, where share prices are in excess of reasonable multiples of expected profit, these prices must fall until appropriate balance is reached.

This point may not yet have been attained with US shares, which may yet have a prolonged bear market.

Support for share prices at higher profit multiples engendered by higher current baby boomer retirement investment may be a false friend if it delays this readjustment.

Eventual reckoning could come when boomers sell off their shares to fund their retirement years.

The question at that time will be whether there is sufficient demand from those still in the workforce to buy the shares at the high-profit multiples retirees might require.

Boomers cannot expect to be able to pass off the cost of paying too much for shares by intergenerational transfer.

For companies, debt will become a less attractive way to fund expansion if low inflation prevents substantial nominal decline in the value of borrowings.

Telecom (chart 1) received a roasting recently for a large share placement to selected institutions but it used the money wisely to retire debt.

Investors will be looking closely at debt-to-equity ratios to determine which companies could have their performance impaired by their ability to rely on inflation to slash their cost of borrowing.

Not every company will be able to imitate Telecom and switch debt for equity at the drop of a hat.

Those companies unable to do so could be unwise investments.

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