Not out of the fiscal woods yet - and it could take several years

Friday 5th April 2002

Long-term mortgage rates are on the rise in the US, according to a recent e-zine edition of MSNBC News.

The lift is in expectation that the US Federal Reserve has reached the bottom of its interest rate-cutting cycle. The Fed warned as much a couple of weeks back when it said the US economy was growing at a "significant pace." Interest rate risk is now biased to the upside.

The credit boom that has turned the US economy around is drawing to a close. Freddie Mac, the Congress-chartered mortgage securitiser, reports that, as of the week ending Easter, 15- and 30-year mortgages have risen four weeks in a row. Low mortgage rates have stimulated a real estate boom that has seen unprecedented increase in single family homes but signs are that the effect is tapering off.

Not that a person would notice the change in borrowers' fortunes. I have been receiving spam emails from the US urging me to take advantage of low interest rates to borrow for anything I like. The spams stress that credit rating is not an issue.

The quality of debt being created in this way is accordingly suspect. Borrowers with poor credit ratings will surely be responsible for a significant amount of default.

Investors will need to plan around a rising interest rate cycle. Those with long- term portfolios might not need to adjust much because they will live through multiple interest rate cycles. Nonetheless, some changes could be wise.

Obviously mortgage funds would look appealing as a conservative option as their income returns increase. There is likely to be a migration of funds toward term deposits as rates improve.

The winners will be the banks. Bank stocks could be a smart investment as margins increase on the back of higher mortgage rates offered at a significant margin over central bank discount rates.

Stocks in general could struggle. Profit expectations are lower. Increased interest rates dampen consumption, lift company financing costs and make dividends look less appealing on a risk-adjusted basis. Low inflation will ensure the real cost of debt rises with interest rates.

Companies will not be able to inflate themselves out of debt and thus will be risk-averse on expansion at a time when the real cost is greater. Surplus capacity built up over the boom period will need to be absorbed.

Bonds are weakening in value as investors head for the storm cellars. Bond values move in inverse proportion to short-term interest rates. However, bonds should find their feet as yields rise to tempting levels. Against that, the Fed has slashed interest rates so deeply that its implied level of radical increase ahead could trigger substantial devaluation in bonds.

Commercial property is another asset class that is sensitive to interest rates. A rule of thumb for valuing buildings in New Zealand, for example, is that the risk-adjusted return on high-quality property should be 2-4% above the five-year government stock rate. The latter will rise and drive up the required return on property, which implies possible stagnant or falling property valuations.

Rental increases, which are another means of boosting property yield, could be harder to obtain in an economy slowed by higher interest rates and associated real costs.

Hedge funds should continue to be the fashion as good managers will be able to make money on falling as well as rising markets. Investors will need to resist the temptation to over-invest in hedge funds.

Such funds should be viewed as part of a diversified portfolio and only make up a smallish percentage - usually 5-15% - of total investment against traditional assets such as cash, fixed income, commercial property and shares.

It is unwise to stake too much on the derivatives markets in case there is a systemic crash. One suspect area is gold futures and options, where some 80% of short positions are held by two related US banks. Their total exposure is immense and raises the spectre of a US banking crash which would put paid to all the Fed's work.

Nonetheless, some investors will overdo it with hedge funds despite all cautions to the contrary. Caveat emptor and stick with diversified hedge funds that are not overexposed to any one manager.

The bear market in US stocks has changed expectations for many who hoped to retire in clover.

Coupled with poorer investment returns expected from a permanent low inflation environment, the need to increase retirement savings is greater than ever.

The more people who wake up to the requirement to rejig the relationship between savings and consumption, the weaker economic recovery will be and the weaker the returns from investing in shares dependent on consumption for profits.

Whatever the market expectations for US recovery, we are definitely not out of the woods yet and could be looking at a timeframe of at least several years to get things sorted out again.

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