Forecasting the future of interest rates is hard at the best of times. It’s even more difficult in the wake of a global financial crisis that few of the experts ever predicted.
Chief Investment Officer of Vianova Asset Management, Michael Schneider, saw trouble looming for credit markets because of issues in the sub-prime mortgage industry in the US.
And it was the sub-prime collapse that triggered the global credit crisis and ultimately led to the economic recession now enveloping the world.
As a result, Michael says there is too much systemic uncertainty now to make any strong predictions about the longer term level of official interest rates.
“As the global economy continues to weaken, it’s likely that interest rates will be lower for much longer than most people would have expected.
“But if the global economy remains weak, the timeframe for getting some clarity about official interest rates will extend even further. Right now, no-one can be sure.”
Watch the signs
Michael says investors should look for evidence that financial stimulus packages by governments around the world might be starting to work. This would be reflected in slowing growth in unemployment and a turnaround in business conditions.
“The global economy has not yet bottomed, and until that happens investors will be very risk averse.”
The official cash rate was lowered by the Reserve Bank in February to just 3.25 percent, a level not seen since the 1960s. Economists tip further rate reductions to as low as 2 percent, although some are revising upward their forecasts following the announcement of the Federal Government’s $42 billion stimulus package.
However, the sharp reduction in interest rates has added to investors’ pain. First, falling equity prices crunched the value of their investment portfolio. Then falling interest rates slashed the returns on bank deposits, where most investors had retreated.
Spending for growth
But better times are in store. Australian Unity’s head of investments, David Bryant, says higher interest rates will inevitably follow the current low-rate cycle.
“All economies are in trouble. Governments are cutting rates and spending big in an effort to retain employment and avoid a greater slowdown.
“But whatever governments spend now to prime economic growth, they will have to pay for later.”
He says almost every government in the world, including Australia, was going deeper into deficit and borrowing money to spend their way out of economic trouble.
“There will be many more borrowers, but only a limited number of lenders. One source of loan funds will be China, where the government has accumulated some big surpluses. Another will be the oil-rich governments of the Middle East.
“But they are vastly outnumbered by governments with increased borrowing demands. In these circumstances, the law of supply and demand means the cost of borrowing must rise. In other words, count on rising interest rates after the short-term shock of the global financial crisis has passed.”
It’s a borrowers market
David believes it is a great time for borrowers to lock in rates, while for investors the opposite advice generally holds true.
“You don’t want to lock in deposits over the longer term because you can expect to be excluded from better opportunities.”
He says the timing of the interest rate cycle is impossible to pinpoint.
“It’s the million-dollar question. We think interest rates will certainly be down for a year or more. The change in the cycle will be slow, but it won’t be many years before rates start going back up.”
The future of share prices in Australia and internationally is another of the great uncertainties for investors.
David believes equities have never been a greater bargain, even allowing for the fact that he expects company earnings to fall by another 20 percent over the next year.
“This will be one of those years that investors look back upon and wish they had more confidence to invest. The fear of getting it wrong prevents most of us from acting, but don’t overlook this chance to recoup some of what you have lost.”
Exercise caution
David is quick to add that boldness must be accompanied by some caution.
“Only invest if you are prepared for more volatility. Can you live with share prices going up and down over the next year? If you can, you should buy shares. If you’ll lose sleep, then stay away.”
He advises that investors should only commit funds they would not need in the short term, and for most people this includes their superannuation fund.
He also stresses the importance of getting professional assistance with selecting the right companies in which to invest.
Platypus Asset Management’s founder and Chief Investment Officer, Donald Williams, agrees.
He says investors should avoid any company where there is a genuine risk that the business might not be around in five years.
“There is a large number of companies in that category at the moment. As a general comment, avoid any business that needs access to credit to make their business work. This includes the entire banking system, listed property trusts and quite a few diversified financials. There are also sections of the equity market you should exclude at the moment. If you were really bearish you would probably avoid most of the cyclical stocks, such as the miners.”
Get back to basics
Don says the sectors to target were those least affected by the economic downturn. Healthcare was at the top of his list, followed by companies supplying essentials such as grocery retailers.
He says there are other ways to increase the safety in stock selections, such as identifying companies which have strong balance sheets and are ranked first or second in their industry in terms of market share and profitability.
“There are also other less obvious companies that are less obvious and are worth owning. It really comes down to a business-by-business investment decision.”
He said the December 08 quarter was probably the trough of the commodities cycle, but he cautioned against expecting a bounce from the resources sector.
“There’s a much lower demand for commodities, and resource sector profits will be lower in 2009 and probably lower again in 2010.”
He adds that Platypus has recently added some gold companies to its portfolio.
“If you believe uncertainty is going to hang over investment markets for the next two or three years, and that seems more likely than not, then gold will be a pretty good investment.”
Key points
• Low interest rates are not here to stay. Borrowers should lock in cheap rates, while investors should take advantage of higher rate opportunities down the track
• Equities are cheap, but be prepared for more volatility
• Get professional advice. Invest in companies that don’t rely on credit, have strong balance sheets and are largely recession proof
• Liquidity is more important when investments are not easy to sell
• Don’t expect a bounce back in resources, although gold could be a bright spot
MARCH 2009