How to cope with rising interest rates

Author: David Potts
Date: March 10, 2008
Publication: Sydney Morning Herald (subscribe)

The credit crunch is biting bank stocks, property outlooks remain uncertain and a stronger dollar is failing to deliver, but there are some positives, writes David Potts.

You can say these are difficult times all right.

But what the heck? High interest rates and a strong dollar aren't all bad.

After all if they were round the other way - which is to say low rates and a weak dollar - we'd be in a recession. But let's take one thing at a time.

Happily there's no sign of a let-up in booming commodity prices that have as much to do with a supply shortage (as in the case of iron ore and gold) and getting protection against a falling US dollar (such as oil) as increasing global demand.

Which brings me to what looks like the parallel universe of the sharemarket.

SHARES

At the risk of speaking too soon, one of the oddities of this bear market is that resources are proving to be safer than bank stocks.

The spreading credit crunch triggered by the subprime home lending crisis in the US is looking for the weakest link in the financial system.

Since this could be anywhere, the banks no longer trust each other, although it's nothing personal I'm sure. They just don't know who's got the next Allco or ABC Learning Centres.

The result is money market rates rising outside anything the Reserve Bank is doing, though even then that's only if they deign to lend to one another.

It sure is disconcerting if the banks would rather trust you or me more than each other, but at least it goes some way to explaining why the sharemarket has taken the chainsaw to them.

What was supposed to safeguard the financial system from the very thing that's happening was the fact that bad debts from subprime lending would be spread so thinly around the system that nobody was left holding the baby. Instead they've got the entire creche.

We now know every bank is affected in some way or other as the subprime crisis keeps popping up in such unexpected places - somehow it even reached the Bank of China for goodness sake - and is starting to erode confidence in the system.

So you can hardly blame speculators such as hedge funds for preferring something solid over a piece of paper, whether or not countries such as China and India - which are the big buyers of resources - remain untouched by a global slowdown.

This bear market is unusual in another way too. You'd expect blue-chip stocks to be walking all over smaller, supposedly riskier ones. Or rather, not going backwards as fast.

Not so. The Small Ordinaries Index has slumped less than the ASX200 in the past three months and a lot of highly spekky stocks have risen, if from a low starting point.

You can thank the stronger dollar for this. While large companies that export or have substantial assets overseas tend to be penalised by a stronger dollar, small ones that are more service- or import-oriented fare better.

Funnily enough, resource stocks also do better under a stronger than a weaker dollar. That's because a strong dollar always goes with high commodity prices and, in this case, there's the extra boost to prices from the deteriorating US dollar.

Oh, one other thing. Have you noticed that amid all this market mayhem most companies have just reported record profits?

True, it's water under the bridge. Since the Reserve Bank is forecasting an economic slowdown this year - industrial production is expected, or perhaps I should say will be forced, to fall from 4.5 per cent to 2.75 per cent in just nine months - the market has good reason to be worried.

The truth is we've just had a great year, but the next 12 months will be anything but.

PROPERTY

With the sharemarket on the skids perhaps property will be the next cab off the rank.

Or perhaps not. There are just two problems.

One is that property prices - except in outer Sydney, outer Melbourne and more recently Perth where the boom has just peaked - had been careering ahead alongside the sharemarket, putting paid to the notion that they take it in turns to boom.

Rather it takes two to boom so to speak, and there's no reason they can't both fall together, as they did in the early '80s.

As the credit crunch takes its toll on high flyers in the sharemarket, not to mention executives in the finance industry who can expect to lose their bonuses, it's possible the top end of the property market, which has so far laughed off successive rate rises, will start to suffer.

The other problem is that interest rates are rising and home affordability is falling.

Unless they buy in the sticks, that would seem to rule out first home buyers coming back to the market in the near future, as well as property developers who will find it a lot tougher to get finance from a panicky banking sector.

The number of properties on the market has soared in the past month, especially in Melbourne, and you have to wonder whether that's because vendors want to get out at the top.

A website that offers free listings to home owners thinking of selling (www.lovethatplace.com.au) reports a 16 per cent increase in the past month of the number who've switched from "would sell at the right price" to "highly motivated to sell."

Mind you, over time the real driving forces behind rising property prices are immigration, which is running at a record level and might even be boosted by the slowdown in Europe, and employment.

And on the supply side there's an acute shortage of houses and especially units in Sydney and Melbourne.

The Reserve Bank thinks the labour market is bursting at the seams, which is why it's so scared that inflation is about to take off.

Although it's knocking the economy on the head, it will take a long time to result in fewer jobs.

Export revenues are booming and profits are in rude health so there's no imminent threat of job slashing.

The Reserve Bank, for example, has forecast the unemployment rate will "increase modestly" this year although that was before last week's rate hike.

If that proves the case, the only remaining question is how high interest rates will go and for how long. Indeed talk of rate rises seems to have a more debilitating effect on the property market than when it happens, a reverse of the old sharemarket adage to buy on rumour and sell on fact.

In fact the Reserve was surprisingly dovish last week. Far from recycling its recent statements calling for "tighter" monetary policy, a sure hint that rates are going to rise, this time there was even a wink and a nod about when they might start dropping.

The Reserve said it "would evaluate prospects for economic activity and inflation in the light of new information".

And get this. Inflation will be "moderating next year in response to slower growth in demand."

Since it's inflation that's caused rising interest rates, join the dots together and bingo, a moderation leaves the way open for a cut.

So whether or not there's another rate rise or two this year - and the Reserve obviously hasn't made up its mind yet - it'll be relatively short-lived.

In which case investors, attracted by rising rents, might wade into the market.

This will be helped by the fact that DIY super funds are now allowed to borrow for property so long as they structure it in the same way as an instalment warrant.

Still, while prices are dropping in the mortgage stress areas of Sydney and Melbourne and the financial sector has the shakes, it's unlikely property will surge.

THE DOLLAR

Whenever the dollar gathers up a puff of steam and seems destined to hit parity with the US dollar, something goes wrong.

This could have a lot to do with the fact that what pushes it up is usually something bad going on out there. Such as rocketing oil prices, or a sinking US dollar.

On its merits, the dollar is nothing to write home about. Even with the biggest commodity boom ever, the second highest interest rates in the developed world and the collapse of the US dollar, it's still struggling.

Sentiment about a currency can change quickly, so nothing is impossible.

But on economic performance the dollar doesn't stack up too well at all. A record current account deficit when we've never had it so good - hmm, perhaps it's because we had it too good - means we depend heavily on the very financial markets that have seized up for funding.

Its fair value is just 70 US cents, says leading economist Shane Oliver, head of investment strategy and chief economist at AMP Capital Investors.

Mind you that doesn't stop him predicting parity on the grounds of what he calls "roundaphobia", which is the desire of speculators to reach a round number on something and most recently seen when oil hit $US100 a barrel.

In any case, Oliver suggests, "it would seem sensible for investors to maintain a reasonable degree of hedging".

As a consumer don't expect too much from the stronger dollar either. Even if it gets to parity, you won't see prices dropping or much cheaper overseas travel.

The problem is rising fuel prices caused by the escalating price of oil. The stronger dollar can prevent them rising too far, but can't wind them back.

Although on-the-ground expenses, especially in the US, will be cheaper as the dollar rises, airfares have hardly budged again because of fuel costs.

And forget Europe - the dollar seems determined not to move above EUR0.60 cents.

If you're buying a new car, you're more likely to get extras that were optionals before rather than a cheaper price.

THE NEW ORDER: 2008 OUTLOOK

Here's how the credit crunch, higher interest rates and strong dollar will affect you:

COST OF LIVING

* More accessories in imported cars

* Dearer food

* Dearer petrol

* Higher insurance premiums

* Interest rates at or near top

* Overseas travel cheaper, but not airfares.

SHARES

* Bear market

* Lower profits, dividends peaked

* Resource stocks hold up

* Bank, insurance stocks remain weak

* Service based stocks do well

ECONOMY

* Jobs harder to get

* Slower wage growth

* Higher Government charges

* Tax cuts on July 1

PROPERTY

* Rising rents

* Home price rises in right locations

* Price falls in outer metro area

* Perth boom over

SUPER

* Lower returns

* Drop in international equities, property

* Higher fixed interest returns

Story from domain.com.au

How to cope with rising interest rates

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