SUMMARY. Very low interest rates have been one of the pillars of the strong global recovery in recent years. As interest rates head up, and with troubles in the US, we consider the implications.
The twin pillars of the global economic boom of recent years, and of the recovery to new peaks of most, if not all, asset classes, are the renaissance of emerging markets and very low interest rates. The emerging market theme appears likely to continue for many years to come; the genie of 3 billion new consumers on the world stage is well and truly out of the bottle. The era of very low interest rates, on the other hand, put in place to ensure that an ugly deflation did not take hold in 2003, is over. When the tide of easy money goes out will those exposed as having no trunks be an isolated (and indebted) few?
Previously we have said that the US sub-prime mortgage debacle will not alone cause a global downturn. So if adjustable rate mortgages in the US have a value of $693 billion, and 23% of these are already in negative equity, who will bear the pain? The last people to board their housing and mortgage bubble will clearly suffer, the NINJA borrowers (no income, job, or assets). As will the banks that clamoured to lend to them. And so will the investors daft enough to have bought the packages of junk mortgages (CDOs), because some bright spark convinced them that this would make default an extremely low mathematical probability – sounds like the sort of maths that threatened to bring down the world financial system when LTCM collapsed in 1998.
The US Federal Reserve is well aware of the risk of these woes impacting the wider economy, so look out for the futures market indicating a rate cut as soon as it looks like US unemployment is rising. In the meantime, even if rates go up no further, banks will not be lending so readily, while losses are nursed.
In the UK, the buy-to-let market has seemed flakey for some time, particularly in the case of recent purchasers that have relied on large mortgages, where the rental yield is unlikely to cover borrowing costs. The number of landlords that are selling at the end of leases has moved up in recent months, and it will not surprise if this trend goes sharply higher as UK interest rates go another notch or two higher before the end of 2007.
Historically low interest rates offered a once-in-a-lifetime opportunity to private equity buccaneers to make small fortunes, particularly as it coincided with more than healthy earnings to cover the debts foisted on their target companies. Ignore the PR guff about this being good for the UK economy, but don’t blame these guys for not looking a gift horse in the mouth. The key is banking fast profits, as the time is not far off where not only will debt repayments be somewhat higher, but earnings (to cover debt costs) will also be under pressure. Again fallout should be limited, though it will also include a de-rating of those medium sized quoted companies whose share prices have a large bid premium in the price.
Hedge funds might be the elephant in the room, but the tangled web of derivatives and borrowings make it difficult to tell how serious the repurcussions of a major failure could be. It could certainly extend to major banks, and institutions including pension funds that have been sucked in by plausible salesmen.
While all of the above illustrate the potential for widespread turbulence in financial markets, they don’t suggest more widespread economic consequences, particularly rising unemployment and consequent recession. As such stockmarkets, which aren’t exhibiting the irrational exuberance evident in some other asset classes, should be bought on weakness.