Over the past twenty plus years two significant waves, or better said tsunamis, of capital have caused major structural shifts in the markets.
The first tsunami was caused by steadily declining interest rates over the past 25+ years. Capital flowed from high-yielding, risk-free investments to riskier equities and other asset classes, bolstering the value of these latter investments.
During this time bonds, as an asset class, performed well as falling interest rates caused bond prices to rise. Viewing this phenomenon in hindsight shows strong historical track records, with just about every bond fund shining very brightly indeed – it is hard to underperform in a colossal bull market in bonds.
The other tsunami came over the past ten years in the form of foreign capital seeking a safe haven. Wealthy citizens of developing countries have always sought a safe haven for their money. One never knows when the political climate will change causing a dramatic shift in fortunes, especially for the wealthy – Venezuela is a good current example. This capital has traditionally flowed into developed world banks, term deposits and real estate in major cities. But the sheer volume in the flow of capital in recent years has destabilized many property markets.
A recent study in Vancouver’s property market showed that the majority of new development is bought by foreign investors. Wealthy foreign citizens have displaced all but the highest income earners in this market. Even highly paid professionals can expect to be slaves to their mortgage payments in that city. The same could be said of other major cities in developed countries around the Pacific Rim, as with other major centres around the world.
We are now at an inflection point. Interest rates that have been in a declining trend for over two decades have begun to rise. The consensus is that rates will rise slowly over a long period of time. We also know that consensus can often be wrong. Inflation could creep in faster than expected, causing rates to rise faster than expected. A Trump tax cut could be just the stimulus to inject inflation into the economy. Rising interest rates could be the turning of the tide on not only the first wave, but also the second wave of capital.
It’s worthwhile reviewing what the impact of a rising interest rate trend might be and what action we might be able to take.
Scenario: Governments with high debt loads will face higher interest payments. This could mean cuts in spending in some areas, usually social programs. They could also face currency weakness leading to further rate increases, which can become a vicious circle. Unfortunately some governments took on more debt when rates were low, compounding the problem.
What to do: In a rising rate environment governments can increase their revenue, for example - raising taxes. Taxpayers would do well to have reserve funds on hand, or be able to increase the household income.
Scenario: In a rising rate environment equities could still perform well, as the economy is growing. But dividend paying stocks will be challenged to compete with risk free investments that have higher yields. Bond prices will drop as yields rise, so bond funds will come under pressure.
What to do: Steady growth still favours equities. For fixed income, highly respected Canso Investment Counsel has positioned their bond portfolios in higher quality. They are also positioning in floating rate bonds, playing it safe. Their philosophy is to buy what others are fleeing and sell what others are clamouring for. This could lead to short term underperformance, but will pay off over time. Laddering bonds is also a good strategy.
Scenario: Those who have mortgages will see increases in mortgage payments – they likely already have. Central bankers will try to keep tight control over rising rates, protecting consumers who are the ultimate drivers of the economy. It’s a delicate balance.
What to do: Reduce debt where possible, lock in lower rates, pay down high interest debt first, control spending or increase revenue. It’s important to keep liquidity available for putting out fires, or to take advantage of opportunities.
Wealthy Foreign Citizens
Scenario: It is assumed that the wealthy do not have to borrow. But quite often big wealth uses big leverage. In a rising rate environment the wealthy foreigner could feel a squeeze in their home country, forcing sales in non-essential assets held overseas. Some foreign investors could also see a time to take profits on successful international investments, which could further fuel a selloff in that market. Unpredictable foreign capital in local markets has proven to exacerbate a bubble, and could prove equally dramatic in the bursting of said bubble.
What to do: Foreign wealthy investors could consolidate profits in their home country and reduce debt. Local residents in markets affected by foreign wealth would be prudent to take profits at home and diversify.
Market trends do not take place in isolation, there are often many dynamics at work. I have highlighted some very general points, but there are often eddies that form around the incoming surge that will cause related, but unexpected events. It’s also important to note that major trends can be gradual, while punctuated by sharp movements in either direction.
Rising rates in a housing bubble could be just the change in tide that many short sellers have been waiting for. The wealthy may get nasty scrapes, but the local residents could be severely underwater. The full impact will only become apparent as the event unfolds.
Being prepared for a general trend and taking action in advance can often prevent painful experiences, and we can then perhaps position ourselves to benefit from the event taking place.