Raise interest rates, let the revolution begin
EXCESSIVE RISK-TAKING SHOWS THE TIME HAS COME
Low-interest-rate policy and excessive central bank liquidity have caused some major dislocations in the market and presented a clear and present danger as they finally begin to be unwound.
This is something few are prepared for, especially since investors continue to buy the dips even on those interest-rate sensitive segments of the market.
Although central bankers would like to continue their quantitative-easing indefinitely, their “inflation is transitory” excuse appears to have finally run its course, leaving them little choice but to finally address ongoing supply disruptions and wage inflation. This isn’t good news for those governments that are recklessly spending and dependent on their central bankers to support their deficits.
You can’t blame the bankers for their persistence in keeping the game going, but one has to wonder at their level of desperation, as evidenced last week by Bank of England Governor Andrew Bailey asking workers not to demand wage hikes, which understandably made the front page. This “let them eat cake” response certainly can’t be going over very well with Main Street.
Meanwhile, real rates on United States Treasuries are now among the lowest they’ve ever been, even going back to the 1970s. This is forcing individuals to onboard more risk by either seeking higher-yielding investments or adding leverage to torque up their yields.
For example, some have been touting the S&P 500 for its dividend exposure even though it offers a negative real yield and it’s heavily concentrated on growth stocks dependent on permanently low interest rates to support their valuations.
In Canada, you have the massive housing inflation forcing young people who want to own a home to take excessive risk by onboarding a ridiculous amount of debt under the guise of low interest rates and debt-servicing costs.
Simply put, it’s time to raise interest rates. For those arguing this will impact the working class, we think they couldn’t be more wrong.
Someone buying a $300,000 house at a fiveper-cent interest rate is much better off than paying $600,000 at a two-per-cent interest rate. Having the same 25-year amortization would result in 37-per-cent higher total interest being paid, but the monthly payment would be 31-per-cent less, making the debt a lot more serviceable.
For a fair comparison, at the same payment level, we calculate it would reduce the amortization by roughly half. The ability to enter into the market is also that much easier given the significantly smaller total down payment required.
For retirees who own a home, having a monster run in housing has no doubt been fantastic for their net worth. But what options do they have to downsize? And, if they do, where can they invest their money in a safe manner or one that won’t eat away at their capital due to high inflationary pressures? It would simply be better to have more moderate housing prices and higher interest rates to provide balance.
Due to the 35-year bull market in bonds, portfolio managers are being told by regulators to hold as much as 40 per cent of their conservative client portfolios in fixed income for risk-management purposes.
But inflation is wreaking havoc on bonds behind the scenes with negative real returns and we’re now seeing them sell off alongside stocks. In some cases, longer-duration bonds have done worse. This situation has the potential to deteriorate as central bankers have no choice but to raise rates to tackle rising costs.
This is where a good money manager can prove their worth by undertaking other options besides bonds as a means of managing risk, especially as interest rates move higher. This could include adding some inflation protection via commodities — energy and financials — and value-oriented equities. We have also found floating-rate bonds and preferred shares, structured notes and alternatives such as market-neutral strategies to be helpful in this environment.
It’s important to be on the right side of the great rebalancing as interest rates finally begin to rise. This means it certainly isn’t the time to be taking on more debt or excessive risk, despite what our central bankers and governments are telling us. Raise rates and let the revolution begin.
Martin Pelletier, CFA, is a senior portfolio manager at Wellington-altus Private Counsel Inc, operating as Trivest Wealth Counsel, a private client and institutional investment firm specializing in discretionary risk-managed portfolios, investment audit/ oversight and advanced tax, estate and wealth planning.