Interest Rates - Is the cycle turning?

Over the last 12-18 months Hong Kong investors have been beneficiaries of interest rates that started at modest levels and became progressively cheaper. This had implications for both affordability levels and asset valuations. Property prices rose steadily as interest rate falls. Certainly there were other factors which contributed to the bull market, but interest rates falling to levels materially lower than the rate of inflation unquestionably played their part.

With inflation now commanding space on the front pages of the financial news, there is talk of interest rates rising due to a combination of central bank action to combat inflation (although avoiding recession is likely to remain a higher priority) and lenders using inflation as a pretext to inflate their lending margins. The yields on investment grade debt securities have started rising already. Expectations of further interest rate cuts have dwindled sharply. It would be unrealistic to expect interest rates to fall further (and if they do, there is only limited room for cuts anyway) and the possibility of increases in interest rates by year end is quite real.

What are the implications for investors?

Rising interest rates should create a headwind for investors in real estate and equities. I say "should" because there is at least a possibility that rising interest rates signal the US economy moving away from the edge of a recession. Bonds will of course be an investment to avoid when interest rates rise. I have no idea what commodities would do in a rising interest rate environment but it would be reasonable to assume that at least some money will be rotated out of that sector. The safe or default strategy in an environment where interest rates are rising would be to focus on deleveraging the portfolio and wait for asset values to come under pressure before buying again. Of course, if the increase in interest rates is only small and real interest rates remain negative then paying down debt is logically a poor strategy but if the values of the major asset classes all enter into a downtrend, there may not be any obvious alternatives.

Monthly Review - May 2008

Although my net worth showed a decent increase for the month this was a case of a substantial bonus from my employment offsetting losses on the investment front.

As a group, my mark to market investments declined by small amounts. Those small declines were partly offset by a very small net gain on the comodities and the net income from my properties and slightly increased by adverse currency movements.

Here are the details:

1. my actively managed funds declined. All of them. I currently have investments in actively managed funds investing in Thailand, Taiwan, Vietnam, Eastern Small Companies and European Small Companies. The MERs are far too high and I will not be adding to these positions;

2. my equity also declined in value. I currently have exposure to Hong Kong and India;

3. my residual equity portfolio was almost unchanged;

4. my commodity investments showed a slight gain during the month. I continue to hold a commodity ETF and lean hogs and nickel ETCs. I made a small profit on a trade in silver during the month;

5. my properties are all fully rented and tenants are paying the rent on time. I have both a positive cash flow and a surplus of income over expenses (which represents an increase in net worth). The cash flow and the surplus have benefited from recent cuts in interest rates although my view is that interest rates have reached bottom (or so close as makes no different);

6. currency movements were adverse (the USD recovered some of its losses), but only marginally.

The only investment made this month was a short term trade in silver which showed a small profit.My income was significantly boosted by the receipt of a bonus this month. My spending was low (about as low as I could reasonably expect). The resulting savings helped to boost the effects of gains on my investments. The end result was an increase in net worth of 2.1% for the month. The year to date increase is 7.4%.

Book Review: Mellon

David Cannadine's very detailed biography of Andrew Mellon weighs in at over 620 pages (with another 150 pages devoted to footnotes and an detailed index). Although it was far from being a light read it was interesting and enthralling for two reasons.

The first is that Cannadine succeeds in portraying Andrew Mellon in a balanced way - conveying a sense of what he was like (good and bad) both as an individual and as a financier, business man, art collector, public official and philanthropist.

The second is the way in which Mellon's life was a reflection of the various "ages"that he lived in. He was a contemporary of people such as Ford, Rockefeller, Frick, Carnegie, Morgan and Gould. Unlike most of the other leading plutocrats of America's guilded age he lived long enough and remained active either in business or in public life to see both the end of "his"era but also the backlash during the Great Depression and the Roosevelt presidency. Cannadine conveys an excellent understanding of the issues and realities of life during the guilded age in particular and the spectacular gulf between the ultra rich and the ultra poor. In many respects the book can be viewed as work of economic and social history as much as a biography.

An excellent read.

Silver sold

With the price of silver going up and down faster than my comfort level I exited the silver position earlier this afternoon. As the position was only opened on 19 May it turned out to be a much shorter trade than I anticipated at the time of purchase.

My entry price was US$17.15 and my exit price was the equivalent of US$17.45 per ounce. These prices include the bank's spread and there are no other costs. A profit of US$0.30 per ounce is not a huge amount (it could have been close to US$1.00 per ounce if I had sold at the end of last week), but is still a pleasant outcome.

Inflation - undertstated (2) - the implications

In part 1 of this post I made the point that CPI type indices which are typically used as proxies for inflation tend to understate the true rate of inflation. If inflation is understated this has a number of potentially significant implications for investors and for personal finance more generally. From a personal finance perspective, underestimating the rate of inflation on your future expenses can result in a significant underestimation of those future expenses. Try calculating the difference between household expenses growing at 4% pa compared to 3% pa over a period of 30 years.

Understating the true rate of inflation also has implications for investments. Bonds and deposits will be overpriced as a result. Inflation indexed annuities and bonds will also be overpriced. All of these instruments will show real rates of return lower than expected. Given that the nominal rate of return in bonds and deposits is very low already, the real rate will be even lower. In many countries it will be negative.

Equities I am less sure about. History suggests that equities are a better investment that bonds in times of inflation. However, pricing is often at least partly done on a comparative basis. If bonds are overpriced this may suggest that equity prices have also benefited from that mispricing as well. Similar arguments can be made in favour of real estate and commodities and just about any asset class.

Debt is under priced. In Hong Kong we have negative real interest rates already. An upward restatement of the rate of inflation would increase the size of the negative margin.

While I do not expect governments to restate inflation numbers any time soon as they need to (i) inflate their way out of massive deficits and debt levels and (ii) do so while managing inflation expectations, growing awareness of how unreliable and inaccurate CPI indices are has the potential to cause changes in the way people invest. Hard assets such as real estate, commodities and collectibles will become more in demand. People will become more reluctant to hold assets that do not at least have the potential to keep pace with inflation.

The biggest question of all is whether central banks will keep interest rates low in an attempt to stave of a recession or raise interest rates to try and cool inflationary pressure (which they are creating by inflating the money supply). My betting is largely on the former (at least until we see signs of an economic recovery). If this is right, then using debt to invest in assets such as real estate and equities is a logical investment strategy.

Inflation - understated (1)

PIMCO's Bill Gross joined the chorus of people who believe that inflation is understated (or, at least that CPI type indices understate the true rate of inflation). Mr Gross stated that the US CPI numbers probably understated the true rate of inflation by about 1%. Leaving aside the technical point that "inflation" is a measure of increase in the money supply rather than a measure of the rate of increase in the price of goods and services, the evidence seems very clear.

In Hong Kong, the most recently released figures show annualised inflation at 5.4%. Basic necessities have been the biggest contributors to this figure (food, utilities and housing). The few things that I can point to which have decreased are rates (i.e. property taxes) and wine which declined or were relatively flat due to tax reductions or waivers by the government or consumer electronics. The true rate of inflation can only be guessed at but to illustrate the point that the CPI index understates the true rate of inflation, the most recent adjustment for jewellery can be used. In the 2007 adjustment to the CPI weighted basket, the percentage of household income spent on jewellery was slashed to a fraction of the figure used in 2003. Given that the economy was booming in 2007 and was in recession in 2003, the reverse should have been true.

In an environment where deposits earn next to nothing and dividend yields on the local stock index are around 3%, 5.4% inflation is high and a serious threat to both personal savings and standards of living. The fact that the real rate is higher still is scary.

Silver purchased

After exiting my position in silver several weeks ago, I have watched as the price of silver (and other precious metals) has consolidated. This morning I purchased a new position at HK$133.8 per ounce (US$17.15) including spread.

From a charting perspective we are now seeing signs that the precious metals have completed a consolidation phase and may be resuming their long term up trend. From a fundamental perspective, equity markets have rallied strongly over the last few weeks while precious metals (possibly excepting platinum which has lead the other precious metals) have lagged the equity markets. At the same time, concerns over inflationary expectations have received increased attention. The latter is generally considered to be bullish for precious metals.

Studies in Wealth (Destruction) - Robert Vesco

Although Robert Vesco died in exile in Cuba in November 2007, his death was not widely reported until last week.

Vesco will be best remembered as the man who rode to the "rescue" of investors in Bernie Cornfeld's IOS group (also a fascinating study in fraud) by launching a successful hostile takeover in 1970. Following completion of the takeover he promptly looted the company and funds under management of US$200MM + and fled from the US. He spent the next 15 years living in various countries which did not have extradition treaties with the US before finally settling in Cuba. Along the way he managed to get involved in the Watergate scandal by contributing substantial sums (sometimes reported as US$200,000) to Nixon's campaign fund through Nixon's nephew Donald Nixon Jr. The campaign contribution was allegedly used to fund the Watergate break-in.

Vesco also dabbled in drug running (being indicted but never arrested) and peddling a miracle immunity boosting drug that could cure a wide range of ailments including cancer. In 1995 after attempting to defraud both Castro and Donald Nixon Jr, he was arrested, sentenced to 13 years in prison for fraud and illicit economic activity and spent the rest of his life in prison in Cuba.

He will not be missed.

Book Review - Richistan

Richistan is Wall Street Journal reporter Robert Frank's look at the "New Rich". It was an impulse buy at the airport to give me something to read on a long haul flight back from Europe last week.

Richistan examines the explosion in the number of "rich" people and the issues which they face. The number of millionaires has multiplied over the last decade, as has the number of households with net worths greater than the US$5MM, US$10MM and higher thresholds. The Merrill Lynch Cap Gemini World Wealth Report produced similar findings. The reasons for this explosion in the sheer number of notionally wealthy people are several and include, ample liquidity, low cost of capital, a salary premium for those with skills most in demand, globalisation and the broader adoption of new technology. Even with the current economic uncertainty, the expectation is that the ranks of the notionally wealthy will continue to expand in sheer numbers as will the various benchmarks.

Where Richistan is interesting is the way it addresses the issues which the wealthy face. Two specific points of note were:

(i) US1MM may put you well within the top decile of household wealth, but it does not make you wealthy. Inflation above and beyond the CPI index means that the middle class millionaire is just that: middle class. US$10MM is considered the new benchmark for being considered "wealthy";

(ii) the sheer number of millionaires and multi-millionaires has created issues ranging from the important (instilling values in children, pressure on places in private schools, rising cut offs for access to some high end investment products) to the trivial (waiting lists for luxury yachts and lack of space for private jets at airports) to the pathetic (charity balls and other status symbols).

One issue which Richistan only mentioned in passing which would have merited further examination was the difficulty in maintaining a given level of relative wealth over a long period of time. This is more of an issue for those in "lower Richistan" than the seriously wealthy, but with the combined risks of lifestyle expansion and high inflation is a material issue for most of the lesser millionaires.

Although we will never be on the waiting list for a private jet or a 200 foot motor yacht, some of the points raised are relevant even to "middle class" millionaires. In particular, the dangers of attempting to emulate those who are significantly more wealthy than yourself, school placements and the rising cost and rising scarcity of some of the very few luxuries which I am tempted by (e.g. business class air tickets for long haul flights).

Richistan was a well written and enjoyable read. Recommended.

HK banks do not cut mortgage rates

For each of the previous instances in this interest rate cycle, the Hong Kong Monetary Authority and the Hong Kong banks followed the action of the US Federal reserve and cut Hong Kong interest rates. Not this time. With deposit rates now close to zero and lending margins under pressure, the HK banks have been at pains to talk up the market to try and preserve or improve their lending margins. It was no surprise to find that none of the major banks cut their prime lending rates (which is one of the two benchmarks for setting mortgage rates in Hong Kong). In effect, prime linked mortgages should not be affected by the latest interest rate cuts in the US. It remains to be seen whether the HIBOR linked mortgages will change at all (although I note in passing that banks are starting to be less willing to lend on HIBOR linked terms).

As a side note, although the banks did not cut their lending rates, they were quick to further reduce the already tiny yields on deposits.

Monthly Review - April 2008

April was a good month financially.

As a group, my mark to market investments appreciated in value by meaningful amounts, although the gains were partially offset by adverse currecny movements. Here are the details:

1. my actively managed funds appreciated. I currently have investments in actively managed funds investing in Thailand, Taiwan, Vietnam, Eastern Small Companies and European Small Companies. The MERs are far too high and I will not be adding to these positions;

2. my equity ETFs also appreciated. I currently have exposure to Hong Kong and India. I may add to my India position (but probably the iShares product instead of the Lyxor one which I already hold;

3. my residual equity portfolio appreciated;

4. my commodity investments went sideways during the month. I continue to hold a commodity ETF and lean hogs and nickel ETCs;

5. my properties are all fully rented and tenants are paying the rent on time. I have both a positive cash flow and a surplus of income over expenses (which represents an increase in net worth). The cash flow and the surplus have benefited from recent cuts in interest rates. I have low expectations that last night's 25 bp cut by the US Federal Reserve will filter through to Hong Kong mortgage rates;

6. currency movements were adverse (the USD recovered some of its losses) and partially offset the gains on investment. Currency movements have played a major role in determining the returns on my investments over the last 6-12 months.

There were no investments made this month.

My income was at the low end of expectations this month. My spending was moderate due to the remaing payments for our Easter family holiday as the cost of car rental and some other items came through in my credit card statement (no effect on net worth as I had adequately provided for the expense) and the adoption costs of a kitten. The resulting savings helped to boost the effects of gains on my investments. The end result was an increase in net worth of 1.8% for the month. The year to date increase is 5.2%.