May 2007 Investment Report
INTEREST RATE CONUNDRUM
Last year I was expecting interest rates to fall due to debt saturation. As companies and individuals had too much debt, I was expecting a reduction in lending and consequently a reduction in the money supply and economy. I was anticipating a temporary fall in interest rates. However, I did not anticipate that the lending policies of the banks and building societies would become even more ludicrous with stories of lending up to seven times salary. Commercial property firms now account for 37% of big British banks’ stock of lending to British companies.
This extension in lending to the property market, apart from being very risky for the banks, has led to an increase in the money supply and continued rises in an already overvalued property market. This is beginning to feed through to inflation. In the short term interest rates will have to rise further and current inflation and the output gap (the amount by which the economy is exceeding its normal potential), suggest that interest rates should already be 7.25%. The current bank base rate is 5.25%.
In the next ten years interest rates and inflation can be expected to rise to in excess of 10% due to a smaller percentage working population being able to negotiate higher wages; a lack of investment in new technology leading to an increase in costs and a fall in Sterling causing higher import prices.
Rather than hoping for a temporary fall in interest rates, we are now advising all clients to sell any fixed interest rate investments and to invest in inflation linked investments for growth or National Savings Income Bonds in preparation for the longer-term rise in inflation, which we expect.
Interest rates are below inflation in a fast growing economy. This cannot continue and a rise in interest rates will be negative for far eastern stock markets.
Corporate Debt and Bonds
The number of companies in the lowest bracket of speculative grade has risen to 20% compared to 3% in 1980. The number of companies in the highest category of speculative grade has fallen to 35% compared to 80% in 1980. This does not bode well for investors in corporate bonds or the UK stock market.
Derivatives are contracts based on the prices of assets such as stocks, bonds or commodities. Partly because it is possible to lose as well as make far more than they cost, Warren Buffett has called them ‘financial weapons of mass destruction’. The total outstanding volume of credit derivatives has increased to $34,500bn and interest rate derivatives have increased to $285,700bn.
Gold is following a similar pattern to the US S&P 500 Index between 1972 and 1988 although over a shorter period of time. If the pattern continues, expect the price of gold to approach $800 an ounce by the end of this year; $1000 an ounce by the end of 2008 and $2000 an ounce by the end of 2011.
Many institutions and private equity investors have only just discovered commercial property as an investment class. But veteran investors such as Chicago’s Sam Zell, are getting out. He sold Equity Office Properties for $36bn in November. Not a good sign.
Private equity houses are in a position to overload companies with debt because those underwriting the risk are insensitive to the dangers this poses. When the music stops, a lot of people will get hurt; most obviously, holders of credit derivatives. Some private equity houses will presumably get caught as well, if they have not managed to extract enough cash before their companies hit trouble. The fall out could be a lot wider. Pension funds are big investors in private equity, and some dabble in credit derivatives. People in bankrupt companies are going to lose their jobs, without any benefit to the economy.
UK Stock Market
Currency movements, momentum and the price-to-book ratio suggest that the market is nearing its peak.
US Stock Market
Productivity growth has reduced to 1.7% compared to 2.5% in the late 1990’s and 3% between 2000 and 2004. As suggested earlier this is a portent to rising inflation and interest rates.
The views reflected herein are those of Mitchell Neale Investment Services and should not be regarded as a recommendation to invest in any product or service; before investing you should always consider personal investment advice.
Mitchell Neale Investment Services does not accept any liability whatsoever for any direct or consequential loss arising from any use of this report or its contents. Investors should be aware that the value and income from investments can rise and fall and that past performance should not be considered as a guide to the future.
3rd May 2007