Too late to board the flight to safety

Gareth Stokes, FAnews Online Editor

When things go wrong in equities, investors latch on to income as their ‘flight to safety’. This was the view expressed by Arno Lawrenz, Atlantic Asset Management at a Momentum Wealth Presentation held in Johannesburg recently. Although cash and bond inve

South Africa is part of the global economy. “If interest rates in the United States are heading in a direction, they will certainly impact the rest of the world,” said Lawrenz. We gain a better feeling for what might happen to domestic interest rates by analysing developments in the world’s largest economy.

The ‘Greenspan conundrum’

When Alan Greenspan was chairman of the Federal Reserve he lamented the fact that long-term interest rates remained low (even falling), despite concerted efforts to raise short-term rates. As the US emerges from recession, current Fed chairman Ben Bernanke, has to unravel a more complicated riddle. He cannot hike short-term rates without doing serious damage to the US banking system.

Lawrenz explained the dilemma by looking at mortgage statistics. US mortgage products are issued at a fixed interest rate for the first four or five years. At the end of the initial period the interest is capitalised and terms of the mortgage recalculated. The sub-prime crisis is a direct result of this practice. Interest rates were cut aggressively in the early 2000s (to 1%) and banks lent massive amounts of money to people with no hope of repaying the loans. By 2007 the sub-prime component of total US mortgages was huge. When these mortgages were reset (around 2007/8) interest rates were less favourable. Homeowners suddenly had to contend with massive spikes in their monthly mortgage repayments and the sub-prime crisis was born. The reset of the sub-prime mortgages “sank” US banks...

The latest snapshot of the US mortgage industry confirms that sub-prime mortgages have been flushed out of the system. But there are other categories of mortgage bonds that still have to reset during the course of 2010/11. “The banking system in the US is still vulnerable – because if mortgage rates rise – a large number of these loan holders will default,” said Lawrenz. The situation is made worse by the negative equity problem still prevalent in the US residential property market. “The mortgage reset is a serious headwind for banks in the US over the next two years,” he said. If interest rates rise in the US over the next two years banks are going to get crushed!

A difficult time for fixed income

There are further pressures on US short-term interest rates in that the commercial-backed mortgage market faces a reset around 2014. Loans taken out to finance developments for commercial properties (factories, warehouses, office blocks and the likes) were also issued at favourable fixed rates when low interest rates prevailed. In four or five years time there’s a huge amount of money that will have to be refinanced in the US commercial property space. And that’s another serious headwind for banks. The US will face serious consequences if it raises the cost of capital too soon.

Fixed income investors are also troubled by the narrowing of yield on risky capital. The cost of capital to corporate seekers of capital skyrocketed during the global financial crisis, but has since fallen back to pre-crisis levels. There is no reward for lending money to these companies despite an extremely risky economic backdrop. As a result local fixed income fund managers are sticking with short-dated credit, instruments that get rolled over in three, six or nine months.

Expectations 2010 and beyond

Governments around the world responded uniformly to the crisis. In doing so they shifted the private sector debt crisis to the public sector. Today, one of the greatest risks to the short-lived economic recovery is sovereign debt, particularly in European Union countries such as Portugal, Ireland, Italy, Greece and Spain. Household debt remains a major global concern too. “The man in the street – on average – has a long way to go to de-leverage,” noted Lawrenz. There are only two ways to change debt ratios to more acceptable levels. Government has to boost GDP or reduce debt. Debt diverts valuable financial resources from growth activities (such as infrastructure investment) to non-productive interest repayments.

South Africa is in a unique emerging market position. The country’s banks survived the financial contagion in tact. This fact has not been lost on international investors who, disillusioned with the 0.5% yield on US-based cash investments, are chasing better yields wherever they can find it. There preference is for countries with advanced financial systems and relatively low risk – making South Africa a perfect destination for short-term cash. “You have a headwind of debt in the developed world, but there are no emerging markets that suffered a bank crisis to the same degree as the West,” says Lawrenz.

If inflation stays within the 3% to 6% band, GDP growth meets expectations and fiscal policy remains on track cash should yield just less than 7% this year. The yield will rise moderately through 2011/12 before declining again. The yield on the R207 long-term bond will trend softer towards the end of this year, but pick up through 2011 as inflation pressures emerge. “Given these bond yields, your income return is fairly constant out of a bond,” said Lawrenz. Through 2010 you should earn 8% income and a modest capital gain for a total return of 9.4%. But 2011 won’t be good at all. As a result, fixed income managers may want to increase money market exposure in 2011.

Editor’s thoughts: A nominal cash yield of 7% doesn’t sound like much in a high inflation environment. It sounds as if fixed income managers will have their work cut out to match long-term returns on their respective portfolios. Are you happy with the returns on offer in the fixed income space over the next three yeas? Add your comments below, or send them to gareth@fanews.co.za