Interest Rates - sticking plasters will not work!

Interest rates – sticking plasters will not work!

In the continuing abuse of well-known sayings "while Rome burns, central bankers and treasury officials fiddle".  

Much of what is going on in financial markets has been well-documented by us and we have been repositioning our clients' portfolios in such a way that the misery being experienced by most investors is instead helping to preserve our clients'  wealth, with many funds we have used going up in value.

It is all very well to gloat; but what happens next?

To a large extent, it is all about globalisation and a rebalancing of wealth between Western economies and emerging markets. In the West we have all the debt, and in the East they have all the cash. Lower interest rates in the West will reduce borrowing costs, but it will also reduce investment returns. Central bankers are bound to insist that banks lend less money and when they do so, adopt far more responsible lending criteria. House price falls will undermine consumer confidence, financial security and, for many, a secure retirement. Spending will decline amongst those people who have high levels of debt, those people who have funded spending from borrowings, but it will also decline amongst people who had capital to invest and relied upon this capital to generate high levels of income and disposable wealth. Spending will also decline as a consequence of lower corporate earnings growth and reduced city bonuses, and there will be a general reduction of cash circulating in the economy. There will be increased levels of personal bankruptcy and repossession of properties.

We have yet to establish exactly how much unsustainable debt exists in the world, but I suggest that the tally will be about $2,000bn (a reasonable amount of this has already been revealed). We should know the final figure during 2008.

It will take the global economy a long time to recover from the current debt binge and over-inflated price of assets, particularly in domestic and commercial property. What we are witnessing in financial markets today is the worry about all of these outcomes and not so much the result of  the actual outcomes themselves. So we must recognise financial markets are discounting these outcomes possibly well ahead of time.

Now for the good news

The stock market recovery from a fairly tumultuous collapse in confidence may begin sooner than we anticipate, i.e. by the end of this year or during 2009. Not all the world is in debt; indeed, China, India, Russia, Brazil and emerging economies in general have little debt and large amounts of cash in the bank. Even certain parts of continental Europe – France and Germany by example - have much less consumer debt than Spain, Ireland, the UK and Italy.

Moreover, corporations around the world are in very reasonable shape. Balance sheets are strong and companies will adjust their marketing strategies to address those areas of the world which can continue to consume. In many cases we believe stock market valuations for companies and sectors of the market are (technically) cheap, though these may yet be depressed further by negative sentiment.

The really good news in our opinion is that, while the global  adjustment phase may be slow to evolve, it will be built upon sounder economic footings than has been the case in the last decade. We have been through the tech bubble of 2000 and the consumer binge to 2007. We can now begin to look forwards to a period of responsible banking, steady economic recovery, reasonable corporate profits and a reassessment of the value of life - i.e. the cost of energy and the cost of food. The above will lead to lower carbon consumption, a greater respect for the environment, and more respect for food and agriculture. In short, a new consumption paradigm.

KMG will be following this new economic evolution and the trends and investment opportunities which will result, and we look forward to weaving these into your portfolio as they arise.

Patrick McIntosh