After a presentation, in 2016, on ‘The Use of Futures Markets to Reduce Portfolio Volatility’, Jeremy O’Friel was back to talk about ‘Investment Implications of Rising Global Interest Rates’, at the invitation of the CFA Society of Mauritius, on Monday at Voilà Bagatelle. The founder and Managing Director of Belmont Investments shared his concerns about the interest rates going up after a long period at zero. He also talks about the interventions of policymakers in terms of monetary policies which have been beneficial so far, but whose consequences are still unknown
>> You started your presentation by saying that there might be challenges in the next few years. What are these potential challenges?
The single biggest challenge I see is the price of money, and the impact that rising price of money has across the investment spectrum. So, it is difficult to find an asset that is not answerable in some way to the cost of capital, whether it is equity, fixed income, property… Looking at the past 50 years of economic history, it’s difficult to see how interest rate is going to stay incredibly low for much longer, and that poses a threat to valuation of money as a result.
>> You said the rise of interest rate is one of your biggest concern. Is it because it has been sudden?
Not that it’s been sudden. But it has been so low for so long. If you look at the interest rates over the last 20 or 30 years, we have seen interest rates being at a long-term average of 6 or 7% in dollar terms, compared to zero as a result of the financial crisis, and the responses of Central Banks around the world to the financial crisis. What we have never seen is interest rates going from zero back up to 3%. The question becomes: how much of the gains in equity markets, or another asset market, over the last seven or eight years were directly derived from the fact that interest rates were so low? Obviously, when interest rate is zero, you can borrow money for free. You can buy an asset. And that purchasing ability or purchasing power looks artificial. What is very real is the fact that it drives prices higher. Once you cut off that free money, there isn’t the same natural support for so many of these assets. As a result, the pricing that was achieved through very cheap leverage comes under threat.
>> Should we expect, in the years to come, another financial crisis or bubble, as a result of this rising interest rate?
Certainly, I would not be thinking this is going to happen. I think that the global financial system is in a much better position than it was in 2007. So, I am not particularly worried about that. But, I am worried about the fact that we know how much of the last seven or eight years of growth was derived from low interest rates to zero interest rates. We also know with a certain degree of certainty that interest rates are going to rise further. They are already rising, and will go further. And that’s a real concern.
A lot of what happened in 2008 was a liquidity issue. I do not see that happening again. This is more a question of first put a number, maybe 25 or 30% drive in asset valuations, equity and property valuations. But that 25 or 30% growth has a very real impact on people’s wealth.
>> You said that the last few years have seen much intervention from policymakers on monetary policy issues. Has it been really beneficial or are we now going to witness the consequences of these interventions?
Yes, there has been huge intervention. But no doubt, it has been beneficial to equity markets. They did it because they wanted to stabilize the global economy. One of the unintended consequences was that equities rose tremendously. So, this has been the most interventionist period in the history of monetary policy. What are the consequences of that? We do not know… Don’t forget that as well as interest rates rising, we have also got the Federal Reserve unloading dollars. The Federal Reserve is an interesting creature in that since 2008 to 2016, they’ve put four trillion dollars’ worth into the market. In exchange, they bought mortgage bonds, fixed income securities from banks and other institutions. They know they cannot hold on to that fortune forever, so they have started unloading it. That puts another pressure on the price of money, and it’s a secondary awkward pressure on it.
>> Is the rising interest rates and intervention a global issue?
Yes, it is. Obviously, it is more pronounced in America because it is the biggest economy in the world. But it happened also in Britain, in Europe and in Japan. Right now, America is about 25% of the global Gross Domestic Product (GDP). Europe also makes up about 25%. That’s 50% of the global economy. Japan is about 8% of the global economy, and the United Kingdom is about 3%. So, all those four Central Banks make up 63% of the global economy, and that’s a lot. It’s not insignificant. Those are four very powerful entities in terms of what they do to the global supply of money. Certainly, most of my conversation focus on the US dollar, but what happens to it is likely to be mirrored in other parts of the world.
>> Have you been able to follow the trends in Mauritius, in terms of interest rates, intervention and monetary policies?
I am aware that there are major concerns of the Central Bank here as regards the rate of the rupee against the dollar. The latter has weakened against the rupee by 6 or 7% in late. It seems to me though that the long-term exchange rate between the dollar and the rupee has been pretty stable. I have been coming here for 14-15 years, and it has not changed dramatically over that period. There has been some intervention on the part of the Bank of Mauritius, and that’s been pretty effective. Certainly they are taking the right view in that, I also come from a small country and small countries need to be realistic about their ability to affect international economics. As a result, they need to be price-takers rather than price-makers.
I know you have had political issues over the last two years, like many countries. But certainly, I think the economy has been reasonably well managed here. I haven’t seen any extremes in terms of interest rates or exchange rates. Mauritius is a country of 1.3 million people, and the stability that has been created is a pretty good achievement. If you look at other countries of similar size, like Iceland for example, it has had intense times over the last eight or ten years, and thankfully they’ve come through it. But there is a real volatility in their currency and interest rate market.
The Mauritian policymakers, both fiscal and monetary, have done a pretty decent job.
What’s happening with interest rates?
Throughout the last nine years – considered as the bull market run – the Federal Reserve (in America) held interest rates near zero. However, recent signs of rising inflation could push the Central Bank into hiking rates more aggressively, which can have far-reaching consequences. For consumers, for instance, rising interest rates has no impact on the ability to borrow, but only the rate they pay to borrow. Higher interest rates compete with stocks as investments and make the cost of borrowing higher for investors and business.
“Not only have we been at zero over the last eight or nine years, but in my lifetime interest rates have been up to 20-21%. I came into the market in 1996. The interest rate in the US at that time was 6%. To me, that is normal interest rate. Over the last 12-18 months or so, interest rates have started going up. It’s about 3-5% in the US, with prospect for other hikes over the next 18-24 months”, explained Jeremy O’Friel, Founder and Managing Director of Belmont Investments during his presentation on ‘Investment Implications of Rising Global Interest Rates’ at Voilà Bagatelle, on Monday.
According to him, equities are interest rate sensitive, but fixed income is most sensitive. Whereas property prices and the behavior of property is not far away from that of fixed income in terms of sensitivity. And the most important factor that determines the price of a currency pair (for example, the US dollar and the Euro) is the interest rate differential.
Monetary policy being the stepping stone that determines interest rates, Jeremy O’Friel is of view that monetary policy has never been so interventionist as it has been over the last 7-9 years. That is, when the global financial crisis happened in 2008, policymakers stepped up to lead the way. They had the choice between either a fiscal point of view (more taxation) or a monetary point of view. The second option was chosen.
“Monetary policy and monetary policymakers have never been more powerful than they were over the last 7-9 years. I don’t think it’s a mandate they asked for. My big worry for the United States at the moment – and last year’s election was proof of that – is that the monetary policy that we are talking about created an excess in asset valuation that benefitted only 10-15% of the population. So inequality has become a terrible problem. Economic growth happens when the middle-class does well. The American middle-class is not doing well,” he affirmed to the audience.
He also worries about the artificiality of the monetary policy over the last years; such that over the next two or three years, “policymakers will have to concern themselves to addressing the excess that came from that artificiality, maybe asset bubbles…”