Tuesday, June 25, 2013

Interest Rate

Interest rate is the most sensitive term in current stock markets now causing markets to be volatile mainly due to the fear of interest rate hike globally next.  Before jumping into the fear wagon have to first think logically if interest rate is for the good or for the bad.  What appears to be a bad news on the surface might be eventually a good news in the long run.  Remember a half-filled glass of water can be seen also as a half-emptied glass of water.

Firstly, one must understand the word equilibrium.  Whether it is the law of physics, principle of macroeconomics, principle of microeconomics or in engineering sense, everything exist in equilibrium.  Should it move out of its equilibrium and unable to move back by itself, any artificial means will have to apply to move it back.  This is what happened to interest rate now.  Due to the 2008 sub-prime crisis, interest rate has been cut to extremely low level by Central Banks to spur economic recovery and for sure this extremely low interest rate level is definitely not the original equilibrium position and hence it cannot be sustained and eventually will have to move back.  Low interest rate though can spur economic activities but it also has the ill effects of driving up asset prices hence inflation.  Similarly, high interest rate is also unsustainable in the long run as it makes economic activities difficult and slow down the growth.  Interest rate is used by Central Banks in the world as a form of monetary policy to fight high inflation.  China suffered this fate in the 2010 to 2011 periods in which its inflation rose to above 5% level and PBOC has to hike interest rate and bring down the inflation. Resultant of the interest rate hike is the slow down in growth which China is facing now, a slow growth.  For those with knowledge of macroeconomic should know of the inflation aggregate demand curve (AD-AS model) and current low interest rate environment is definitely not in the long run equilibrium phase.

US Fed decision to halt bond purchase, its QE3 by mid 2014 and caused a stir in global markets as anticipation of tapering as early as 3Q2013 and thereafter a possible of rate hike.  On the surface it is bad news (short-term wise) as businesses will no longer able to borrow money cheaply (not unreasonably).  However, if thinks logically and rationally, the halt of QE3 and possible interest rate hike will only carry out once the US economy is able to stand on its own foot without life support and self recover from the 2008 crisis, in a way the interest rate is moving back to its prior equilibrium position.  In the long run, this is not a bad news.  Hence, jumping into the fear wagon might not be a wise move

For Singapore, should US Fed hike interest rate, our financial system will also be seen hiking interest rate but underneath of that will be a second thought.  After all, the benefit of Singaporeans putting money in the bank to enjoy a higher interest rate might not be the same as those in US.  As mentioned earlier, Central Bank uses interest rate to control inflation but MAS all along uses exchange rate to control inflation and interest rate is the last resort for it.  As such, the pace of interest rate going up will not be as fast as US or rest of the world.  Singapore bank saving rate at the moment is about 0.1% on average and the recent released of CPI is +1.6%, clearly the interest rate from the bank still quite a distance away from the inflation rate.  

Just 2 weeks ago the food stalls in the food court near my house most of them did a price hike with as much as 20%.  Reason was suppliers price hike so they have to pass the cost to consumers.  Isn't Singapore inflation cooling down from the past months of more than 2% how come the price of the necessities move in the opposite direction ?  If you have noticed, Singapore is not an agriculture nation, the vegetables, the rices and the meats that we everyday eat all imported from overseas.  Due to the import nature, the products will have to pass through multi levels of middleman before reaching the consumers as compared with agriculture nation.  Each level will do a price mark up to gain profit and hence at the consumers' end, price can never be cheap.  I do not remember there is an incident of price lowered for the past 30 years for those necessities for your information.  Prices just keep going up but interest rate from banks is a different story it can move up and down due to monetary policy to spur economic activities.  Not to forget wages or income can also move up and down too depending in economic condition.  Hence, we are always at a "disadvantage" level in term of outflow and inflow of your money.  The next time when you visit supermarket (NTUC, Cold Storage, Giants, etc) do make an effort to observe the cost-quantity relationship of the products that you are buying, has it getting more expensive or cheap ?

Singapore just has this unique situation in which even if an interest rate hike we might not enjoy the maximum benefit by simply putting money into saving bank.  In short, one must always stay vested in some investment instrument that generate and grow the money apart from putting in bank to earn the interest.  Primarily, one must always invest in something that can keep pace with inflation so that the value of your money will not be erode away due to inflation.  Investment is not a risk-free thing and with majority taking investing in share as the primary source of investment, one can imagine how risk-free it can be; share prices move accordingly to economic condition.  To have a buffer for the downside risk and to have the hedging effect against inflation, the return of the investment (be it in the form of capital gain or dividend payout) over a long period of time must be a substantially higher than inflation.  In most countries, the 10-year Government bond yield is used as a reference but since Singapore Government bond is not as popular as those US Treasury Bill and most might not even know what is the yield for that.  Likely, for Singapore, there is a very effect tool to serve as a good reference, the CPF interest rate.  CPF interest can never go below inflation (if it does, who is willing to contribute to CPF and the Government is just asking for trouble to get voted out in the next election).  Current CPF rate is 4% vs inflation of 1.6%, this already creating a comfortable buffer, a spread of 2.4%.  As such, any share investment must have a return that is higher than CPF rate, that is more than 4% at the moment to further create the buffer for the non risk-free situation and also cater for price swing of the share.  A rule of thumb, at least 1% higher than CPF rate would be a bare minimum.

Present volatile markets with bias towards selling is caused by none other than funds moving out of the stock markets to something that can achieve better gain.  It is very typically for funds to move from A to B to C to D and then back to A as their primary aim is to get the profit in possible shortest period of times.  Having say that, in the long run, moving in and out is actually a zero sum game, moving out from A and some times later moving back to A.  However, for long-term investors who always stay invested in not zero sum game in the long run.  Majority will achieve higher and better gain.  Warren Buffett will not be Warren Buffett today if he practiced what funds did by moving his investment in and out rather than staying long term for it.

Having saying all the above, it is no surprise that it points to one must always stay invest in the long run and current markets turmoil probably present another opportunity but with certain conditions.  If one already vested during the 2008 - 2010 periods, can continue to sit on it and no strong reason to add more.  It is only those under-vested that current situation is an opportunity but can only invest a maximum of 50% of the total investment capital available as the remaining 50% is to cater for recessionary situation to average down or double up.  At the moment only selective stocks that are worth looking into, mainly those high-yield stocks in which after weeks of selling, the yield has again become attractive (use CPF rate a a reference).  As you are going for long term investment so have to ride through peak and trough with your investment in order to see the eventual gain.

After all, interest rate is not a bad news in the long run.  

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