Roger J Kerr wonders if the harsh lessons learned from the meltdown of the finance company sector have been forgotten already

Roger J Kerr wonders if the harsh lessons learned from the meltdown of the finance company sector have been forgotten already

By Roger J Kerr

The super-low interest rates we have been experiencing for some time are as distortionary and disruptive to investors, borrowers and the wider economy as high interest rates.

Last week the NZ share market was pushed to fresh record highs as the weight of investor’s money seeking some kind of yield return flooded into dividend stocks.

Mum and Pop retail investors are turning away from 2.00% returns on bank deposits and taking on higher risk positions in the share market to improve cash investment returns that the live on.

Aggressively marketed property syndicates are back in town offering higher yield returns, however, they come with considerable liquidity (lack thereof) risk, tenant risk and property market risk in general.

Do not be too surprised to see more retail investors placing their hard earned money into higher risk finance companies and peer to peer lenders in the quest for a higher yield return.

Have the lessons of history just a few short years ago been forgotten already?

The pursuit of investment properties to achieve something over 5% return has spread out of Auckland to the provinces.

Do those property investors realise that the ultimate determinant of residential rental prices is the tenant’s income levels?

Provincial incomes will struggle to record any increases with the dominant dairy industry in its current state.

The investment risk/reward equation is been seriously skewed as many investors cannot survive on 2.00% bank deposit interest rates.

Record low mortgage borrowing interest rates are allowing higher debt levels as the servicing metrics are easily achieved.

Let us hope that the bank lenders are also appropriately stress-testing Auckland mortgage borrowers as well as dairy industry borrowers against a scenario of a rising interest rate environment.

If the bank lenders are not doing this they would be failing their customers as well as their shareholders.

The last RBNZ Monetary Policy Statement took the view that the Auckland residential property market boom had peaked and the annual rate of price increase would continue to decline.

Anecdotal evidence suggests that the market is as hot today as it was last October when the extra regulations were enforced on foreign buyers.

As was expected, lower mortgage interest rates have refueled the housing market.


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Roger J Kerr is a partner at PwC. He specialises in fixed interest securities and is a commentator on economics and markets. More commentary and useful information on fixed interest investing can be found at rogeradvice.com

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26 Comments

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Certainly some massive distortions, bubbles and excess capacity due to low (or non existent) interest rates. Nobody is sure how this will end.
RK: "the ultimate determinant of residential rental prices is the tenant’s income levels? Provincial incomes will struggle to record any increases"
Surely those provincial towns with house prices with a one, two or 3 in front of them wouldn't present much of a risk - you can buy or rent one on one income or even a benefit. Your 5, 6, or 7K Auckland rat hole not so much.

"Certainly some massive distortions, bubbles and excess capacity due to low (or non existent) interest rates. Nobody is sure how this will end."

Interest rates a low, because of the excess capacity built up in the good times when commodity prices were still high, not the other way around. Business rates after the crisis were still high, because capital investment was considered high risk activity. I think we have an overhang of excess capacity, has little to do with low interest rates, but rather a consequence of PROC government policy, because they are concerned that a fall in its economic growth rate will be a cause of social unrest and fear the threat of popular dissent. Chinese don't really give a fig about democracy. They just want economic security and a better future for their children. They've had to sacrifice a lot for the sake of economic development and won't be happy if the PROC leadership can't fulfill those very basic expectations.

"Surely those provincial towns with house prices with a one, two or 3 in front of them wouldn't present much of a risk - you can buy or rent one on one income or even a benefit. Your 5, 6, or 7K Auckland rat hole not so much."

Yes, but you can pack three or four to a bedroom and a few in the garage in one of those Auckland rat holes? How do you expect poor people live in Auckland now? They can't just up and move like the comfortably well-off middle class professional. They can't afford to and their often deeply embedded into the local social fabric. They often need free childcare from family or friends while they clean the offices or toilets of the well to do. They may need the support of the church or family when they run into financial diffficulties or suffer family illness which may not be so easily available if they move. The poor just have to make do.

On the contrary, there is plenty of evidence to suggest that the current low interest rates are contributing to excess capacity. The availability of cheap finance encourages business to expand production. We have seen it in oil, shipping, retail, mining, cars and so on; almost everywhere you look including our own dairy industry.
Let's not forget that the median NZ income is only $32K (half of us earn less than that) so I'm sure things are difficult for low income folk in Auckland but there is no way I'm suggesting they abandon the place and head for hills if that's how they want to live.

Thought it was high $30's if not low $40's by now. This figure must actually be near impossible to obtain if you have the likes of part time work thrown into the mix. In terms of the median hourly rate based on a 40 hour week the figure must be in the low $40's by now. Minimum wage on a 40 hour week puts you over $32K so that got to be wrong. No point putting retired people on Super into the mix, your supposed to have paid for your house by then so its all plain sailing on that disposable income !!!

So Chinese now expect us to suffer for them irresponsibly having a population they cannot provide for?

exactly.

And 5% plus yields (7% possibly without much worry) is so far ahead of the 3% in auckland that even if tenant incomes only rise with inflation you're not going to be in any trouble any time soon. The amplification of local FHB's to prices of these 200-300k houses using their now full withdrawal of kiwisaver will mean prices in solid growing cities like PN are safely underpinned and likely to follow the 20% p.a plus gains seen up the road in hamilton

The super-low interest rates we have been experiencing for some time are as distortionary and disruptive to investors, borrowers and the wider economy as high interest rates.

“When does our credit based financial system sputter / break down? When investable assets pose too much risk for too little return. Not immediately, but at the margin, credit and stocks begin to be exchanged for figurative and sometimes literal money in a mattress.” We are approaching that point now as bond yields, credit spreads and stock prices have brought financial wealth forward to the point of exhaustion. A rational investor must indeed have a sense of an ending, not another Lehman crash, but a crush of perpetual bull market enthusiasm. Read more

Hmm, but are real interest rates any lower for deposit accounts? Usually they were higher, but so was inflation, this gave the illusion of a fairer rate of return. In reality bank deposit accounts were being steadily looted by devalueing the currency (and pretending it was "inflation" and far too complicated for ordinary folk to understand). To add insult to injury the currency is steadily devalued and we are taxed on the illusary interest just to make sure the value of funds on deposit goes down.

"Give me control of the money supply and I care not who makes the laws." Bankers rule.

Hmm, but are real interest rates any lower for deposit accounts?

Depends upon the veracity of what is considered an appropriate factor to include to determine "real" when calculating the method of discounting nominal everyday costs.

The Labour Party wants you to have even lower interest rates.

Super low interest rates are a necessary evil to combat the scourge of deflation.
Deflation will collapse the financial system more quickly and efficiently than any level of inflation can ever do.
Economies around the world face ever decreasing prices for goods and commodities as modern methods become more efficient and less and less reliant on human resources.
This is a race to the bottom and we can look forward to negative interest rates where banks charge depositors instead of paying them, such as now the norm in Japan and Switzerland.
The idea behind low and yet lower interest rates is to encourage people to spend so as to keep businesses going, as the spiral of deflation pushes down prices.
Jobs will be lost enmasse and businesses will go bust if deflation seriously takes hold.
People will not buy today if they believe they can buy more cheaply tomorrow.
We see clear signs of that already with endless "sales" promotions and recent examples such as the demise of Dick Smith and Fisher and Paykel succumbing to the pressure of cut throat competition. Likewise the internet is playing havoc with some kinds of businesses. Ultimately only businesses that cannot be sourced through the internet will survive, or those who sell goods that must be seen and felt.
As a result of all this downward pressure people are investing in anything that is in short or limited supply, and real estate is one of them. We can also see that in the art market where a Goldie painting recently sold for a jaw dropping $1.33 M when 10 years ago it may have struggled to achieve $100,000.
Other examples can be seen in classic cars, jewellery, gold and collectibles the prices of which have gone through the roof as compared to a decade ago.

Super low interest rates are a necessary evil to combat the scourge of deflation.

The idea behind low and yet lower interest rates is to encourage people to spend so as to keep businesses going, as the spiral of deflation pushes down prices.

Yeah, right.

The data suggest Japan’s economy is still plagued by the weakness of domestic demand as it enters a fourth year of record monetary stimulus, with wages not rising fast enough to persuade consumers to spend. Read more

Sorry BigD I think that's humbug - "Super low interest rates are a necessary evil to combat the scourge of deflation." Super low interest rates are promoted as a necessary evil in order to prevent a collapse in the debt bubble. It's all propanganda though. The current bank worship system of finance needs it, but there are are more ways to kill a pig than drowning it in butter.

We currently create money by lending it into existence through the foreign owned banking system. This is an exorbitant privilege that we give away. Perhaps a banking licence fee of 1% of total assets is in order? Or move the reserve requirement up from the current 4% or so (yes, I know they pretend it is higher) to, I don't know, maybe 100%. Make deposits be held in trust in a limited purpose banking system like Mervyn King suggested. If new money is needed then just put in citizen's bank accounts until there is enough in circulation. Lots of other ways of doing things but we continue to worship the false gods of cargo cult banking.

Dick Smith was victim to corporate raiding.

The low interest rates are completely ineffective. They are just making people take on more debt and bury us deeper in a liquidity trap. People are responding incorrectly to the low interest rates. They are the chance to decrease debt at a faster rate and free up money for spending. Instead people are spending by taking on large volumes of mortgage debt. The money that the selling receives doesn't appear to be going into consumer spending, it's going into investments instead. You've even pointed this out.

Collectibles, jewellery and gold aren't consumption. As such deflation is taking hold because those with money aren't spending it they are looking for anything they can to retain value. Although gold is a terrible store of value in a deflationary environment.

Dick Smith was trying to compete with JB Hifi, Noel Leeming, Warehouse etc.
In shabby little premises with limited overpriced outdated stock.
A few years ago I realised they were on the way out when I found I could not buy a $10 multimeter there anymore!!
Jaycar is what Dick Smith used to be.

Incorrect. DSE was doing OK and then private equity moved in and broke the company. Jaycar while a nice replacement is doing little more than selling chinese made parts at a 5~20 fold mark up, aliexpress is eating their lunch if my purchases are any indication. Actually I was in there today and a 3d printer for 2k? Mitre10 has one for $1600 and Aliexpress $295US = $400NZ, yes I have to assemble it, no biggee.

DSE have been having "issues" for years ( I used to work there - big mistake). When I first started profit was around the $30 million mark for NZ - and was still heavily into components etc. By the time I left they had shifted into TV's etc, profits were dropping and even Woolworth's admitted they didn't know how to run the company successfully in the market to which they had repositioned the company. I could have predicted the company failure - and leaving was my way of saying I had no confidence in the future of the company (nor in the management). I joked with a friend a few weeks ago when it was announced that the company was closing that I destroyed DSE - must update my CV - "destroyer of company's".

Jaycar only got leverage into the market because Dick Smith abandoned that market sector. I used to get my electronic components from DSE like 30 years ago when I was a kid by mail order. They jumped into a market with too many players in it already. As far as components go these days the likes of DigiKey is just killing the local suppliers. Gone the full circle really used to be local mail order now its overseas Web based ordering and courier supply.

Things are actually so distorted that something's got to give , and it wont be pleasant

Low interest rates , over-capacity , money printing /QE , currency devaluations and "bad" investment decisions are setting the stage for a humungous fallout .

Once you are out of debt , stay there , its going to be much easier to sleep at night

We are all agreeing with each other one way or the other and the rest is semantics.

will eventually be seen in higher taxes, higher infrastructure spending by govt.'s, higher subsidisation of the poor and unemployed.

UK is taxing everything it can; increased stamp duties on rentals, ie buy a rental over 130k pounds (350k-ish NZD) and pay a stamp duty tax. Sugar tax. Tax and spend to keep economy ticking over.

Anyone who thinks they can tax their way to wealth should be treated for insanity!!

Slowing outflows is typical way to extend the life of a ponzi scheme, by reducing the yield or coupon.
Negative interest rates signify that it is indeed a ponzi scheme as this is a blatant attempt to reconfigure outflows as inflows.
It means basically that all fiat denominated now in that NIRP environment is essentially worthless.
It means that all the float and the income has now dried up and nothing is left for interest.

If anyone has fiat in a nirp environment then I suggest you get the hell out of Dodge as it would appear that right now, some people have woken up to the fact that NIRP is in fact worthless tat.
Which means Yen and Euro currency especially.

Floating mortgage rates have fallen little since 2009, when they were 6%, and this was soon after an OCR of 8.25. Floating rates now in the mid 5s. Where is the drop?
NZ is still paying high interest rates on mortgages, personal loans, overdrafts, business loans, business overdrafts, credit cards etc - interest well in excess of amply legitimate business income.

Not once in his piece does RK mention inflation. The fact is-and the long term graphs show this very clearly- that inflation has been falling for many years and this has been pulling interest rates down with it. What has caused inflation to fall? in no particular order; central bank inflation targeting, globalisation and its effects on incomes in developed countries,loss of unions bargaining power and technology.
Of course very low/negative interest rates are distortionary and central banks should be much tougher on banks' capital ratios, while governments should impose other measures to keep a lid on property markets. The stock market will at some point react negatively and the shock will be substantial. Some investors will be wiped out,but that is part of Schumpeter's 'creative destruction'.
Long term investors will ride it out,as we have many times in the past.

Mortgage rates will keep on dropping too. I see no scenario where we see rapid or even slow OCR rates. The UK, Eurozone and America have been sub 1% for getting on a decade. Nz follows, not leads. As far as stress tests are concerned ANZ made me jump through hoops on a 80% LTV Auckland mortgage 12 months ago. Its certainly not like 2003 where you could do self certified, no deposit, no income verification and the like.