One's focus can be very short-term, what happens if we step back to look at the forest rather than the trees? What major investment outcomes might occur in the next several years that we should reflect upon...
Could global interest rates fall to substantially lower levels?
Could Canadian real estate finally see a meaningful price correction?
But first, how do we find ourselves in a position with the highest interest rates in 22 years? Collective central bank actions lagged, occurring after inflation had already headed higher Do we have any confidence their current focus on inflation is more timely?
As the central banks of the world push interest rates ever higher, how do they judge their earlier prognostication that higher inflation was "transitory"? Transitory has, unfortunately, a pretty loose definition..." of brief duration". What is brief in economic cycles? I would think that the inflation level over the past two years is more than a brief time frame. But will we look back in several years and see that higher inflation was brief when measured against the prior 30 years of low inflation?
Looking out several years, I can imagine consumers pulling in their spending habits, particularly with goods and services so expensively priced. Anecdotally, car dealer lots are filling up as buyers decide their five-year-old SUV is just fine. Over the past months, price cuts have been announced by Ford (electric F150) and Tesla as they work to move excess inventory. Will we experience discount pricing soon across multiple products?
Central banks have apologized for their late action in raising interest rates. Transitory is likely a term they would rather forget! Imagine though that interest rates on 10-year government bonds fall back from the current 4% to 3%. The whole interest rate structure from GICs to mortgages, reverts to a much lower level. Such an occurrence would bode well for the stock markets and provide a lift for the bond market.
As investors can we rely on bond managers that may actively extend the term of their portfolio to lock in today's better rates? One hopes that they get the timing right. Cash reserves pay 4%-to 5% in today's world but could these cash yields revert to 1% to 2% over time? I am inclined to think so, justifying my decision to hold 40% of my portfolio in professionally managed, fixed income, with a three to five-year term.
In my view, governments have the incentive to move rates substantially lower as they are the largest issuers of debt. Two years ago they were paying 1% (or less) to issue shorter-term debt. Imagine the budgetary pressure as interest costs on newly issued short-term debt quadruple. Why not underpay savers as they did in the past, since savers rarely complain?
Real Estate
Morgan Kelly (writing on Irish real estate) before the meltdown in Irish home pricing. "There is an iron law of house prices....the more house prices rise relative to income and rents, the more they subsequently fall" (referenced from Michael Lewis's book, Boomerang...an entertaining and worthwhile read)
We know that housing is expensive relative to income. In the U.S. home prices have moved to 7.5 times median income. This is very much at the high end of the chart below.
This ratio is not necessarily predictive. The experience in Canada has been that elevated home price-to-income, can last decades.
"Canada has had the longest sustained real estate boom in the world...even with price dips, prices rose a world-beating 553% in the 25 years ending March 2022". (Bloomberg July 25, 2023)
What about mortgage rates? Two years ago U.S. homeowners were able to lock in mortgage rates of 3% fixed for 30 years. The same mortgage today will cost you 7%.
One would think that high mortgage rates, occurring at a time of high home prices would be a cause of concern. I am concerned!
Perhaps interest rates will decrease over the next five years allowing for improved affordability. In Canada, two-thirds of mortgages have not yet come up for renewal. The years, 2024 and 2025 will bring substantial pain. U.S. home prices suffered substantially from 2005 through 2012 (as indicated below in red), while Canada was spared.
Is it time for a Canadian taste of Irish home price reality?
Investors should consider all unexpected possibilities, ensuring that their financial structure can absorb what the future might bring.
regards, Tim
Tim Morton, CFA is a retired portfolio manager with 45 years of experience working with private clients and is the editor of mortonir.com and a contributor to Barron's. My comments are not to be taken as investment recommendations. They are purely for discussion purposes. Please see your registered advisor for investment advice.
James, I wonder if the timing of the change in interest rate levels (either up or down) will be a major factor. If the central banks hold rates at this level for multiple years there could be longer-term economic damage.
Wallace, I agree with your thought, interest rate changes will not be the only variable. We will also encounter Donald Rumsfeld's Unknown/ Unknowns!
As I read these questions, answers that come to mind reveal just how much I am influenced by my daily reading list. I suspect interest rates may not be the only source limiting our potential.
A
You ask some very timely and very important questions, Tim. Given a history of some inaccuracy, how will errors in judgment now play out in time? The future is being shaped before our eyes, with interest rates limiting the potential.