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Taking Stock of Rates - Eureka Report Article

November 7, 2007
Taking stock of rates
By Scott Francis

PORTFOLIO POINT: In a volatile equities environment, higher interest rates are making cash returns of 6% to 7% reasonably attractive.

Today's rate change must be the most widely anticipated in recent times. Though it's only a small change - from 6.5% to 6.75% - the move by the Reserve Bank of Australia has been deemed crucial to the national economy, not to mention the electorate which goes to the polls in a few weeks time.

But what does it all mean to stock market investors? The 'price of money' is crucial to stock market listed companies and imperative to stock exchange investors for many reasons: Here's why

Last month at the start of the election campaign, former Prime Minster Paul Keating, while launching Labour candidate Greg Combet's campaign, made mention of the 2% to 3% inflation target that the RBA has as its target. Keating produced notes from a cabinet meeting on the 30th of May 1995, discussing this interest rate target, with his commentary linking the interest rate target to discussions with union leaders. This is an interesting first step in understanding interest rates - the relationship between the RBA, interest rates and inflation.

The aim of RBA is to keep inflation in a band between 2% and 3%. Inflation is the measure of the price of goods and services - so the objective is to ensure the prices of goods and services increase slowly over time. We know that high inflation is not good for an economy. As an extreme example, think of Zimbabwe, which is currently enduring 1000% inflation. Deflation, falling prices of goods and services, is not good for an economy as people and companies tend to spend very little money. This is because if goods and services are falling in value, it will be cheaper to buy something in the future than now, so there is a financial incentive to not spend money today.

Therefore a low rate of inflation is good for an economy.

The RBA's key tool is interest rates - which affect the demand for goods and services in the economy. For example, today's rate increase came as "core inflation" looked like moving higher than the 3% upper inflation band. By increasing interest rates:
Consumers will have slightly less money to spend (i.e., more money will have to go towards paying debts like mortgages).
Consumers will be less inclined towards borrowing money to spend (for example, on credit cards rates will now be more than 17%).

This decreases the demand for goods and services, and therefore decreases the upward pressure on the price of goods and services (i.e. inflation).

The opposite can be true as well. If inflation starts to look like it will fall below the 2% rate, then an interest rate cut will increase the likelihood of spending, and therefore increase the demand and price of goods and services.

It is interesting to look at this mechanism in the light of the tax cuts over recent budgets, and the promise of tax cuts in future budgets from both political parties. Tax cuts increase the amount of money that consumers have to spend, creating more demand for goods and services and putting upward pressure on interest rates. Some years ago a one-off $600 tax bonus was branded the "Harvey Norman tax cut" - a clear link between tax cuts and retail stocks, which continues to today. Among the best performing stocks since the election package tax cuts were announced last month are Harvey Norman and JB Hi-Fi.

The key impacts of interest rates on the economy

The best description I have read of interest rates is that they are the "price of money" in an economy.

For investors, this price of money is very important when it comes to assessing stock market listed companies. And it's not just retailers - every listed company will be affected by the changed "funding costs" linked with higher rates. Most companies have some borrowed money that they use to finance their operations. As money becomes more expensive (interest rates go up) their interest expense becomes higher - effectively reducing profitability. While they may have some long-term debt at a fixed interest rate, they are likely to also have some short-term borrowing exposure. It also becomes more costly to borrow for future projects, with these projects less likely to be profitable, or have their profitability reduced, if the financing for them becomes more expensive.

There is a reverse side of this "price of money" understanding of interest rates. What if you have some money to lend? Suddenly you can expect more for lending that money - whether it be to banks on a short-term basis (cash account), a longer-term basis (term deposit), or to governments or companies (through government or corporate bonds).

This is often overlooked by the media, who focus much of their interest rate discussion on people with mortgages who have to pay more to finance their home. For those people who are investors, however, increased interest rates provide the opportunity for them to get a higher rate of return on their cash and fixed interest "yield" investments.

As interest rates rise, fixed interest and cash investments become comparatively attractive. At the last election, cash accounts were generally paying interest between 4% and 5% a year. With this latest interest rate rise, most of them will be paying interest rates of more than 6% a year. Suddenly, investing in cash and fixed interest investments becomes a lot more attractive.

Consider Australian shares, yielding around 4%, or 5.3% including the effects of franking credits (assuming a franking level of just under 80%). Compared to cash interest rates three years ago of 4%, shares seemed to be a very attractive investment. Not only did they offer the potential of capital gains, you actually received a higher gross income from the dividends than a cash interest return, plus you could reasonably expect the dividends to increase over time.

Moving forward to today, shares with a gross yield of 5.3% still have a lot going for them - it's just that a cash rate of return of above 6% - and over 7% at some online accounts - starts to look attractive as well.

There has been recent talk about how much money is invested in the market through margin loans. I can remember having a margin loan facility charging less than 7% only three years ago. Today, most margin loans are toward 9%. This makes margin facilities far more risky. The chances of having a portfolio of shares provide a return of above 7% a year is a better bet than having a portfolio of shares providing a return of above 9% a year.

Interest rate movements

With today's interest rate rise we will see the "price of money" change through the economy. Mortgages will become more expensive and cash accounts will offer a higher return to attract investors' money. This is very much a market reaction to changing interest rates - it is not one that is controlled by the Government or the Reserve Bank.

The Promise - Keeping interest rates at historical lows

Having looked at the mechanisms of interest rates, it should be obvious as to why it was flawed for Prime Minister Howard and Liberal Party advertising to promise to "keep interest rates at historical lows" during the last election campaign. Interest rates are set by the RBA - an independent body - and move to inflation in a 2% to 3% band.

While a promise to maintain policies that put downward pressure on interest rates might have been more the in the realm of reasonable, promising to keep them at record lows was not. With less than three weeks left in the campaign, there is bound to be a lot more discussion of interest rates to come.