Rising rates, inflation could stifle market

(June 23, 2005) The North American economy is likely to slow down, as a flattening yield curve indicates the current cycle is reaching maturity, according to Gavin Graham, vice president and director of investments, Guardian Group of Funds.

“When interest rates are falling or flat — and we’ve been at 45 year lows in the U.S. and 40 year lows in Canada — financial assets in general will do well,” he told attendees at the CIFPs’ annual conference in Niagara Falls earlier this week.

The economic growth stimulated by such low interest rates has led the Federal Reserve to raise rates in an effort to stave off inflation. U.S. interest rates have spent the past year sharply on the rise, now standing at 3% from a low of 1%.

Investors have been earning equity-like returns on their bonds due to this increased demand, but Graham said this era is coming to close.

“It’s done, stick a fork in it, because rates are going up,” he said. “The first thing you don’t want to be in is conventional long-dated bonds because you are getting the lowest yields in 45 years, interest is going up and inflation is coming back.

“Mr. Greenspan has said it is a conundrum to him why, when he is raising rates, long bond yields have gone down.”

This conundrum has confounded others as well, including GGOF’s bond manager, the massive California-based PIMCO, which manages over half a trillion dollars in fixed income assets.

“When we were seeing them in Newport Beach last October, they said ‘Sorry Gavin, we got it wrong last year’,” he said. The firm had expected long yields to rise to 5% as investors sold off positions, but instead the yield dropped to 4%. “They still managed to beat the index, because that’s how you get to run half a trillion dollars of bonds, because you can add five basis points here and 10 basis points there.”

While conventional long-term bonds are becoming less attractive investments to hold, there appears to be no shortage of demand. Graham suggests it is the central banks of Asia which are buying U.S. Treasuries, not because they are good investments, but because they benefit their high-growth economies in another respect.

As long bond yields decline, so too do mortgage rates. Graham said 50% of mortgages taken out last year in the U.S. carried an adjustable rate. Americans have been fueling their consumption with debt, using the equity in their homes and taking advantage of the low interest rates they face.

With an increasing portion of American consumer goods coming from China, it is in Beijing’s best interest to prop up U.S. consumer demand by buying up the less than attractive long-dated U.S. Treasuries.

Graham said the Fed will raise rates 25 basis points next week, with a similar hike expected in August. Interest rates are expected to stabilize at that point, because so many Americans hold floating rate mortgages. As the cost of carrying these mortgages rises, consumers should scale back on their overall spending.

So far, Graham said inflation-fighting efforts have been unsuccessful, despite low core inflation numbers. While the media tends to focus on core data, he points out that this number strips out increases food and energy prices.

“We include food and energy in the CPI, because we have this old-fashioned notion that people still need to eat and heat their house,” he said. “If you leave out all the things that go up, you will have no inflation.”

The real inflation rate in the U.S. is about 4.8% annualized, when food and energy are included, he said. Even the sluggish core numbers are not accurate, he says, as they are hedonically adjusted — meaning that if the benchmark computer, for example, is twice as powerful but the same price as last year’s benchmark, it is considered to be a 50% price cut, for the purposes of CPI calculation.

The flow of capital into Asia’s developing economies has helped to drive global inflation. Since the late 1980s, the world’s fastest developing economies have become net importers of raw materials. Indonesia, for example, is an OPEC member, but because the state subsidizes gasoline prices, it has become a net importer of crude.

The same is true of virtually every other raw material resource, including base metals and coal. The expansion of manufacturing plants and build-out of infrastructure is expected to sustain the rally in these markets for some time to come, and Graham foresees continued strength in stocks and income trusts with exposure to these markets.

But the rising interest rate environment and higher inflation should put a damper on overall markets, especially in the U.S. where the dollar will continue to weaken. As the stock market trades sideways, any earnings growth will be rewarded as investors pick companies with improving valuations.

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(06/23/05)

Steven Lamb