Assets in a time of low interest rates

Business Times - 13 Nov 2008

SINGAPORE'S already modest interest rates, as reflected in the key three-month interbank rate, have fallen further to a four-year low of 0.88 per cent, placing savers and investors in a quandary. In a normal environment, a negative real interest rate should be supportive of asset prices. Inflation in September was over 6 per cent, and the Monetary Authority of Singapore (MAS) has forecast inflation at 2.5 to 3.5 per cent for 2009. But these times, of course, are far from normal. Stress in the credit market is still starkly in evidence, even as the US dollar Libor rate has trended down to 2.18 per cent from a peak of 4.8 per cent a month ago. Non-investment-grade corporate bonds, for example, are trading at record spreads not seen since the 1930s. While that market segment has fallen victim - along with most other assets - to the savage pace of deleveraging, market participants are also pricing in a level of default and economic stress that fund managers believe is irrational.

The irrationality extends across asset classes. In numerous markets, stock indices have fallen to multi-year lows. The Straits Times Index (STI) is currently trading at a price-earnings ratio of six times and a dividend yield of 5.7 per cent, for example. The yield on Asian investment-grade corporate debt stands at nearly 9 per cent. At a time when deposits of less than $50,000 fetch less than 0.3 per cent, it would seem a no-brainer to begin to take some risk, even as analysts continue to debate the billion-dollar question: Is the world heading for a deflationary-type era reminiscent of Japan in the 1990s?

For now, it would seem that concerted action by governments to reflate economies and kick-start the credit markets should at some point begin to show results. By far, the biggest challenge is to restore confidence, particularly among consumers who are notoriously driven by the rear-view mirror. Deep portfolio losses this year are exacerbated by faltering home values as well, almost wiping out any of the feel-good wealth effect that had buoyed Singapore in the last couple of years. But the last thing the economy needs now is for consumers to retreat into a shell. This is where falling interest rates should help once they begin to translate into lower interest expenses on mortgages and corporate loans.

Looking ahead, the financial landscape is indeed in uncharted waters, as banks scale down investment banking activities and cut risk generally. But for investors and savers with medium to long-term goals, the math does not change. A low interest rate that could well trend to near zero is a positive for investments with a steady stream of cash flow and dividends, as a low discount rate should translate into higher asset values. What remains then is to pick good-quality and defensive assets with low gearing, whose coupon or income payouts will help to cushion price volatility. Those assets are in abundance today, even with the caveat of slower growth. The alternative is to sit on cash - an unpalatable option given the long-term history of returns.