The Hudson Forum :: October 2009::

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Phil:

Welcome to the Hudson Forum. We’ve got all the advisors around the table here. Andrew, Steve, Michal, Philip, Ivan, Louise and Hamish and we’ll be looking at some frequently asked questions that are coming up, some very topical ones as well >>

Q1 - "How will the recent interest rate rise and the highly anticipated future rate rises over coming months / quarters, impact on the share and property markets and given the FHOG is being gradually withdrawn over the coming 3 months will this pull the rug out from under the property market?"

Ivan:

I always start with the property markets because that’s the one I guess is the more topical of the two when we talk about interest rate rises, because you know the size of the mortgages etc on our homes and on our investment properties. Usually what I say to members, and I may say, often leaves them in a state of confusion is, "Property is usually going its best when interest rates are rising". That may seem like a conundrum; or seem an irony; but when we strip it down, property grows well when the economy is growing well.

There was a very direct relationship when the economy come to a standstill and we had a global crisis and no-one left the front or back door, we all stayed indoors. "Henny Penny the sky was falling" and the property market came to a standstill. Buyers fled the market. Sellers fled the market. Developers couldn’t get finance. Nothing happened.

Stimulus Cash But, as the economy starts to come out of recession, which is what we’re hearing now, and we start to see more activity, see results on retail sales and unemployment figures improve, (only last week, unemployment dropped 0.1%), these little signs are signs that the economy is coming good again, and what does the Reserve Bank do? The Reserve Bank says 'well we don’t want inflation to become our next nightmare, so we’re going to start staggering interest rates up'. Okay, but property is starting to become more favourable again.

Obviously we’ve got stimulus packages, first home owner grants, that are having their affect in keeping things ticking along but, the buyers and sellers are coming back to the market. The developers are starting to find it a little bit easier to get finance to put new properties out there. We know there’s demand, we hear every day that there’s a shortfall, but that’s only going to get bridged when developers can actually build more properties, and create more dwellings for people to take up, and the buyers and sellers get into that market and soak that up, and that’s what I think we see ahead of us.

Now is it all going to be changed overnight? No, but for the next few years fundamentally property growth should still tick along.

Phil:

I suppose what you’re saying is interest rates are but only one impact on the property market, and other factors, more on the supply and demand equation, probably impact more, given the lack of dwellings, the lack of new suppliers coming on board, and the continuing demand. Their impact is probably greater than interest rates.

Michal:

I was going to say it’s like a short term and long term view as well. The under supply and demand issue is a long term thing. I think they will always support the property market fundamentally, but I think interest rate rises may have some short term impact, but I don’t think it will be anything significant, that’s my view.

Louise:

With the recent rate rise being such a small rise, I don’t think it is going to have any significant impact on share or property markets. Similarly if the reverse was the case and rates fell by 25 basis points. I believe markets will continue to run as they currently have been. There may be a slight impact on small businesses with the rate rise putting a dent in their future plans, however the overall sharemarket shouldn’t be stifled by the recent interest rate rise.

Phil:

Given interest rates in the recent past have been at historically lower levels, and ticking it up by 25 basis points, and maybe a few more over the next few months, still gets it at a fairly cheap rate. Hamish?

Hamish:

Yes as Phil was just saying when rates are at historical lows ( we’re paying around 5% now), even if we go up to 6% or even 7%, it’s still quite low in a historical context, and generally people don’t really start to be concerned about interest rates until they start getting up around that 8% mark. That’s when people really start to become concerned about it, and that’s a long way from here.

Phil:

Would you also say though that getting rates up to 7% or 7.5% for the people who have already had debt for many years, and had enjoyed the recent rate cuts, is not as big a concern? But, for people who took a lot debt out now in the last 12 months when rates have been very, very low? If you go from 5% to 7%, that’s a big increase, that’s a 40% increase on your lending and on your capacity and what your repayments are. So how will those sorts of people be impacted?

Michal:

Hopefully they factored that in when they took out their debt.

Phil:

Now Michal, you’re being very generous with people’s outlook into the future; but given lots of first home buyers with grants and the government also splashing lots of stimulus money around, is that a concern for at least a portion of the market and how does that impact on the first home buyer people first into the market place now, in 12 months time when rates are a lot higher?

Hamish:

Yes as Michal said you would hope that when people went into it, they were factoring in a much higher interest rate than 5%. Perhaps they didn’t, but I guess that leads us into how much extra demand has come from the first home buyers, and how much of the market are they now. From the figures we’ve looked at here first, home buyers have gone from being about 15% of the market to almost 30% back in May. Since then, they’ve actually started falling away as a percentage of the total market. They now make up about 24% and historically, they made up more like 15%. So certainly you would expect the first home owners to be withdrawing from the market as the first home buyers boost continues to reduce until December, and then it will be back to the $7,000. I read some interesting information this morning that said in 2002 the first home buyers grant reduced from $14,000 down to $7,000, and when that happened, they had a 40% drop in interest from first home buyers. So after the grant reduced they then came down to 10% of the market. So if that happens again, we’ll have gone from a situation where the first home buyers made up 30% of the market to 10%, and that’s a big gap in the market.

Phil:

I suppose all that is saying is perhaps that future first home buyers have been brought into this period now and so the next 12 to 18 months will see declining levels of the first home buyers.

Michal:

Yes, bringing forward their purchases. So once it fluctuates again short term, I think long term the average remains.

Phil:

Anything to add Steve?

Steve:

Coming in virtually last in the conversation there’s not too much to add I don’t think. Basically I agree with what’s been said so far.

Phil:

A take from you Andrew on a Gen Y perspective maybe?

Andrew:

Yes, maybe people don’t give Gen Y enough credit!

(all laughing)

Maybe they did their sums when they bought a house and they created a buffer. I mean I’m pretty sure the finance companies when they’re assessing you, take in a 2% rise of interest rates?

Steve:

That’s exactly right

Andrew:

And, we’ve gone up 0.25%, so there’s still a way to wiggle there and they’ve also got that home owners grant at the moment, so I pretty much agree with what Ivan said. The reason the Reserve Bank raised the rates is because they see the economy improving, and businesses that operate in that economy will start to increase their earnings. Consumer confidence is up so people are still going to spend money and they’re still going to buy houses because people have to live somewhere.

Steve:

So in essence and agreeing with Andrew, as confidence of people increases they will begin to feel more secure in their jobs, and may even have the potential to earn more – giving increased confidence to undertake debt for property purchases even without or minimal stimulus prompts.

Q1b - "How will the rate rises impact on the share market?"

Phil:

I mean individual companies will find their debt levels (which are a bit lower than they were before the equity raisings) incurring higher borrowing costs so profits should be lower. As interest rates continue upward will that impact on the level of the share market?" What are our thoughts there?

Ivan:

The global financial crisis, and let’s call it the “credit crisis” which is really the catalyst of all of this, it was access to finance and the lending of monies worldwide that really bought a lot of attention to debt management by companies.

"Companies with higher levels of debt have been severely punished and penalised by share market"

Their price has dropped more so than others that suffered in the share market drop, but still had reasonable control of their debt or low debt levels. A lot of companies have done capital raising to put themselves in a better position so that their balance sheet presents a little bit better.

It’s one of those ‘once bitten, twice shy’ phenomenoms – the market is very, very aware of companies carrying a lot of debt, and I think companies carrying a lot of debt will be the last ones to move going forward – just as a general comment. But in terms of financing costs for businesses, again the “credit crisis” was making it difficult for businesses to get finance. Some were closed down because they had their finance taken off them. As liquidity improves and credit becomes more readily available, and we’re starting to see that on the business levels, then it’s all going to be good for business. However, those that are carrying high debt levels will continue to be held with a little bit of disrespect and contempt, I would think by the share market.

Hamish:

An interesting point just to follow up on that is, the corporate rates didn’t reduce by nearly the margin that the residential borrowing rates did because of the “credit crisis”, and the of lack of liquidity and concern about business viability going forward meant banks were still charging a significant premium to lend to companies. Sso whilst most investors have been paying about 5% on their residential mortgages, certainly big businesses haven’t been paying anywhere near that. We may find that as liquidity improves in the credit markets, the actual interest rates that companies pay won’t rise by the same margin that the RBA is increasing it.

Phil:

You would think that interest rates would have to click up quite a bit from here to have a big impact on the share market as people transfer some shares into fixed interest, but it’s more a case of how it impacts on the companies’ profitability for me as rates rise up higher and higher, will that flow through to lower profits.

Ivan:

And, as far as the individual investor goes, which I guess has a bearing on whether it's okay to borrow to invest in shares at the current rates? I mean you just look at it simply – if you did your own projections or you took somebody else’s, or you read all writings from the economists in the World, and you’re borrowing at today’s rates of 5.25% - 5.3%, "Are you going to get that return on your share market in capital growth on average over the next 5 years?" No-one can ever guarantee this, but where we’re coming in on the market right today, versus where interest rates are today, (even if you add in an extra 1% or 2% on the rising of interest rates), there is still pretty good long term fundamentals to stack up. And say, if the share market averages up towards 12% per annum over the long term, and interest rates today are just over 5%, and we’ve come to the trough of the deep share market recession recycle, the odds are stacked a bit better in your favour than they were back in November 2007 (says Mr Hindsight).

Phil:

Yes, Mr Hindsight – I’d like to meet him. But that’s definitely, as a lot of Hudson members reading this report take that on board, because if you can borrow money at 5% - 5.5% against equity in residential property, the share market on a capital growth side is looking relatively attractive over a forward estimate over the next 3 or 4 years, and the yields on some dividends out there are pretty good as well. A lot of companies have cut dividends, but you can still get some pretty attractive dividend deal as we have all seen over the last 6 to 12 months. So if you borrow money at 5.25%, and you should be able to get 3.5% - 4.5% dividend yield and above, plus you’ve got capital growth on top; it's a relatively attractive time to still look at the share market.

So that's it on shares, we'll move onto the second general question given all things we just spoke about.

Q2 - "Given the economy is at best still flat and recovering and for some areas of the economy we probably are in recession. Why has the local share market jumped 50% in 6 months?"

Andrew:

Essentially, it’s because the share market is a forward looking mechanism. What happened in the past is not really relevant. The share market fell 55% from November ’07 to March ’09 because participants in the market were basically forecasting a severe recession or depression, and in an economy like that, companies would earn a lot less money than they would in a good economy, and now we’ve sort of realised that it was probably an overreaction, and it’s not as bad as that. There will be slower growth but we’re not even in recession, we didn’t even have a technical recession. We certainly didn’t have a severe recession or a depression. So there’s been an adjustment in what people anticipate the earnings of the companies will be 6 to 12 months into the future. So that’s essentially why it’s been such a strong rally.

Phil:

So it went down a fair way amid the doom and gloom and will, to a certain extent, go on into the future looking better.

Andrew:

And it’s worth knowing that we’re still 30% lower than we were in November 2007 which is still a fair way to go. To get back up to there we have to rise about around 45% so we’re still a long way below where we were in November 2007

Michal:

Yes I think there’s more good news than bad out there and that’s contributing to confidence.

Phil:

So the economy is looking better next year? What do you say to people in the non resource states of Victoria and NSW that are looking a bit shaky on the job front? “Things are better next year?”

Ivan:

I think unemployment didn’t rise as fast here as it did in America so you probably might expect the same in reverse. You’ve got companies that cut people from 5 days down to 4 days are likely to go back to 5 days before they would recruit a new person. So I think it makes common sense that the unemployment didn’t skyrocket anywhere near as much as the rest of the World, but as we come back down that slope, it will probably be at a similar pace.

Phil:

Is the share market now sustainable given that – has all the future growth been factored in, or have we still got a reasonable upswing potential?

Ivan:

I think there’s two things to factor in when we go back to March 9 or 11, or whatever date it was that we were sitting in the dark room wondering when it was all going to end, there were two things that were then ahead of us - As Andrew was saying, the market went too far, and I believe the market always overreacts to everything because it is trying to predict what’s going to happen. In the first instance, it’s doing that on very little information and they always tend to overreact and go a little bit too far. What that meant was, that the share market was significantly undervalued. The very first step of recovery that we’ve seen in the last 6 or 7 months, where we’ve actually had a nice solid gain in 6 months, is that it was just 'value being soaked up'. We’re now at a point where the value has been soaked up and we might be where we’re meant to be.

The next phase of the recovery process of the share market is going to be about the earnings growth of the companies. Right now we’re in the middle of American reporting season. Keep your eye on American news in the next couple of weeks, the big American companies will be reporting on their third quarter results. The market has estimated where they’re going to be at, and if they disappoint estimations there might be an adjustment backwards. If they come out and give excellent news, and surprise positive results, then you’ll see continued capital growth.

To put that into perspective, if they’re going to adjust back because they’ve priced in earnings growth, it’s not quite there in reality. We’re talking about 5% and 10% type of adjustments we’re not talking back down to below 4,000 points in the ALL ORDS in the local market.

So that’s where we are up to. We’re now actually dealing with getting more in touch with corporate news. The economic news needs to keep coming along with it because the two go hand-in-hand. But as the value has been soaked up, the real value that significantly underpriced ridiculously went far too low, that’s gone, so now we’ve still got our fundamental growth and earnings. Companies start to do better in better economic times, whether it be slow or fast, you’ll still see the share market mirroring along with that as it’s a leading indicator predicting what’s coming next.

Q3 - “If rates are rising, should I take some advantage of the rise in the share market and maybe sell some of the shares & managed funds I have to pay down some personal non-tax deductible debt?”

Phil:

Now that’s a question we can all put our hands up and say we get asked of late. What are your thoughts Michal?

Michal:

Going back to what we were discussing earlier in the piece about the return on shares being generally greater than what you can expect on borrowed funds, I think that will continue because rates, even though they will rise, they’re still very, very low. So I believe from a financial perspective, I don’t think there’s any rush to go out and start selling managed funds or share portfolios now, because you can get arguably a better return than what you can borrow at, but I think it’s more and more a subjective idea, and it comes down to a cashflow issue for a lot of people. If they have borrowed too much initially, then the rate rise would impact on them. If they’ve got some liquid assets, it might make more sense to sell those and reduce personal debt. I think it all comes down to psychology and how comfortable people are holding on to personal debt when rates are rising.

Louise:

I don’t think now is a good time to be selling shares or managed funds as there is still a lot of growth to be had still. As Ivan said earlier, the rise since March has been primarily due to the market being undervalued. Investors looking to get into deep discounted capital raisings pushed prices up. Company earnings will drive the market from here. I don’t think the market has yet built in earnings growth. With the economy improving I believe the market will start to build in earnings growth, and we will see further improvement in share and managed fund valuations. It therefore may not be best to sell now to pay down non-deductible debt. It obviously depends on individual circumstances, however if cashflow is tight or close to becoming tight with further small rate rises, now may be the time to sell to pay off non tax deductible debt.

Steve:

The comment I had was that there would be a far few people out there, who given the crisis, we’re coming through maybe working less hours and earning less income, so as Michal said, it could be really a cashflow issue where they might just have to sell their managed funds or their shares, so they can pay down the debt. A good opportunity for those sort of people though, is that once things start turning around, and your earning more income, you could replace that debt to replace or borrow again, to replace those shares in managed funds, and actually in the long run convert that debt from non-deductible debt to deductible debts. So in a year or so's time, cashflow is back to where you want it to be.

Phil:

So it’s really individual circumstances to look at them. The only concern I’d have on that same basis is, if people are working less hours or getting less bonuses or whatever, it may be, "are you living a bit beyond your means" and if you sell off your managed funds and shares, is there a risk that in 3 month’s time you’ll you be in the same situation, but with less assests as you sold them off to sustain your unsustainable budget?

Steve:

Possibly so. So yes it’s really a personal type decision you have to make and if you are struggling cashflow, you wouldn’t ( if you do go back into debt to get back into the share market) you would obviously do it at a level that you’re comfortable with. So you may not go to the same extent that you were currently, but it is a way that you get back into the market and also help our cashflow short term to medium term by reducing debt now.

Phil:

So don’t make your short term decisions now that may impact you longer term as well. Hamish, comment?

Hamish:

Yes just to reiterate what Steve was saying there. I think there’s really 3 issues with that question as we’ve already mentioned. Which one we think will be the higher returning? Is it the mortgage repayments or the share market? How is your personal cashflow situation, and also as Steve mentioned, the actual restructuring benefits? So going beyond which ones going to be the higher returning, if you’ve got an existing, (particularly managed fund portfolio), that may have a reasonable amount of equity in it, you may still find that you can sell that portfolio without any capital gains tax. Then use that equity to reduce your own personal non-deductible debt, and redraw the loan to end up with a fully geared share portfolio or managed portfolio debt to the same value that you had before the strategy. So it’s just a way of restructuring things to benefit you and your situation in such a way that you can do it without any capital gains tax, and with minimal transactional costs. That’s probably something worthwhile looking at.

Phil:

Yes and speak with your advisor and go through the figures perhaps on that basis, they may sort of re-jig things around a bit.

Ivan:

I guess just adding to what Hamish just said, because it’s a strategy we have employed for a few people, is that, if you only started your portfolio in the last 3 or 4 years, you’re probably not going to have equity profit in there to be able to take advantage of that strategy because the share market went down. So if you’ve already borrowed for those investments, then your equity might be less than your borrowings. If you’re a new investo, however, it is very valid for people that may have borrowed and invested 5 or 8 years ago, where they’ve had lots of up-times, paid a lot of capital gains on their managed funds through the course of time, and now are sitting in a technical capital loss position but really in a profit position, and that’s where Hamish’s strategy really takes its own. For example, you can "take the cream out all of the profit and pay it down on your home loan and then re-borrow it back as your investment loan and improve your tax deductibility".

Editors Note # The comments and strategy mentioned above by Ivan are part of a general discussion and require further advise before an investment strategy be employed. It is strongly advised that you discuss your personal situation with your professional financial advisor and taxation agent BEFORE employing an investment strategy such as the ones mentioned in this discussion.

Phil:

And that’s a strategy definitely worthwhile discussing with your advisor again because we can go back and work out what the capital gain scope implications may be, and we may well be able to give you some advice on that so have a chat to your advisor individually to see whether it’s worthwhile. Andrew, anything?

Andrew:

Yes most of my points have been mentioned. But the only thing I could add is - I guess it depends on what type of personal debt? If you’re talking about a home loan, paying 5 and a bit percent, the share markets probably got more upside than that but if you’re talking a credit card – about $15,000 on a credit card at say 20%, then it might be worthwhile getting rid of that (the credit card).

Phil:

Yes definitely, so the hierarchy of interest rate levels they are at, which is all good. No other comments there? Andrew you had a comment – a quote you were going to throw in?

Andrew:

Yes, it was in regards to people who are obviously pretty cynical when it comes to economists these days after their failed predictions,and wondering whether they’re worth what they’re paid. I read this in “Business Spectator” which is a website run by Alan Kohler, who people may have seen on ABC News. He’s a bit of a talking head but he knows what he’s doing.I thought that was pretty funny and worth sharing His definition of an economist was -

“An economist is someone who can tell you today why what he predicted yesterday didn’t happen”

(all Laughing)

Phil:

What a great way to end up. Thank you.

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