Beware of the looming debt trap.
The Reserve Bank’s 12th increase in official interest rates a little over 12 months is more evidence, if any were needed, that life is about to get a lot tougher for many Australian consumers and businesses. Rising costs for everyday goods, rising rents and mortgage repayments mean that the truly “disposable” part of after-tax income for more than half of Australian households will have shrunk dramatically over the past year.
For investors an environment of rising rates offers a mix of risks and opportunities. The opportunities are simple to identify – after several years of earning next to nothing on bank deposits, it is now possible to earn up to 4.8% of some savings accounts.
The main risk for investors is that the share prices of some companies are beaten down due to the rising cost of debt hurting profits and earnings per share. It’s inevitable that companies that have debt facilities needing to roll over in the next 12-18 months are going to be hit by massive increases in borrowing costs.
Companies that were able to borrow during the global slump in interest rates at less than 3 percent will be faced with rates of 6 percent or higher. Judging by a cursory glance at analyst forecasts for the next few years it seems that that market is still a long way off from properly factoring in the rising cost of debt.
There is a widely held view among market participants that we are near the top of the current interest rate cycle. We certainly hope so. However, there is no certainty that rates will peak at around 4.5%, as most players seem to assume.
Even after the latest rate hike real interest rates (official interest rates less the rate of inflation) are still negative (see chart below).
In order to defeat inflation the Reserve Bank may need to increase official rates to the point where the real cost of borrowing money is positive. That would mean an official interest rate of close to seven percent.
Let’s hope that that does not happen, but time will tell.
