Rising interest rate may not be a bad thing for the economy

The market has been talking and speculating about a rise in the interest rate since last year. There is a lot of fear about this and a lot of people are predicting doomsdays scenario on this. Personally, I think there is a lot of misunderstanding on the impact of rising interest rates on the economy. My blog for today is to show you why rising interest rate is not necessary a bad thing for the economy and you. There are a lot of reasons for this but I will just focus on two of them. Firstly, interest rate is a tool to keep inflation manageable. Secondly, rising interest rate that is well managed, will not affect business or consumer sentiment. Ok, let’s move on to the first point.

Interest Rate is a tool to keep inflation manageable

In an inflationary environment where the economy is booming, there is simply too much money chasing after too few goods. Things will get more and more expensive every day and the value of your dollar will drop dramatically. It hurts savers and lenders. For example, in an inflationary environment, a loaf of bread that costs you $1 today may go up in price to $3 tomorrow. Everything in your savings accounts and CPF will be devalued. To prevent this from happening, the central bank will raise interest rate to cool the economy. Higher interest rate will increase the borrowing cost and this will reduce the demand for goods and services. It will eventually stabilize the economy and make growth more sustainable. Hence, rising interest rates is necessary to keep inflation at bay.

Well managed interest rate policy will not affect business or consumer sentiment

Before today’s close to zero interest rate environment, most of us will remember that we could get about 2%-3% p.a. for a normal fixed deposit. It is only from 2008/09 onwards that interest rate has dropped close to zero. This is neither the norm nor a new norm. The interest rate has dropped to zero because Federal Reserve in US has to do it to rescue the economy from the Great Recession then. If we look at the 12 month FD interest rate for the past 20 years in Singapore (all the way back to 1994), it has always ranged from 1% to 4%. And, we still have some of the best growth in GDP during those years. For example, in year 2000, GDP grew close to 9% and 12m FD rate was close to 2.5-3% p.a. To say that an increase in interest rate will crash the economy is seriously over exaggerated. In fact, a well managed increase in interest rate will not necessarily affect the business or the consumer sentiment.

All said, I hope this blog will alleviate the fear regarding the impact of rising interest rate on the economy. In months to come, when the interest rates goes up, do remember that it is not a bad thing after all.

 

CPF Review Wish List - Inflation Indexed bonds

There is an ongoing debate on CPF and its minimum sum scheme in supporting the retirement needs of our local residents. Today, the return on our CPF OA is pegged to a weightage of 80% of the average of 12-month fixed deposit rate and 20% of the average savings rate published by major local banks. As you know, fixed deposit rates and savings rates are very low now, and the computed pegged rate will probably give you a return of less than 0.5% per annum on CPF OA. This is really worrying because the latest CPI rate is close to 2% and we will get -1.5% (yes, negative 1.5%) for our CPF OA on real return basis if not for the legislated minimum of 2.5% per annum return on our CPF account. Nevertheless, CPI is expected to hit between 2% and 3% this year, and this will leave us with close to 0% real return on our CPF OA even with 2.5% per annum. I believe it is time to look at something that Monetary Authority of Singapore has mooted a couple of years back – inflation indexed bonds.

Imagine you buy an inflation indexed bond with real return of 3%. If there is no inflation, the return will stay at 3%. If inflation rate goes up to 2%, then the actual return will be adjusted accordingly to 5% to account for the 2% inflation rate. In a way, your investment is protected from inflation risk and you will get 3% for your investment. And, if CPF OA can be invested in inflation indexed bonds, this will help, in a great way, to alleviate the worries that we have today regarding whether our CPF is enough for our retirement. We are assured of a positive real return on our CPF saving over the years.

I really like this idea although I believe the implementation of such scheme will not be easy. There will be concerns like the credit ratings of these investments, risk-free or not risk free and others. However, at the end of the day, inflation will eat away our savings if we do not do anything about it. We definitely need more innovative ideas to protect our CPF savings.

2014 World Cup

Finally, the 2014 World Cup is coming to an end. On next Monday morning, the final will be between Argentina and Germany. Interestingly, some punters will start to look at some of the most unusual animals during this period for guidance and prediction on the World Cup winner. I still remembered the Octopus that picked the wrong team in the 2010 final. I wondered what had happened to it after that game. I bet it had not predicted its own bleak future correctly then. This year, we have other animals like the Oracle turtle that has picked Argentina to be the winner and the Nelly the elephant that backs Germany to be the winner. Wonder whose future will be at stake this time?

Recently, I have read an article about whether it makes more sense to invest like Germany where you will have high volatility and high return or to invest like Argentina where you will probably have low volatility and low return. Well, Germany has beat Brazil 7-1 before reaching the final. Argentina is a relatively less exciting team and it has so far managed to beat the opponents by only a single goal before reaching semi-finals. In a way, Argentina looks boring while Germany looks vibrant and energetic.

Warren Buffett and George Soros have said this before. Good investing should be boring.  Good investment should be the ones that are able to give you good and stable return over the years. The wise saying is that the dullest of businesses can make the best investment. Look for those companies with good franchise and strong management. If you are able to find one such company to invest in, stay with them. Ignore the noises and volatility of the market. You can fall into a deep sleep for the next 10 years and you can rest assured that these companies will still be around and profitable after waking up from your sleep.

I have also come across the following quote in some investment seminar and I think you may find it useful - “You will not die if you have no class, but you will certainly fail if you have no substance”. And, that’s Argentina. One single goal is enough to wipe out your opponent. Why need more? I hope Argentina wins the World Cup this year, perhaps by a single goal.

Coca Cola Index - Open Happiness

Whenever I am down and weary, I always remember to drink a can of coke. Somehow, it helps to lighten my mood and keeps me going.  I know, I know. They will dissolve your bones and slowly melt you away. Just kidding. Of course, there are some side effects to doing anything. And, you have to worry about this and about that in life. You have to worry about it everyday but not today. It is Coke day today !! So, I drank up and relaxed.

Anyway, when I was about to empty my last drop, some funny idea came to my mind. Whenever I go overseas, I will always try my best to get a can of coke just to see whether it tastes the same. Well, so far, Coca Cola has been able to maintain its standard. But, what about its price? Uhmm...does the law of one price work for Coke? As usual, I work out some statistics to show that it does not work - just like the Big Mac index. Just for info, law of one price states that the price of a particular product will eventually be the same when exchange rate is taken into consideration. If one product costs more in country A than B, people will buy this product from country A and eventually the price will be the same because the currency for country A will appreciate. Yes, you are right, this is just hypothetical and it may take many years for it to happen or it will never happen.

Let's look at the Coca Cola index below.

Coca Cola			SGD
	Local Currency	Exchange Rate
Singapore	$0.68		$0.68
Malaysia	RM1.49	2.57	$0.58
US	US$0.83	1.25	$0.66
China	CNY 2.90	4.98	$0.58
UK	68p	2.13	$1.45

The price of a can of 330ml Coca Cola cost almost the same in countries like Singapore and United States of America. They are relatively cheaper in Malaysia and China. But, look at UK. Wow, it is more than double the price of the other countries. Maybe cough syrup costs more in UK (serious - Coca Cola started off as a cough syrup. And, why can't they make modern day cough syrup as tasty as Coke?). Well, before law of one price works (if it really can), I better enjoy my Coca Cola happiness now.

Fraser Hospitality REIT vs Transformers

There was an article on the Fraser Hospitality REIT this morning. Interestingly, the yield reported is about 7%. If you compare the 7% REIT return versus the return that you are getting from the bank for your saving account, I bet you will be overwhelmed by the spread that you will be getting from this REIT. However, do take note that the gearing ratio of this REIT is close to 40%. Well, I have not read the prospectus. So, I cannot comment much about this REIT. But, I really think you have to be careful about some of the accounting that goes into deriving the dividend yield. Take the following for example.

Scenario	Gearing	Equity	Debt	Asset	Dividend	Dividend  per share	Price	Dividend  Yield
A	20%	$100	$20	$120	$5	$0.05	$1	5.00%
B	50%	$80	$40	$120	$5	$0.06	$1	6.25%

Assuming there is a REIT (Scenario A) with gearing ratio of 20% and dividend of $5, the dividend yield will be 5% for a share price of $1. In layman term, it means I borrow $20 from the bank and I get $100 from you to buy a building of $120. I get $5 as rental income which will be paid to you yearly for the $100 that I get from you.

However, under Scenario B, if I increase the gearing ratio (i.e. amount of debt from bank) to 50%, I can basically push up the dividend yield by reducing the amount that I get from you. Now, the dividend yield is 6.25%. The above is a very simplistic example with the assumption of interest expense for debt borrowing = $0. This is, of course, not ok because more debt means more interest payment. In the current ultra-low interest rate environment, it can only mean one thing in the near future - interest rate goes up and interest payment goes up. This will eat into your dividend return. Hence, it is very important not to judge a REIT just by its dividend yield.

I will probably spend my time watching Transformers 4 - Age of Extinction this weekend rather than looking into the details of this REIT. I think it will be more exciting. Anyway, always remember - "There’s more to them than meets the eye."

Is CapitaMall Trust retail bond worth a look?

When CapitaMall Trust launches its retail bond today at 3.08%, I start to wonder whether it is worth a look given that we all know interest rate will likely move up after 2015. Frankly, I am not too worried about its credit risk because of its strong issuer credit rating of 'A2' and this is a Temasek related companies. The business is sound and the management is equally strong. So, the chance of defaulting is low and you will likely get your coupon payment till maturity. The major risk that I see at the moment will be the macroeconomic environment, specifically interest rate risk. US Federal Reserve has only indicated that they will keep the federal fund rate near zero into 2015. So, the question is how much can the federal fund rate go up after that and how is it going to affect our interest rate?

The above chart is a comparison of the US Federal Fund Rate and SGD 12 month Bank Deposit Rate from 1983 to 2013. In Singapore, investors view retail bond like long term deposit. Most investors hold the bonds to maturity and there is hardly any liquidity after the bond is listed.  The maximum tenor readily available for retail fixed deposit is about 36 months. I have used 12 month deposit rate as a proxy for comparison.

As you can see, our interest rate moves very closely to US Federal Fund Rate except for the period between 2005 and 2008. In 2002, we were hit by SARS crisis and our 12 month bank deposit rate has stayed consistently below 2% since then. Between 2005 to 2007, US Federal Reserve had increased the interest rate aggressively to keep inflation under control. That explains the divergence during that period. Now, both federal fund rate and the SGD 12 month deposit rate stay close to zero. Unless there is a drastic spike in inflationary pressure in US, we are unlikely to see Fed moving the interest rate to 3% or 4% within a short to medium time frame. Even if they were to do it, I am also not sure whether we will follow suit. We should always take note that exchange rate is the main tool that MAS is using to control inflation. The last time that our 12 month SG deposit rate went above 4% was more than 15 years ago in 1998. In a way, the chance of our deposit rate staying low for the next few years is still high. 

However, no matter how small, an increase in interest rate will definitely affect the bond prices (you must always take note that bond price moves inversely to interest rate). In Singapore, the trading volume for retail bond is very low. With low trading volume, you may have difficulty in selling the bond. Unless you are able to hold the bond till maturity, you may face capital loss. Therefore, if you have excess fund that you will not use for many years and you do not mind parking money in an investment that gives low but relatively stable return, this may be an option. 

Of course, there may be more bond issues for retail investors in the near future. A short while ago, there was some news article about Temasek looking into issuing bonds for retail. So, there will always be such investment products coming your way. Do your sum and make your decision wisely.

Disclaimer: The content in this blog contains purely my personal opinion and it is in no way a substitute for professional financial advice. You should seek advice from a professional financial advisor with any question regarding your financial matters.

Update on inflation

I have written a few articles a couple of years ago on the inflationary environment at that point in time and the main reasons behind this. 

Now, I am quite happy to say that this inflationary pressure has slowly come under control by several measures put in place by our government. For example, the escalating housing prices have virtually come to a stop by policies targetting at both supply and demand. This is commendable.

Though difficult, these policies are very important and necessary to maintain sustainable growth of our economy. And, we should not forget that we are still a savers' nation and high inflation will eat away our saving and cpf.

Well done.