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Debt up to our ears

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Bruce McLachlan, Chief Executive

Debt up to our ears

My generation loves to remind today's younger generations that first mortgage rates were near 20% in the mid-1980's. This fact is often recalled within a statement of either "toughen up" or "be careful it could happen again", directed at today's younger generations buying exorbitantly priced houses. That though was over 30 years ago and the world has changed immeasurably since then. However, only 10 years ago the RBNZ Overnight Cash Rate (OCR) was 8.25%; today it is 1.75% and it has been at that level since November 2016. Having experienced very high interest rates in such recent history does dominate many investors thinking. This tends to create undue caution to their investment decisions today or creates undue expectations of what represents fair and sustainable medium term returns. So many investors are caught up in this old paradigm.

Debt up to our ears

At the most recent RBNZ OCR review, Governor Orr signed off by saying that they would ensure the OCR is at the current expansionary level for a considerable period. That is, a sub 2% OCR is here for the foreseeable future unless something materially changes, which is not currently on the RBNZ radar.

Low interest rates are here to stay

So why are interest rates likely to stay so very low for an extended period, and why should we put aside such recent history? The answer is the world is awash with debt. To offset the depressing effect of the GFC, governments and households have taken on mountains of debt to maintain employment, sustain incomes and to take advantage of the very low interest rates to buy assets, particularly property. In New Zealand household debt was $14b in 1985, $135b in 2008 and $211b today. Increases in interest rates today, would apply to a far greater pool of household debt, and therefore affect consumer spending in a far greater way than it would have in earlier years. This significantly increases the power of the RBNZ (through the level of interest rates) to impact the wider economy. It also suggests that even modest lifts in interest rates could cripple many households, reducing the chances that this will be allowed to occur.

The situation is no better in many other western nations. In Australia for example, household debt in 2008 was $1.1 trillion whereas it is $2.5 trillion today. The Australian economy is now in effect held hostage by the mortgage market.

Shares will remain attractive to investors

It is very difficult for many of us to get high-interest rates out of our investing mindset. Yet when the level of global debt is analysed, it really does suggest that the upside risk to interest rates is limited, relative to our recent memories. That also suggests that we all have to re-engineer our businesses and lifestyle for this new paradigm. It also means that shares will ultimately remain a core part of investors portfolios long into retirement. Living entirely off interest from term deposits and government bonds is a strategy most likely destined for the distant memory just like 20% mortgage rates. You can all thank households' appetite for ever increasing mortgages for that.

 

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