As more and more people get vaccinated and infection rates come down, most businesses can expect to grow again. And vigorously for that matter: a lot of things we could not possibly buy for money during lockdown will become available one after the other, with shops and restaurants reopening, leisure travel resuming and Crocs being changed for stilettos and brogues as we step out into the daylight.
Economists talk of “pent up” demand, meaning we have all saved up for this moment when we can finally start to spend again with abandon, and trade and industry are readying to make profits. This means, as I have pointed out in my previous column, that consumers and purchasing managers will be less deterred by rising prices and perhaps willing to accommodate a more pronounced inflationary spike.
This has started to worry bond investors for quite a few weeks now. Inflation-sensitive, fixed-rate bonds are sold off hectically, causing long-term interest rates to rise more quickly than could have been anticipated. To add insult to injury, the big central banks, like the US Federal Reserve, do not seem to care, expressing the need to support labour markets rather than fighting the first blossoms of inflation.
We do not know how long central banks can maintain such a blasé approach towards a growing change in market sentiment. But a majority of investors seem to expect a benevolent shift from ‘growth stocks’to ‘value stocks’. The talk is about a ‘rotation’ from companies like delivery services provider Ocado, home trainer manufacturer Peloton or video-conferencing provider Zoom, which had so handsomely profited from our lockdowns, towards firms that have remained cheap because their business had stagnated. Re the latter, think of discretionary consumer goods makers, materials companies, capital goods, car makers, or the travel and hospitality sector.
A set of companies will be negatively affected by rising interest rates ‒ those that have grown fast in both their turnover and market capitalisation with the promise of future financial success, without earning much or any money today. Usually, money earned in the future is worth less than money today, as the accumulative effect of interest rates make present cash more valuable.
With interest rates at or below zero there is not much difference between money today and money tomorrow, as long as it arrives, that is. Rising interest rates will alter the picture. Why should we bank on Uber’s or Tesla’s hoped for profits in the future, when such profits have a heavily discounted present value and will possibly suffer from inflation?
This broad investor consensus of a return to stocks that can be evaluated on their profitability, have a positive cash flow and pay dividends, make a lot of sense; the groupings and generalisations that come with it less so. When we talk about ‘tech’ stocks, we group companies which are hard to compare and have not much in common. I cannot quite understand how cash cows like Goggle, Amazon or Apple can be peers of the umpteenth payment provider fighting it out with Visa, or with a start-up cloud service, when all that counts is the investment made by the incumbents.
It is a myth that banks, even the most pedestrian, live from the difference between borrowing at short-term rates and lending long-term
The most salient example is banks. For weeks, a ‘rotation’ into banking stocks was eagerly predicted and can be observed now as banking indexes start to outperform the broader market. The reasoning is as simple as it is questionable.
If the economy is growing, so will the services that banks provide: more growth, more customers and hence more profits. These profits will be boosted by widening lending margins. As banks borrow short term and lend long term, the difference they pocket will grow, as long-term interests will rise dynamically and short-term interest rates will be kept low by central banks which increasingly and explicitly care little about inflation. This iron logic seems to cover all banks, independent from their geography, business acumen or profile of work, essentially putting Goldman Sachs and BOV in the same boat.
It would certainly be more instructive to talk about the hoped-for advance of traditional banks as many finance houses covering brokerage, mergers and acquisitions, asset management, security and currency trading, or private equity have anyhow made a killing in 2020, lifting even always-too-late-to-the-party goers like Deutsche Bank.
So what about the banks that engage in more traditional business, like mortgage lending, credit card business, retail banking and such? I think the picture is hazier than rotation pundits make us believe.
To begin with, it is a myth that banks, even the most pedestrian, live from the difference between borrowing at short-term rates and lending long-term these days. Most commercial credit is at best medium-term and has floating rates, which make the yield curve not that relevant. The European Central Bank is willing to generously subsidise bank lending, but most banks decline the offer. A dearth of lending possibilities, imagined or real, will not disappear with rising interest rates. Nor will expensive saving deposits. Contrary to common belief, what will suffer are the ‘risk free’ long-term government bonds sitting on the banks’ books in lieu of lending.
Universal banks extending credit card overdrafts must have experienced quite some profit dents lately, hardly to be mended by rising interest rate differentials. As we have used our government-financed lockdowns to save more, we first of all started to pay off our credit card arrears. Card loans are priced to the maximum, with no visible link to prevailing interest rates, hence no upside for the bank when interest rates tick higher.
We go into the red because we are always on the brink of disaster, not because interest rates were so low. As we dig ourselves a little bit out of our debt hole over the last months, banks will have to be content with reduced income.
Traditional mortgage lending cannot have fared much better. Commercial property is hit by dormant offices and closed shops, resulting in payment arrears, which extend to residential property too. Much commercial space will have been destroyed for the long term. Banks seem to have coped well so far and even talk about undoing some urgently arranged bad load provisions to return them to shareholders as dividends.
But imagine what will happen with a bank’s mortgage book if interest rates would indeed rise substantially over longer periods. Real estate, an asset class defined by its yield, is a mirror image of the bond market. When interest rates rise, prices will come down. Property rents will go up while real estate values will nosedive.
In such a scenario, bank collateral will quickly lose its value, perforating balance sheets, forcing a lending stop and triggering foreclosures. Mortgage customers like developers, buy-to-let landlords and construction companies will struggle to service their debt and falter. This is not only a threat to overleveraged Maltese builders and our banks, but to the financial system at large. Hello and welcome rising interest rates? Banks and banking investors should beware what they wish for.
The purpose of this column is to broaden readers’ general financial knowledge and it should not be interpreted as presenting investment advice, or advice on the buying and selling of financial products.
andreas.weitzer@timesofmalta.com
Andreas Weitzer, Independent journalist based in Malta