Persistent inflation may be here to stay and though interest rates may be close to peaking, the danger is not over yet, as Simon Edelsten explains.
My mother was furious. It was 1977 and my father, who was a BBC lighting designer and not an investment specialist, had bought shares in Peachey Properties – a development company run by the flamboyant Eric Miller.
Miller – the original ‘champagne socialist’, whose lavish lifestyle included spending more than £1.5m in today’s money at Bond Street jeweller Asprey, and nearly as much as a deposit on a private jet – was caught using the business as his own private bank. He also lent money to Fulham football club and as a club director tried to poach Bobby Moore from West Ham, so he was not all bad in my eyes.
My mother did not see it like that, though. As the story broke, Dad’s investment looked decidedly uncertain.
Be wary of transition
Property seems to attract excess. Rising interest rates often expose vulnerabilities and prick the bubble, and in the mid-1970s rates hit double figures for the first time in the UK’s history. They peaked later in the US – in 1981, when the Federal Reserve moved aggressively to tame rampant inflation. The federal funds rate hit a record 22.36% that July, according to data from the St Louis Fed.
We forget the world has often coped with single-digit interest rates. The danger lies in transition. Companies and households that have based their financial plans on much lower rates have difficulty adjusting. They are not alone. Lenders – historically, banks – can be swept up in the damage that often emerges only after rates are ramped.
In the mid-1970s dozens of small UK lending banks faced bankruptcy as property prices plunged in reaction to rising rates – most famously Slater Walker, whose boss, Jim Slater, noted he had become a ‘minus millionaire’. Between 1980 and 1994 in the US, more than 1,600 banks closed or had to be rescued.
I began working in the city in 1984. That year, the grandly titled “Continental Illinois National Bank and Trust Company”, with over $40 billion of assets, failed. It was the largest bank collapse in US history – a record held until the Global Financial Crisis.
When lenders struggle, there is a knock-on effect for industries that rely on credit and find it has suddenly disappeared. In 1984, it was the oil sector which had seen over-investment. It could not cope with the combination of rising interest rates and falling oil prices – especially as oil exploration has a pay-back period from discovery to well depletion of 30 years or more.
We are in this danger zone today. The collapse of SVB bank in the US and Credit Suisse in Europe, along with the ongoing travails at First Republic, are a reminder. But there will be others. Anticipating where and when the next eruption will come is not easy.
Property looks an obvious choice. Commercial property companies often negotiate five-year leases. If they think inflation will average, say, 6% for the next five years, their optimum position when renegotiating is to make the new rate what it would be in five years were it to rise in line with inflation – a 34% hike. This is unlikely to go down well with a tenant facing inflation pressures themselves.
Most managers of major property companies understand this, and the wise ones resist the temptation to borrow too much in the good times. Currently in the UK, debt costs most property companies around 5%-6% and properties are priced on yields of between 3.5% and 4.5%. This does not work. In addition, real estate trusts are facing the after-effects of the pandemic. Working from home and the consequent reduced spending in city centres has affected demand for space in unexpected ways.
This combination of factors has seen property shares sharply lower. For instance, Land Securities shares – £10 before the pandemic – are £6.75* today. European commercial property companies look particularly vulnerable because they have not faced this environment for 15 years. Some property stocks, such as Shaftesbury, which owns much of Covent Garden, will probably bounce back and may even look attractive at 114p – its recent annual report valued assets at 192p per share, following a recent merger.
As for lenders, I own only two banks – in Japan, where depositors are unlikely to move their cash in search of higher rates because they are not available. If inflation proves persistent, interest rates could be allowed to rise modestly there, enabling these banks to make more from lending than has been possible in recent years.
All that glitters is not gold
Investors may think technology companies well-placed to cope with rising rates. The time between inventing a new software app and bringing it to market is often shorter for them than for those developing physical product, but marketing can require heavy cash burn just when the fuel of credit is running low.
Entrepreneurs (and potential private equity funders) are motivated by reward. Floating a company on an exchange like the NASDAQ has been a valuable way of generating that – as well as a source of additional capital.
But valuations today are much lower than they were three years ago. And this affects more than just lenders and founders. Staff like coders may be remunerated in part with stock options. These now look less valuable, just as employees’ monthly mortgage payments are spiking.
We are underweight tech and our preference is for companies like Google, Microsoft, Salesforce and Adobe – mature businesses, not dependent on banks and other lenders.
Biotechnology could face a different squeeze. Rising rates squeeze the public purse. Although we are seeing a dramatic rate of innovation, especially in genetic biology, public health bodies face mounting bills from caring for an ageing population using existing treatments. Money for new cures, especially of rare diseases, may be scarce until proven successful and unless cheaper.
Finally, we should not assume that renewable energy will escape. Investment in any utility requires a long pay back. We assume governments will support this sector but they may be less protective of shareholders if they are perceived as profiting too much from the climate crisis.
More Peachey than peachy
Inflation is starting to fall and the risk of it escalating is now reduced with oil around $78** rather than the $123 it was a year ago. Hopefully that means companies need make more modest adjustments – perhaps preparing for persistent inflation and interest rates between 3% and 4%.
But this is a time to re-check the debt carried by companies in your portfolio. Interest rates may be close to peaking, but the danger is not over yet. The world looks decidedly more Peachey than peachy.
** Source: oilprice.com 28 April 2023