Tuesday, March 01, 2016

Negative interest rates, skyrocketing asset prices!

This is a continuation of the previous post.

Inflation had always been around, so the nominal zero that we saw was never really zero. Inflation of 3% meant that money depreciated value 3% every year, we just didn't see it so we think it's not there. When inflation is 3% and interest rate is 2%, effectively money in the bank is still being burnt. After the Global Financial Crisis (GFC), nominal interest rate became zero, but inflation was around 1% and hence real rate was already negative. But unfortunately our primitive human minds can only think in nominal terms, not real terms. Hence in the long history of financial markets, nominal interest rate  (ie the one that we have been talking all this while, which is the one always quoted on TV and news) didn't need to go subzero since inflation was always positive.

But now that inflation is negative, things are really different, and actually also dangerous. It might make sense for interest rate to go negative. In real terms, we will still be fine though. In negative inflation or deflation, money now appreciates in value, so negative interest rates serve to stop that appreciation which is not normal and actually harmful.

Banana money issued in Singapore during WWII

You see, deflation is a silent killer. It is not as dramatic as hyperinflation when money becomes worthless like how Singapore's own history with banana money showed (pic above). Banana money notes worth $10 might be just $5 a few months later and then dropped to $3 after a year or two. By the end of the war it was not even justified to be used as toilet paper. There was a famous anecdote told by our late founding father Mr Lee Kuan Yew that when he received his salary in banana money, he simply bought anything he could because the money would be worth much less very quickly. So he quickly bought stuff like a billiard table, machines and what not even when he had not much use for them. It turned out to be an important strategy.

When the next global financial crisis hits, it might be worthwhile to learn this because fiat currency and investment assets could become worthless as the global financial system comes to a halt. It would be vital to own hard assets that are useful for sustaining life: land, livestocks, electric vehicle, solar panel and power generator etc. Well, that's story for another day.

The topic of the day is not inflation but deflation.

Deflation, as alluded to in the previous post, causes a different set of problems. First prices to decline, that's by definition. This procrastinates consumption, slows innovation and brings economic growth to a standstill, which exacerbates further price declines. It creates a vicious cycle and leaves the economy in stagnation. It's a slow death process that could trap an economy indefinitely. Again, we have go back to the Ant-Man analogy. It really feels pretty much like being trapped in the subatomic quantum realm.

Quantum realm, or rather, the black hole from Interstellar

Economic theory tells us that interest rate is the key lever to pull to regulate the economy. Inflation is one of the results that we see, the others being employment and growth. In an economy that is growing well, inflation is usually at around 2%. Interest rates could be around 2-3% to be moved up and down accordingly. If the economy is weak, interest rate should be lowered to stimulate growth and vice versa to prevent overheating. However, conventional wisdom put a limit on this powerful interest rate lever. Interest rate cannot go below zero. When the Global Financial Crisis (GFC) happened, interest rates were lowered to zero. But it wasn't enough. Now that China is at the risk of imploding, coupled with the world slowing drastically, the global central bankers are at their wits end.

Drastic times calls for drastic measures. In order to stimulate the global economy which is not growing and having negative inflation, a few countries started with negative interest rates. If zero interest rate is not enough to get people to borrow money, then we pay them to borrow money! In theory, this should work if it's not prolonged. People would wake up, work harder, come up with ideas, create new businesses which would require capital, borrow money, increase consumption, innovate and in no time, the economy is up and running again.

Unfortunately, reality works differently.

If money being deposited into the bank costs money rather than earning interest and if lending to people means I have to pay the borrowers instead of them paying me, then I better do something else with my money. What will happen is asset inflation. For quality assets, it would be massive asset inflation, perhaps even hyper inflation. The most accessible hard asset for most people is property. So negative interest rates also mean that property prices will skyrocket. This has important implications for Singapore's property market.

Stylized chart of Singapore Property Price vs Value

The chart above shows how Singapore property price and value had move over the past 10 years. Essentially prices nearly doubled from 2005 to 2008 but collapsed as a result of the GFC but went on to more than double, peaking at 220% of 2005 prices in 2013. The red line shows my estimation of the true value of Singapore's property. Recall that in value investing doctrine, we buy when price is less than value. Unfortunately, this only happened once in the last 10 years for Singapore property. This was in 2009 when the blue line i.e. price dipped below my estimation of value which is the red line. Well, we might get a chance in 2016 and 2017 if the world hadn't gone into negative interest rates.

In the following chart we try to understand what happens to value and ultimately price in the negative interest rate environment or NIRE. This has nothing to do with basketball shoes. Here we show prices in blue (price) and red (value) again, essentially the same data points from the previous chart but we also added a purple line.


Stylized chart of Singapore Property Price vs Value in NIRE

In the red value curve, I assumed that Singapore property value grew at 4-10% over the past 10 years. (4% growth during the lean years and 10% for the boom years) and should grow around 4% until 2020. Singapore is a mature economy and hence growth at 4% would roughly mirror GDP growth which is fair. This is just simple compounding at work and we see that in 2020, Singapore property value should be around 2.5x of what it was in 2005. In the graph, it reads about 250 on the y-axis. This means that if property prices remain where it is today until 2020, value gets to be higher than price and we would be able to buy Singapore property soon!

Alas, with the reality of NIRE hitting us (NIRE again stands for negative interest rate environment and has nothing to do with basketball shoes), what is likely to happen is that global money will start chasing high quality assets as discussed in the first half of this article. Singapore property is at the forefront of high quality assets. Global rich started buying Singapore around 2005 which caused prices to skyrocket as we had seen. Billionaires from all over the world starting to buy up bungalows. District 9, 10, 11 properties are already used for money parking of rich Chinese, Indians and Indonesians. This is going to further exacerbate.

This is depicted in the purple line in the same chart. While the red line shows a pedestrian growth in value mirroring GDP growth, negative interest rates know no bounds. We know that property value doubles when rental yield drops by half. Now that yield can go negative, it could only mean value can only skyrocket! In the chart, I arbitrary computed that value could shoot up to 600 by 2020 (vs only 250 for the red line).

To put this into better context, let's use some real numbers. In the past, say a good property in a good location (i.e. District 9, 10, 11) have provide a monthly rental income of S$4,000. This comes up to around S$40,000 a year after subtracting the peripheral costs. A property, valued at 4% rental yield means that its value should be S$1,000,000. As global interest rates fell, some of these good properties are being valued at 2% rental yield, which mean S$2,000,000, which is roughly what it is today.  This was more or less what happened with the Singapore property market over the past decade. Then the government stepped in to cool it down, some rationality prevailed and prices finally started falling in 2014 and 2015.

With negative interest rates, it means that money being put in the bank would lose value. The banks will be charging 1% for funds park there. These rich people having 10 million dollars in the bank will not be happy paying that bank $100,000 every year. They will be happy to buy Singapore property at 1% yield or even 0.5% yield. At 1% yield means the same property we talked about is worth S$4,000,000 and at 0.5% it is worth S$8,000,000. We may see Sky Habitat selling at $3,000 psf some day. This is the reality facing us.

Can this prediction be wrong? Of course, and actually it shouldn't be viewed as a prediction.

Nothing is ever cast in stone. The future is always a set of probabilities ascribed to a few scenarios. This could be one future reality. Its probability of actually happening gets higher if more central banks adopt negative interest rates. The big swing factor being the US Fed. There is always the alternative reality that the world finds its growth trajectory again, we move away from NIRE *Phew* and we get one chance to achieve the Singapore 5C dream again!

Let's hope that's the future waiting for us.
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