Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 436

The three prices that everyone should worry about

“… is my math basically correct that if there were 100 basis point increase in interest rates, 1% increase in interest rates when we’re looking at a $27 trillion debt, you’re looking at more than a $200 billion a year additional mandatory interest payment … and if you extrapolate that on a 10 year basis … that’d be close to an additional $2 trillion over 10 years of mandatory spending? Is there, Madam Secretary, anything faulty with that analogy or my math?” - Senator Mark Warner September 2021

“I don’t believe there’s anything at all faulty about the math.” - US Treasury Secretary Janet Yellen September 2021

A wise analyst once pointed out that there are three prices that ultimately matter for the world. One is the price of oil. Two is the value of the US dollar. And three is the US 10-year treasury yield. These represent:

  • the price of energy which everyone relies on
  • the price of the world’s reserve currency, and
  • the price of borrowing money.

When these prices rise it acts as a constraint on global growth. When they fall conditions improve. The bad news is that energy prices have been rising. Bond yields have been moving higher but are still relatively well behaved. The US dollar has been trending sideways but is well below its pre-pandemic levels.

It’s not hard to reflect on why these can act as headwinds or tailwinds for growth.

1. Oil

In a world that is furiously trying to de-carbonise and shift its energy sources away from fossil fuels, the fact remains that the world is still massively dependent on carbon-based energy sources.

One doesn’t need to be a seasoned commodity analyst to recognise that oil, in particular, is still the lifeblood flowing through the veins of global production. The graph below taken from the International Energy Agency clearly paints a picture of a strong recovery in energy demand since 2020 and a much more limited response in supply in 2021.

Rising energy prices represent a meaningful cost impost on business and consumers and whilst end prices and wages can eventually adjust, these take time. In short, the move acts as a tax on growth at least initially. We recently saw a study highlighting that the lowest 30% of US Income earners spend approximately 15% of after-tax income on energy (gasoline and heating costs).

Brent crude is up more than 20% in 2 months and at the highest level in 7 years.

Natural gas prices are up more than 80% this year and, granted are off their recent highs, are suggesting a perfect storm for gas dependent regions such as Europe going into winter where low storage levels and dwindling swing supply sources are exacerbating the problem.

Energy prices are flashing red at the moment. They’re not a positive sign of strong demand so much as a function of insufficient supply as the post-COVID opening progresses. Indeed, activity leading indicators continue to soften led by China, reminding us that this is not your garden variety recovery.

2. The big dollar

The value of the US dollar matters because the world is short the currency that it requires to do business. Indeed oil, like other commodities, is transacted in US dollars. In addition, the global stock of debt denominated in USD is gargantuan, continues to grow and so any increase in the USD acts to tighten financial conditions. Emerging markets with current account deficits are particularly vulnerable to a stronger USD but in general the world doesn’t work well with the big dollar surging.

The good news is the US dollar has risen but is still well off the highs of levels in 2018/19. Were the US dollar to start to appreciate, alongside higher commodity prices we would worry even more than we currently do. In fact, the Bloomberg US Dollar Index which measures the US dollars against key currencies is well below its pre-pandemic levels.

3. US 10-year yields

The third price that matters is the yield on the US 10-year treasury bond. It matters because no other interest rate forms the basis of present value discounting models of the world’s assets. No other rate is more significant in setting the benchmark for term funding for the world. The higher it goes, the more vulnerable asset prices become. Moreover, in a world drowning in debt, the higher nominal yields rise, the more nominal income has to rise just to preserve debt serviceability. And of course, the USD is not only the world’s most used currency but the world’s most borrowed-in currency. Just ask central bankers across the emerging world how they feel about a rising USD.

Although yields have adjusted higher, they of course are so far somewhat contained and just below highs seen in Q1 2021. In a longer-term context, they remain low. Where we expect they stay.

The post COVID world is limping out of the pandemic with record levels of debt.  Consider the following:

  • BIS data shows that in 2007 Debt/GDP in all Emerging Economies was 124%. In 1Q 2021 it was 236%.
  • Advanced economy debt/GDP has gone from 242% to 309% over this period.
  • In case you wonder why Europe’s negative interest rates are probably here as long as the European Union remains in existence, France’s debt/GDP has increased from 223% to 371%!
  • Perhaps most worryingly of all, China’s total debt-to-GDP ratio has doubled from ~160% of GDP in 2008 to 322% of GDP by 1Q 2021. The most rapidly growing, reliable source of global growth post GFC did so on a credit binge that is now of course being rapidly reined in.

With interest rates still relatively low, the US 10 year is signaling that all is well for the moment. Your writer found it utterly astonishing recently that the current US Secretary of the Treasury, Janet Yellen, when asked about the surging level of US government debt as part of a testimony to the US Senate responded that it wasn’t a concern given the low level of interest rates.

That sounds remarkably like a sales pitch to a sub-prime mortgage borrower that a short term artificially low teaser rate is a good measure of long-term home loan affordability. If only the US Treasury adopted APRA’s approach of requiring Australian lenders to stress would-be home loan borrowers by adding 3% to the proposed interest rate.

At the moment, markets aren’t buying into the media-driven inflation hyperbole which continues to be dominated by click-bait around shortages here and there which look to be easing slowly. If they were to, we would see expectations for higher interest rates surge which could drive 10-year yields higher and certainly strengthen the US dollar as the likelihood of the Federal Reserve lifting rates aggressively was priced.

A stronger USD driving borrowing costs higher at a time when the world is once again short oil and energy products would be disastrous for the uneven, unconvincing highly indebted post-COVID recovery.

For now, one out of three is manageable.

 

Andrew Canobi is a Director, Fixed Income; Joshua Rout, CFA, is a Portfolio Manager and Research Analyst, Fixed Income; and Chris Siniakov is Managing Director, Fixed Income at Franklin Templeton, a sponsor of Firstlinks. This article is for information purposes only and does not constitute investment or financial product advice. It does not consider the individual circumstances, objectives, financial situation, or needs of any individual.

For more articles and papers from Franklin Templeton and specialist investment managers, please click here.

 

RELATED ARTICLES

Rising bond yields complicate the COVID recovery

Listed infrastructure: finding a port in a storm of rising prices

Inflation: friend or foe of Value stocks in 2022?

banner

Most viewed in recent weeks

A tonic for turbulent times: my nine tips for investing

Investing is often portrayed as unapproachably complex. Can it be distilled into nine tips? An economist with 35 years of experience through numerous market cycles and events has given it a shot.

Rival standard for savings and incomes in retirement

A new standard argues the majority of Australians will never achieve the ASFA 'comfortable' level of retirement savings and it amounts to 'fearmongering' by vested interests. If comfortable is aspirational, so be it.

Dalio v Marks is common sense v uncommon sense

Billionaire fund manager standoff: Ray Dalio thinks investing is common sense and markets are simple, while Howard Marks says complex and convoluted 'second-level' thinking is needed for superior returns.

Welcome to Firstlinks Edition 467

Fund manager reports for last financial year are drifting into client mailboxes, and many of the results are disappointing. With some funds giving back their 2021 gains, why did they not reduce their exposure to hot stocks when faced with rising inflation and rates?

  • 21 July 2022

Welcome to Firstlinks Edition 466 with weekend update

Heard the word, cakeism? As in, 'having your cake and eating it too'. The Reserve Bank wants to simultaneously fight inflation by taking away spending power, while not driving the economy into a recession. If you want to help, stop buying stuff.

  • 14 July 2022

Welcome to Firstlinks Edition 465 with weekend update

Many thanks for the thousands of revealing comments in our survey on retirement experiences. We discuss the full results. And with the ASX200 down 10%, the US S&P500 off 20% and bond prices tanking, each investor faces the new financial year deciding whether to sit, sell or invest more.

  • 7 July 2022

Latest Updates

Economy

The paradox of investment cycles

Now we're captivated by inflation and higher rates but only a year ago, investors were certain of the supremacy of US companies, the benign nature of inflation and the remoteness of tighter monetary policy.

Shares

Reporting Season will show cost control and pricing power

Companies have been slow to update guidance and we have yet to see the impact of inflation expectations in earnings and outlooks. Companies need to insulate costs from inflation while enjoying an uptick in revenue.

Shares

The early signals for August company earnings

Weaker share prices may have already discounted some bad news, but cost inflation is creating wide divergences inside and across sectors. Early results show some companies are strong enough to resist sector falls.

Property

The compelling 20-year flight of SYD into private hands

In 2002, the share price of the company that became Sydney Airport (SYD) hit 80 cents from the $2 IPO price. After 20 years of astute investment driving revenue increases, it sold to private hands for $8.75 in 2022.

Investment strategies

Ethical investing responding to some short-term challenges

There are significant differences in the sector weightings of an ethical fund versus an index, and while this has caused some short-term headwinds recently, the tailwinds are expected to blow over the long term.

Investment strategies

If you are new to investing, avoid these 10 common mistakes

Many new investors make common mistakes while learning about markets. Losses are inevitable. Newbies should read more and develop a long-term focus while avoiding big mistakes and not aiming to be brilliant.

Investment strategies

RMBS today: rising rate-linked income with capital preservation

Lenders use Residential Mortgage-Backed Securities to finance mortgages and RMBS are available to retail investors through fund structures. They come with many layers of protection beyond movements in house prices. 

Sponsors

Alliances

© 2022 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.