LONG-TERM ECONOMIC AND INVESTMENT TRENDS- Using Interest Rates to Assess the Risk of Foreign Investments

The money markets are a very sensitive mechanism making interest rates adjust quickly to small changes in economic growth and in the overall financial environment. Because of this sensitivity, they provide an objective view of the state of the investment environment. As Sydney Homer once said: “Interest rates are the fever chart of any economy”.

Rising interest rates are the result of a strong economy, making investments in stocks a risky proposition. Periods of rising interest rates have been notoriously accompanied by poor market performance. During such times investors have two basic options:
• Have money invested in money market instruments, thus providing a return equal to short-term interest rates.
• Find stock groups that perform unusually well during those periods. This takes lengthy research and requires special tools.

On the other hand, declining interest rates provide investors with confirmation that the economy is slowing down and the stock market again represents a good investment. The relationship and turning points between interest rates and stock prices can best be understood by remembering that equity prices are a leading economic indicator and interest rates are a lagging economic indicator.

Besides their trend, there is another important element about interest rates - that is their level. Since 1955, in the United States, the average level of short-term interest rates has been about 5-6%. The further interest rates have moved away from this range, the more the country was subjected to economic and financial disturbances in various degrees of intensity. In the 1970s short-term interest rates rose to 20%, well above the 5-6% range. As they moved toward this level, the economic cycle became more unstable, inflation increased to higher and higher levels, and the unemployment rate moved to all time highs. The country was clearly confused by social and war issues, and it wasn't clear what was happening. Political and monetary policies were in disarray. Inflation had a negative impact on investments and financial assets, and corporate performance. Clearly, rising interest rates to these levels created poor return for financial assets. The lesson is the higher interest rates rise, the more they indicate unstable economic conditions, poor economic performance, a weak dollar and strong inflationary times.

It is also true that the further interest rates move on the downside, below 5-6%, the more the country's economy is in serious trouble. Growth stagnates, the unemployment rate soars, prices of hard assets decline, deflation becomes a major issue, and corporate performance and earnings deteriorates as business attempts to survive by cutting prices. A decline in interest rates well below 5-6% is an indication that there is poor demand for money because of lack of business opportunities. When interest rates fall close to 2 or 1%, the country experiences not inflation, but deflation. Deflation is that condition whereby business has to cut prices to sell. But of course, the reduction of prices has a negative impact on profitability and profit margins. Therefore, business feels compelled to aggressively cut costs. But cutting costs means laying people off, delaying capacity expansions in order to cut interest rate costs, and reducing inventories. Of course, this is a vicious circle that provides a very negative environment for any type of asset.

Major examples of these periods in the last century were the United States in the 1930s and Japan in the 1990s. During these periods the currencies of the countries that endure this kind of environment are very weak. There is no doubt that a country with 5-6% interest rates has an economy that performs well, with a stable political environment and sound financial markets. The level of interest rates is the stamp of approval or disapproval of the financial markets on the policies followed by Congress, by the Federal Reserve, or by the policymakers of any country.

The behavior of interest rates provides very important clues on the performance of any country. This information is available daily from the financial pages of most newspapers or on the Internet. It is a simple, fast, and powerful way to assess what is happening around the world. The closer interest rates for a given country are to 5-6%, the sounder its economy is, because it reflects economic stability and low inflation. Under these conditions, it is likely the currency is firm, confirming the policies followed by the local policymakers are sound.

However, there is another element that can easily be checked to confirm your conclusions. This element is the level of real interest rates, which is measured as the difference between short-term interest rates and inflation. For instance, if a country has a level of interest rates of 20%, and an inflation of 10%, real interest rates are very high—approximately twice the level of inflation. This indicates that the country is committed to bringing inflation down and monetary policy is conducive to that result.

However, if a country has, for instance, short-term interest rates of 10% but inflation is 15%, real interest rates are too low because they are well below the level of inflation, and the country is not following policies conducive to lower inflation. Actually, they are leading to higher inflation because the interest rates are kept below the inflation level. Only if interest rates would go to 25-30%, would the country have a possibility of bringing inflation down from the current 15%. The weekly publication, The Economist, makes these data readily available in each issue.

Let’s see now how to use the available data to evaluate a country’s risk from an investment viewpoint. Let's say Country A has interest rates of 30% and Country B has interest rates of 15%. The markets are saying that Country B is considerably better than Country A even if both countries have higher interest rates well above the 4%-5% benchmark range. Both countries are not following sound economic and financial policies and provide a high level of risk. Let's also assume that Country A has an inflation rate of 29% and Country B has an inflation rate of 10%. Real interest rates between the two countries are considerably higher in Country B than in Country A. The message is that policymakers of Country B are more determined than those in Country A to bring inflation under control by keeping the price of money more expensive than that of Country A. Country B is a better managed country than Country A, and as a result it should be the country of choice. However, another element comes into the picture, and that is the value of the currencies of Country A and Country B. In fact, since the currency of Country B follows sounder policies, the odds are the currency of Country B is stronger than the currency of Country A. Investing in Country B provides a hedge against your own currency because your investment is denominated in a stronger currency than Country A, and therefore, your investment will appreciate, other things being equal, because of the increase in value of the currency of Country B.

To make things more interesting, let's assume the investor is in Country C where interest rates are close to 4% - 5%, and inflation is close to 2%. Clearly Country C is in much better shape than Country A and Country B, because it has higher real interest rates and interest rates are close to the ideal level. This is the situation of the United States in the 1990s. The odds favor Country C will have a much stronger currency than either Country A or Country B. If the investor is in Country C, where should he invest? If the investor places his money in Country A or Country B, clearly he will see the investment depreciate in terms of the currency of Country C. Even if the investor makes money on his investments in Country A or Country B, he is most likely to lose on the depreciation of the currencies of those countries relative to the currency of Country C.

The lesson here is that investors should place their money first of all in those countries with the strongest currencies. This is the first and foremost guiding principal. This is not an easy decision to make for the average investor, because predicting currencies is a very tricky and difficult business indeed. However, the above examples can provide simple, yet useful, guidelines.

Making foreign investments is not as simple as some may make it sound because there are many decisions to consider: the evaluation of a country, the risk that the country offers, the value of the currency, and the trends of the currency vis a vis the trend of the dollar. And then there is the issue of buying the stocks in that particular foreign country, and we know how difficult it is to buy successful stocks. This is a note of caution for investors that get excited about the possibility of making more money in foreign investments. Quite frankly, this is a very difficult feat.

(From Chapter 5 of my book Profiting in Bull or Bear Markets. Published also in Mandarin and on sale in China. The book is available at Amazon.com).

George Dagnino, PhD Editor,
The Peter Dag Portfolio.
Since 1977
2009 Market Timer of the Year by Timer Digest
Portfolio manager

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