THE current conventional thinking is that the US’ improving economy, coupled with falling unemployment, will cause wages and prices to rise. Along with that, domestic consumption and investment should grow. Consequently, bond yields and interest rates will also rise due to both policy decision and market forces.

Higher interest rates in the US will then cause the US dollar to appreciate as funds flow back to the US. Global interest rates will follow suit as countries manage their exchange rates, and to keep their real interest rates in positive territory. As interest rates rise, asset prices, notably properties and equities, will fall. And the impact will be more severe in developing countries, which also has the added negative effect of countering fund outflows.

This scenario is very logical. However, we think this chain of events will be broken, or at least delayed, in this cycle.

Here are some of our reasons:

1. Last week, we presented the facts that the velocity of money has fallen sharply. In a financial crisis triggered by excessive debts, such as in 2008, rising money supply does not quickly cause a rise in nominal GDP growth. Indebted consumers and firms must first repair their balance sheet before they consume and invest. And it explains why there is a long lag effect on investments even as interest rates are kept near zero, due to the absence of higher demand.

2. Demography (an ageing population), technology and global supply chain changes that cause greater income inequality also result in a breakdown in the relationship between employment and consumption.

3. Last week, we highlighted the beginning of the competitive currency devaluation trend with Japan thrashing its yen. Europe has clearly indicated its intent to bring down the euro to fight against deflationary pressures. Others surely will also follow suit, especially large exporters like South Korea. The USD will rise, even in the absence of any increase in its domestic interest rates (see Chart 1). The rise in the USD could be further accelerated if funds begin to unwind their USD carry trades.

4. The rising USD is inherently deflationary, driving down commodity prices — at least in USD terms. This will drive down price levels, and reduce inflationary pressures and the need to raise nominal interest rates. The prices of crude oil and other commodities have plunged in recent months, and this will reduce the input cost of many products.  (See Chart 2)

5. Highly leveraged governments and households will make it difficult for countries to raise nominal interest rates.

6. Finally, the rise in the USD will negatively impact US exports, which will further delay a rise in interest rates.

Monetising public debts

A longer term challenge faced by many countries is the rising level of government debt. Japan is one end of the extreme, where government debt is 250% of GDP.

Cutting government spending or raising taxes is always politically difficult. If deficit spending is not reined in, it is plausible that some countries will find their non-discretionary spending plus interest expenses greater than revenue at some point in time in the future. In other words, the debt of these countries will implode, where tax revenue cannot even pay off debt servicing costs and committed expenses (see Charts 3 and 4).

The easy solution, especially for countries that borrow primarily in their domestic currency, such as the US, is to monetize their debts. The central bank would buy bonds from banks and investors. Through currency depreciation and negative real interest rates, these countries would be able to reduce their debt burden without painful structural adjustments.

This appears to be precisely what the Bank Of Japan (BOJ) did recently. It committed to expand its assets by 15% of GDP every year. This is twice the size of the government deficit. In other words, it will buy more government bonds than what is necessary to finance the deficit.

Who will it buy from? At the same time as the BOJ announcement, the largest pension fund in Japan decided to sell down its bonds to buy equities. Other private sector holders of Japanese government bonds will inadvertently follow.

What is the consequence of the above actions?

It will increase the ability of the private sector in Japan, especially the pension funds, to lend, and to buy equities to stimulate growth.

Critically, it protects them from potential losses in their portfolio when interest rates are eventually raised, as they diversify more from bonds to equities.  Thrashing the yen also reduces the costs of these debts. Meanwhile, the Japanese pension funds are encouraged to invest abroad to protect against the yen depreciating.

What could investors do?

The hypothesis presented leads us to the following conclusion.

1. Nominal interest rates globally will remain low for now. Interest rates may not increase anytime soon and when it does, it will not be by much.

2. Consequently, there will be a desperate search for yield. This means asset prices are unlikely to fall anytime soon and in fact, could actually see a recovery.

3. For Malaysia, the need to search for higher yield will be even more imperative. Malaysia’s inflation in 2015 will rise as a result of imported inflation (from the weaker ringgit) and implementation of the Goods and Services Tax (GST) regime. It must mean that investors in Malaysia will experience negative real interest rates in terms of bank savings.

How do investors find investments that provide higher yield, and yet are safe?

Among equities, the market is generally not cheap relative to historical averages. Most large-cap stocks are fully valued, and heavily owned by both local and foreign institutional funds. Those with high levels of foreign ownership have the added risk of being sold down if foreign funds start to exit in a big way.

Many of the mid and smaller cap stocks, on the other hand offer much better value with low valuations, decent yields and good balance sheets. Many of these companies have sustainable income streams, sound business models and operate in niche markets with proprietary products.

But identifying good companies in the past has been difficult. There are some 1,000 companies listed on Bursa Malaysia and only a handful of large ones are regularly covered by research houses.

They key is not about buying the market BUT being able to discover stocks. How can you go about beating the overall stock market?

That is why we have introduced The Edge Markets — to help you discover undervalued companies (Please visit www.theedgemarkets.com)

We use a combination of fundamental research by InsiderAsia and The Edge Markets Research and our proprietary algorithm system, powered by Anticipatory Analytics,  which detects a pick-up in trading momentum.

From the above combination of analytics and research, we identify daily stock picks for value investors, stocks with corporate action potential, stocks with momentum as well as red-flagged stocks.

There are also two real portfolios — Tong’s Value Investing Portfolio and Tong’s Momentum Investing Portfolio — which highlight investment strategies and stock picking using different risk appetites. We are happy to note that both portfolios have fared well.

And soon, we will also introduce property analytics to help you in your property investment.

We encourage you to familiarise yourself with The Edge Markets. It has comprehensive data, news and powerful analytics to help you make better investment decisions. And it is completely free!

This article first appeared in The Edge Malaysia Weekly, on November 17 - 23, 2014.

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