In a low interest rate environment and when there is a net inflow of capital, some investors may easily develop a bullish sentiment. Many might expect asset prices (e.g. stock prices) to keep going up.
If you are one such investor, under such circumstances, you may be tempted to shift money from deposits in banks to the equity market or other assets such as properties. However, you should not just ride on the bandwagon and be carried away by seemingly attractive returns because no investment is risk free. You have to be mindful of the downside risks, in particular the risks associated with interest rate hikes and capital outflow.
Risks of reversal of low interest rate and capital inflow
In the aftermath of the global financial crisis at the end of 2008, the highly accommodative monetary policy adopted by the US and other major economies in Europe have led to low interest rates and abundant liquidity looking for investment opportunities all over the world. There have been inflows of funds into asset markets in Asia. As for Hong Kong, the net fund flows into the Hong Kong dollar reached HK$640 billion between the fourth quarter of 2008 and the end of 2009. Recently, more aggressive monetary easing in advanced economies, particularly with the announcement of the third round of quantitative easing (QE3) by the US Federal Reserve in September 2012, has further increased global liquidity and triggered a new round of fund flows into the Asian markets, including Hong Kong which saw a net inflow of HK$107 billion during the fourth quarter of 2012. By the end of 2012, the major Asian stock markets rebounded from their levels at end-2011 (Note). Despite the fact that the GDP growth in Hong Kong was only 1.4% in 2012, the Hang Seng Index rose 23%, outperforming most major markets. In such an environment, the risks associated with an "asset bubble" have been building up.
Under Hong Kong's Linked Exchange Rate System, the local interest rates broadly follow the US rates. As the Fed deploys quantitative easing to help revive the US economy, the federal funds target rate, an important benchmark in financial markets, has been set at near zero (0-0.25%) level since late 2008. Accordingly, Hong Kong's interest rates have followed the same downward trend, with the base rate maintaining at 0.5% during the same period.
However, historical data show that both the federal funds target rate and the base rate in Hong Kong underwent cyclical movements. For example, the US federal funds target rate experienced an upward cycle, reaching a peak of 5.25% in the period of mid 2004 to September 2007 before a downward trend. The base rate of Hong Kong moved in line with the US federal funds target rate, peaking at 6.75% in 2007.
Interest rate movements and capital flow are not predictable, and depend on a wide range of macroeconomic and market factors. Apart from the monetary policies of countries around the world, the rate of inflation, the unemployment rate in major economies and the global economic situation, as well as market sentiment, are some of the other risk factors. Such factors may trigger a reversal of the low interest rate trend and capital inflow. For instance, a sudden rise in inflation or decline in unemployment rate may cause an unanticipated increase in the interest rates by the US Fed. On the other hand, any sudden deterioration in the situation in local and overseas markets, such as the US and European debt problems and economic slowdown in China and other emerging markets, may affect market confidence and cause capital outflow. While capital inflow may cause surging stock and asset prices, capital outflow may cause corrections in stock and asset prices. The magnitudes of these corrections can be very high if such outflows are unexpected.
Changes in interest rates and capital flows can have a significant impact on the economy at large and different kinds of investments in particular, because they affect the cost of financing and investor sentiment.
A successful investor is one who is engaged and monitors risk factors that may affect them. Investors should stay alert to the risks of asset price adjustment and their possible impacts on your investments such as stocks, bonds, bond funds and properties.
A rise in interest rates increases the cost of borrowing and is normally not conducive to a growing business environment. This may affect economic activities and a company's earnings. In an adverse scenario, the lower earnings and cash flows can impact on a company's share price and valuation. On the other hand, an interest rate surge may trigger some fund managers to adjust the asset allocation in their investment portfolios if the risk-return tradeoff becomes less favourable for holding stocks. Under such circumstances, shifting from stocks to the less risky investments such as Treasury bills and bonds may cause corrections in the stock market.
Generally speaking, the prices of a fixed rate bond move in the opposite direction of interest rates. If the interest rate rises, the price of a fixed rate bond will normally drop. That means if you want to sell your bond before it matures, you may get less than your purchase price. Moreover, you should be aware that bonds with higher duration are more sensitive to fluctuation of interest rates than those with lower duration.
Duration measures the sensitivity of a bond's price to a one percentage change in interest rate. Time to maturity is one of the factors that affects a bond's duration. The longer the maturity, the higher is the duration in general. For example, if two bonds with similar investment grade and coupon rate, the one with longer maturity has higher duration and is more sensitive to the interest rate changes. Coupon rate or yield is another factor that affects a bond's duration. A bond that pays high coupon rate or offers high yield tends to have lower duration. Therefore you should pay attention to the risk associated with the duration of a bond.
Default/ credit risk is another key risk associated with bond investing. Bondholders will suffer losses if the bond issuer fails to pay the interest or principal as scheduled. Investors should be aware of the credit risk and monitor factors such as the issuer's financial situation as well as any adverse changes in the economic and business environment that may affect the repayment ability of the bond issuers.
A bond fund holds different bonds as the key assets in its portfolio. So it is subject to the interest rate risk and duration risk and can only partially diversify these risks. A bond fund with a concentration of longer-term bonds has higher duration risks and is more sensitive to interest rate changes. For example, a bond fund with 10-year duration will decrease in value by 10% if interest rate rises by 1%. A bond fund is subject to credit risk too. The value of a bond fund will be adversely affected if any of the bonds it holds are default.
Changes in interest rates directly affect your cost of borrowing. For instance, if your mortgage loan is charged a floating interest rate linked to the best lending rates offered by your bank or the Hong Kong Inter-bank Offered Rate (HIBOR), an increase of the best lending rates or HIBOR will increase your interest payments. The cost of investing in a property will increase accordingly. That may have an adverse impact on the property prices.
Stay vigilant to macroeconomic changes
The macroeconomic risk factors are inter-related rather than exist independently. You should always stay vigilant to any changes in the big picture and manage the risks of your investment carefully.
For example, you might consider such strategies as deleveraging and diversifying your assets in order to be prepared for the possibility of future interest rate hikes and capital outflow.
Note: Please refer to the SFC's research paper "A review of the global and local securities markets in 2012" for more details.