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Get Ready For Higher Interest Rates

If the Australian Dream is home ownership, then surely the Australian Obsession must be property prices and interest rates.

Nothing is more certain to stop a barbeque than the latest price survey, interest rate forecast or the latest sale price in the street.

And for good reason. We’ve written before about overpriced (by more than half!) housing in Australia, and the coming housing hangover. In that context, who wouldn’t be at least a little nervous?

Mortgage Repayments On The Rise

Easy credit and a penchant for debt, plus a dose of restrictive land management practices by some state governments (yes, I’m looking at you NSW) fuelled spiralling house prices. Average mortgage repayments have risen from around 21% of income in 1997, to be on the wrong side of 35% by last year, according to ANZ. For those of you in NSW, that percentage is now well above 40%.

If that wasn’t bad enough, interest rates were lower at the end of 2010 than at the end of 1997. You can see what will happen when rates continue their upward march…

The Recession You Have When You’re Not Having a Recession

Against that near-certain reality, Australians have had the good fortune to have a Claytons recession (for those of you not old enough to remember Claytons, it was billed as ‘the drink you have when you’re not having a drink’).

We’ve seen the US banking crisis that precipitated the worst recession in many generations, the European Union stretched by near-defaults in Greece and Ireland, and US unemployment numbers with a 9 in front of them.

For much of the rest of the world, the past three years have been a pretty torrid time – not that you’d know it living in Australia. The mining boom continues apace (maybe another bubble, but that’s a discussion for a different day), unemployment remains low, and while parts of the economy appear sluggish, our problems are pretty small compared to almost anywhere else in the developed world.

Watch and Learn

Our ‘Claytons recession’ has allowed us to see the pain across the globe without feeling it ourselves. As a result, we’ve become more frugal; saving more, cutting down on personal debt (such as credit cards) and spending less – just ask the retailers who seem perennially on sale these days.

Fortuitously, we’ve been able to learn our lessons by proxy, and many have – to use some economic jargon – de-risked their economic situation by de-leveraging – reducing the proportion of their assets and lifestyle funded by debt.

Undoubtedly good news, but deleveraging and a new frugality won’t be enough to stop rates rising.

The Only Way Is Up

With recovering economic growth, once-in-a-lifetime terms of trade (the relative prices of exports compared to imports) and essentially full employment, the Australian economy will be operating at its limits in the coming few years.

As sure as night follows day, there’s no surer recipe for inflation. When economic inputs like raw materials and labour become scarce, it’s a seller’s market. Any rational seller will respond by demanding the highest price they can get – and inflation is the result.

The Reserve Bank have the task of keeping inflation in check, and interest rates are the Bank’s weapon of choice. If you’re a homeowner with a mortgage (or an investor with an investment loan), rising interest rates will be painful. Many have extended their borrowings as a result of sustained low rates (in part fuelling the growth in house prices) rather than enjoying lower repayments on the original loan balances.

Margins Under Pressure

If you’re a Coca-Cola Amatil (ASX: CCL) or Goodman Fielder (ASX: GFF) shareholder, you’ll be very aware of the other impacts of inflation – rising input costs. Both companies’ management have recently blamed rising input costs for putting margins under pressure. As demand for resources increases faster than supply, higher prices are the result.

For companies that have a high exposure to global commodities – such as sugar and wheat respectively – rising commodity prices are hard to negotiate away.

Unless these companies can increase prices at a rate that keeps up with their costs, profitability is at risk. Not only that, but retailers such as Woolworths (ASX: WOW) and Wesfarmers (ASX: WES) owned Coles are notoriously reluctant to accept price increases.

These impacts aren’t contained to the grocery sector either. If you’re a ‘price taker’, you’re at the mercy of local or global prices. Companies who are price takers are often in commodity businesses, with little differentiation. ‘Price makers’, on the other hand, often have more influence over their pricing and tend to sell products that have a point of differentiation from their competition. For example, steel makers tend to be in the former camp, while luxury car makers can often be in the latter group.

Oh, and if there’s significant debt involved, you can add that to the margin pressure for a double whammy.

Foolish Out-take

As an investor, no matter what you’re invested in, you need to understand the impact that both inflation and rising interest rates will have on your investment. No matter what the asset, investing in a ‘price maker’ will leave you much better equipped to withstand the attacks from both sides. Price takers may not be so lucky.

Of the companies mentioned above, Scott Phillips owns shares in Woolworths and Coca-Cola Amatil. The Motley Fool has an inflation-free disclosure policy.

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