Friday, 23 May 2014

Asset Prices Can Go Up For A Very Long Time But It Can't Go On Forever

The rise in asset prices in Malaysia for the last six years has benefited many while impacting others negatively. For those who own property and invest in the stock market, the run-up in property and stock values have certainly increased their net worth.

However, if you ask people who are just starting our in their careers, tenants who rent instead of owning their homes and the low income group, the rise in asset prices has been a burden, a heavy one for some.

With the benefit of hindsight, I am now extremely grateful to have graduated in 1998, right in the middle of the biggest financial crisis Malaysia ever faced. Although some of us had difficulty finding jobs, eventually all found work and within a few years could afford to buy our own homes.

Those graduating in the last two years would find it easier to get a job but owning a home is another matter. I am not sure whether they can afford to buy a middle class property within a comfortable distance to their workplace, and if they could, it would be with maximum loan and definitely not a freehold landed property.

The rise in asset prices has been fuelled mainly by a huge increase in liquidity and lower lending rates. Awash with liquidity from the Fed's never ending quantitative easing policy, financial institutions, corporations and high net worth individuals globally had to find ways to invest the money.

Keeping it in the bank is useless as risk free returns are almost zero. Since money can now be moved globally fairly quickly and need some place to go, assets in emerging markets have been the main beneficiary.

The other contributing factor is cost of funds, i.e. low interest rates.  But low rates have been the norm for quite some time after the 1998 financial crisis  The overnight policy rate (OPR) set by BNM was surprisingly stable over the last ten years if you look at the chart below. 

 
In view of this, I believe that asset price inflation in Malaysia has actually been driven by gradually lower rates banks provide to customers.

In 2001, I took an Islamic financing, with a profit rate of 7.75%.  A few years later I refinanced the debt and they charged me only BFR+0. Later, my wife bought a property at BFR - 1.65%.  Finally three years ago I financed another property and they gave me BFR - 2.3%! 

The table below shows that BLR (which the BFR is based on) was quite stable after 1998.


This clearly indicates that the main factor fuelling the asset price boom is the gradually lower rates that banks give to customers. Low rates means that they have excess liquidity and their cost of funds are very low. But what happens if the banks' cost of fund rises? Will their margins be squeezed? Will NPL's rise? 

Although this may not be an issue right now as the financial authorities in the US and Malaysia are reluctant to raise rates, problems may arise in the not too distant future.

One variable that that may force a rate increase is inflation. Easy money drives inflation, not only in asset prices but for goods and services. I think we are beginning to see the effects now, although the situation is still under control. This may prompt BNM to raise rates.

The other worry is excessive risk taking, especially on unproductive activities. Easy money encourages people to speculate in the property and stock market, as opposed to investing in real value producing activities. We are seeing more and more of this now. While speculation drives asset prices up, problems may arise if money is no longer available cheaply.

Long term increase in asset prices may or may not result in a bubble and the eventual bursting of the bubble. While I feel that property and stocks may be overpriced right now, I don't think we are actually in bubble territory.

A better outcome than a crash would be a moderate asset price deflation and stabilisation in an environment of continued economic growth. However based on past record, the tendency is for prices to overshoot at the top and later come down drastically.

If you own properties or  invest in the stock market, how do you monitor the situation?  A simple way to gauge price levels is to look at yields. For the stock market, you can monitor earnings yield and dividend yield while for property, look at rental yields.

Usually when yields become too low, we have a situation where the asset prices have become expensive. Personally for me, I would start to get really worried when most major companies in the stock market are trading at earnings yield below 5% and and/or dividend yield below 3%. For properties, if yields for middle class and luxury apartments fall below 3%, then I would be concerned.

The other factor to consider is interest rates. When rates are kept low, price of assets may stay at elevated levels as people may not like the alternative of keeping money in the bank. However, when rates start to go up, then investors consider switching from risky assets to almost risk free savings. Then things may get interesting.

While I don't think we will encounter serious issues this year barring an external shock, we could face problems within the next one to three years if asset prices continue to rise without a corresponding increase in earnings or rent.

Note:
Earnings yield = earnings per share / share price
Dividend yield =  dividend per share / share price
Rental yield =  net rent / property value
BLR/BFR - Base lending/financing rate
NPL - Non-performing loans

Earnings yield is the opposite of P/E ratio, i.e. E/P. If you already own the stock or property, the yield you get is calculated based on your purchase price. However, when calculating the current yield, we should use the current share price or the current property value.

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