02 Nov What do we do now?

By Ian Robinson

There is a natural sense of decision paralysis when it comes to sudden shifts or changes in environment.  In an extreme sense, any event that is perceived stressful or frightening will trigger the sympathetic nervous system into an acute response of fight or flight.

There is probably a third behavioural response in this cliché – freezing (a deep survival technique to camouflage into the environment so not to be seen by the immanent danger.  It is a response technique that unfortunately fails to bear fruit in financial markets).

In relation to managing debt within a business, flight would be considered consolidation or selling down assets to reduce or payout debt.  This is a sound strategy if the timing in the business cycle suits or there are redundant non-core assets that achieve this outcome.  But for most businesses this is not a strategic direction to achieve long term growth and wealth creation.

Fight, on the other hand is a more hands on response to address the challenge head on.  Restructuring and / or repricing your debt structure can be a formidable approach to managing the cash flow obligation of current debt structures.

Now that the RBA has raised rates again by another 0.25% to a cash rate of 2.85%, this is now pushing the interest rate for commercial and agri borrowers to 5.00%.  If the cost of debt for borrowers was only 2.5% twelve months ago, simple mathematics indicates the cost of borrowing has now doubled in 12 months.  Interest expense on debt increasing by 100% over 12 months far exceeds the annual inflation rate of 7.3% and therefore requires special attention.

 

Action Items for Borrowers: Do’s and Don’ts

The very first initiative to undertake is to ascertain if your interest rate is competitive or reflective of your risk rating.  There is no benchmark other than seek advice from an independent source to run the comparative analysis.  This can be achieved quite quickly and efficiently.

The second is then review your options – and there are several and easy to execute.

One could be as simple as requesting a restructure of the loan facilities into an Interest Only arrangement until the business has realigned the profit drivers back into a regime that can handle principal reductions.

The other is presenting a business case to demonstrate that the credit risk profile has improved and can justify a reduction in client margin on the interest rates.  A recent finance tender for $8.0m saved the client $70k p.a. in interest costs alone.

But we recommend you don’t do the following;

• Make decisions without knowing the full extent of your position and options first.
• Threaten the bank that you will refinance if they don’t drop their rates – this type of behaviour does not add value to a supportive banking relationship.
• Commence negotiating with a bank when you are not financially prepared in your presentation.

 

RSP Forecast

(A full disclosure that this is our forecast and not advice on where markets are heading)

First some background points.

About 40% of home loans are fixed at very attractive low rates.  This means the interest rate increases being applied to the market are only impacting 60% of home loans.  Hence, the RBA must increase rates 1.6 x the normal increase to have the immediate desirable impact on the economy.  The risk of overshooting the rate increases is quite material.

Discretionary spending is correlated to available cash flow.  When these fixed rates roll off during the second quarter 2023 and attract the much higher variable rate next year – available discretionary spending will evaporate.

We are already at full employment – there is only one direction this can go which is to an arena of less than full employment (over time).

 

What Now

RBA will put rates rises on hold to at least Feb 2023 (after they review Christmas retail sales data and quarterly CPI on the 24^th Jan 2023).

There will be renewed pressure to apply further increases in early 2023 based on lagging data but this directive will quickly take an abrupt turn late in 2023 when the impact of maturing fixed loans destroys discretionary spending at a concerning rate.

Here, we believe, the RBA will need to drop rates 3 to 4 times to bring an element of ease and capacity back into the economy.

 

Conclusion

Be flexible, react, adapt, and take action.  Fight or flight but don’t freeze.

Feel free to call anytime to discuss these points of view.