Which countries are most vulnerable to higher interest rates

Consumers and housing markets in certain small, open economies will be acutely sensitive to higher rates, or even the prospect of hikes, due to high levels of household debt and slowing wage growth. This could limit the interest-rate hikes that these countries can bear, which we believe creates opportunities in the countries’ bonds.

Key points
Small, open economies that were not at the epicentre of either the global financial crisis or eurozone sovereign crisis have seen a sharp rise in household debt over the last decade. Like everywhere else, they have also experienced a slowdown in wage growth.
That increases the sensitivity of consumers and the housing market to interest-rate hikes, which is likely to limit how far those countries’ central banks can raise rates unless wage growth starts to lift.
In contrast, many of the economies at the heart of the two major crises of the past decade have seen significant household deleveraging.

The market is pricing similar amounts of monetary policy tightening across developed economies over the next couple of years — despite countries facing very different issues. Some small, open economies — notably Norway, Sweden, Canada, New Zealand and Australia — are potentially more vulnerable to higher interest rates due to high levels of household debt and slowing wage growth. This could limit the interest-rate hikes that these countries can bear.

The five countries mentioned have one major factor in common — their central banks cut rates aggressively over the past decade, adopting emergency monetary policy despite not being at the epicentre of either the global financial or eurozone sovereign crises. With no brakes to slow the flow of credit, household debt has risen sharply in response to low rates at a time when other developed markets consumers have been deleveraging. As a result, real property prices have risen by more in these economies since the global financial crisis, and housing valuations are more elevated relative to income and rents, than anywhere else in the OECD.

FIGURE 1
Real house prices growth (percentage change 2008 – 2016)

Debt servicing close to pre-crisis highs
Because households in these countries borrowed a lot more in the decade since the financial crisis, their debt service ratios (interest and capital payments on debt as a percentage of income) have not fallen much below their pre-crisis highs, despite some of the lowest policy rates on record. The implication is that rates would not have to rise by much to lift debt service ratios back to their pre-crisis highs.

FIGURE 2
Household debt as a percentage of income

Wage growth has slowed
Moreover, looking just at the ability of households to service their debt understates how sensitive consumers in these countries are likely to be to interest-rate rises because it does not take into account the slowdown in wage growth since the financial crisis. Rising incomes make debt more manageable over time, so the fall in wage growth since 2008 means a higher average debt service ratio over the life of a mortgage (we look at mortgages since they represent the vast majority of household debt in these economies).

Wages have decelerated particularly sharply in commodity-producing countries such as Australia, Canada and Norway, where a negative terms-of-trade shock in recent years has impacted national income and weighed further on salaries.

Taking that into account, it would take an even smaller increase in rates to lift average debt ratios back to the highs reached before 2008. In some cases, wages have fallen and household debt has increased so much since 2008 that the average debt service ratio over the life of a 20-year mortgage is already above previous peaks.

In contrast, in countries where households have been deleveraging, such as the US, there is scope for rates to rise further before reaching those highs.

Implications for investors
The implications of these countries’ vulnerability to higher rates include:

Consumers and housing markets in these small, open economies will be acutely sensitive to higher rates, or even the prospect of hikes. We have already seen house prices soften recently in Sweden, Norway and Australia.
Wage growth is crucial. If it returns to pre-crisis norms, for example, it would significantly increase the scope for rate hikes in these economies. However, continued slow wage growth will limit the size of the rate cycle. Short-dated rates in these economies are likely to be more pinned than others until wage growth starts to lift.
The large household debt imbalances in these economies put them at greater risk of a housing crisis. That risk seems low at present — housing crises are rare when growth is so strong and unemployment so low. However, the risk would rise if their central banks started to raise rates before there is a rise in wage growth, perhaps in response to a commodity price shock.
Reflecting the potential constraint on rate rises in the five economies, we favour owning the bonds of these countries, at least until labour costs show signs of accelerating.