As its decision last month to increase interest rates showed, the South African Reserve Bank (SARB) is in an unenviable position. Despite weak domestic growth and high unemployment, external factors are forcing its hand when it comes to deciding on monetary policy.
As its decision last month to increase interest rates showed, the South African Reserve Bank (SARB) is in an unenviable position. Despite weak domestic growth and high unemployment, external factors are forcing its hand when it comes to deciding on monetary policy.
Traditionally, interest rates are increased to rein in inflation due to the ‘over-heating’ of an economy. There is no danger of that in South Africa.
Instead, the SARB has acted because of concerns around how a weak rand will lead to ‘imported inflation’. The likelihood that the US Federal Reserve will begin raising rates this month only increases that concern.
“The Reserve Bank is mandated to target inflation within a band of 3% to 6%, so from that perspective it has increased rates to curb inflation concerns due to a depreciating rand,” says Leevania Naicker, investment analyst at Sygnia Asset Management. “In effect, when we look at interest rate decisions taken by the Reserve Bank, we have to take the US Federal Reserve’s actions into account as this has a palpable effect on domestic inflation. The fact that the rand appreciated in response to the Fed decision to keep interest rates unchanged in September suggests that some depreciation is likely when US rates are increased.”
To know what to expect in terms of interest rates locally, one therefore has to anticipate what will happen in the US. Given that the economy there is not exactly roaring either, Fed Chair Janet Yellen has indicated that any rate increases will be measured.
“The pace of increases will be gradual because the Fed wouldn’t want to risk the chance of the US slipping back into a recession.” Naicker explains. “Even though jobs data for the last quarter has been very good, there are weak spots like manufacturing activity, so they do need to be careful about raising rates too quickly.”
The consensus is that interest rates will only go up slowly and in small increments, but there will nevertheless be an impact on the markets. As Naicker explains, both bond and equity markets will be affected, although what happens in the former is usually more predictable.
“Bond yields tend to change direction immediately and go up as the first hike comes into the cycle,” Naicker says. “And at the end of the hiking cycle, yields tend to fall immediately.”
As bond yields rise their value decreases, which is bad news for bondholders.
The effect on the stock market is more complicated. Typically, equities are negatively affected as borrowing rates increase but there are many other factors at play.
“As the Fed increases interest rates, investors pull more money back into the US, chasing higher returns,” Naicker explains. “The result could be a withdrawal of some of the capital invested in emerging markets, including South Africa. However, due to the slow rate of increases, we expect a rebound in the markets after an initial shock reaction, followed by a period of stability.”
The overall message is that rising interest rate environments can be tough for investors. Only cash starts to look more attractive as deposit rates go up.
In this environment, investors need to be very cognisant of their time horizon. That will determine how they should be positioning their portfolios.
For investors able to take a long term approach, the most important thing is not to be influenced by short term market movements. If you are thinking about retirement in ten or 20 years’ time, you can afford to weather the storm.
“Over time, equities should out-perform all other asset classes and inflation,” Naicker says. “But investors who focus on short term market fluctuations tend to forfeit returns as they sell their investments when the markets are declining and miss out on the upside when markets recover.”
She adds that when thinking over the long term, it is also vital to consider the impact of inflation.
“Cash might look attractive when rates go up, but your investments have to grow by more than inflation each year before you achieve any real return,” Naicker explains. “And the asset class that has out-performed inflation by the widest margin over the long term is equities, even though that comes with a degree of risk and volatility.”
If your investment horizon is shorter, however, then it may be worth considering reducing your risk exposure.
“Interest rate increases, market volatility and the uncertainty around what the Fed will do can make an investor uneasy,” Naicker says. “And from a short term-perspective, if you are risk averse, you should perhaps be more conservative.”
Naicker suggests that investors who will need their money in under five years should consider a balanced portfolio with relatively lower exposure to equities and significant offshore exposure that can mitigate against the effects of a depreciating rand.
“A portfolio like Sygnia’s CPI+2% fund would be a good bet,” she says. “The fund’s objective is to provide inflation-beating returns in a conservative manner.”