Up, up and away
Inflation is increasing and interest rates are going up. It is not unusual for them to move in the same direction because interest rates are the primary tool used by our Reserve Bank to control inflation. Whilst higher interest rates are not happy news for many, it is nevertheless good news for some. Negative real yields have not been beneficial for pensioners and income funds who rely on interest rates. The only asset class that benefits from higher interest rates is cash and for some that is very good news indeed.
After more than a few years of low to almost no interest rates across the developed world and some developing markets, things have changed. Yes, interest rates and inflation are going up, up and away!
Inflation has hit a multi-decade high in the USA, the world’s largest economy. By March 2022, the US rate of inflation was sitting at 7.9%. That is the highest it has been since January 1982. The US government has also changed its view that inflation in the country is transitory; it now admits that inflation will be long term.
That means that interest rates are going to go up because interest rates are used to curb and control consumerism which ultimately drives inflation. Higher prices will lead to less demand which in turn impedes economic growth. We may for some time experience stagflation in the US with stagnant demand and persistent high inflation….
Expect the US Federal Reserve to start
Inflation has hit a multi-decade high in the USA, the world’s largest economy. By March 2022, the US rate of inflation was sitting at 7.9%. That is the highest it has been since January 1982. The US government has also changed its view that inflation in the country is transitory; it now admits that inflation will be long term.
That means that interest rates are going to go up because interest rates are used to curb and control consumerism which ultimately drives inflation. Higher prices will lead to less demand which in turn impedes economic growth. We may for some time experience stagflation in the US with stagnant demand and persistent high inflation….
Expect the US Federal Reserve to start
raising interest rates soon, with the European Central Bank to follow.
Back in good old SA
In South Africa things are not quite as bad as in the US. Who thought we’d be able to say that! As a small country with a high level of imports our inflation is very dependent on external factors – such as the oil price which has been bouncing all over the place, thanks to the war in Ukraine, and started trending higher again of late. Increasing costs in food, labour and electricity all contribute to our inflation rate which is edging to the upper end of the inflation target band of between 3% and 6%. The Reserve Bank now sees headline consumer prices peaking at 6.2% in the second quarter of this year and averaging 5.8% in 2022. That’s well above the 4.5% midpoint point of its target range at which it prefers to anchor expectations. As with all countries our Reserve Bank (Sarb) uses interest rates to control inflation.
Expect Sarb to enter a phase of regular
Back in good old SA
In South Africa things are not quite as bad as in the US. Who thought we’d be able to say that! As a small country with a high level of imports our inflation is very dependent on external factors – such as the oil price which has been bouncing all over the place, thanks to the war in Ukraine, and started trending higher again of late. Increasing costs in food, labour and electricity all contribute to our inflation rate which is edging to the upper end of the inflation target band of between 3% and 6%. The Reserve Bank now sees headline consumer prices peaking at 6.2% in the second quarter of this year and averaging 5.8% in 2022. That’s well above the 4.5% midpoint point of its target range at which it prefers to anchor expectations. As with all countries our Reserve Bank (Sarb) uses interest rates to control inflation.
Expect Sarb to enter a phase of regular
interest rate increases. Expectations are that the interest rate may be increased by 0.25% per quarter for the duration of 2022 and 2023. That means 2% increases are on the cards over the next two years.
Interest rates have broadly been way too low for too long. Negative real yields do not bode well for pensioners and income funds who rely on interest rates. An up-ward adjustment of interest rates is necessary to bring the financial system back into equilibrium. Almost free cash via loans has increased debt levels globally and the effect of debt incurred to finance assets such as property and vehicles will have to be watched very carefully and interest rate increases will have to take place moderately. A strategy of too aggressive interest rate adjustments may just trigger the next financial crisis such as what we experienced in 2008.
Ironically, the country that over the past year imposed strict regulations on some sectors, which caused havoc on the share prices of many companies including our own Naspers, is going against the trend. China recently reduced its interest rates in an attempt to counter the slowdown of its economy over the past year. The Hang Seng is the worst-performing index over the past year, with a return of (-) 16.7%. For investors that is not a bad thing. Actually it may be a huge investment opportunity which does not come along too often. But that is another story and needs to be considered independently.
Interest rates have broadly been way too low for too long. Negative real yields do not bode well for pensioners and income funds who rely on interest rates. An up-ward adjustment of interest rates is necessary to bring the financial system back into equilibrium. Almost free cash via loans has increased debt levels globally and the effect of debt incurred to finance assets such as property and vehicles will have to be watched very carefully and interest rate increases will have to take place moderately. A strategy of too aggressive interest rate adjustments may just trigger the next financial crisis such as what we experienced in 2008.
Ironically, the country that over the past year imposed strict regulations on some sectors, which caused havoc on the share prices of many companies including our own Naspers, is going against the trend. China recently reduced its interest rates in an attempt to counter the slowdown of its economy over the past year. The Hang Seng is the worst-performing index over the past year, with a return of (-) 16.7%. For investors that is not a bad thing. Actually it may be a huge investment opportunity which does not come along too often. But that is another story and needs to be considered independently.
What about your investments?
How would higher inflation, resulting in higher interest rates, impact your investments?
The only asset class that benefits from higher interest rates is cash. All other as-set classes are negatively affected by higher interest rates.
How will things change?
Bond yields (see explanation right) react inversely to interest rates. Since the coupon rate on a bond is fixed the real return compared with cash varies according to the interest rate changes. If interest rates increase, the demand for the bond will reduce thereby reducing the value of the bond and vice versa.
So, if interest rates increase, bond values will reduce, leading to an increase in bond yields. Newly issued bonds will take this into consideration and be issued with higher coupon rates.
With one exception. With inflation-linked bonds the coupon is fixed at a rate above inflation. Although the rate is fixed, the overall return will follow inflation + the fixed coupon rate. For example, if the link-er (see explanation right) is inflation + 3% the return will be 7% if inflation is 4%; it’ll move up to 9% if inflation increases to 6%.
We can expect income fund managers to increase their exposure to linkers during this time of expected interest rate increases.
How would higher inflation, resulting in higher interest rates, impact your investments?
The only asset class that benefits from higher interest rates is cash. All other as-set classes are negatively affected by higher interest rates.
How will things change?
Bond yields (see explanation right) react inversely to interest rates. Since the coupon rate on a bond is fixed the real return compared with cash varies according to the interest rate changes. If interest rates increase, the demand for the bond will reduce thereby reducing the value of the bond and vice versa.
So, if interest rates increase, bond values will reduce, leading to an increase in bond yields. Newly issued bonds will take this into consideration and be issued with higher coupon rates.
With one exception. With inflation-linked bonds the coupon is fixed at a rate above inflation. Although the rate is fixed, the overall return will follow inflation + the fixed coupon rate. For example, if the link-er (see explanation right) is inflation + 3% the return will be 7% if inflation is 4%; it’ll move up to 9% if inflation increases to 6%.
We can expect income fund managers to increase their exposure to linkers during this time of expected interest rate increases.
South African bonds still offer one of the best yields in the world.
With interest rates rising globally, global bonds will become even less attractive (many of them already provide negative real yields) and demand from foreign buyers for SA bonds may just increase.
How will property react?
Property tends to act in a very similar way to long-dated bonds. In SA the property sector has been through turmoil for various reasons. It is also experiencing a boom in some places (like the Garden Route) and decrease in value in places like Johannesburg. Covid has also played its part in the destruction (and increase, depending on where a property is situated) of value within the sector. The tendency will however still be that demand will determine the price.
Properties that are highly geared will be impacted more than those that are less geared, since the financing cost of bonds/bank loans will increase as interest rates move higher.
It will therefore be important to understand what properties are included in a portfolio; how much gearing is applied; and if the leases are linked to interest rate increases and/or inflation.
How will Equities be effected?
Different sectors will be impacted differently and gearing, as in property, will be the determining factor of how company
With interest rates rising globally, global bonds will become even less attractive (many of them already provide negative real yields) and demand from foreign buyers for SA bonds may just increase.
How will property react?
Property tends to act in a very similar way to long-dated bonds. In SA the property sector has been through turmoil for various reasons. It is also experiencing a boom in some places (like the Garden Route) and decrease in value in places like Johannesburg. Covid has also played its part in the destruction (and increase, depending on where a property is situated) of value within the sector. The tendency will however still be that demand will determine the price.
Properties that are highly geared will be impacted more than those that are less geared, since the financing cost of bonds/bank loans will increase as interest rates move higher.
It will therefore be important to understand what properties are included in a portfolio; how much gearing is applied; and if the leases are linked to interest rate increases and/or inflation.
How will Equities be effected?
Different sectors will be impacted differently and gearing, as in property, will be the determining factor of how company
prices will be affected. Those with higher gearing will be more adversely affected than those companies that are cash flush. Fortunately there are many cash-flush companies in SA. Dividends of companies with high gearing will also be affected since the companies will use the gearing to fund the dividends resulting in a lower dividend. This may in turn reduce the demand for such companies which will ultimately lead to lower share prices of such companies. Lower consumer demand due to a higher interest burden on consumers will ultimately also influence profits and the value of some companies.
From a value perspective, investors value a company by using a discount rate to calculate the present value of its future cash flow, also referred to as the discounted cash flow method.
When this valuation methodology is applied, increases in the interest rate will result in a higher discount rate, and thereby reduce the present value of that company’s future earnings, and consequently, the price that investors are willing to pay for that share. Picking the right share will become increasingly important in an environment of rising interest rates.
Onwards and upwards
Higher inflation and rising interest rates aren’t a new phenomena. The financial mechanisms that were put in place to ease the fallout from the pandemic have, unfortunately, allowed us to become accus-
From a value perspective, investors value a company by using a discount rate to calculate the present value of its future cash flow, also referred to as the discounted cash flow method.
When this valuation methodology is applied, increases in the interest rate will result in a higher discount rate, and thereby reduce the present value of that company’s future earnings, and consequently, the price that investors are willing to pay for that share. Picking the right share will become increasingly important in an environment of rising interest rates.
Onwards and upwards
Higher inflation and rising interest rates aren’t a new phenomena. The financial mechanisms that were put in place to ease the fallout from the pandemic have, unfortunately, allowed us to become accus-
tomed to low inflation and unrealistically low interest rates.
However, there is no reason to panic and move portfolios to cash. We rely on the ability of fund managers to select the appropriate share and investment instruments to continue providing meaningful returns over the long term.
With every uncertainty an opportunity is created. SA shares are cheap and it is clear that prominent fund managers have adjusted their portfolios over the past 12 months to include more SA shares than five years ago. This is not because they are bullish about South Africa or the South African economy. Actually, quite the contrary. Their decisions and strategies are based on fundamentals and pricing.
Rising interest rates are often the equaliser in a market where sanity has gone astray. Stay invested and stay calm. We are for once entering a normal investment environment.