Interest rates and our economy

26 Sep 2011

Shane Hussain, Head of International Institutional Sales and Trading at PSGK Corporate, says, "Even though the interest rate was left unchanged in the last meeting, with South Africa's repo rate at a 30-year low there are indications that the Reserve Bank might start lifting interest rates before the end of the year or early 2012". The main repo rate has remained unchanged at 5.5% so far this year, after 650 basis points of cuts in the last two years.

The next twelve months...

Currently inflation is at 5% and gradually climbing since hitting a five-year low of 3.2% in September last year. It is expected that Consumer Price Index (CPI) inflation will continue on the upward trend for the remainder of the year, reflective of steep price increases in food, electricity, petrol, rates and taxes. With the current wage increase demand from unions, wage increases also pose upside risks to the inflation outlook. This meant that the Governor of the Reserve Bank, Gill Marcus, raised the inflation forecast and said inflation was likely to pierce the 3-6% target band briefly in the first quarter of 2012, peaking at 6.3%. This is likely to result in an increase in the repo rate in the next 6-12 months.

How is the global economy doing?

The Global economy continues slow recovery with some of the economies still in a fragile state, making progress toward overcoming many of the setbacks that emerged earlier in the year-Middle East political unrest, the earthquake and related events impacting Japan, and continued sovereign debt problems in Europe and most recently the United States debt ceiling in focus and the fear of a downgrade of their credit rating

However, investors around the globe have been encouraged by improvements in the economies, strong earnings, and continued accommodative monetary policies.

Lower interest rates, typically encourage borrowing and lower the cost of capital for individuals and businesses and is considered ideal for expanding businesses and starting new projects. The US interest rates are near zero and at a record low of 0.5% in the UK, with South Africa's repo rate at a 30-year low, are some of examples of expansionary monetary policies put in place in an effort to get the economies back on track.

So, what are the effects of a raising interest rate?

If interest rates rise too high or too quickly the impact on the stock market and economy could be substantial. But if interest rates rise gradually and are consistent with keeping up with the growth, it is considered a byproduct of a growing economy, so you wouldn't expect the market or the economy to get hit that hard. Interest rates hikes might even be a bullish indicator as long as corporate profits hold up.

How can you benefit from rising interest rates?

"It's a question of when interest rates will go up, not if they will," says Shane. "By setting expectations and preparing your portfolio now, you can avoid getting hit and actually benefit further down the road when rates begin their inevitable ascent." That means many investors may need to adjust their expectations, and their portfolios, in anticipation. A diversified portfolio is less risky than a portfolio that is concentrated in one or a few investments.

What are considered good investments in rising interest rates and inflation?

Fixed-Income Securities:

During this phase of economic recovery and the beginning of a tightening of monetary policy (rising interest rates) long term bonds suffer the most among all asset classes, particular from duration risk that leads to a loss of capital.

However, short bonds have less duration risk and may benefit from a lower chance of losing capital, with potential gain from rolling yield. So, in this phase, short-term fixed income securities such as short-dated deposits, money market instruments, short term /high yield bonds, certificates of deposits, etc. are considered good investments. Investing in short term fixed income securities when interest rates are rising has a compound effect and it can improve capital gain.

And gold?

One may also consider investing in gold in this phase to diversify the portfolio as a 'safe haven asset' to protect the purchasing power (against inflation). And also adding inflation-linked bonds to the portfolio can ensure that your purchasing power won't be eaten away by rising prices and interest rates.

What about stocks and shares?

Over the long term, stocks have historically outperformed all other investments. On average, stocks have generated positive returns in rising interest rate environments as well as in declining interest rate environments. "During the recovery phase," says Shane, "considering market conditions and the outlook. Investments that focus on large-cap, growth-oriented dividend-paying companies are considered to be well-positioned to benefit. Dividends become attractive again, as they not only offer a current income but the potential for longer-term price appreciation". In addition to this, rising rates typically accompany a rebounding economy which means that these companies should have extra cash on hand to increase dividend payouts. Stocks that provide regular payouts should give you a greater chance of staying ahead of rising rates.

Global recovery and commodities

Investment assets associated with global recovery such as commodities (in particular oil and agricultural products) and equities will also benefit in this cycle, an increased demand for commodities in turn, boosts corporate earnings.

Real estate

Rising interest rates may also be considered good news for the real estate sector because companies that profit from homebuilding and construction may be good players too.

"We know," says Shane, "that interest rates will not stay low forever, but the speed at which rates rise and how far up they climb is difficult to predict. Those who pay no attention to interest rates can miss out on valuable opportunities to profit in a rising rate environment."

Conclusion

It appears that the financial market offers a number of opportunities during a rising rate environment. However, without adequate financial skills, knowledge and information in order to weigh up the risks and rewards it won't necessarily mean financial gain.