Ray Wallace is the CIO of Taquanta Asset Managers. Taquanta manage the Nedgroup Investments Money Market Fund, Nedgroup Investments Corporate Money Market Fund, and the Nedgroup Investments Core Income Fund.
It’s happened. After years of historically low interest rates in the United States (US) following the 2008 Credit Crisis and the resultant accommodative monetary policies (like Quantitative Easing), the Fed finally started raising the US federal funds rate. The most recent hike was in March 2017, the second hike since December 2015 and, as expected, raised the federal funds rate by 25 to 100 basis points. The graph below shows just how low US interest rates have been since 2008.
US federal fund rates - historically low prices
The recent rate hike wasn’t a surprise
Everyone knew that the low rates in the US would not continue indefinitely. In fact, the Fed had been communicating potential rate increases of up to 100 basis points during 2015 and 2016. However, these plans were thwarted by persistent unfavourable economic conditions in the US and abroad. The latest small hike, therefore, did not come as a major surprise especially given recent signs of growth in the global economic outlook and the rate guidance given beforehand. The Fed has also indicated a potential 100 basis point increase in rates over the next two years, although there is a chance that President Trump's fiscal stimulus of tax cuts and infrastructure spending could result in higher inflation. This is something that the Fed may not have factored into their forecasts.
According to the International Monetary Fund (IMF), activity rebounded strongly in the US after a weak first half of 2016. The economy is approaching full employment. Economic activity in both advanced economies and emerging market economies is forecast to accelerate in 2017/2018, with global growth projected to be 3.4% and 3.6%, respectively. Global growth will not be uniform across all economies, especially in those with negative interest rates (Europe, Japan), but the positive expected growth in the important economies of China and the US will support the Fed’s view on continued rate hiking.
What effect will rising US interest rates have on the South African economy?
As a result of low interest rates globally since 2008, emerging markets like South Africa have had significant inflows of investment from investors seeking higher yields in bonds and equities. The adage ‘when the US sneezes, the world catches a cold’ certainly holds true for the prospect of US rates doubling from 1% to 2% in a relatively short timeframe, but none more so than for emerging economies like South Africa. Even relatively small changes in US economic variables have a significant bearing on currencies, bonds, shares and other financial assets. Any economic uncertainty can often lead to a sudden ‘flight to quality’ away from the more liquid currency emerging market countries like South Africa.
Rising yields available in developed countries often also result in a reversal of carry trades, a strategy where investors borrow money in low interest currencies and invest them into high interest-bearing currencies, such as the rand. This can be a lucrative investment strategy until market conditions change (such as US rates rising substantially), and then it becomes a race-to-the-door to unwind rand positions at any cost. This in turn further weakens the rand, requiring even more aggressive selling to exit, and so on. Foreign ownership of South African nominal bonds currently exceeds 40% of the total bonds in issue, and whether held by short-term carry trade investors, or long-term bondholders, this represents a substantial risk to our economy if things unwind.
A rise in US interest rates may not be all bad
However, a rise in US interest rates may not necessarily be negative for emerging markets, especially considering that the Fed has communicated the increases well, and they are likely to implement the increases gradually. Lesetja Kganyago, Governor of the South African Reserve Bank (SARB), recently said a Fed interest rate increase could be positive for emerging markets if it is a sign of US economic strength.
South Africa saw the rand strengthening against the dollar by more than15% (from R14.76 at the end of March 2016 to below R12.50 during March 2017). This was before the chaos of President Zuma’s recall of the Finance Minister from his Roadshow in London, the subsequent cabinet reshuffle and credit rating downgrades.
Over the longer term though, if South Africa is unable to rise to the major economic and political challenges it faces (such as namely growing unemployment, an over-burdened tax base, economic policy paralysis, institutionalised corruption, increasing debt and a divided ANC), it is likely to experience all the predictable negative consequences of rising global interest rates.
These negative consequences of being unprepared for a sustained upward interest rate cycle in the US include:
- A reversal of investment flows, as described in the carry trade example above.
- Rising bonds yields in South Africa, and a declining equity market as investors leave.
- A further weakening of the rand.
- Increasing imported inflation, which would prompt the SARB to raise interest rates.
- More downgrades. We saw Standard & Poor’s (S&P) Global Ratings and Fitch already downgraded South Africa’s foreign currency sovereign debt rating to non-investment grade. Moody’s is expected to review their ratings within two months.
All the above would result in a higher risk premium for South Africa and therefore higher borrowing costs. A continuing downward spiral would ensue, with one factor feeding the further decline of another.
The South African interest rate environment
Despite continued domestic political uncertainty, foreign investors looking for yield over the last few months appear to have largely overlooked South Africa’s problems. In fact, rand weakness following the recent cabinet reshuffle and subsequent ratings downgrade was rather muted, compared to its reaction to the removal of Nhlanhla Nene as Finance Minister in December 2015. This can be attributed to the market having mostly priced in a downgrade, with high expectations for the Finance Minister to be eventually removed. During the first quarter of 2017, the local economic outlook seemed to be showing signs of improvement. External factors, such as the strengthening of the rand and an improved outlook for commodity prices were adding to the positive sentiment and outlook for improved growth. However, given recent developments, the overall level of uncertainty has since increased.
Domestic inflation was expected to fall to around 5% by the end of 2017 (from 6.7% at the end of 2016) because of sharply lower food prices, a stronger rand, stable oil prices (around the $50/barrel level), and lower electricity increases (of around 2.2%) for the next year. These inflation expectations may change based on changes to imported inflation from further rand weakness.
There is a possible scenario where the SARB may start cutting interest rates sooner rather than later. However, our view is that the SARB resisted rate hikes during 2015/2016. They held rates lower when higher inflation expectations may have warranted it at the time. Thus, we believe that given the CPI expectations, current rates are low enough already for the SARB not to have to cut rates again until growth and lower inflation is well established and the effects of possible US rate hikes are evident. Possibly only in 2018.
It is worth noting that since the cabinet reshuffle – and its inherent consequences – the likelihood of interest rate hike(s) is higher than the probability of a rate cut at this point. In fact, the forward rate agreement (FRA) curves now indicate that the market is expecting a rate hike in the next three to six months.
These improved economic prospects assume some stability and normalisation in domestic politics and government policy development. As I write this article, Finance Minister, Pravin Gordhan and his deputy, Mcebisi Jonas – along with a handful of other ministers - have been fired by President Zuma and the rand and bond market have weakened in response. The ANC’s National Policy Conference in June, and its National Elective Conference in December, should provide some insight into the direction the economy may take longer term. This assumes that events don’t overtake this beforehand, as witnessed by the extension of the ANC’s recent National Working Committee meeting.
How will rising rates affect investors’ income or money market portfolios?
Making accurate predictions on the direction of interest rates and the economy in general, can be extremely tricky and it almost becomes a lottery given the binary aspect of domestic and global politics, for instance.
Taquanta’s stated investment strategy has always been to ensure we manage our money market and fixed income portfolios with the benchmark top of mind. To this end, we structure the portfolios in such a way that we minimise the interest rate risk as far as possible. We do this by investing mainly in floating rate assets that provide a consistent return above the benchmark yield (which is floating in nature) over any interest rate cycle. In this way, we eliminate the uncertainty of economic forecasting. Our strategy has provided investors with greater annualised returns than the benchmark under all interest rate scenarios, since inception.
The challenge for emerging economies is to prepare against the possible adverse consequences of rising rates and to ensure their domestic economies are robust enough to withstand the negative effects thereof. Investors and fund managers too, have a tough task ahead to ensure that they carefully consider the composition of their portfolios to ensure they can weather any potential economic storm ahead.