September was a tough month for equities, even though interest rates had declined by month end.
September proved to be a difficult month for equities and it was especially difficult for emerging market (EM) equities, including the JSE that once more behaved like the average EM equity market. The S&P 500 lost less than 2% of its US dollar value in the month while the EM bench mark lost almost 8% of its value and the JSE All Share Index, measured in US dollars, had fallen by more than 8% by the end of the month.
This EM weakness can be regarded as a mixture of share market and currency weakness (the JSE in rands was 3% weaker and the rand was over 6% weaker vs the US dollar) but a more revealing explanation would be that the decline in EM equities led the rand and other emerging markets lower.
This rand weakness was not for SA specific reasons, even though there was little by way of news flows that would have improved the outlook for the SA economy or the rand. September was a month of distinct dollar strength as well as of some EM currency weakness. The US dollar gained almost as much against the euro as it did against the rand and other EM currencies. We also show that the Brazilian real and the Aussie dollar fared even worse than the rand in September. The trade weighted rand however had still lost about four per cent of its exchange value by month end.
Especially worthy of attention through September was the behaviour of long term interest rates. US long term rates took their cur not so much from what the Fed had to say but from bond market developments in Europe. 10 year German Bund yields and their US Treasury equivalents had moved up sharply by mid month and then retreated almost as sharply by month end.
The interest rate spread between US and German yields widened significantly and then stabilised more or less after 19 September. This wider spread or carry in favour of the US no doubt helps explain US dollar strength.
Of interest also is that the spread between RSA and US long term interest rates remained largely unchanged through much of September 2014 but then widened by the month end.
We have long regarded these long term interest rate trends as important for the direction of equity markets. However the bond markets have long factored in rising short and long term interest rates in the US –a normalisation of US rates – in response to the well established recovery in the US economy and for interest rates everywhere to follow the US lead.
The upward slope of the yield curve in the US and SA, among other bond markets, reveals these expectations. The one year interest rate in SA was yesterday expected to rise from 7% to 8.5% 10 years’ time. The expected path of the yields on RSA bonds of longer duration and of the three month Treasury are shown below. However it should be appreciated that these forward rates have been lowered significantly in recent months: the RSA yield curve has flattened significantly for durations below 10 years. Interest rates are now not expected to rise as rapidly (or as far) as was the case earlier in the year.
It would appear that the decline in European rates, led by growing fears of deflation in Europe and expectations of decisive European Central Bank (ECB) action (even QE), has led global rates lower. The expected increase in rates therefore has been postponed rather than confirmed by events. It is the ECB rather than the Fed that has been leading interest rates lower. The potential threat to equity valuations in the form of higher bench mark interest rates and so the concomitant cost of capital has been postponed.
From the perspective of equity investors, a combination of low interest rates with continued growth in earnings and dividends – implying a still helpful spread between dividend yields and money market rates – would be very welcome. The recent reversal of longer term interest rates in late September therefore might have been more helpful to equity markets than they appeared to be – and especially EM equities. In the figure below, we show how the relationship between equity valuations (represented by the S&P 500) and long term interest rates (represented by 10 year US Treasury Yields) altered through the course of September.
Until mid month interest rates and equities moved in the same direction: higher rates (lower bond prices) led to lower share prices and vice versa. After mid month, lower interest rates (higher bond prices) and lower equity values came together. What might have been good news for equity values in the form of lower interest rates had become bad news by month end.
We remain of the view that the more important threat to equities is from higher not lower interest rates and that the almost perverse relationships of late September (lower rates lower equity values) cannot easily persist. We hope for a combination of stable rather than rising long term rates and good earnings growth.
It is EM equities that appear particularly vulnerable to competition from higher developed market interest rates. Any less pressure on interest rates would surely be helpful rather than harmful to EM equities. It was perhaps the wider spread in favour of US bonds – rather than higher rates – that has caused the recent weakness in EM equities and currencies. However there is consolation in the thought that these spreads in favour of the US dollar are unlikely to widen continuously and thus add further to the case for US dollar strength. One might argue that the spread itself should narrow as funds flow from Europe to the US. If and when it does, the EM bond and equity markets will have a better case to argue with global fund managers.
The interest rates might have decreased because SA is about to go into recession.
The rand is hitting its lowest point in 5 years. Part of the reason for this is because South Africa does not have enough local savings to pay off its deficits. Meaning South Africa is selling less than it is buying.
Another statement to look at is the long term interest rates between RSA and the US and why it didn’t change in September of 2014?
I agree with you, Arisca, I also see from this blog that there is not much that the SARB can do in terms of stabilizing the weak exchange rand value. I really hope we are not heading towards another recession.
When one looks at the long term interest rate between RSA and the US, you do wonder why it has remained unchanged. But does the decreasing of interest rates really mean that the economy is headed for yet another recession? If so, can we expect it to be as bad as it was before. And shouldn’t the lowering of interest rates increase borrowing, spending and investment in the economy, which increase the country’s output.
It is interesting that the
fluctuations of rand are not entirely depending on this country’s own doings
but rather from many clear and unforeseen circumstances of external forces. From
recent history of inflation, it should be obvious that there is not much the
reserve bank can do to stabilize the weak exchange rand value through monetary policy
(interest rates) intervention because it cannot influence it in any predictable
way. So that is why Equity holders should be prepared for the battle of their returns as these things happen in every coutnry in this world.
The mining labour unrest devastated the economy as the rand hit the R10/$-mark for the first time since 2009, Plummeting gold prices and rising US treasury have also played a role, as well as the ongoing unrest in our mining sector, which relies heavily on exports of gold and therefore weakening the Rand.
The new reserve bank governor has indeed his work cut out for him. But there is only so much that one man can do. Its time to look at all equity and-stakeholders.It seems as if every man must be ready to take the plunge for what is about to come.
I personally feel for the new governor, as it seems we have condemned him to be the sole decision making force in the reserve bank. Yet it is important to remember that he is simply the leader of a vast team that analyses and interprets the economic state constantly with him. There is only so much one man can do, but somehow i hope that as a team they can do what they have been entrusted to do and stabilize this country’s economy, despite outside forces. Even if that only means curbing the eventual effects of the pending recession to set the country up in the best possible position to ride the period of growth after the recession.
The benchmark interest rate in South Africa was last recorded at 5.75 percent. Interest Rate in South Africa averaged 13.17 Percent from 1998 until 2014, reaching an all time high of 23.99 Percent in June of 1998 and a record low of 5 Percent in July of 2012.
Was the reversal of interest rates in late September this year really a good one, taking long term investments into consideration? The statement about long term rates being bad news by month end is one that is not properly explained in this article and I was wondering if this is indeed accurate. Based on my prior knowledge on the subjects, higher interest rates tend to have more advantages in the long run, although the middle gap experienced in months is not very good. The average rate of dividends seem to be quite good but I do not think that it can, at this time, be compared with the money market rates just yet. The new president at the Reserve Bank clearly has a lot to do.
There is a great economic burden that has been put on the
new Governor of the reserve bank. He surely does have his work cut out,
although all equity stakeholders should be prepared for the plummet that is
going to occur in the near future. Also the strikes within the country are the
cause of the Rand/Dollar exchange rate dropping, which is the result of
increased interest rates. There are also external factors that influence the
exchange rate such as stock markets of other countries. The South African Reserve
bank cannot rectify this and therefore equity shareholders should be prepared
to take the knock.