Developed and emerging equity markets, including the JSE, came under pressure in January 2014 but recovered strongly in February and early March. The JSE in February did especially well for both rand and US dollar investors.
We show in the figures below how these developments on the JSE – a poor January followed by a recovery since – are strongly associated with movements in the bond markets. In January, long dated US Treasury yields were falling while SA yields in rands (unusually) were rising. In February, US yields moved sideways while SA yields fell. Hence the yield spread between SA bonds and US Treasuries widened sharply in January and narrowed in February, to the advantage of the JSE (in rands and US dollars) and the rand. These relationships between interest rates, the rand and the JSE developments are not coincidental. They are causal.
The yield spread is the risk premium attached to SA assets. The wider the risk premium, the higher the discount rate attached to rand income, and the lower the value of the rand and the US dollar value of SA assets. In the figures below we show how the rand/US dollar exchange rate and emerging market (EM) equities responded to the yield spread in 2014. The rand responds to capital flows into and out of the SA bond market and the JSE.
If we could accurately predict the direction of US interest rates and the risk premium, we would be able to accurately predict the direction of the rand and the JSE.
In the figures below we demonstrate these relationships since January 2013, using daily data. The S&P 500 has been an outperformer over this period and the JSE in US dollars consistently tracks the EM average very closely. This relationship is not coincidental either. JSE earnings and dividends in US dollars track the EM average closely because JSE earnings are more dependent on the state of the world than on the SA economy – as is the case for most EM listed companies. The JSE and EMs generally have performed better relative to the S&P 500 recently after lagging behind badly in 2013.
The patterns may be more or less regular, but predicting the direction of US rates and the yield spread is anything less than obvious. We can however suggest alternative scenarios and their implications, and assign our sense of the probabilities.
Four possible scenarios for the US economy:
+ = above expected growth or inflation
– = unexpectedly low growth and inflation.
1. Growth + Inflation – The triumph of Bernanke
2. Growth – Inflation + The scourge of Stagflation stalks the land
3. Growth – Inflation – More of the recent same?
4. Growth + Inflation + Punchbowl not removed in time
Scenario 1: Unexpectedly strong growth with no more inflation. This implies higher US nominal and real interest rates and will call for an early reversal of quantitative easing (QE)
Implications: Good for US equities and cash but bad for long dated bonds, yield plays, inflation linkers and EM. Good for the US dollar. EM currencies will come under pressure. Risk spreads may decline, helping higher yield credit, including EM credit, given less default risk. The preference then would be for developed market equities over EM equities since they are more able to win the tug of war against the higher cost of capital (though in due course EM equities will also benefit from a stronger global economy).
Assigned probability: 30%
Scenario 2: Stagflation – slow growth with more inflation
This implies low real interest rates with a steep yield curve as higher expected inflation gets priced into the long end of the bond market. This is ideal for inflation linkers: risk spreads widen and more inflation will be better for equities than bonds, though not good for either. Stagflation will be better for EM equities that offer more growth at lower real discount rates. Cash will have appeal if short rates stay above inflation. Fears will enter the markets of not only inflation but also of inflation fighting responses that will further reduce the US and global growth outlook. Bad for the US dollar, good for precious metals.
Probability: 10%
Scenario 3: More of the recent same. Below par growth – below par inflation
More QE will mean low real and nominal rates (the failure of QE will raise policy issues and encourage more direct intervention in markets, adding risk and volatility). Bonds to be preferred over equities – EM equities and currencies will be preferred to developed markets and currencies and defensive stocks may be worth paying up for. Gold will have appeal given low real rates and danger of intervention.
Probability: 25%
Scenario 4: Punchbowl not removed in time; QE overshoots, meaning above par growth with above par inflation
Real and nominal interest rates will kick up. Equities will be preferred over all bonds – credit may offer equity like returns. Developed market equities will be preferred over emerging markets. Cash will be better than bonds – high real interest rates will counter inflation expected in the gold price. Real estate with rental growth prospects will have strong appeal as an inflation hedge.
Probability: 35%
The least promising short term scenario for EM equities bonds and currencies, including the JSE and the rand, would be expectations of still stronger growth in the US with less inflation and higher real and nominal interest rates. This would represent something like the conditions that prevailed in 2013 after the tapering tantrums of midyear that threatened emerging markets. Over the longer term, a stronger global economy would help emerging market economies and their companies.
For now less optimism about US and global growth and lower interest rates would be helpful to EMs and currencies. Over the long run, the ideal conditions for all equity investors would be strong global growth rates with low inflation. For bond investors, a combination of higher real interest rates and higher real income from their bond portfolios – without more inflation to drive up nominal bond yields and drive down bond prices – would also be welcome.
The least promising short term scenario for EM equities bonds and currencies, including the JSE and the rand, would be expectations of still stronger growth in the US with less inflation and higher real and nominal interest rates. This would represent something like the conditions that prevailed in 2013 after the tapering tantrums of midyear that threatened emerging markets. Over the longer term, a stronger global economy would help emerging market economies and their companies.
For now less optimism about US and global growth and lower interest rates would be helpful to EMs and currencies. Over the long run, the ideal conditions for all equity investors would be strong global growth rates with low inflation. For bond investors, a combination of higher real interest rates and higher real income from their bond portfolios – without more inflation to drive up nominal bond yields and drive down bond prices – would also be welcome.
