Springtime in the south looms, while in the north autumn approaches. Of course, the weather cares little for human-made calendars, and cold or heat might linger too long or come too early, depending on where you are and what your preference is.
But ultimately, the seasons do change. This is a time of transitions.
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Interest rates
The big transition in global markets is the turning point in global interest rates after a period where they were at elevated levels across most economies (China and Japan being notable exceptions).
When interest rates rise, a few things happen. The cost of servicing existing debt often rises, reducing disposable income for households and margins for companies. The cost of new borrowing or rolling over existing debt rises, potentially discouraging the purchases of homes, cars and capital equipment. It raises the hurdle for the expected return any new investment must generate before being considered profitable and worthwhile.
These effects slow economic growth, though they are somewhat offset by the fact that savers now earn higher returns on their cash. Slower growth, in turn, weighs on company profits, and therefore, the bond and share prices of these firms should adjust to reflect the new reality.
Since all asset classes compete for capital with one another, high interest rates make cash and cash-like investments more attractive.
Bond, real estate and equity valuations tend to adjust lower to reflect the relative loss of attractiveness. Finally, since not all countries raise interest rates at the same time and at the same pace, the gap between countries’ interest rates shifts, resulting in exchange rate movements.
Money tends to flow to where risk-adjusted returns are highest, weakening the ‘sending’ currency and strengthening the ‘receiving’ currency.
Most of these happened with the 2021 to 2023 global surge in interest rates. The notable exception is that we did not see much of the first item on the list in the US since most mortgages have fixed interest rates these days. Most homeowners did not experience rising interest burdens, but this also meant few were prepared to sell their homes and lose their low mortgage rates.
This blunted the impact of the rate hikes, and the US economy remained resilient but also effectively froze the housing market.
There were other factors behind the resilience, including fiscal stimulus and a surge in immigrants, which boosted the labour force and kept wage increases under control. Nonetheless, there are parts of the US economy facing the squeeze from higher interest rates and will benefit from relief, including lower-income consumers, small businesses, and home builders.
The same goes for other countries where central banks have already cut rates and places like South Africa, where the SA Reserve Bank (Sarb) is likely to do so soon.
Read: Sustained low CPI may spur South Africa rate cuts, Kganyago says
As interest rates start falling, the effects listed above should start reversing. The impact on markets is perhaps most pronounced, and since markets tend to price in the future before it happens, it is most immediate.
We’ve therefore seen a rally in interest-rate sensitive assets of all stripes across the globe, as well as currency moves. Let’s look at a few of these in turn.
Dropping dollar
The US had a stronger recovery from Covid than other major economies, and therefore its central bank, the Fed, could hike interest rates to higher levels to combat inflation than some of its peers.
The result was a jump in the US dollar against the euro, the yen, the yuan and others, including the rand. The dollar has probably also benefited from its traditional role as a haven amid rolling geopolitical crises.
A strong dollar is rarely good for the rest of the world and is probably not very good for the US economy, either.
A strong dollar means that servicing the trillions in dollar-denominated debt owed by governments and companies outside the US becomes more expensive. It tends to put upward pressure on inflation and interest rates in vulnerable countries, and it throws sand in the gears of global commerce since most trade is still invoiced and settled in dollars.
Listen/read: Quo vadis the rand/dollar?
The past few weeks have seen the trade-weighted dollar index losing ground, however, as shown in the chart below. The index is back to early 2022 levels, reversing most of the gains it made when US interest rates started rising.
Seen from a bigger perspective, it still looks quite strong, trading above its long-term average of 97. There is probably room for further declines, but it will depend on how the US’s growth and interest rate outlook evolves compared to those of its major trading partners.
US dollar index
Source: LSEG Datastream
Bonds rallied (meaning yields fell) in the first few days of August as US growth fears resurfaced and equity markets slumped. Bonds performed their traditional role as portfolio diversifiers, something that was possible because yields are at respectably high levels today, unlike in 2022 when bonds and equities crashed simultaneously.
While equities have recovered, bond yields have not, pointing to the deeper rate cuts now priced in.
The benchmark US 10-year Treasury yield fell from 4% to 3.9% during the month, while the two-year yield also fell to 3.9%, ending the 25-month inversion of the yield curve, one of the longest stretches ever.
Global bond indices have not yet recouped the 2022 losses, except for high-yield corporate bonds. But for new investors, that is not a bad thing, and most South African investors only started paying attention to global bonds after the sell-off – in other words, after yields had risen.
Listen/read: Bond basics: Global bonds and how they fit into your portfolio
Real estate endured a torrid time when rates rose since it is by nature a leveraged business. Coming soon after Covid-related disruptions to property use patterns, notably the office sector, the sentiment shock was pronounced.
As the chart below shows, global listed property (the FTSE EPRA/Nareit Developed Index) fell more than bonds and equities when the Fed started hiking rates in 2022.
With a cutting cycle now coming into view, the sector gained 12% in July and August, but this has not yet put it back to pre-2022 levels.
Global asset class returns in US dollars
Source: LSEG Datastream
Equities suffered a major drawdown in the first few days of August, 6% in the case of the S&P 500 and 13% in the case of the Japanese Nikkei 225.
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However, these losses have largely been recouped, and global equity indices ended the month near a record high in dollar terms.
A US soft landing of slower growth, lower inflation and lower interest rates is a constructive backdrop for global equities, but valuations are stretched in the US, more specifically, among the large caps. Elsewhere they’re more reasonable and capable of generating decent real returns for investors in the years ahead.
Back home
This brings us to South Africa. Locally, inflation has been falling faster than expected, while the medium-term outlook has also improved with a stronger currency and stable global energy prices.
With the Fed about to start an easing cycle, the South African Reserve Bank (Sarb) has a green light to lower the repo rate at the next four or so Monetary Policy Committee meetings, starting on 19 September.
Read: Be realistic about the extent of rate cuts, warn analysts
Lower interest rates should help stressed consumers. According to the Sarb’s own data, the share of after-tax household income going to paying off debt increased to 9.2% in the first quarter, the highest level since 2010.
Though this number is not at a historically extreme level, such as the 13% peak it reached in 2008, it is starting to get uncomfortably high, and relief will be welcome. Smaller businesses will also benefit.
Weak credit growth points to the need for lower interest rates. Household credit growth was only 3.2% year on year in July, while corporate borrowing only advanced by 4.5%, barely keeping up with inflation.
South African bonds and currency
Source: LSEG Datastream
An improved growth outlook in turn should give rise to a somewhat better fiscal outlook as tax revenues should rise. The October Medium-Term Budget will update the fiscal projections, but declining debt risks mean investors should demand a smaller premium for lending to the South African government.
This translates to somewhat lower bond yields, all else equal, which further reduces the debt burden and lowers borrowing costs in the private sector, potentially further stimulating the economy.
On the JSE, the big winners have also been the interest rate-sensitive sectors, including banks, life insurers, retailers and listed property.
SA interest rate-sensitive investments in 2024
Source: LSEG Datastream
However, it hasn’t been plain sailing across all local sectors. Resources shares are under pressure, except for the gold miners, which benefit from a record price for the precious metal.
Unfortunately, there aren’t many gold miners left on the JSE, and having largely mined out most of its major ore bodies, South Africa has dropped from being the global number one producer to only number nine.
Read: Will gold’s tailwinds be enough to overcome September curse?
The slowdown in Chinese economic activity, specifically construction, has weighed on iron ore and industrial metals, while platinum group metal (PGM) prices reflect uncertainty over global demand growth for conventional vehicles amid competition from electric cars. (PGMs are primarily used to reduce emissions of toxic gasses in internal combustion engines.)
Juice in the tank
After the rally in domestic assets, it’s reasonable to ask whether there is any more juice left in the tank.
Expectations of a global soft landing are probably largely priced in, while the positive surprise of the government of national unity is similarly reflected in local markets, as are the looming Sarb rate cuts.
Further rallies require more positive surprises, either globally or locally, while disappointment with the pace and extent of rate cuts could still unwind some of the positive sentiment.
Read: Godongwana says stable politics buoying rand
However, valuation remains on the side of South African assets, while the various improvements in the economic fundamentals – lower inflation, lower interest rates, no load shedding, rising confidence – can be mutually reinforcing and can snowball in a good way after years where one crisis compounded another.
We’ve already seen growth forecasts by major banks being upgraded in recent months. Future upgrades should provide fresh impetus to local market valuations.
It is always natural to anchor off the lows, which will make current levels seem very high.
Take the rand, for instance. Compared to a level of almost R20 to the dollar in May last year, the end-August close of R17.76 seems very strong. But not that long ago, in August 2022, the rand traded between R14 and R15 to the dollar, around 20% stronger than today.
Similarly, despite the rally in South African bonds this year, the All Bond Index has not yet returned to pre-Covid levels. Of the 12% year-to-date return, 5% was due to higher bond prices, with the remainder being interest income. Even if the improvement in bond prices stalls, yields are still high enough to offer solid real returns to patient investors.
As always, the patience part is crucial. This time of year, a string of cold days can be interspersed with a few hot ones, and vice versa. Markets similarly don’t go up or down in straight lines.
Izak Odendaal is an investment strategist at Old Mutual Wealth.
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