Pospects for short-term interest rates

For the first time in more than three and a half years, South Africans have begun to feel the relief from lower short-term interest rates. The South African Reserve Bank lowered the repo rate by 50 basis points during December 2008 and again by a full 100 basis points this month.

But with most South Africans still over-indebted, rates will have to decline much more before consumer spending improves significantly. Inflation in South Africa is declining, but the important question is by how much interest rates will fall and how soon?

According to Dr Prieur du Plessis (pictured) Plexus goup executive chairman, the Forward Rate Agreement (FRA) curve can be used as a barometer of market participants’ expectations regarding the future direction of interest rates.

“The FRA curve shows the market expects the South African repo rate to decline from the current level of 10,5% to 7% over the next 12 months,” says Du Plessis. “This represents a decline of 33% which, if implemented, will be very good news for consumers and the South African economy.”

There are, however, two sides to the coin. Investors who had significant exposure to the money market over the past year may not welcome interest rate cuts as their double-digit returns begin to dwindle. “Retired persons in particular who depend on income from their money-market investments are going to feel the loss the most,” says Du Plessis.

Du Plessis’ advice for investors is to gradually increase equity exposure, especially if they are still relatively young. “People are retiring earlier nowadays and may have to rely on their retirement savings for 10 to 20 years. If you don’t have some equity exposure, you are bound to run into trouble.”

According to Du Plessis, Plexus research reveals that equities perform best in lower interest rate environments. “The research took into account six interest rate cycles from 1979 to 2008 and the corresponding performance of the FTSE/JSE All Share Index. Each cycle was divided into four phases.

The research showed that in the declining interest rate and low interest rate phases, equities achieved average returns of 46,0% p.a. and 28,5% p.a. respectively. Equities delivered an average return of 18,7% p.a. in the rising interest rate phase and 1,8% p.a. when interest rates were high. Furthermore, the majority of the 18,7% returns in a rising interest rate phase came from the initial period of the phase, when interest rates were still low.

Although equity markets are still vulnerable to further shocks, Du Plessis warns investors whose investment portfolios are too conservatively structured not to try to time the market.

“Delaying investing for too long may result in a huge opportunity cost. Rather start phasing money into the equity market gradually over the next couple of months,” says Du Plessis.