Where will you be when the interest rate music stops?

It’s time to be conservative on interest rate exposure, and wait for better investment opportunities. This is the message from PSG Asset Management in an investment note to clients.

Since the global financial crisis of 2007-2008, most of the financial world has experienced a sustained period of generationally low interest rates as central banks have tried to inject growth into their economies. This has provided an accommodating environment for many asset classes.

“But we all know that this merry dance cannot last forever,” says Ian Scott, Head of Fixed Income at PSG Asset Management. “It’s time to be mindful of the fact that, when the music stops, you do not want to take a major duration hit on your portfolio.”

Globally central banks are still in accommodative mode and various central banks are still reducing rates. Inflation and growth in most developed and emerging markets remain muted, keeping their central banks on hold.

Where central banks have moved rates it has been in countries where currencies have come under pressure due to poor fundamentals, such as Brazil, Russia and South Africa.

The US Federal Reserve (the Fed) is the major central bank driving the change in the interest rate view, which could affect many emerging markets. It still remains unclear how emerging market currencies, interest rate markets and central banks would react in the face of a change in US rates policy. Even if the move is small in size, it will send the message that the US has finally changed their rate cycle after years of trying to do so since the financial crisis.

“There has been ample guidance and public statements from various Fed officials that the rate change will occur soon,” Scott says. “It seems all the more clear that the Fed is feeling more and more uncomfortable staying on zero percent interest rates as time progresses, irrespective of what current economic data suggests.”

In South Africa the inflation clouds are gathering momentum. “Inflation in South Africa is now driven by regulatory decisions, not by an exuberant spending consumer,” he says. There have been increases in petrol levies, personal taxes and Eskom tariffs, which will all impact consumer finances.

“It will be interesting to see in this environment of higher structural inflation and below-trend growth how the Reserve Bank’s Monetary Policy Committee (MPC) will conduct monetary policy.”

Will the mandate to contain inflation supersede the requirement to stimulate growth? The MPC has sent warning signals to the market that they will increase interest rates if Eskom tariff increases surprise on the upside, the Fed raises rates or the rand suddenly weakens against a basket of currencies. These are all very material risks to the inflation and interest rate outlook, and could happen in a short space of time.

“When the fixed income music stops, it will be sudden and painful to investors exposed to duration fixed income assets,” Scott says.

“Accordingly, it is prudent in the current fixed income environment of low term premiums and reduced liquidity for investors to be more conservatively positioned in their fixed income allocation.”

Scott says there is good value in certain parts of the bank funding curve, but less so in the government curve. Nominal yield bonds are more attractive than real yield bonds at the moment.

“Cash currently has a positive real yield and this gives us firing power to deploy when opportunities arise, as we think they will over the next year,” Scott concludes.