The South African Monetary Policy Committee yesterday announced a further interest rate cut of 0,5%, added to a succession of cuts following the global financial crisis.
At glance low interest rates mean lower credit card fees, while the climbing rand may seem like good news if you are planning to travel overseas or shop on Amazon.com. However, is all this really good news? These lower rates also mean less interest on your cash savings, So, what does this mean for the economy, and how does it impact your investments?
How does the currency, interest rates and the economy all fit together?
An interest rate is essentially the price of money charged by a lender, and should be determined by supply and demand. Inflation is the rate at which the general level of prices for goods and services rises, while purchasing power falls.
The South African Reserve Bank is tasked with keeping inflation between 3% and 6% to balance supply and demand. One way to achieve this is by raising or lowering interest rates to increase or decrease the money supply. These interest rate changes, as well as the movement in inflation, will affect your investments.
Low interest rates and your investments
The affect of low interest rates is more immediately felt on investable assets like bonds than equities, which are essentially company shares, where there is a lag in the impact because the interest rate change needs to filter down into company earnings.
Of the two asset classes, bonds are less well understood, but many unit trust funds invest in them. Simply put, a bond is an IOU, with a formal contract to repay your invested capital and to pay you out interest at fixed intervals. This interest is known as yield.
Bond prices move in the opposite direction to bond yields (interest paid out from your investment): as interest rates decline, bond prices go up and vice-versa. Therefore, if you buy a bond and hold it to maturity, it makes little difference what interest rates are doing as you will receive the yield you have chosen, plus your original capital.
However, if interest rates are rising, it probably isn’t the best time to invest in bonds as they are likely to lose out based on a decreasing price. On the flipside, if consumer demand is falling, inflation is likely to decline and so should interest rates, as we’ve seen in our current economic environment.
However, investment markets are continuously looking forward, so the impact of the falling interest rate environment is already factored into current bond prices. The outlook for interest rates is that they’ll probably stay low for a while and then start moving up again, which isn’t good for bonds.
The economic situation at home and globally
In South Africa we are currently seeing the lowest interest rate levels in decades. You will have seen your mortgage repayments decline with each rate cut. Rates have fallen by 6,5% in total since the end of 2009, in line with similar global efforts to jump start the economy through loose monetary policy, and all signals point to low interest rates remaining in place for some time to come.
Overseas, developed economies were hit hardest by the financial crisis and as a result have applied never-before-seen measures to ease the pressure on their economies, like printing more money. When you have an increased supply of something, it generally means its value will decline.
Therefore these measures, known as quantitative easing, coupled with investors fleeing to traditional safe haven investments like gold or higher yielding assets like emerging market bonds, have caused the dollar to weaken. The instability and lack of yield in developed economies has resulted in investment in emerging market economies such as SA, which have higher yielding assets (aka interest rates) than their developed market counterparts. This is one of the reasons the rand has been so strong.
The strong rand is making many economists uncomfortable as it impacts exporting offshore — an important source of revenue for our economy — as SA goods are no longer as affordable as they were with a weaker rand.
Finding income from your investments
With lower interest rates, higher yield (interest on your investment) is harder to come by. For many investors this means looking for opportunities outside of traditional “fixed interest” investments such as bonds and money market instruments and considering instead listed property, preference shares and even dividends (the portion of a company’s earnings distributed to its shareholders).
It is clear that attractive yields are going to be scarce for some time to come, given the fact that interest rates are not likely to increase anytime soon. However, you can still earn income from your fixed interest investments in the current economic climate by choosing a fund that is actively managed by an expert fund manager who seeks out higher yields across all asset classes. You should also be considering funds that are diversified (not bonds only) to spread the risk.
The first rule of investing remains preserving your capital. When yield is scarce, the impact of tax, fees and high annuity withdrawal rates is exaggerated in the performance of your investment. This makes the decision of where to invest even more important. These are all key considerations in a low interest rate environment.
Candice Paine is head of retail at Sanlam Investment Management
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