By Miranda Van Rensburg
In response to rising inflation both locally and around the globe, on 24 November the South African Reserve Bank (SARB) raised its benchmark repo rate by 75bps to 7.0%, marking the seventh consecutive hike since November last year.
Although most economists will agree that these rate hikes have been a necessary measure to help curb inflation, the reality is that changes to the interest rate can have a major impact on ordinary South Africans.
Understanding how it all works is therefore important, as doing so cannot only help you make better-informed decisions about your finances, but also help you maximise the returns from your investments.
Here we take a closer look at some of the main points that you should consider when it comes to rising interest rates, your money and your investments.
How the SARB uses interest rates
Interest rates typically work in cycles and are used as a mechanism for the SARB to control inflation (the rate at which the cost of goods and services increases) over time.
To ensure that inflation remains within the SARB’s target range of between 3-6% p.a, the Reserve Bank either decreases or increases interest rates to support or moderate economic activity, which in turn has a direct impact on consumer and business spending and borrowing, and consequently… inflation.
The recent spike in inflation has largely been in line with increases seen across the globe, brought on by higher food and energy prices caused mainly by supply disruptions following Russia’s invasion of Ukraine.
Prior to this, global economies were already dealing with elevated levels of inflation (albeit to a lesser extent) due to an uptick in economic activity as the world lifted many of the remaining Covid-19 lockdown restrictions, and various governments introduced fiscal stimulus measures to help spur economic growth.
Most central banks were therefore already on a rate-hiking path leading up to the Russia-Ukraine war, which they then accelerated to help curb the rapid rise in inflation.
South Africa’s headline CPI sits at 7.6% currently and is expected to come in at 7.3% for 2022 before edging lower to 5.4% in 2023, back within the SARB’s target range.
Whether or not the forecasts pan out as expected, consumers and investors are likely to experience some level of discomfort over the next six months or so, amid elevated levels of both inflation and interest rates.
Impact on consumers
When interest rates increase, loan and bond repayments become more expensive. This is because the rate at which the interest component of the loan is calculated rises.
This isn’t good news for anyone with high levels of debt, especially if you could just about afford to make your repayments when rates were lower. If you find yourself in this position, now may be a good time to reduce your high-interest debts (like credit cards) as far as possible.
Or at the very least, not assume any new debt unnecessarily. Of course, this won’t be easy amid the rapidly approaching holiday season.
Impact on investments
Cash investments usually benefit from interest rate hikes, as banks generally pass on the SARB’s increase by raising the amount investors can earn from call and fixed deposits, as well as savings accounts.
However, the interest rate that investors are likely to receive may still be lower than inflation, which means that the real rate of return from a cash investment will still be negative (and may remain this way for a while).
When it comes to equities, higher interest rates have a broadly negative impact on company earnings and stock valuations. In terms of earnings, borrowing costs and input costs become more expensive, while consumer spending slows down.
The combination of higher costs and a reduction in sales results in lower corporate profitability.
As for fixed-income instruments, higher inflation erodes the value of bonds already in issue, causing investors to demand higher interest payments for their holdings.
Equally, as interest rates rise, newly issued bonds entering the market will typically offer investors a higher coupon (interest) rate. This makes previously issued bonds with lower fixed coupon rates less attractive.
Meanwhile, inflation-linked bonds are usually more sought-after by investors in a rising inflation and interest rate environment, as they offer built-in protection against inflation. Their coupons are adjusted higher or lower based on the changing inflation rate.
It’s important to remember that markets are forward-looking and that expected changes to the economy and financial markets are already taken into account in current market valuations well before an actual interest rate hike or cut, or inflation data release.
Markets will react to surprises where news or data departs from what has been anticipated, with investors adjusting asset valuations up or down accordingly.
As a concluding thought, the returns from cash investments may become appealing if interest rates continue to rise, but we would caution against buying more cash assets given that cash has historically been the lowest-performing asset class over the long term.
If you are looking to add to your portfolio, a better option would be to look out for investment opportunities that are trading at discounted valuation levels and that have significantly better long-term growth potential.
Another sound option would be to simply add to your existing portfolio and allow your chosen fund manager to adjust the asset allocation within your portfolio based on their assessment of future returns.
Miranda Van Rensburg, National Sales Manager, M&G Investments.
*The views expressed here are not necessarily those of IOL or of title sites.
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