The JSE as a play on interest rates. The scope for still lower long term interest rates in SA
The importance of movements in interest rates for share prices over the past 12 months has never been more obvious on the JSE. Interest rates turned out to be significantly lower than expected early in 2014 and a group of large cap interest rate sensitive stocks, banks, retailers and property companies, have accordingly performed outstandingly well.
Since 1 February 2014 to 30 January 2015 our market cap weighted Index of large cap interest rate sensitive stocks generated a total return (including dividends) of 48.7%. The Global Consumer Play Index, also market weighted and one that includes Naspers and Aspen, while also performing well returned a lesser 42.9% while the JSE All Share returned 16.8%. The S&P 500, the best performer of the developed equity markets provided a 12 month return in rands of 19.6%, a highly satisfactory outcome, but less than half the return provided by the SA interest rate plays, as may be seen below.
(The index of Interest Rate Plays is made up of the following 30 companies: BGA, FSR, GRT, INL, INP, IPL, MSM, NED, RMH, SBK, TRU, CCO, CLS, CPI, FPT, HYP, NEP, PIK, RDF, RES, TFG, WBO, MPC, WHL, CPF, ATT, PSG, RPL, AEG and FFA. The Global Consumer Plays are: APN, BTI, CFR, MDC, MTN, NPN, SAB, SHF, NTC and ITU)
These interest rate sensitive stocks on the JSE should be regarded as demandingly valued by the standards of the recent past. They were priced at January month end at a well above average 16.9 times trailing earnings. They surely have benefitted from unexpectedly lower interest rates.
Presumably these interest rate sensitive stocks will remain so, making the further direction of interest rates in SA of great importance in stock selection and asset allocation. Long term interest rates in SA will moreover continue to take direction from interest rates in the US and Europe. Furthermore the value of the rand is bound to be strongly influenced by the self same interest rate trends.
When interest rates in the developed financial markets decline, all things remaining the same, especially country specific risk factors, funds will tend to flow towards less developed markets where yields are higher. The search for yield in a low interest rate world will tend to compress yields and yield spreads everywhere, so adding to the demand for emerging market currencies that supports exchange rates, including the rand. And where the rand goes will influence the outlook for inflation in SA and so the direction of short term rates. Over the past year lower euro yields have been very strongly associated with a stronger rand vs the euro, as well as a weaker euro and rand vs the US dollar. A weaker euro, both against the US dollar and the rand, has come with additional demands for and lower yields on RSA long dated government bonds.
The wider spread between US and German yields shown in figure 1 has clearly helped to add to US dollar strength and can be expected to continue to do so.
Given the freedom to move capital from one market to another, it is clear that interest rates in Europe must influence rates in the US and vice versa – rates in the US must influence rates in Europe as well as SA and elsewhere. It seems as clear that, were it not for the weakness of the Eurozone economies and the threat of deflation there, as well as the promise of European Central Bank (ECB) quantitative easing on a large scale (and so very low Eurozone interest rates), long term interest rates in the US would have been a lot higher than they now are. The leading force in the longer end of the global bond market may well be European deflation rather than US economic growth and the reactions of the US Fed. The US economy seems firmly set on a good growth path. The impressive growth in the numbers of workers employed in the US is ample testimony to the strength of the US economy. The latest employment numbers have been revised sharply higher for 2014, when an extra 3.04 million employees were added to private payrolls. The response of long term US interest rates to these bullish developments has been quite muted.
These employment numbers may well encourage the US Fed in June to raise its own key short term Fed Funds rate from its current zero level, as is now widely anticipated in the money market. But longer term rates may still take their cue from rates in Europe and stay where they are, with 10 year Treasury yields staying closer to the current 2% level than the 3% level, which might be regarded as more normal. In such a case, long term interest rates in SA will also not move sharply higher any time soon. If however rates in Europe trend still lower under pressure from aggressive QE interest rates in Europe, the US and SA can still surprise on the downside. A stronger dollar would press on both US inflation and growth rates and weaken the case for higher short term rates.
While the level of RSA rates will respond to the directions of global markets it may be asked what should be regarded as the normal level of interest rates in SA? The Reserve Bank has spoken of the normalisation of SA interest rates, implying higher rates should be expected, though in its latest Monetary Policy Statement it referred to a likely pause in rates given the much improved inflation outlook. Normal must refer to rates after inflation or, when longer rates are interpreted, it would be by reference to market rates after expected inflation, that is to say real rates.
In figure 7 below we compare RSA 10 year nominal bond yields with their inflation protected alternative yield since 2005. Nominal RSA Yields have a daily average of 8.13% p.a since 2005 with a high of 10.9 % p.a. in August 2008 – and a low of 6.13 in May 2013. Inflation protected real yields averaged 2.4% p.a with a high of 3.65% p.a and a temporary low of 0.38% p.a. in May 2013. The daily volatility of both these yield series, measured by the Standard Deviation (SD) of the daily yields about the average, was about the same, 0.69% p.a.
The difference in these yields, nominal and real, may be regarded as compensation for bearing the inflation risk in vanilla bonds in the form of higher yields, has averaged 5.8% p.a with a SD of 0.61% p.a. Inflation expectations revealed by the RSA bond market appear as highly stable about the 6% p.a level, which is the upper end of the Reserve Bank’s target range for inflation. Headline inflation in SA calculated monthly has not co-incidentally averaged 6.1% since January 2005. Thus normal long bond yields might be regarded as 6% for inflation plus 2.5% p.a as a real return, summing up to approximately 8.5% p.a yield on a long dated RSA bond.
The evidence is that inflation compensation in the bond market follows the inflation trends with a long lag. It will take a sustained period of well below average 6% inflation to reduce the expected inflation priced into nominal bond yields of about 6% p.a. It will take faster growth in SA and globally to raise inflation linked 10 year real interest rates in SA meaningfully above their current 1.72% p.a. This seems an unlikely development in the short term. The equivalent 10 year real inflation protected (TIPS) yield in the US is only 0.28%, offering investors in inflation linked RSAs a real yield spread of 1.5% p.a. This real spread appears rather attractive in current global circumstances and may well decline. This real spread can be compared to a nominal yield spread of 5.44% p.a. in favour of 10 year RSAs on 9 February 2015 (that is the RSA at 7.38% – US Treasury at 1.94% = 5.44%, which is very much in line with the trends in this spread since 2008).
The case for JSE listed interest rate sensitive stocks at current demanding valuations could be based on the prospect of a further decline in SA interest rates. In the first instance this is on US rates rising less than the currently modest 20bps expected by the US Treasury bond market in a year’s time. The market is expecting the 10 year US Treasury Yield to rise from the current 2% p.a to approximately 2.2% p.a in a year. This expected increase should not be regarded as a grave threat to the SA bond market. It could take lower rates in Europe to deny such expectations or any softer actions or words from the US Fed regarding its Fed Funds rate.
The other hope for interest rate sensitive stocks on the JSE would be a decline in the RSA real rate, which appears quite high, compared to real rates elsewhere. A modest decline in the real rate would help depress nominal rates. A more likely, but more and more potentially significant decline in RSA bond yields could follow any decline in inflation expected. This could occur if SA headline inflation stays well below the 6% mark for an extended period of time. Clearly, with interest rates and the valuations of interest rate sensitive stocks where they are, there are upside as well as downside risks to interest rates in SA and to SA interest rate sensitive JSE listed companies.