With Tuesday’s announcement of a 100bps cut in the interest rate, investors are no doubt hoping for a strong market reaction, perhaps even the beginning of a prolonged rally. However, Regarding Capital Management’s Piet Viljoen says that rate fluctuations shouldn’t necessarily affect your portfolio.
Theoretically, when interest rates are low, stock markets perform well because companies can redirect money they save on interest rate payments to more productive uses, and consumers can borrow more and thus buy more. Conversely, when rates rise, corporate profits should fall thanks to higher interest payments and lower consumer spending, sending markets plunging downwards. The idea is that a rising-interest-rate cycle means a bear market and a falling-interest-rate cycle means a bull market.
All this falls in the category of typical economic assumption. But for Viljoen, things just aren’t that simple. Consider our most recent bull market, between late 2005 and mid-2008, which took place against the backdrop of a rising rate cycle; interest rates rose 4.5% between June 2006 and June 2008.
Said Viljoen, speaking in the Moneyweb Market Commentator Podcast, “The last bull market … was the bubble in commodity prices and I think that for a country and an index like South Africa, which is very commodity heavy, that means a bull market happens despite what happens to other underlying economical fundamentals like interest rates.
If interest rates aren’t the crucial factor in determining the net returns you earn on your equity portfolio, then what is? According to Viljoen, one critical element is the price you pay for the asset you buy.
“I find it very difficult [to predict the effects of a rate cut] because each time the conditions are different and when I say conditions, I refer to the one condition which is your starting price of your investment. So when prices are very high, your returns are going to be poor, notwithstanding interest rates going down or up.”
“One only has to look at Japan for an example, they cut interest rates down to zero and they’ve kept it there for a long time, yet returns have been very poor and the reason for that is you started out with a very high price 20 years ago.”
“Conversely, if prices are low, you’re going to get good returns again, irrespective of what interest rates do, so one has to take the starting condition into account and then also the underlying economic conditions. You know, interest rates are only cut to stimulate economic activity, in other words, when economic activity is poor, so if you are an outlook-based investor, then you’re not going to buy shares based on the interest rate movement, but rather on what the immediate economic outlook is and it’s normal at its worst when interest rates have been cut, so there’s a bit of a dilemma there. So the conditions are very important.”
Ever the contrarian, Viljoen also argued that the risk-free rate (the rate of return on an asset with zero risk, like a US Treasury bill, or, in South Africa, a long-term government bond) shouldn’t be a factor in your decision making.
“I’m not sure that [using the risk-free rate as a guide is] a logical process. I think one should have your own required rate of return which is a fairly stable number over time and not be beholden to risk-free rates linked to interest rates that move up and down through time, because then the same asset is worth more while interest rates are going down and then worth less while interest rates are going up and that strikes me as being slightly illogical.”
“I would take a long-term assumption about interest rates, add my 6 to 8% margin on top of that and say, ‘Well that’s my required return’, and I will price the assets consistently according to that.”
Undeniably, however, the rate cut caused the JSE to jump, although it admittedly ended the day in the red.
Explained Viljoen: “Possibly one of the contributing factors [to the jump], amongst many, is that the old buy on rumour, sell on fact type of situation where you buy stocks or traders would buy stocks in anticipation of interest rates being cut and then close out those positions when or just before they cut. So there’s a bit of that, there’s a bit of reaction to the massive monetary inflation policies happening in the US, all those sorts of things have caused this rally and very importantly, prices were very, very low when it started.”
The monetary stimulus in the US has caused many to voice worries over inflation – as the US Federal Reserve prints trillions of new dollars, economists are warning that inflation can’t be far away.
Viljoen agreed: “Inflation is generally bad for financial assets, by and large, although in the complete spectrum of financial assets, equity is probably one of the asset classes that can best protect themselves against inflation, through pricing power good companies can increase their prices along with inflation, but it’s still not a great thing for financial assets. I think there’s an illusion of growth in that earnings grow up the whole time, but most of that earnings growth is due to inflation, not due to real growth.”
For more of Viljoen’s wisdom on inflation, asset pricing and the JSE, listen to the full Market Commentator Podcast.