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Policy tightening has implications for all the asset classes






The SARB’s 50 basis point hike of the repo rate on 8 June was the first increase in official rates since the repurchase rate was upped by 100 basis points in September 2002. The move was chiefly a response to global market conditions and the ultimate influence of those factors on the domestic inflation outlook. The tumultuous state of the global markets has been a function of high commodities prices, inflation fears, interest rate uncertainties and a greater aversion to emerging market risk. When the Monetary Policy Committee met in early June it was faced with higher oil prices and a weaker currency than was prevailing at the time of its previous meeting in mid-April. When the latest oil and currency data were fed into the SARB’s model it warned of a breach of the upper end of the 3-6% inflation target range in Q1 2007. Due to the long lead time between policy adjustments and their effect on the real economy, the SARB had little choice but to tweak rates higher, a trend being followed by most of the world’s central banks in recent times. Pensioners prefer higher interest rates from the point of view that they earn more income on their money market deposits (real income arguments aside). Cash is, however, one of the few asset classes that performs better in a rising interest rate environment. Bond yields and prices have an inverse relationship in that as market interest rates move higher, the capital value of a bond declines. As most bonds pay a fixed amount of interest, however, it is only the capital value of the bond that fluctuates while the income remains constant over the life of the bond. Holding a bond to maturity though does ensure certainty of capital as bonds pay out their full nominal value when redeemed. For listed property stocks, higher interest rates generally have a negative connotation and there is usually a high degree of correlation between bond market yields and the yields on listed property stocks. What is important is the magnitude of the interest rate increases. A small increase in rates as we have just witnessed should not have a dramatic effect on economic activity and rentals and consequently the earnings and distributions of the listed property companies should continue to grow at a forecast pace above 7% p.a. Should rates rise by a greater amount, however, such that economic growth is stifled, demand slips and rentals decline, then listed property stocks would come under greater pressure. With listed property, unitholders’ capital is at risk but companies with well-managed property portfolios should grow distributions (and hence unitholder income) over time. The income from listed perpetual preference shares also benefits as interest rates rise as they distribute a fixed percentage of the prime rate. As the repo rate increases, banks increase their prime rates and the dividend income from prime-linked preference shares increases. Capital values can fluctuate as supply and demand ebbs and flows and also as sentiment around the instruments changes. Higher interest rates affect equities negatively through the higher borrowing costs that companies have to pay and also via their affects on the general level of economic activity and hence corporate earnings. The performances of the various instruments will remain linked to the magnitude of monetary policy tightening. Is the SARB set to embark on a process of “measured” policy tightening that could push rates significantly higher? For now we need to believe the governor that this hike was just a small “adjustment”. Any further weakening of the currency or any significant increase in crude oil prices could well require more “adjustments” and that would have implications for all of the asset classes.
Source: Craig B Pheiffer
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