High interest rates threaten stock market returns

Investors should be cautious when dealing with equities as tail risks from elevated interest and inflation rates and a very uncertain geopolitical backdrop could put a dampener on hopes for a quick equity market recovery.

This is according to Melville Douglas, Standard Bank’s boutique investment management company, who said these factors require a more cautious approach from investors for the time being.

This warning comes as the global economic recovery is gaining traction, boosting investor appetite for international stocks, even as the geopolitics in the Middle East casts a shadow over investment markets.

“While we have no reason to doubt the improved economic growth outlook, we must also recognise that several indicators suggest that the global economy appears rather mature or ‘late cycle’,” said Melville Douglas chief investment officer Bernard Drotschie.

He explained that while a late cycle is not a sufficient condition for a significant slowdown in economic momentum or, indeed, the next recession, it is usually associated with a period of more lacklustre investment returns.

“We believe that a lot of the good news linked to a combination of positive earnings momentum, lower interest rates and falling inflation is already reflected in many share prices, with little margin of safety for investors in the event of disappointment,” he said.

He added that the Israel-Gaza war is a potential risk to the oil market, inflation and interest rates if it escalates into a wider regional conflict.

“As such, caution must be the watchword for investors in the immediate term, with the focus centring on quality businesses until the margin of safety from a valuation perspective becomes more favourable.”

He said investors are counting on central banks to start cutting interest rates from the second half of this year, particularly in advanced economies, given the deceleration in consumer inflation trends. 

Inflation has been particularly acute for consumers and businesses in advanced economies in the last two years, prompting policymakers to aggressively hike rates, which at the time raised concerns of a sharp economic slowdown or even a technical recession.

The South African Reserve Bank started raising interest rates in November 2021 and has since hiked by a cumulative 475 basis points.

This has brought the repo rate to a 15-year high of 8.25% and the prime lending rate to 11.75%.

Melville Douglas research showed the US economy remains “in good shape” relative to Europe and the UK, having absorbed cumulative rate increases of 500 basis points in a space of one and a half years.

“While high interest rates have played their part in dampening credit extension and in turn slowing excess demand, fiscal support in the US together with drawdowns on savings and buoyant labour markets have in most part offset the negatives from restrictive monetary policies,” Drotschie said.

The US Federal funds rate currently stands at 5.25% to 5.50%, the highest level in more than 20 years, having drifted from near zero during the Covid-19 pandemic.  

However, with inflation slowly drifting back to the Federal Reserve’s 2% target band, the markets expect the Fed to start cutting rates from the second half of the year. 

Melville Douglas believes the Fed policy pivot has far-reaching implications for other central banks around the world, including emerging markets such as South Africa, to the extent that it shapes inflation profile and interest rates via the rand/dollar exchange channel.

“In a low-rates environment, global equities and fixed-income markets tend to do well,” he said. 

“We believe bonds are appropriately priced and, together with cash, currently provide investors with favourable income yields and diversification while equity markets are trading at elevated levels.”