How to invest with interest rate cuts looming

The South African Reserve Bank (SARB) is expected to start cutting interest rates this year. Investors should note that rate cuts typically prove negative for cash investors while benefiting bonds, equity, and listed property.

This is according to financial planner Naviga and Efficient Wealth, which said there are growing expectations for rate cuts in South Africa.

Since November 2021, the Reserve Bank has hiked interest rates by 475 basis points to a 15-year high in response to rising inflation. 

The bank has been reluctant to cut rates since then for fear of reigniting inflation and weakening the rand. Since March 2023, it has kept the repo rate at 8.25% and the prime lending rate at 11.75%.

However, there is now increasing space for the Reserve Bank to bring interest rates down in South Africa.

One reason for this is inflation in South Africa, which appears to be sustainably near the midpoint of the SARB’s 3% to 6% target range. 

The latest CPI print for July came in at 4.6% – the lowest it has been in about three years. 

In addition, the US Federal Reserve has turned dovish in recent meetings, with many experts predicting interest rate cuts at its next meeting.

This will allow the SARB to start cutting rates for South Africa without risking significant capital outflows from local assets towards markets offering superior risk-adjusted returns.

In addition, weaker-than-anticipated US economic data has accelerated the timeline for potential rate cuts.

These developments afford the Reserve Bank greater latitude to reduce interest rates at its upcoming September meeting.

Naviga and Efficient Wealth said these growing expectations for local rate cuts should prompt investors to consider the potential impact on their portfolios. 

They explained that lower interest rates reduce the cost of borrowing, stimulate economic activity and boost consumer spending. However, it also reduces the return available on savings. 

The companies noted that, although interest rates are just one factor impacting asset returns, rate cuts typically prove negative for cash investors while benefitting bonds, equity, and listed property.

However, they warned that when studying historic returns, the picture does not necessarily reflect a straightforward relationship.

“Certain inferences can be drawn from analysing past results, such as equities tending to outperform during cutting cycles, cash performing better during hiking cycles, and bonds typically reacting ahead of announcements,” they said.

“But for investors, it is important also to consider the significant impact of cycle-specific variables such as starting valuations, structural imbalances, asset-specific metrics, and the level of cuts or hikes implemented when drawing conclusions.” 

The table below illustrates how the different asset classes have historically performed over cutting and hiking cycles.

Below is an overview of how interest rate cuts could affect listed property, bonds, and equities in South Africa.

• Listed property

Naviga and Efficient Wealth said listed property, a debt-heavy asset class, tends to benefit from lower rates, as they lead to lower interest costs and increased spending on commercial properties.

• Bonds

Naviga and Efficient Wealth explained that bonds benefit from the inverse relationship between interest rates and prices. 

“As interest rates fall, investors are willing to pay more for bonds that offer higher rates than the prevailing market rate, increasing prices,” they explained.

Bloomberg recently reported that the outlook for emerging-market local-currency bonds is less than rosy – except in South Africa.

Locally, bonds have delivered world-beating returns this year, and this run is expected to continue.

In July, Bloomberg reported that local bonds have already returned 9.3% in dollar terms this year, more than any other local-currency sovereign debt. 

The average return for emerging markets was just 0.1%.

While the investor-friendly outcome of the May general elections was the catalyst for this rally, interest rate cuts later this year should continue to boost local bonds.

This is not only because of the inverse relationship between interest rates and prices, but also due to the economic boost interest rate cuts will give South Africa.

Lower interest rates can stimulate economic activity, leading to increased demand for credit and, consequently, for bonds. This increased demand can drive up bond prices.

• Equities

Naviga and Efficient Wealth further explained that the expectation of future earnings is a key driver of share prices. 

Therefore, lower interest rates can potentially increase company revenue and profits through higher consumer spending and lower borrowing costs. 

However, they warned that the impact can differ depending on the specific market sector. 

For example, financial stocks tend to suffer from lower interest rates, which reduce the profit margins of banks and other lending institutions.

Conversely, consumer discretionary stocks, particularly retailers like Shoprite and Mr Price, tend to benefit from interest rate cuts.

This is because lower interest rates increase the disposable income and spending power of consumers.

FNB Wealth and Investments’ Chantal Marx recently said the introduction of the two-pot system, possible interest rate cuts, decent momentum in wages, and lower inflation could boost consumer confidence and drive an increase in spending in the months ahead. 

She said this is expected to be positive for domestic retailers, particularly discretionary names.