Interest rates will rise but you can still get real returns in equities
SURE AS THE SUN WILL RISE, so will interest rates. Climbing inflation is putting pressure on the SA Reserve Bank to increase rates. It’s happening worldwide, offering opportunities in some countries – especially emerging markets. But investment opportunities will come with risks. The nascent recovery in South Africa could stall, the biggest threat probably being politics.
Looking at offshore opportunities in a rising interest rates environment, Michael Hasenstab, a portfolio manager and codirector of international bonds at Franklin Templeton Investments, sees good opportunities in many economies outside the G3, namely the United States, the Eurozone and Japan. “Most emerging economies and many developed ones were not overly reliant on leverage before the crisis. Consequently, they’ve been well positioned to recover quickly with relatively low levels of indebtedness in their consumer, financial, corporate or government sectors. We think robust growth, higher interest rates and good credit conditions should contribute to strong capital inflows and currency performance in those markets.”
Paul Stewart, MD of Plexus Asset Management, says the main concern for South African investors isn’t whether there will be a rate hike but rather when and by how much. Asked for his forecast, he says by 0,5% by year-end 2011. “I think the total quantum of rate hikes over the next two to two-and-a-half years will be 2% to 2,5%.”
What does that mean for investors? Focusing on emerging markets, Hasenstab says the combination of good fundamentals outside the G3 and excessive liquidity in the G3 should continue to provide capital to emerging markets, which should continue to boost investment and growth. That was seen over the past month as foreign investors became big buyers of South African bonds. “The challenge is managing that growth and these capital flows to avoid asset price bubbles or consumer price inflation,” Hasenstab says.
Countries where he’s taking investment opportunities include Australia, due to its conservative fiscal policy. He’s also investing in Asia (excluding Japan) and select countries in Latin America. “Countries in Scandinavia and central Europe are attractive to us due to good policies and benefits from integration with strong German export performance,” he says.
Plexus conducted a study comparing the performance over 11 years of the FTSE/ JSE resources, industrial and financial indices during different interest rate cycles. The cycles were divided into down, flat and rising interest rates. “The negative effect on financials in an up cycle can be explained by the higher debt burden on borrowers from banks, resulting in fewer loans and more bad debts, while bank margins remain unchanged,” Stewart says.
With inflation and, in turn, interest rates increases, the opportunity to obtain real returns becomes increasingly difficult. “Bonds and cash generally don’t provide positive real returns in an increasing interest rate environment.” Stewart is therefore looking at equities, saying real returns can be obtained in a rising interest rate cycle – even when it’s negative for other asset classes.
But what shares is he investing in as rates begin to rise? “In resources its Lonmin, Mondi, ArcelorMittal and BHP Billiton. In the industrial sector we like Pick n Pay, JD Group, Massmart, Vodacom and Telkom. Financials include Santam, Liberty Holdings, Discovery and Standard Bank.”
Telkom is the interesting choice in the portfolio. Stewart says with the problems it’s going through it’s looking like an unattractive investment. “Which is precisely the time to buy it.”