For the first time in more than three and a half years, South Africans have begun to feel the relief from lower short-term interest rates. The South African Reserve Bank lowered the repo rate by 50 basis points during December 2008 and again by a full 100 basis points this month.

But with most South Africans still very much over-indebted, rates will have to decline much more before we see consumer spending improve significantly. We all know inflation in South Africa is on the decline, but the important question is by how much will interest rates fall and how soon?

The Forward Rate Agreement (FRA) curve (see accompanying Graph A) can be used as a barometer of market participants’ expectations regarding the future direction of interest rates. This curve shows the market expects the South African repo rate to decline from the current level of 10,5% to 7% over the next 12 months. This represents a decline of 33% and will be very good news for consumers and the South African economy.

However, there are always two sides to the coin. Investors who have been lucky enough to have a large exposure to the money market over the past year are going to find the going hard when their double-digit returns begin to dwindle. It is especially retired persons who are dependent on income from their money-market investments that are going to suffer most.

My advice to people in this situation is to gradually increase equity exposure, especially if they are still relatively young. People are retiring earlier nowadays, and they forget they may have to rely on their retirement savings for another ten to 20 years. If you don’t have some equity exposure, you are bound to run into trouble.

A recent study by the Plexus research team shows that equities perform best in lower interest rate environments. We analysed six different interest rate cycles from 1979 to 2008 together with the performance of the FTSE/JSE All Share Index. Each cycle was divided into four phases (low interest rates, rising interest rates, high interest rates and declining interest rates) with the coinciding returns from equities for each phase. The results are shown in Table B.

The table clearly indicates that equities performed the best in phase four (declining interest rates) and phase one (low interest rates) with an average return of 46,0% p.a. and 28,5% p.a. respectively. Equities delivered an average return of only 18,7% p.a. in phase 2 (rising interest rates) and 1,8% p.a. in phase 3 (high interest rates). Added to that, the majority of the 18,7% of the returns in a rising interest rate environment came from the initial period of the phase, when interest rates were still low.

Although equity markets are still vulnerable to further shocks, I need to warn that people whose investment portfolios are too conservatively structured should not try to be too clever and time the market to a T. Delaying for too long may result in a huge opportunity cost. Rather start phasing some money into the equity market gradually over the next couple of months.

Graph A

Graph B

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