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By understanding inflation and interest rates, investors will be empowered to make savvy investment decisions during these volatile times.
Without doing anything, you took a pay cut this year. Your salary may have stayed the same, but the money you’re earning is worth less – and that’s thanks (or no thanks) to the hot mess of rising inflation and rising interest rates. At the end of June 2022, South Africa’s inflation rate hit 6.5%, cracking the target band (3% to 6%) for the first time since March 2017.
But the hits keep on coming. In September the South African Reserve Bank (SARB) raised its benchmark repo rate to 6.25% (up 75 basis points). It was the sixth consecutive hike since November 2021, and it’s enough to make a grown investor cry.
What do those numbers mean? How does inflation work? What’s the deal with interest rates? And what should investors like you do in response to what’s happening in the economy right now?
How inflation works
Inflation is a sustained increase in the price levels of goods and services throughout an economy. All economics textbooks will agree on that. What they won’t all agree on is the cause of inflation.
Inflation typically happens when unemployment rates fall. In this case, businesses are forced to raise wages, which increases their production costs, which leads to higher prices for goods and services. But unemployment in South Africa is still high (33.9% in Q2 2022), so that’s not the reason for our current situation.
Instead, the SARB is seeing its hand forced by external factors. South Africa’s inflation woes are partly due to sudden increases in the prices of commodities such as wheat and oil – which have both spiked due to supply shortages stemming from the war in Ukraine. The rand is also weakening against currencies like the dollar; and then there’s the very real problem of “imported inflation”, caused by high inflation in other markets like the United Kingdom (where the annual inflation rate in August was an eye-watering 9.87%), the United States (8.3%), and Europe (9.1%).
What interest rates do
The SARB tries to keep inflation under 6% per annum. It does so by increasing or decreasing interest rates, which impacts consumer spending, which impacts the economy, which impacts (you guessed it) inflation. But interest rate fluctuations have other impacts as well – including on investments.
An interest rate is the amount a lender charges a borrower, and it is represented as a percentage of the principal (the amount borrowed). If you’re the borrower, you’ll want interest rates to be low so that you’re not paying too much on, for example, your car financing. In late 2020, with the economy reeling from Covid-19 lockdowns, the SARB dropped the repo rate (the rate of interest charged by the central bank on the cash borrowed by commercial banks) to a record low 3.5% to try to kickstart the flagging economy.
At the time, you’d have heard people telling you there was no better time to take out a loan. When interest rates increased, however, some of those loan repayments would have suddenly become a lot more expensive.
What that does to investments
What does this mean for investors? On the face of it, you’d think that investors would want interest rates to be sky-high. After all, as an investor you’re in effect lending money to banks (cash), businesses (equities), or governments (bonds). Of course, it’s not as simple as that. Various underlying assets react differently to interest rates.
Cash investments, for example, tend to benefit from interest rate hikes, as banks increase the amount investors can earn from call accounts and fixed deposits. The trouble is, your interest rate as an investor could be lower than inflation – so your real rate of return from a cash investment might still be negative.
Equities, meanwhile, usually react negatively to high interest rates because of their negative impact on company earnings and stock prices. Borrowing costs are higher, consumer spending slows down, and companies, generally, become less profitable. In normal conditions (in other words, not the economic hellscape that we’re all living through right now), interest rates rise during bull markets or periods of economic strength, so it all balances out. Current conditions, however, are by no means normal.
Bonds and interest rates sit on two sides of the same see-saw: when one rises, the other falls. Newly issued bonds will have higher coupons after rates rise, making bonds with low coupons issued in the lower-rate environment worth less.
So to sum it up: higher interest rates are good news if you have cash, bad news if you have bonds, and good or bad news if you have equities. Usually. But unusual things are happening right now, so it’s best to speak to a trusted and qualified financial advisor before you make any investment decisions.
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