Equity markets rallied sharply in June 2019 on expectations of lower interest rates by the US Federal Reserve. This resulted in the JSE All Share Index outperforming both global (MSCI World) and emerging market (MSCI EM Index) in rand and dollar terms. However, the gained confidence on the back of the expected looser monetary policy, may have an opposite effect if the US Federal Reserve (Fed) fails to deliver on interest rate cuts in the short term. If the Fed fails to deliver on interest rate cuts in the short term, the elevated downside risks posed by a slowing global economy will be imminent and financial markets are likely to be negatively affected.
On the local front, President Cyril Ramaphosa delivered the first state of the nation address of the 6th parliament. He highlighted the depressing economic conditions that the country is currently under and acknowledged that there is much hard work needed to rebuild it. He emphasised that the time for planning has gone and that the time for implementation has arrived.
Implications of the news
- The president`s state of the nation address
While the president`s state of the nation address was criticised by opposition parties and by some members of the public as mere dreams, a close look into it will reveal real economic plans which can rescue South Africa from its current predicament. President Ramaphosa reiterated the independence and mandate of the Reserve Bank to calm international investors and reverse the damage done by the ANC secretary general (Ace Magashule). Earlier in the month, Magashule had announced that “ANC NEC Lekgotla agreed to expand the mandate of the South African Reserve Bank beyond price stability to include growth and employment. It also directed the ANC government to consider constituting a task team to explore quantity easing measures to address intergovernmental debts to make funds available for developmental purposes”. This had a negative impact on markets and the president had to clarify this statement for investors.
In summary, the President identified seven key priorities which the government must focus on to revive the economy:
- Economic transformation and job creation
- Education, skills and health
- Consolidating the social wage through reliable and quality basic services
- Spatial integration, human settlements and local government
- Social cohesion and safe communities
- A capable, ethical and developmental state
- A better Africa and World
He also mentioned that the key priorities will be driven by five sub priorities, which include fighting hunger, growing the economy at a faster rate than population, creation of two million youth employment, improving educational outcomes and halving violent crimes.
As a result of his speech, the rand recovered some of the ground that it lost, indicating that foreign investors have confidence in the President. If the government, private sector and the civil society could work together to implement these priorities, economic growth will be recovered.
- US Federal Reserve (Fed) rate cut
The Fed has turned sharply dovish as a result of threats to the growth outlook due to weaker global trade, low inflation and geopolitical tensions from the trade war. Wage pressures remain muted and unable to boost inflation, while the threat of a recession mounts.
- Likely effects
When the economy is slowing, the Federal Reserve cuts the federal funds rate to stimulate financial activity. Economic theory asserts that a lower interest rate is a catalyst for growth. This has a direct positive impact on both personal and corporate due to the reduction in the borrowing costs. Consumers will spend more, with the lower interest rates, while businesses will enjoy the ability to finance operations, acquisitions, and expansions at a cheaper rate. This will ultimately result in economic recovery. On the other hand, the increase in business` future earnings potential, will be expected to result in robust stock market.
Since markets are forward looking and always price in all the available information, we have seen a sharp recovery in June as markets anticipate a Fed rate cut. The below graph illustrates this recovery from May 2019 (decline caused by issues around trade war) using the JSE All Share Index and other developed markets indices in USD terms.
Source: Morningstar; Cornerstone Asset Management
While the relationship between interest rates and the stock market is indirect, the two tend to move in opposite directions. A general rule of thumb is that, when the Fed cuts interest rates, it causes the stock market to go up and when the Fed raises interest rates, it causes the stock market to go down. But there is no guarantee how the market will react to any given interest rate change the Fed chooses to make.
On the other hand, bonds and interest rates have an inverse relationship. As interest rates increase, bond prices generally fall, as interest rates fall, bond prices go up. When the Fed decreases the federal funds rate, newly offered government securities, such as Treasury bills and bonds, are often viewed as less attractive investments and will usually experience a corresponding decrease in interest rates. In other words, the risk-free rate of return goes down, making these investments less attractive.
Markets During the Month
- Local equity market (as measured by the JSE All Share Index) followed the global markets lower, down 4.8% in June 2019, supported by the sentiment that looser monetary policy is on the horizon. The news that China and the US agreed to continue dialogue on trade also had a positive effect on financial market’s performance.
- Global equities were up 3.2% for the month on hopes of a positive breakthrough in the ongoing trade negotiations between the US and China at the G20 Summit in Osaka, Japan.
- Listed property (SAPY) increased by 2.2% for the month.
- Bond index (ALBI) ended the month up +2.3%, supported by a ‘trade truce’ between the US and China at the G20 meeting which fuelled risk-on sentiment, enabling EM assets to post a rally at month-end.
- Cash posted a modest +0.6% for the month.
Source: Cornerstone Asset Management; Morningstar
The rand traded firmer in the second half of the month, as dovish developed markets central bank posture and hopes of positive trade talks between the US and China. The rand strengthened against all major currencies, up:
- 2.9% against the US dollar
- 2.7% against the British Pound
- 1.1% against the Euro
June was a positive month across the board with news of continued dialogue on trade issues between the US and China having a positive effect on financial market performance. The expectations of lower interest rates by the US Federal Reserve also supported stock markets in June.
While locally, the President presented his State of
the Nation Address, which highlighted key issues the government must focus on
in order to unlock economic growth. If the government, private sector and the
civil society can work together to implement these key issues, economic growth
will be unlocked.