We all know that the South African economy is trouble and a technical recession is on the cards.
The monetary policy committee (MPC) is stuck in a catch-22 situation in trying to fight inflation but at the same time, trying to stimulate economic growth.
There is no doubt that we are entering an interest rate hike cycle and the MPC has laid its cards on the table.
Rates are going up and this not only affects you as a consumer but it also affects the stock market and investors.
Here’s how…
- Understand the interest rate
Interest is nothing more than the cost someone pays for the use of someone else’s money.
Most of us use the bank’s money to finance a home and a car and for this “privilege” we pay interest.
Credit card holders borrow short-term money and for this short term “loan” you pay a whack of short-term interest.
In plain English, by raising interest rates, the Reserve Bank is essentially making less money available by making it more expensive to borrow.
- The ripple effect
The ripple effect is a logical domino effect and the dominoes fall like this:
Rising interest rates means consumers have to pay more to service debt.
That means that they have less money for other stuff.
We call that “discretionary” money.
When consumers have less “fun tokens” to spend, businesses start to see their profits drop.
When businesses are also servicing debt and making less profit, we start heading to lower future valuations.
Simply put, interest rates determine how consumers and businesses spend their money.
This increases expenses for companies, lowering earnings especially for those with debt to pay.
- The stock price effect
One method of valuing a company is to take the sum of all the expected future cash flows from that company discounted back to the present.
A stock’s price is this expectation divided by the number of shares in issue.
When companies cut back on spending (loans for growth) and is making less profit, the share price comes down.
When this happens to a lot of companies, the market comes down.
I want to make it quite clear that the interest rate is not the only consideration in rising and declining share prices.
There are many, but I am just pointing out the impact rising rates can have on stocks.
- Interest-bearing securities become more attractive
The other phenomenon which tends to occur when interest rates are expected to rise is that a lot of cash moves to the money market.
Investors to some degree move out of stocks and go to the “guaranteed” income offered by bonds and interest-bearing securities.
This shift or selling out of stocks tends to put pressure on individual share prices.
- The currency effect
We all know that the Rand has become pretty much worthless in the eyes of the world, but a change in interest rates has a direct effect on the currency.
It may be short lived or extended for some time, but when interest rates rise and are expected to rise, the currency strengthens.
In a South African context, a stronger currency directly impacts many of our shares.
Commodity and mining stocks that rely on a weaker Rand start feeling the pressure as they earn fewer Dollars for the commodities they sell.
Exporters of goods and services bear the brunt of a stronger local currency.
Further pressure on margins is added if they happen to be servicing debt too.
On the flip side, importers benefit from a stronger currency as they need fewer Rand for the goods and services they bring in a foreign currency.
- Investment effect
Knowing how interest rates affect the market and shares can go a long way to not only profiting from the move to trade in the right areas, but also the knowledge is vital in capital preservation when things go bad.
It’s not rocket science by any means, but knowing the impact of simple interest rates will go a long way to making you a better investor.
Benoni resident Roberto Pietropaolo, or Robby P, as he is known in the financial markets, is committed to educate you on financial wellness, investing, and general money matters. He works for Vunani Private Clients as a trader, investor, mentor and tutor. He specialises in trading the short- term derivatives market and longer-term equity or share market.
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