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Don't Miss Out On The Rate Cutting Cycle
31 August 2017 | SA Views | Joani van Wyk
 


On 21 July 2017, the SARB announced a 25bp interest rate cut which now positions the repo rate at 6.75%. This is the start of the fourth interest rate cutting cycle since October 1998.

When looking at some of the major indices which date back to 1998, there are interesting trends in the six months prior to and six months following the start of each cutting cycle. We decided to have a look at the performance of some indices for the past three cutting cycles, and the results can be seen in Table 1 and Table 2 below. These cutting cycles started in October 1998, June 2003, and December 2008, respectively:

image1

image2

Table 1 contains the average return for each sector, over the given period pre or post the start of the cutting cycle. For example, the ’-6 Months’ column in Table 1 is the average of the returns over the six-month period prior the start of the cycle, for each cutting cycle. Table 2 assigns a score to each return in Table 1 according to the legend below Table 2. A score of 3 indicates that the return for that period length was positive for each cycle. A score of 2 indicates that 2 out of the 3 returns were positive and one was negative.

When looking at Table 1, it can be seen that all average returns were negative six months prior to the start of the cycle, and positive six months after the start. Another observation is that there is a recovery in all of the sectors from "-6 Months" to "-1 Month", a slight turnaround from "+1 Months" to "+3 Months", and a maximum average is reached by all indexes in the "+6 Months" period except for the Life Insurance Index, the Financial 15 Index and the Banks Index. The average returns for all three of these indices reached their peak during the "-1 Month" period.

This result can be expected since the earnings of the banking/finance and life insurance sectors increase with interest rate hikes, due to investment in interest-sensitive securities. As banks hold large amount of cash deposits, they can invest the deposits on short-term notes and pay interest to client accounts at interest rates below the short-term rate. Should a rate cut be announced, this spread (yield on cash minus interest paid to customers) narrows. Should banks lower the interest paid to clients, they would simply move their deposits into higher-yielding investments.

Life insurance companies face considerable interest rate risk being invested in fixed income securities and having to match liabilities with assets. A decrease in interest rates can affect the liquidity and earnings of a life insurance company and make products less attractive than, for example, investing in life annuities providing higher yields.

In general, lower interest rates reduce savings and increase consumption spending and investment in assets. All else equal, an increase in demand will increase the prices of these assets and increase the earnings of the firms.  Lower interest rates also reduce borrowing costs which provides an incentive for firms to pursue profitable new and expanding business ventures. This is likely the reason for seeing mostly positive average returns for the period "+6 Months" as the performance of those indexes are impacted by the propensity of consumption and investing in higher yielding investments.

From this analysis, we can conclude that it would be best to be lighter on financial sector investments compared to the better performing sectors in Table 1 to benefit, should history repeat itself, from the interest rate cutting cycle that has just commenced.



joani

Joani van Wyk
Analyst

Joani van Wyk joined the asset management team in January 2017, responsible for quantitative research of equities across all industries. Joani completed her degree in Mathematical Science in 2015, as well as an Honours degree in Financial Risk Management in 2016, both at the University of Stellenbosch. She is currently a CFA candidate.


Disclaimer:
The information contained in this article is for informational purposes only and must not be regarded as a prospectus for any security, financial product or transaction. It is neither to be construed as financial advice nor to be regarded as a definitive analysis of any financial issue. Investors should consider this research/article as only a single factor in making their investment decision. We recommend you consult a financial planner/advisor to take into account your particular investment objectives, financial situation and individual needs.

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