Are we seeing a paradigm shift in interest rates?
Investors are always looking for "triggers" that they believe may result in fundamental shifts in direction between bond and equity investment. The most widely used trigger is the yield gap or, in SA’s case, the reverse yield gap (RYG)
Investors are always looking for "triggers" that they believe may result in fundamental shifts in direction between bond and equity investment. The most widely used trigger is the yield gap or, in SA’s case, the reverse yield gap (RYG).
It’s a simple concept; when the gap in yield between equities and bonds becomes too great on a historical trend basis, one should switch out of one and into the other.
So, for example, the gap between the yield on the US government 10-year bond (currently 1,5%) and the yield on the S&P 500, (2,35%) is now 0,85%, or in bond parlance, 85 basis points. It is also significant that the US has reverted to a normal yield gap, having largely had a
RYG for almost 50 years. Britain, too, had a RYG between 1959 and 2008, since then it has largely followed a yield gap pattern. Today, the yield gap is at 2,25% or 225 basis points.
These are large yield gaps and should, theoretically, signal a switch from bonds into
equities. This is obviously the main reason certain local fund managers have been flogging the dead horse of suggesting that local investors switch out of local equities into foreign stocks, such as those in the UK or the US. Historically speaking, their advice is correct; the difference this time around is that the market isn’t paying a blind bit of notice.
UK and US (and European) bond yields continue to decline even though they are perilously close to zero, and dividend yields continue to rise. UK
and US blue chip companies sit on relatively low price:equity ratios and high dividend yields, making them highly attractive. So why is this happening?
Why is the usually immutable law of comparative yield switching not working this time round?
Richard Hokenson, an economist who applies demographics to market forecasting, provides a clue in an article in the March/April 2011 issue of
CFA Magazine, "The Race to Zero". He believes that progressively lower interest rates are not just a temporary phenomenon but are intimately related to demographics. In other words, he is making the case for a paradigm shift in thinking in relation to interest rates, not just something that has been occasioned by the backwash from the global financial crisis of four years ago.
No matter how much central banks such as the US Federal Reserve try to reflate their economies by reducing rates and providing liquidity to their markets, consumers just aren’t biting. Looks like rates may have to go even lower. But why are they not biting? The answer could well lie in demographics – in ageing populations in the developed world.
A couple of years ago, Investec CEO Stephen Koseff stated at a results presentation that the people who want to borrow from the bank are not creditworthy and the people to whom the bank wants to lend don’t want to borrow. This is the nasty vice that banks find themselves in. But it can be rationalised on the basis of demographics.
As people grow older, they become more selective in their purchases and tend to buy with cash rather than on credit. Younger people are seduced by the latest ephemera and more often than not buy on credit rather than with cash. There have been questionable stories in the media recently about youngsters foregoing food in order to buy airtime for their ephemeral gadgets.
So the combination of ageing populations coupled with high and growing unemployment is toxic. Not only is the labour force in many countries not growing (a necessary condition for rising interest rates), in a number of large developed economies it is actually falling.
Demand destruction caused by demographics can’t be cured by lowering interest rates to those experienced in previous economic cycles; they will require to go much, much lower in order to stimulate demand. Hokenson believes this is a race to zero interest rates and it is a race that nobody really wants to win.
So where does SA stand in all of this? SA still has a RYG; its long-term bond yield is still comfortably above that of the dividend yield on the all share index (Alsi). But given that the Reserve Bank unexpectedly reduced the repo rate by 0,5 percentage points in July and is now widely expected to do the same in September, the way appears to be open for a continuation of the secular decline in interest rates in this country that has been apparent for the past 20 years or so. Bank Governor Gill Marcus has told markets not to expect another cut, saying:
"Further easing ... cannot be taken for granted and will depend on changing local conditions, further inflation and growth developments".
Well, if global conditions militate against inflation/reflation and global interest rates continue to go even lower, the bank’s Monetary Policy Committee may decide to cut again.
The dividend yield on the Alsi is rising and the outlook for earnings growth, especially from industrial and financial companies, is good – significantly better than in the US, for example.
A tendency also appears to be developing for companies to progressively cut dividend cover and in the process, collectively, help to increase the average dividend yield on the Alsi. Many South African companies have also chosen to increase their dividends as a result of the switch from secondary tax on companies to a dividend tax as from April 1 this year. This has had the effect of increasing dividends generally and in turn improving the dividend yield.
The chances of significant gains in the S&P 500 or the FTSE 100 appear to be diminishing. In the absence of such improvement, it seems unlikely that the Alsi is going to move upwards substantially, at least in the short term.
Given a continuation of decreasing interest rates coupled with a gradually rising average dividend yield, it is not inconceivable that SA could revert to a YG in the foreseeable future.
Absa Asset Management Private Clients analyst
* This article was first published in Investors Monthly