Interest rates are low, but rising. You don’t earn a real return on cash in the bank, bonds look expensive, or risky, and property valuations are similarly inflated. Equities offer the best bet for real returns, but there are risks to many industries as the economic cycle swings around and rates begin rising. Navigating all this is no easy matter, and the best thing for investors to do is probably to get as well-informed as possible. For example, in this interview, an investor can get some interesting insights into how money managers are thinking about income generation in the low-rate environment (spoiler: they’re thinking it’s difficult) as well as some insights into particular interest-rate-sensitive stocks, like Capitec and African Bank. Armed with this information, hopefully you can make informed choices with your own money. But know that it’s choppy waters ahead, even for the best-informed. – FD
To watch this interview on CNBC’s Power lunch click here
ALEC HOGG: You might be wondering where to invest conservative, short-term monies. In other words, the cash that you might need in an emergency. Ian Scott is Head of Fixed Income at PSG Asset Management. He too, is a Capetonian. Now, he was telling me off-air…for nine months – moving from Stanlib to PSG…a bit of a culture switch.
IAN SCOTT: A good culture switch I hope, but I am enjoying the Cape Town lifestyle, so I am becoming a true Capetonian but I’m not supporting the Stormers yet.
ALEC HOGG: Well Ian, if you’re a member of the PSG team and you don’t support the Stormers, you’re not going to last very long. This whole story about where we put our money in an environment where we have low interest rates, one or two percentage points is quite a big difference nowadays.
IAN SCOTT: It is quite a number and I think the SARB has changed the world for us in the sense that they’ve now actually signalled in January that we were at the rate cycle. Now we’re moving up, they’ve hiked rates, and we think that there are probably going to be more rate hikes because the SARB will probably say we need to have some real repo rate in South Africa because of what’s happening to tapering in the world. Rates are therefore low, but they’re not as low as they were and they are going up, so where do you want to be? You always have to run this equation at the moment. Inflation is going to be six percent this year. Yes, we will probably get to six-and-a-half somewhere in the middle of the year, but then it will come back again. We also believe in inflation targeting, so the SARB will hike rates as inflation goes up. You say ‘well, if we’re sitting…cash yield at the moment is still at five-and-a-half percent. It was five and now it’s five-and-a-half’. Inflation is six, so you’re already getting a negative real return, so you’re actually doing worse than inflation. At PSG, we think that the income fund space is quite an interesting space – why – because there’s not much value in long bond yields. We think they’re expensive. We’re not necessarily very positive on inflation bond, although they give you some sort of inflation protection, we think there’s a lot of capital risk on inflation bonds. We’re a little bit concerned around the valuation in property, so what we’re saying in a nutshell, is that we’re worried about the asset classes that have a long interest rate sensitivity. In this higher rate environment that the SARB will create, we think you need to be conservative with your money. You therefore want to have this cash-like yield in your portfolio, but you don’t want to have money market funds in a sense, because the yields are just too low. Income funds will yield you – let’s say – CIP plus one, so let’s say more into the seven percent level.
ALEC HOGG: It seems as though everyone’s pretty convinced that interest rates are going to rise. We had an interview with Mike Brown from Nedbank who said they are positioned to make nine hundred million per year in a rising interest rate environment. He told us that the market is discounting one-and-a-half percentage points in the next year already. I guess the downside is that it’s going to hurt borrowers, but on the upside the lenders would not want to lock themselves in right now.
IAN SCOTT: Exactly, so you want to add a floating rate nature to your interest rate exposure – I agree with that. We’re not exact on the timing. I’m not of the view that the SARB is going to hike at every meeting. I think it’s a wait and see approach. What happens to the Rand? What happens to the inflation profile? You’ll probably find that one to one-and-a-half percent is probably the number. Are we going to have two, or two-and-a-half? I think that would probably be closer to the end of the year – early next year. It’s all driven by the Fed. What’s going to happen to tapering? We are getting the idea…if you listen to what the Fed speakers are saying, they don’t want QE anymore. They want to do this tapering. They want to end it in 2014. The Fed would actually like to be in control of monetary policy again. They would like to probably get into a situation where they would be able to hike rates if there’s more inflation in the US. They don’t want to be in a position where they can’t move rates because there’s still Quantitive Easing in the system, so I think we’re getting to that environment where there are higher global rates. We’re going to follow because South Africa trades at a premium two years’ rates. If you call the US as your base and it lifts up like a tide then emerging market rates will also have to be higher.
ALEC HOGG: What about the difference between a borrower like Abel and a borrower like Capitec? Your group’s pretty close to Capitec so if anybody knows what’s going on there, you would know. However, there is still a perception that if Abel’s in trouble, why isn’t Capitec following?
IAN SCOTT: Because of the provisioning in Capitec. To give you a good example, I think the provisioning for bad debts in Abel has historically been very low, whereas in Capitec it’s much higher. For us, as debt investors in Capitec, we find a lot more comfort. We know there are issues in the unsecured lending market. With Abel, we’ve seen pressure. We’ve seen pressure in the numbers from JD Group, we’ve seen pressure in Lewis Group as well, and we’ll probably see it in other lenders. We saw there’s pressure in real people as well. We’re getting all these noises out of the market. We’ll probably see pressure in Capitec as well, but their provisioning has been very conservative and the way they account for non-performing loans has been very conservative. That gives us a lot of comfort around Capitec. Not all micro lenders are born/created equal, so we say you can’t say Abel and Capitec in the same sentence anymore. A good example would be the deposit-holders: Capitec has more than five million deposit-holders now and Abel doesn’t. Abel solely expects to get its funding from the capital markets, whereas Capitec has deposit-holders.
ALEC HOGG: It has a lot of retail funding.
IAN SCOTT: It’s different.
ALEC HOGG: The Abel Head of their Treasury or of their balance sheet, was telling us that they have something like fifty billion Rands worth of loans that are outstanding? Are you buying them?
IAN SCOTT: No, we’re not. We’ve actually put Abel on an embargo list. We would like to see what happens, so we’re not buying. We’re not debt holders or equity holders in Abel. We’d like to see how it plays out. Will there be another rights issue in Abel? We’d like to see that. We’ll have a wait and see approach on Abel, so we have exposure to Capitec, we’re very comfortable with that position, but we’re not comfortable with Abel. I don’t think they’ll default, but there could be a lot of spread pressure and pain in Abel risk, so guys will say ‘well, we’ll get a nice yield out of Abel paper’, but at what risk. The risk-adjusted reward is not symmetrical for us.
ALEC HOGG: Risk and reward.
IAN SCOTT: It’s about risk and reward.
ALEC HOGG: That’s what life’s about, isn’t it?
IAN SCOTT: That term ‘return of capital’ and not ‘return on capital’ is really coming back into markets as Central Banks are actually pulling liquidity out of the world at the moment.
