Figure JSE and short term interest rates by jolinmilioncherie


									                                August 2003



   The Impact of Interest Rates on the Performance of JSE Equities

   Outlook for Interest Rates

   Investment Implications of Declining Interest Rates

   Investec Preference Shares

Dr Gad Ariovich, editor and Investment Consultant
                     Contributors: Desmond Esakov, Charl Marais
                       PERFORMANCE OF JSE EQUITIES

Interest rates are a powerful force influencing the JSE equity market. The reasons are straight

    a) Interest rates present alternative investment opportunities (via fixed income instruments),
       thus changes in interest rates should affect the opportunity cost of investment in equity.

    b) From the listed company’s point of view interest rates can have a significant impact on
       costs. The severity of the impact on interest rate movements will be a function of the
       gearing of the company.

    c) Also, from the individual company’s point of view, interest rates may have an impact on
       the demand for its products. The more products are sold on terms, the stronger will be the
       effect of interest rate movements on the company’s sales.

    d) Last but not least, interest rate cycles are related to general economic activity and the
       latter should influence earnings and business confidence. Consequently, a buoyant
       economy and expectations about future economic activity should have an impact on share

Figures 1 and 2 show the well-recognised inverse correlation between interest rates and the
performance of the JSE share price index.

                                    Figure 1: JSE and short-term interest rates

                                          JSE ALSI vs. Short Term Interest Rates
                     23                                                                       12000

                                          ST Interest Rate                                    10000

                     17                                                                       8000


                     11                                                                       4000

                      5                                                                       0
                          92   93    94     95     96    97     98   99   00   01   02   03

Similarly, Figure 2 shows the relationship between the JSE share price index and real interest
rates expressed by the difference between nominal interest rates and inflation rates.

Anglorand Securities: Investment Outlook - August 2003                                                Page 2 of 8
                             Figure 2: JSE and real short-term interest rates

                             JSE % Change vs. Real Interest Rates (Short-Term)
                  60                                                                    14

                                    Real Interest Rate                                  12

                  10                                                                    6

                                                          JSE                           0

                 -40                                                                    -2
                       93   94     95     96         97     98   99   00      01   02

Exhaustive research on the impact of interest rate movements on the JSE share price index has
been conducted by many academics and investment analysts (including ourselves) and the above
relationships are already well known to the S.A. investment community.

Perhaps less obvious is the relationship between the activity on the JSE and financial liquidity in
the economy. In examining these relationships, the difference between short-term and long-term
interest rates is used as an indication of the degree of financial liquidity in the economy. The
reasoning behind this is that short-term interest rates tend to be much more sensitive to liquidity
than long-term interest rates. Hence, the difference between the two should reflect the degree of

                                     Figure 3: JSE & financial liquidity

                                    JSE & Financial Liquidity (yield curve)
                  80                                                                    60

                  40                           JSE                                      30

                   0                                                                    0

                 -20                                                                    -10

                                 Yield Curve                                            -20

                 -60                                                                    -40
                       93   94     95      96        97     98   99   00      01   02

Anglorand Securities: Investment Outlook - August 2003                                        Page 3 of 8
Figure 3 shows the relationship between financial liquidity and changes in the JSE all share price
index. According to this graph, the higher the liquidity the higher the JSE index.

In order to form a view on the impact of interest rates on JSE equities over the next twelve
months, our forecast for SA short and long term rates are discussed below.

                               OUTLOOK FOR INTEREST RATES

The consensus view suggests falling of both long and short term interest rates.

Outlook for short-term rates:

According to the consensus view, it is suggested that SA short-term rates will fall further by at
least 3% to 4% over the next twelve months.

                 Figure 4: Outlook for SA short-term interest rate – consensus view.

                                                   SA Prime Rate









                          92   93   94   95   96    97   98   99   00   01   02   03

We support the consensus view from the following reasons:

    (a) The monetary policy is too strict for the prevailing economic circumstances. For instance,
        the yield curve is abnormal and has an inverse shape i.e. the short term rates are much
        higher than long-term rates.

    (b) The global economic environment is currently characterized by a very accommodating
        monetary policy, which is contrary to the prevailing policy in South Africa.

    (c) Real interest rates are still higher in South Africa than in most other countries.

Anglorand Securities: Investment Outlook - August 2003                                       Page 4 of 8
    (d) It appears that the level of the economic activity in South Africa is fairly subdued.
        The authorities are therefore more open to reflating the economy (especially, when
        elections are due in 2004).

    (e) Perhaps the most important reason is that inflationary expectations in South Africa
        are abating substantially.

Outlook for SA long-term rates:

According to the consensus view long-term interest rates will drop further but to a much lesser
extent than the short ones.

                            Figure 5: Outlook for SA long-term rates (R153)

                                            Long-Term Interest Rates





                      92   93    94    95     96    97   98    99      00   01   02   03

Contrary to short rates, the long rates have strongly responded to lower inflationary expectations
now prevailing in South Africa and we forecast a further fall of about 1% to 2% in the next 12
months (as against 3% to 4% for the short ones).

We suggest a further fall in long-term rates for the following reasons:

    (a) We believe that the local inflation rate will be below 5% by yearend and at the end of 2004
        below 4%. There is no justification therefore to have real rates in South Africa of above 4%
        (as the economic theory in Fisher’s model suggests real rate of 2, 3 percent for a stable

    (b) The SA fiscal situation is in a very healthy state and the government deficit is comfortable
        below 3% of GDP (a benchmark recommended by the EEC). Thus, the issuing of new
        long-term bonds by the government is decreasing.

    (c) World inflation is very subdued and there are fears of deflation.

Long and short rates tend to move in tandem. If we believe that the local monetary policy should
be more accommodating and short rates will fall further, long rates should follow suit.

Anglorand Securities: Investment Outlook - August 2003                                     Page 5 of 8
                           INVESTMENT IMPLICATIONS OF
                            DECLINING INTEREST RATES

Investors often select a share according to the internal qualities of the company e.g. its
management, systems, financial ratios etc. Much of the company performance, however, is as a
result of favourable or unfavourable developments in the investment environment. Interest rates
are one such example. Shares of highly geared companies tend to fall further during a period of
rising interest rates and vice versa. This study therefore investigated the behaviour of the JSE as
a whole, as well as the behaviour of various individual shares as a result of changing long and
short-term interest rates.

We have selected thirteen individual shares for the sensitivity study. The selected shares are
Anglo American, Goldfields, Impala Platinum, Sasol, Sappi, Standard Bank, Investec, Old Mutual,
SA Breweries, Pick & Pay, Dimension Data, Richemont and Imperial. We had to eliminate five
shares from our study because of their relatively newer listings and lack of historical data. As Old
Mutual’s market capitalisation value is so large, we used the JSE Insurance Industry as a long
enough proxy for the company. The result of our investigation is presented below:

The sensitivity of JSE shares to interest rates

The table below shows the correlation and the sensitivity of JSE shares to interest rates.
The investigation examines the impact of both short-term (Three Month Treasury Bills) and long-
term (RSA 150) rates. As should be anticipated, there is a negative correlation between interest
rate movements and the performance of equities i.e. lower interest rates tend to result in higher
share prices.

                The sensitivity of various blue chip shares to interest rate movements

                       Company               3 Month - T Bill              R150
                                         Coeff     R-Squ   Beta    Coeff   R-Squ   Beta
              Pick & Pay                 -1.03     0.14    -1.80   -1.00   0.13    -1.33
              Sappi                      -0.84     0.08    -1.48   -0.76   0.07    -1.01
              Standard Bank              -0.79     0.14    -1.39   -1.10   0.28    -1.48
              Anglo                      -0.75     0.12    -1.32   -0.87   0.16    -1.17
              Imperial                   -0.72     0.16    -1.25   -0.92   0.26    -1.23
              Life Assurance Index       -0.68     0.17    -1.14   -0.98   0.37    -1.29
              Sasol                      -0.58     0.06    -1.02   -0.59   0.06    -0.79
              Implats                    -0.57     0.04    -1.00   -0.31   0.01    -0.42
              All Share Index            -0.57     0.16    -1.00   -0.75   0.34    -1.00
              Investec                   -0.52     0.07    -0.91   -0.94   0.24    -1.25
              SAB                        -0.52     0.09    -0.93   -0.86   0.26    -1.15
              Goldfields                 -0.36     0.02    -0.63   -0.44   0.03    -0.59
              Richemont                  -0.34     0.05    -0.60   -0.43   0.08    -0.58
              Didata                     -0.28     0.01    -0.49   -0.77   0.09    -1.03

The table above shows that JSE share price movements are fairly correlated and sensitive to the
development in interest rates. Pick & Pay, Sappi, Standard Bank, Anglo, Imperial and life

Anglorand Securities: Investment Outlook - August 2003                                     Page 6 of 8
assurance companies (Old Mutual) are all very sensitive to short-term interest rate movements.
In general, the JSE as a whole is more sensitive to the long-term rate than to the short one. A 1%
rise or fall in the long rate tends to result in a 0.75% fall or rise in the JSE Overall index. The
most sensitive JSE shares to long term rates in our sample are Standard Bank, Pick & Pay, life
assurance companies and Investec.

It is believed that the findings can be a useful tool in investment strategy and decision-making.
To use this tool for trading purposes, the investor should make a judgement on the macro
developments. For instance, if the investor takes the view that interest rates will fall further, he
should invest aggressively with retailers in this case Pick & Pay. One could also invest in banking
shares namely Standard Bank and Investec and perhaps also in transportation, in this case
Imperial. Of course, the investor still has the difficult task of assessing how much of the change in
interest rates have already been discounted by the markets.

A particularly useful application of this study is in structuring well-diversified portfolios. In
structuring a long-term portfolio, the investor does not need to take a specific view on future
developments but needs to build a portfolio in a way that will actually hedge the investment
against unexpected changes in interest rates. This means investors can build a balanced portfolio
sheltered, to an extent, from unexpected long-term developments of interest rates.

   The methodology of the study
   Using a statistical technique, we investigate the degree of association between the share price
   movement and various macro developments. For the readers who still remember their course in
   statistics, we applied linear regression analysis to measure both the degree of correlation (Rsq) and the
   sensitivity (b coefficient) of various JSE shares as a function of various macro developments. By
   normalizing the b coefficients, we also calculated the Beta of the share. More specifically, in this study
   we measure the sensitivity of the price movements of the above-mentioned JSE shares as a result of
   the developments in South African short and long-term interest rates. We have also conducted similar
   studies on the impact of international equity indices, the gold price, the rand exchange rate and
   commodity prices on JSE equities.

                           INVESTEC PREFERENCE SHARES

Like Nedcor, Investec too will be issuing preference shares. The preference shares will be listed on
the JSE and will yield 75% of the prime rate (currently 15.5%) tax-free. The face value or listing
price will be R100. The shares will be non-redeemable meaning that the shares cannot be
redeemed at any time in the future unless in the highly unlikely event the company goes under.

Dividends will be paid out semi annually. Preference shareholders have preferential access to
dividends, which means that ordinary shareholders cannot receive dividends until preference
shareholders have been paid.

The Investec preference share is ideal for individuals that wish to have exposure to a low risk,
high-yield, and tax-free investment. Investors will be able to sell their shares on the JSE at the
ruling price and they will trade like any equity instrument thus alleviating liquidity risk. At the
current prime rate (15.5%) the projected returns of various tax rates are shown in the table

Anglorand Securities: Investment Outlook - August 2003                                            Page 7 of 8
                                               Annual Yield       Equivalent
                                Tax Rate
                                              (Not Taxable)      Taxable Yield

                                  30%             11.63 %            16.61 %
                                  35%             11.63 %            17.88 %
                                  40%             11.63 %            19.38 %

The minimum required investment is R100 000 per investor but smaller amounts are also
available to our clients via share splitting. There is no maximum investment for private clients but
the minimum issue size is R500 million. This means that investors may not be allotted their full
subscription amount if it is oversubscribed. Given the popularity of the Nedcor preference share
we feel that over subscription is a very real possibility.

In summary the benefits are:

       The investment provides an attractive tax-free yield.
       The preference shares can be traded on the JSE.
       No upfront participation fees.

David Lewis (CEO); David Palmer (Director/Head Dealer); Adriaan Kamper (Financial Director);
Yulindi Taljaard (Compliance Officer/Settlements Manager).

Harold Bernstein (Chairman); Dr Gad Ariovich (Investment Manager); Richard Bonnichsen; Charl Marais;
Desmond Esakov.

                                           ANGLORAND SECURITIES

Tel: (011) 484 7440 • Fax: (011) 484 6647 • Website: • Email:
                    Address: 3rd Floor, Werksman Chambers, 22 Girton Road, Parktown, 2193

Anglorand Securities: Investment Outlook - August 2003                                           Page 8 of 8

To top