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Our host Ayabonga Cawe is in conversation with Chris Holdsworth, Chief Investment Strategist and Zenkosi Dyomfana, Investment Manager at Investec Wealth & Investment, where they discuss the impact that the economy has on markets and the connection between the global and the South African economy.
In this, the third instalment of season one of our Unpacking Wealth Creation podcast, fund manager Zenkosi Dyomfana and chief investment strategist Chris Holdsworth, both at Investec Wealth & Investment, discuss why and how the broader economy matters for financial markets and asset values.
What’s the connection between the economy and financial markets?
“What matters for companies over the short term is earnings and dividends, but what matters for current share prices is how you value those future earnings and dividends today," explains Holdsworth. "To do this, you have to discount future earnings and dividends at a particular interest rate, to figure out what they’d be worth today. If you attach very little confidence to a company’s forecasts, you’re going to discount at a higher rate to compensate you for the risk you’re taking on. But if you have great faith in a company’s forecasts, you’re going to discount at a lower rate because it’s less of a risk that the outcome will be different to what you expect.”
Investing in the stock market is riskier than investing in government bonds because companies have a greater chance of defaulting on their debt than governments do.
What if you want to look at the whole stock to determine whether it’s cheap or expensive?
“For the whole market, you’ll look at the broad discount rate, or the risk-free rate which is the yield on your 10-year government bond," says Holdsworth. “Investing in the stock market is riskier than investing in government bonds because companies have a greater chance of defaulting on their debt than governments do. You need to add an appropriate premium to the risk-free rate to determine the best rate at which to discount the future growth and earnings of your stock market investment.”
On the topic of government bonds, how does the yield curve work?
“The yield curve is a proxy for investor sentiment on the direction of the economy," says Dyomfana. “You get a normal yield curve, which indicates a stable economic environment in which both growth and inflation, and therefore interest rates, are rising over time. It shows that short-term bonds carry lower yields to reflect the fact that investors’ money is at less risk relative to long-term bonds. Long-term bonds demand higher yields because of the longer period of commitment required.
“When the yield curve is flat, it implies an uncertain economic outlook. Investors don’t know whether growth, inflation and interest rates will rise or fall in the future. This usually happens when the yield curve is transitioning from normal to inverted.
"An inverted yield curve happens when short-term yields exceed long-term yields and it signals an economic recession ahead. If investors believe interest rates (and therefore yields on fixed income investments) will fall in the future, then they’d rather lock in current (short-term) yields before they fall further.”
If investors believe interest rates (and therefore yields on fixed income investments) will fall in the future, then they’d rather lock in current (short-term) yields before they fall further.
Ok, so back to the stock market. Why does the yield curve matter to equity investors?
"The yield curve matters because it shows what investors believe growth, inflation and interest rates will do. Typically, higher inflation expectations are negative for risk assets, including equities," explains Dyomfana. “This is because higher inflation will require higher interest rates. You’ll therefore be discounting the future earnings of your equity investment at a higher rate, which will result in a lower present value (or share price) today.”
So as an equity investor, you want lower inflation. How does that come about in an SA context?
“We’ve recently experienced a massive boom in commodity prices and if this continues, we’ll see improved government revenues - as miners will pay more tax as they earn more. More revenue for the state means it can either reduce taxes or reduce borrowing. Reducing borrowing will lower the long-term bond yield, which is the reference rate – or tax-free rate we spoke about earlier – for discounting SA assets.”
Discounting the future earnings of your stock investment at a lower discount rate will result in a higher present value (or share price) today.
“Commodities are a key leading indicator for the SA market, not just resources stocks," asserts Holdsworth.