The Fed and us

In October US non-farm payrolls grew by 271 000. This was the fastest rate so far this year and was well above market expectations.

Job numbers for the previous two months were also revised upward. Furthermore, wage growth in October quickened to 2.5% year-on-year, the fastest rate in six years.

The strong labour market report suggests that US economic growth momentum remains solid despite soft global growth.

This has increased speculation that the US Fed will begin raising interest rates at its December meeting.

Rising US interest rates matter for countries like South Africa as it will impact both our financial markets and economies.

The prices of risky assets like equities are driven by the rate of profit growth and the interest rate with which those profits are discounted.

Therefore, risk asset prices can increase significantly even in an environment of muted but stable economic and profit growth so long as interest rates are very low.

Thus, despite a muted recovery in SA’s economic growth from the 2008/9 global financial crisis, the performance of the South African equity market has been stellar.

The JSE’s All Share Index bottomed at a level just shy of 18 400 in October 2008.

It was trading at near record-high levels of 54 000 in the first week of November.  This strong performance has in part been driven by the extremely easy money conditions engineered by the Fed since 2008.

By keeping US interest rates exceptionally low the Fed has provided a strong underpin for global equity prices, SA’s included.

Exceptionally low US interest rates and quantitative easing have also underpinned emerging market currencies like the rand by encouraging portfolio inflows.

Over the past year financial markets have been discounting the commencement of Fed interest rate hikes.

The recent non-farm payrolls report has increased the expectations that the Fed will begin raising rates in December.

South African equities, along with those of other emerging markets, have lost ground as a result.

Besides causing volatility in equity prices, rising odds of higher US interest rates have coincided with significant dollar strength the flipside of which has been weakness in emerging-market currencies including the rand and Brazil's real.

Looking forward, there is a fear that there could be further and sustained exchange rate weakness among vulnerable twin deficit emerging-market economies like SA. 

This is an excerpt from an article that originally appeared in the 10 December 2015 edition of finweek. Buy and download the magazine here.