Interest rates can set off a major contraction

As the first semester came to an end, the trend in worldwide markets since the third week of April, seems to have entered a downward phase.

The normal gyrations are still there but average returns at the end of the semester was down by around 4% from the lofty heights of early April. On an annual basis, in general, the big markets are still some 10% up however the second quarter down trend is corroborated by the data from many other trading and investment platforms.
There is much talk from foreign analysts about a market correction. Depending on whose data set one follows, the correction can range anything between 10% and 40%. The only problem is, it has not happened, and from a macro-economic perspective, is unlikely to happen, especially a correction of more than 10%. But in my view the markets are not out of kilter only slightly, they are massively distorted, so a 40% correction is not completely off my radar. It is only that there seems to be no single catalyst that will trigger such a calamitous correction.
So what constitutes a potential trigger event with enough force to shake markets. I believe there is only one candidate and that is American short term rates.
Since February, the Federal Reserve has tweeked its rhetoric, now including references to the likelihood or need for an interest rate increase later this year, but nothing is firm. Meanwhile the Fed keeps promising it will not act with undue haste, and certainly not in a way that will erode confidence and undermine markets.
Short term interest rates are potentially a very disruptive force. When one comes from a zero interest rate environment, even the slightest adjustment has major repercussions for a host of sub-disciplines in the investment industry. It is for this reason, I and many others, expect the Fed to make initial adjustments in the order of only 100 basis points.
It is not immaterial when the Fed starts raising interest rates but it is more important how fast they choose to make these adjustments. Again, I can not find a consensus view with opinions ranging from 24 months to 10 years. But what I do find is a general agreement that higher interest rates in America may be highly disruptive for emerging capital markets.
I do not buy the reasons offered by our Bank of Namibia for the necessity to raise domestic interest rates but I do believe, the central bank, perhaps in consultation with the Reserve Bank in South Africa, and other central banks in the region, has taken a decision to act pre-emptively on short term interest rates. I further sense that this is for only one reason, not to be caught off guard when America raises its rates.
It is a futile exercise to try and convince politicians the weak exchange rate has nothing to do with the interest rate differential but everything with the South African government’s mismanagement of its own economy, and particularly of its own currency. In our case, the deterioration in the foreign reserves are stated, alongside household indebtedness as the major reasons for the incremental interest rate rises. The weak currency is the favourite scapegoat for the negative balance of payment but that is because government analysts approach the problem from a conventional point of view and not from a development perspective.
Any country that is stimulating its economy as aggressively as we have done for five years, will find it has created more inflation than it can handle. Any country where large capital projects are taking place at a rate that far outstrips the rest of the economy, will develop balance of payment problems for one simple reason.
The projects require more imports than the rest of the economy can collateralise, but the deficit must be funded from somewhere, usually from the capital market through additional domestic liquidity, and this has an impact on the external value of the currency, which in turn, exacerbates the balance of payment problem. The solution is then simply seen as an interest rate problem. It is not that simple, and the wrong people get penalised.
It is good that we prepare for higher interest rates but the balance of payments must be fixed at the point of entry. In other words, the sponsors of the large projects must pay more to import their capital goods. This will relieve the pressure on the balance of payments, on the currency, and on foreign reserves. Then household indebtedness will no longer need to be offered as the reason for higher interest rates.