The inflation conundrum
The South African Reserve Bank (Sarb) has a tough job to do. They are responsible for setting local interest rates at an appropriate level to keep domestic inflation in check, preferably within their self-imposed 3% to 6% inflation band recently. Through 2011 their task will be complicated by rampant global inflation which is pushing the price of food and energy through the roof. Their interest rate decision will also have to take into account the delicate interaction between interest rates, inflation and economic growth. If they hike rates ahead of the curve they will face a groundswell of resistance from trade unions, big business and government – but if they hike rates too late then inflation may become a real problem!
Arno Lawrenz, chief investment officer at Atlantic Asset Management, says we are still living in a two-zone inflation world. He made these comments at a recent Specialist Investment Manager Conference, hosted jointly by Atlantic, Cannon Asset Managers, Catalyst Fund Managers and Kagiso Asset Management. He observed that developed market inflation remained low despite the record amounts of funding injected by their respective governments in an attempt to kick-start economic growth. In contrast emerging market inflation was surging on the back of higher food and energy prices.
Where too for interest rates?
This two-zone situation will persist for some time. “There is no way Japan can even contemplate raising interest rates in the wake of the quake/tsunami/nuclear triple disaster,” says Lawrenz. And the state of the US housing market and its fragile employment statistics make rate hikes improbable there too. Similar arguments dictate to policymakers in Euro-zone countries. Meanwhile the BRIC (Brazil, Russia, India and China – but excluding South Africa) have recently, or are contemplating, interest rate hikes to tackle their overheating economies.
JP Morgan Asset Management recently published an interesting diagram illustrating likely inflation scenarios for the world’s major economies through 2011/12. The group assigned weightings to three likely scenarios as follows: deflation (15%), disinflation (60%) and inflation (25%). Lawrenz says countries such as China, Brazil, Korea and other mainstream emerging economies fit under the inflation header, in a sub-category titled “fast and looser”. These economies will typically exhibit rapid growth with surging inflation, requiring rapid intervention to slow things down.
South Africa doesn’t exhibit similar growth traits and is better compared to the US, which falls in the “dream ticket” sub-category under the disinflation header. Our economy will probably exhibit slower growth through 2011/12, with monetary policy making it easier for companies and consumers to raise finance. The problem for local economists (and the Sarb) is we have rising inflation without growth! Policymakers have a serious problem: in the US interest rates cannot be cut further, while in South Africa the cuts needed to stimulate economic growth cannot take place due to inflation targeting policies that demand rate hikes to “cool” consumer spending.
Even so, there is little doubt the Reserve Bank’s next monetary policy intervention will be to hike interest rates. A quick look at real repo rates confirms we have the lowest real interest rates since inflation targeting was implemented a decade ago.
A tough challenge for income fund managers
The bond markets are very quick to price in likely interest rate movements, but despite the expectation of increases later this year we are still investing in a low yield environment. Lawrenz sketched the likely return situation using three different financial products. Investors can expect a total return of 9.10% from government bonds (based on the R186) provided interest rates remain unchanged. But the return plunges sharply, to just 3.4% in the event bond yields rise by 0.75% this year. The returns on inflation linked bonds aren’t much better. The R197, assuming inflation averages 4.5% through 2011, offers a total return of 6.8%, dropping to just 3.6% if its yield rises by 0.35%.
As a result income fund managers are turning to preference shares and the listed property segment for returns. There are a number of locally listed preference shares with yields in excess of 7%, while listed property yields are pegged in the 8%-plus region. The bulk of assets under management in the Atlantic Enhanced Income Fund were invested in money market (42.6%), government bonds (12.4%), inflation-linked bonds (12%), listed property (11.8%) and preference shares (4.1) at 31 March 2011.
Editor’s thoughts: The domestic economy is becoming increasingly complex. Our politicians are beaming after we were invited to join the so-called BRIC nations; but just about every macroeconomic measure suggests this pairing is wholly inappropriate. While the dominant emerging economies try to keep inflation in check (with record growth), we’re battling the same problem with the economy on quarter throttle. Can South Africa cool inflation without hiking interest rates? Please add your comment below, or send it to [email protected]
