The Reserve Bank will have to hike rates – eventually
South Africa’s ongoing economic recovery hinges on the consumer. The consumer, in turn, relies almost entirely on improvements in net disposable income to fuel his/her consumption expenditure. And there are only two ways this improvement can take place – income goes up – or expenses go down. In the perfect world the forces of inflation are balanced by annual salary increases… But the world isn’t perfect. Most local consumers have discovered their annual inflation-plus salary hike isn’t enough to accommodate their personal inflation profiles. Yes – their wage increase outstrips official inflation – but by the time they factor in “real world” increases in municipal rates, water and lights bills, medical aid expenses and food and transport they’re actually going backwards.
The problem is made even worse because we’re at the low-point in the interest rate cycle. After benefiting from repeated interest rate cuts since December 2008 households with fixed-rate mortgages, vehicle finance agreements and loans will have to accept that the next Reserve Bank decision will leave them out of pocket! How “out of pocket” – and how soon? To find out we attended an Investec Asset Management media presentation hosted at the group’s Johannesburg head office, 13 April 2011. Malcolm Charles, portfolio manager at Investec Asset Management, shared some of his views on interest rates and inflation.
The next interest rate move is up
“There is consensus that we are at the end of the interest rate lowering cycle and that the next interest rate move is up,” says Charles. The only room for argument is when this move will occur, with a lesser debate around the quantum of the move... Investors don’t always price the market for perfection and fixed income fund managers usually get a feel for things by looking at the short-date FRA (forward rated agreements) curve. In January this year the market was pricing in a 1% interest rate hike before 30 June, but this view has since softened considerably. Economists are now pencilling in a rate hike before year end.
Inflation remains one of the best leading indicators of likely interest rate interventions. “We expect inflation will remain benign over the next month or two,” says Charles. “But it will tick up sharply from July 2011 due to external price shocks from food and oil.” The rest of the components of South Africa’s inflation basket are trending sideways at present.
Local consumers will love this “stalling” tactic
Economists like to consider inflation from a number of angles. A technique made popular by the US is to consider inflation with the impact of food and oil stripped out… This “core” inflation is typically lower than CPI. Although not the official position of the Reserve Bank there is a chance future Monetary Policy Meeting (MPC) decisions will place more emphasis on core inflation when making interest rate decisions. That’s good news for consumers because it will effectively allow the central bank to delay the inevitable 2011 rate hike to as late as November 2011. Investec believes we will have a 50 basis point interest rate hike possibly as early as September, but more likely in November. “You can expect our central bank to be more Bank of England than European Central Bank,” says Charles. They will act cautiously because there isn’t a central banker in the world who wants to be responsible for pushing their economy back into recession.
“It is important to realise the first 100 basis points of interest rate hikes represent a normalisation of the local interest rate regime rather than a change in cycle,” observes Charles. The extent of the sub-prime economic contagion forced central banks around the world to cut rates much further than they would normally have done. South Africa took similar steps and current interest rates are definitely lower than they would have been had recession not occurred.
Destroying the “strong rand” myth
A study of recent foreign investor capital flows to the domestic bond market suggests the rand isn’t as sensitive to “hot flows” as previously thought. The rand continued to strengthen through the first quarter of this year despite R44 billion flowing out of the bond market. Charles says the rand strength is actually due to longer-term capital from offshore pension funds and foreign corporations, mostly to local equities.
For this reason the rand could stay “stronger for longer”! Charles pointed out that South Africa’s “rand must weaken” attitude stems from the whipping we received during currency shocks in 2001 and 2008… But these six week dips have typically been followed by long periods of rand strength relative to a basket of offshore currencies. In fact – if the rand retraces its post-2001 recovery – we could see it strengthen to R4.50 to the dollar. It’s an unlikely scenario but stranger thing have happened in the world of currency trading.
The irrationality of global investors is further illustrated by the 4.5% “gap” between the yields on Emerging Market bonds versus G10 bonds… “On average the advanced economies are technically bankrupt – so lenders are effectively receiving a 4.5% premium for backing the less risky opportunity,” says Charles.
Editor’s thoughts: The frightening thing about the current inflation and interest rate outlook is that South Africans are as indebted as ever. We weren’t able to reduce our debt burden during the “good” times, with 550 basis points in cuts beginning December 2008… Instead of paying down our existing debt we used the notional savings from lower mortgage instalments to cover “cost of living” expenses. Is there room in your household budget for a couple of interest rate hikes later this year? Please add your comment below, or send it to [email protected]
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