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Local lowflation

27 August 2019 Dave Mohr (Chief Investment Strategist) & Izak Odendaal (Investment Strategist) from Old Mutual Wealth

The week ended on a very sour note as markets were shocked by the sudden and unexpected escalation in the trade war between the US and China on Friday evening. However, there was some good news when Stats SA announced that local inflation fell to 4% year-on-year in July. This was down from 4.5% in June and substantially below the Reuters consensus forecast of 4.4%. Core inflation, which excludes volatile fuel and food prices, ticked lower to 4.2%. Inflation is comfortably below the midpoint of the SA Reserve Bank’s 3% to 6% target range.

Overestimated
Over the past five years, private sector economists have overestimated inflation by a cumulative 2.6%. One would expect forecasters to overshoot as much as they undershoot over time, so the extent of the miss is telling. The inflationary dynamics of our economy appear to be undergoing a fundamental shift, somewhat catching analysts, businesses and policymakers off-guard. Broadly speaking, inflation is low because competition has increased in the South African economy, partly as a result of technological advancements (a trend clearly in play in other countries), lower global inflation, and a lack of consumer demand. Price setting has been more flexible in a number of areas (goods, services, rents, wages) and dependent on current realities rather than simply on past inflation. Though low inflation is typically good for consumer purchasing power, income growth has also slowed so that the real income of households is barely growing.

Inflation numbers are credible
We often hear scepticism from clients that inflation could not possibly be as low as the official numbers suggest. Why? Firstly, to state the obvious, inflation refers to increases in the broad price level, and not changes in individual prices, which people often focus on. They tend to note the volatile items such as food and fuel more, but not items where prices adjust annually, such as insurance premiums and bank charges, or items where prices don’t change much. For instance, vehicle insurance premiums fell by 3.5% over the past year, indicative of a very competitive market. That doesn’t mean everybody’s premiums declined, but enough people saw their premiums decline, possibly through switching insurers. Secondly, a common mistake is to confuse expensive with high inflation. Inflation is the rate at which the general price level changes. Falling inflation means prices are rising, but at a slower pace than before. Something can be expensive and have no inflation, as South Africans visiting Japan later this year to support the Springboks will experience. Japan is consistently ranked as one of the most expensive countries, but its inflation rate has been 0% over the past 20 years. Thirdly, people are very bad at doing a mental compound growth calculation. A price that has increased by 50% over 10 years grew at a compound annual rate of only 4%. Four, the imputed prices of some items decline because quality improves. A cell phone might cost 5% more than a year ago, but if its technical specs are 10% better, the real value to consumers has increased.

If you don’t believe the official numbers, you can always look at what listed retailers are telling us. Shoprite, South Africa’s largest retailer with a presence in the high and low income market, reported average inflation of 1.2% over the financial year ending June, though by the end of this period it had increased to 2.5%. Shoprite said 9 679 items on its shelves saw falling prices over this period (though none so dramatic as the decline in the price of Shoprite shares). This highlights an important technical difference between how Shoprite (and other retailers) and Stats SA measure inflation. Stats SA fixes the weights of the basket of goods and services it tracks for five years, while Shoprite’s measure accounts for how shoppers adjust spending patterns on a daily basis as prices change. For instance, if red meat prices rise, consumers might buy more chicken, and vice versa. The actual inflation experience of South African consumers might therefore be lower than the official numbers suggest. After all, the challenge for Stats SA is to construct a basket that replicates that of the average urban South African, but most of us will have different individual baskets. Of course, the official consumer price index number covers a broader category of spending than just retail sales. It includes fuel, vehicle purchases, housing, communication, financial services and a few quasi-taxes. The two big outliers in the inflation report can be found in the latter categories. Health insurance with a large weight of 8% in the index increased 8.9% year-on-year. Electricity has a weight of 4% and increased 10% over the past year. Stats SA noted that not all municipalities have implemented the annual tariff increase yet, so this number could still rise. Health insurance inflation is substantially higher than the inflation rates of medical services and goods (5.4%), pointing to a certain level of inefficiency in the private healthcare sector. As for electricity, we are paying for Eskom’s massive inefficiency, the lack of competition in the electricity market, and the fact that the municipalities rely on electricity sales for revenue. Excluding such administered prices (i.e. prices not dynamically determined in competitive markets), consumer inflation was only 3.8% in the year to July.

Investment implications
What does this mean for asset classes? For domestically focused shares, low inflation has been a massive headwind. After all, one person’s inflation is another’s income. More specifically, low inflation means a severe margin squeeze as input cost inflation has not necessarily slowed to the same extent. Inputs differ from sector to sector, but usually wages, electricity, fuel, municipal charges feature high on the list, along with imported items that are sensitive to exchange rate weakness. Sticking with the Shoprite example, the labour minister recently approved the sector wage determination of retailers and wholesalers at 4.5% higher than a year ago. While this is lower than the wage increases we are accustomed to, it is higher than Shoprite’s local revenue growth. Shoprite is also a large renter of space in shopping centres. If it cannot negotiate leases down, these also eat into its margins. If it is successful, it is the property companies like Hyprop and Resilient who have to make do with lower income growth. However, they in turn face electricity and municipal tariff increases of close to double digits, along with other maintenance costs. Like energy, the margin squeeze can be transferred, but not destroyed.

But firms cannot pass the full extent of cost increases on to consumers. Even the latest bout of rand depreciation is unlikely to result in much higher consumer inflation. The sustained margin squeeze of domestic-focused South African businesses, plus the overall negative sentiment surrounding the local economy has seen several share prices fall to multi-year lows. Only a few large-cap rand hedge shares are keeping the overall JSE index up. Most companies have responded to the margin squeeze by cutting as much fat from their cost base as possible. When the economy finally picks up a bit of speed, higher top-line growth should see substantial profit improvement. A boom is not necessary, growth above 1% rather than below 1% would already help, but even that modest improvement still appears some way off. Lower inflation is positive for fixed income assets, especially longer-term bonds. Most bonds pay out a fixed coupon for the duration of their life, so bondholders are vulnerable to higher inflation eroding the real value of that coupon. The opposite is also true, and those coupons become more valuable if inflation is lower than expected. Inflation expectations are usually slow to adapt, but they are adapting. Still, investors in the local bond market appear to be paying more attention to fiscal risks than inflation, which is a more important long-term driver. The difference between nominal bond and inflation-linked bond yields gives an indication of the market’s inflation expectations. It is an imperfect indication since the nominal bond market is much larger and more liquid than that of inflation-linked bonds, but it is still useful. Over the longer term (10 years plus), these “breakeven” inflation rates are still close to 6%, suggesting investors don’t quite believe low inflation is here to stay. It means there is a substantial margin of safety in buying local bonds. In contrast, US breakeven inflation rates of 1.5% over 10 years appear on the low side, with yields not offering sufficient compensation for the risk of higher-than-expected inflation over the next decade.

Waiting for rate cut
If lower inflation leads to Reserve Bank interest rate cuts, it’s a (positive) double whammy for bonds. However, the Reserve Bank is likely to maintain its cautious approach. The recent weakness in the rand will be of concern (though pass-through from rand weakness to inflation has declined substantially), but its biggest worry is seemingly on the fiscal side. Specifically, if the substantial increase in government borrowing leads to a credit ratings downgrade, further currency weakness could result in higher inflation. The November Monetary Policy Committee meeting, which follows the October Medium-Term Budget and Moody’s scheduled ratings announcement, appears a better candidate for a rate cut than the September meeting. However, September is still likely to see plenty of action on the monetary policy front. Both the Federal Reserve and European Central Bank interest rate meetings are expected to result in monetary easing, and both will release forecasts that will help guide the markets as to policymakers’ thinking. These will influence the Reserve Bank too.

Number one enemy
Generally speaking then, for investors, lower for longer inflation is good news. Inflation is the number one enemy of savers as it erodes the value of the money we put away for the future. Even at a low rate of inflation (2%), prices will double in a generation (37 years). For this reason, investments in growth assets like equities are necessary. Your inflation rate is essentially companies’ revenue growth, which they will over time translate into an even higher rate of profit growth. However, at the moment, local companies are struggling to do so as they adjust to the lower inflation environment. Fixed income currently still looks like the more attractive local asset class, but nobody knows exactly when the market will turn so equity exposure remains important. After all, the number two enemy is our own emotional and behavioural biases, including our tendency to extrapolate recent experiences into the future.

 

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