Rates on hold despite declining inflation

Dave Mohr, Chief Investment Strategist at Old Mutual.

Izak Odendaal, Investment Strategist at Old Mutual Multi-Managers.

The expansion in the US, the world’s largest economy, is about to turn eight years old. This will make it one of the longest on record, and many worry that it won’t last much longer. This is a valid concern, since major bear markets on US and global equity markets tend to happen when America goes into recession. At the same time, US equities posted a fresh record high last week trading at above-average valuations.

However, the US economic expansion has occurred at a below-average pace, with low inflation and low interest rates. This suggests that it can run for longer. Economic expansions don’t die of old age. Something needs to trip it. Usually, it is policy induced, when a central bank hikes interest rates quickly in response to rising inflation or the fiscal authority tightens its belt too quickly. It can also happen with a large-scale build-up of imbalances that are simply unsustainable, like a debt-fuelled housing bubble or a significant current account deficit that has to close quickly when capital flows dry up (a so-called sudden stop). Another reason for it to end can be an external shock, like an oil price shock, a drought (if you are dependent on agriculture), a natural disaster or a war. The 2008 global recession was a combination of all three (interest rates, sub-prime debt and a doubling of the real price of oil between 2006 and 2008) making it so much more severe.

To get a sense of recession risks, we need to look at imbalances and policy stances in the major economies. Geopolitical shocks are hard to predict but their impact can also be easy to overstate.

An interest rate shock is very unlikely in the US. Although the minutes of the Federal Reserve’s recent policy meeting – released with a three-week lag – showed that officials expect it to “soon be appropriate” to raise rates again, it remains the most gradual hiking cycle in modern history. And with inflation and wage growth still stubbornly low, there is no reason to expect the pace to increase any time soon. The US dollar is weaker since the start of the year and bond yields are flat. Low interest rates mean that debt service costs are close to historically low levels for consumers and businesses.

New data from the US show that household debt has surpassed the 2008 peak, but remains below this peak in real terms. Outstanding mortgage debt is less than in 2008, growing slowly.

The Eurozone business cycle is still in its early stage, as it suffered a second recession in 2012 and 2013 when the effects of the sovereign debt crisis and fiscal austerity hit.

Recovery in Eurozone is gaining strength. The Eurozone Markit Purchasing Managers’ Index was at a six-year high in May, reflecting healthy business conditions for service and manufacturing firms. Business sentiment in Germany suggests that the continent’s powerhouse is booming. The Ifo Business Climate Index reached a record high. The European Central Bank does not seem to be in a hurry to reduce quantitative easing and seems set to keep interest rates in negative territory.

Japan had two recessions since the global financial crisis, firstly in 2011because of the tsunami and then again in 2014 following the sales tax hike. It appears to also only get going now, although its potential growth rate is constrained by a shrinking population.

China downgraded

China has experienced an epic build-up of debt since 2009. Moody’s downgraded it last week by one notch (still investment grade) on concerns that servicing this debt could become problematic as growth slows. But unlike Western countries, the debt is mostly linked in some way to the state, with state-owned enterprises responsible for most of the borrowing and state-controlled banks responsible for most of the lending. China has taken steps to open up its bond markets to foreign investors, but 98% of bonds traded are still in Chinese hands.

No oil shock in sight

The oil price is slightly below its long-term average in real terms and is likely to remain volatile. OPEC is slowly losing its grip on the market as technological change has allowed growth in non-conventional oil supply (North American shale) and reduced demand growth (electric vehicles, ride sharing). Last week, OPEC countries and Russia announced that they would extend production cuts by another nine months to decisively clear the global glut in oil. The initial market reaction suggests that this is not enough.

South Africa’s weak recovery

South Africa came close to recession last year, with growth of only 0.3%. This reflected the lagged impact of a combination of shocks, including drought, a food price spike, load-shedding, and collapse of export commodity prices. At the same time, rather than providing support, fiscal and monetary authorities tightened policy, with the Reserve Bank hiking the repo rate from 5% to 7% and the Treasury instituting modest tax increases. Avoiding the recession is cold comfort to many who are enduring tough times, but does suggest an underlying resilience. Brazil, facing similar problems, descended into its deepest recession on record over this period.

Hope for rate cuts

There is little hope that fiscal policy will loosen. In fact, continued tightening is necessary since the failure to do so could lead to unsustainable debt levels. But there is some hope on the monetary policy side. The SA Reserve Bank’s Monetary Policy Committee (MPC) held the repo rate steady at its meeting last week, as expected. One member voted for a cut. The meeting occurred against the backdrop of lower actual and expected inflation outlook and a steady rand while economic growth prospects have dimmed somewhat.

The Bank cut its GDP growth forecasts due to deterioration in business and consumer confidence following the credit rating downgrades to 1% this year and 1.5% next year. The Reserve Bank lowered its inflation forecast for 2017 to 5.7% (from 5.9%), while it expects inflation to average 5.3% in 2018 (down from 5.5%). It may have to lower these forecasts further, as April inflation data which was released too late to be incorporated into the forecast, fell faster than expected.

The consumer price index (CPI) rose 5.3% year-on-year in April, down from 6.1% in March, and has therefore moved within the South African Reserve Bank’s inflation target range (3% to 6%). Food and non-alcoholic beverage inflation fell to 6.7%, down from 11% at the start of the year. The Reserve Bank expects food price inflation to average 7.7% and 5.4% in 2017 and 2018 respectively.

Petrol price inflation declined to 5.4%. A modest cut in the petrol price is likely for next month, but base effects will be unfavourable from July onwards. Core consumer inflation, excluding volatile food and fuel prices, fell further to 4.8%, the lowest level since January 2013.

Producer inflation also declined by more than expected in April, falling to 4.6% from 5.2%. Import prices excluding petroleum declined 12% year-on-year in March. This suggests a lack of inflationary pressures in the goods value chain (aside from meat prices, where farmers are rebuilding herds).

Rand is key

The rand exchange rate is a key determinant of the inflation outlook given the large component of imported items in the CPI basket notably oil, vehicles, appliances and clothing. Food prices are also rand-sensitive, because local maize and wheat follows global prices. Currency weakness or strength influences inflation with a lag, since many imported items can sit on shelves for a while and many importers lock themselves into fixed exchange rates for several months. A six-month moving average of the exchange rate gives a rough indication of these dynamics. The six-month moving average of the rand-dollar exchange rate was at its lowest in June 2016. This creates a very favourable base from which year-on-year comparisons can be made.

Usually when both the growth and inflation forecasts are lowered, the case for a rate cut is strong. Especially since the MPC noted that the risks to the inflation outlook are balanced, while the risks to the growth outlook are to the downside. However, the Reserve Bank has consistently worried that the rand is vulnerable to sudden depreciation in the face of US interest rate hikes or domestic political developments. This stance was vindicated in 2014 and 2015 when the rand blew out against the dollar. But as the Fed actually started hiking (with three hikes under its belt already), the dollar has been softer. Meanwhile, the rand was relatively unscathed through the credit rating downgrades. The MPC will want to see what Moody’s decides when it reviews South Africa’s ratings (expected soon). If Moody’s maintains South Africa’s local currency rating at an investment grade level, it will have to seriously consider cutting. The MPC’s statement indicated that it had likely reached the end of its hiking cycle – probably an understatement - but that cutting will depend on inflation falling faster and remaining low on a sustained basis. Lower interest rates will not fix South Africa’s problems, but could relieve pressure on small businesses and consumers and help get our recovery going again.

Chart 1: The SA Reserve Bank’s evolving GDP growth forecasts (at the time of each MPC meeting)

Chart 2: The SA Reserve Bank’s evolving inflation growth forecasts

Chart 3: Consumer inflation and the repo rate

Sources: StatsSA and SA Reserve Bank