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Markets never move up in a straight line, so a correction every now and then should not by itself be cause for concern, say Izak Odendaal and Dave Mohr.

Inflation is still very much in
focus globally. Investors are nervous that sharply higher inflation will put
pressure on central banks to raise interest rates, potentially knocking the
global economy and short-circuiting equity markets. After a strong run, most
global equity indices pulled back in recent days as risk aversion increased.

This despite most US and European
companies reporting unexpectedly strong earnings growth. Of course, markets
never move up in a straight line, so a correction every now and then should not
by itself be cause for concern. Rather, the question should be whether
something fundamental has changed, causing a complete repricing of the outlook.
As discussed further below, that does not seem to be the case. Last week the
spotlight also turned to domestic inflation, its future trajectory and interest
rate implications.

South Africa’s consumer price index
rose 4.4% in April from a year ago, slightly faster than expected by
economists. This is quite a jump from March’s 3.2%, but not a surprise since
base effects play a big role. Fuel prices were 21% higher than a year ago,
largely reflecting the fact that global oil prices slumped in April 2020 and
have since returned to pre-pandemic levels. Food prices were also 6.7% higher
than a year ago, reflecting global food price increases. A big monthly increase
in oil and fats cannot be blamed on base effects, however.

Though food inflation is at its
highest level since mid-2017, the outlook is fortunately better. South Africa
was recovering from severe drought conditions then, whereas bumper harvests
should offset the impact of sharply higher global food prices. The firmer
exchange rate also helps to ease price pressures. The big drought in 2015/16
coincided with a weak rand, which compounded the misery as South Africa was
forced to switch from being a food exporter to importer.

The rand traded around R14 per
dollar last week, despite the increase in global risk aversion. It means the
increase in global oil prices over the past few months has basically been
neutralised, and no petrol price increase is expected for May. It also limits
the impact of rising global inflation more broadly. Over the last year, the
rand appreciated 20% on a trade-weighted basis, and 8% over the past six
months. It is basically flat on a two-year view.

Chart 1: Oil price in rand

OM chart 1

Refinitiv Datastream

Core inflation, which excludes the
impact of volatile food and fuel prices, was at 3% year-on-year in April, off
the record low posted the previous month. This suggests that the underlying
inflation trajectory has probably bottomed out as the negative impact of
Covid-19 on items such as clothing, medical services (regular medical
check-ups) and restaurant visits eases up.

Repo rate unchanged

Against this backdrop, the Reserve
Bank’s Monetary Policy Committee (MPC) unanimously decided to leave the repo
rate unchanged at 3.75% as expected.

The Reserve Bank expects inflation
to average 4.2% this year, 4.4% next year and 4.5% in 2023. This compares
favourably with the Bank’s 4.5% inflation target. It noted that the relatively
strong exchange rate would counter global price increases, while a lack of
pricing power on the part of firms and bargaining power on the part of unions
(both a consequence of an economy still not running at full steam) will contain
the inflationary pressures stemming from food prices and electricity tariffs.

However, it noted that its
forecasts are more likely to underestimate than overestimate inflation (The
risks to the inflation outlook are to the upside, in central banking speak.)
One of the items on its list of potential risks is higher import tariffs as a
result of government’s policy to encourage more domestic production. Tariffs
typically only have a once-off impact on inflation (similar to a VAT increase),
but it depends to what extent firms can pass costs on to consumers.

Chart 2: SA repo rate and inflation,

OM chart  2

Source: Refinitiv Datastream

In terms of real economic growth,
the Reserve Bank upgraded its growth forecast for 2020 to 4.2%, though of
course the impact of a possible third wave of Covid-19 infections is uncertain.
Growth for the following two years is still expected to be above 2%. It is
worth noting again that local economic growth averaged only 0.5% in the five
years before the pandemic, so while 2% average growth over the medium term does
not sound impressive, it will be a huge improvement.

Overall, the MPC statement was not
particularly hawkish. Like its global peers, the MPC is cognisant of inflation
risks but also recognises that the economy still needs plenty of support and
will take time to return to pre-pandemic levels of activity and employment.

The Bank’s forecast model suggests
two rate increases of 25 basis points each this year, but the MPC has not
always followed this guidance and is unlikely to in this instance. Barring any
dramatic changes, rates should remain at current levels for the rest of the
year. As average inflation rises towards the midpoint next year, the real repo
rate will turn negative, which is not something that has historically sat well
with the MPC. Rates should therefore rise gradually from next year on if the
SARB’s projections materialise.

The global picture

The MPC always pays close attention
to the direction of monetary policy in the rest of the world, especially the
US, and with good reason. An abrupt shift in the US Federal Reserve’s policy
could provoke capital flight, putting upward pressure on long-term interest
rates and downward pressure on the rand. A weaker rand in turn can lead to
higher inflation, though this impact (or pass-through) has declined significantly
over time.

Chart 3: SA repo rate and
inflation, %

OM chart  3

It helps greatly that South Africa
is currently running a current account surplus and is not as vulnerable to
capital outflows. In contrast, South Africa was running a massive 6% of GDP
current account deficit the last time there was an unexpected major shift in
market perceptions of Fed policy, the infamous 2013 ‘taper tantrum’. The
Reserve Bank expects a current account surplus of 2% of GDP in 2021, shifting
to a modest 0.6% deficit next year.

The Fed’s public messaging has been
clear: we don’t expect the inflation surge to last, and we want to be sure the
recovery is on a sustained footing before making any changes to the bond buying
programme or interest rates. Minutes from the most recent policy meeting
suggest Fed officials are starting to wonder whether the time to start
considering making changes is drawing closer. Or to paraphrase an earlier
comment from Jerome Powell, that it is time to start thinking about removing
the emergency support measures.

That day will inevitably come, and
the next month or so will provide important data points to guide the decision.
Markets will constantly price in these expectations. Things can therefore be
choppy for the next while as both investors and central banks assess the
situation. However, we need to remember four things.

Firstly, while central banks are
not in the business of bailing out markets (their official targets are
typically inflation and unemployment), they are nonetheless very sensitive to
market movements, since financial markets are key channels through which their
policies impact the real economy. They will therefore be very careful not to
pull the rug out from under markets, but rather signal their intentions as
clearly as they possibly can.

Secondly, central banks, the Fed in
particular, have learnt the lessons of the past decade on overdoing interest
rate hikes. They will probably err on the side of caution.

Thirdly, it matters why they are
tightening policy. If it is because they see their economies as substantially
healed and no longer in need of emergency support, it is a good sign. Hiking in
response to sustained higher-than-expected inflation is a different matter.

Four, some investments are very
sensitive to higher interest rates, either directly or indirectly. But others
are more likely to respond positively to the stronger economic growth
conditions that give rise to higher rates. It will become increasingly
important to distinguish between the two. Clearly developed market bonds and
similar ‘duration’ assets (like technology companies whose earnings growth
prospects are far into the future) will be harmed, but cyclical companies such
as banks, miners and industrials can benefit.

The most likely path of global
inflation is still, in our view, that it will moderate going into next year.
Firstly, the base effects will fade. To use a simple example, the oil price
rose 80% over the past year as it recovered from bombed-out levels. It is not
going to rise another 80%. If it stays around current levels of $65 per barrel
for the next 12 months, oil inflation will be close to 0%.

Secondly, the big reopening boom is
likely to be fairly short-lived. People are desperate to travel and visit fancy
restaurants and watch live sports and so on, but there is a limit to how much
they do even once it is safe. People are not going to eat in restaurants seven
days a week, for instance. The pent-up demand is mainly for services. On the
goods side, people have been consuming all the way through the pandemic.

Thirdly, supply will eventually
respond. If there is massive demand for something anywhere, firms everywhere
across the global have every incentive to meet that demand as soon as possible.
To use an example from a recent Wall Street Journal article, a year or so ago,
getting hold of a bottle of hand sanitiser was difficult across the globe.
Today the world is awash in hand sanitiser, and retailers are running promotions
to clear shelf space for other items. Supply responded to demand. For some
items, the response is slow. Increasing food supply is weather dependent and
increasing the output of minerals and metals often requires expanding mines.
Therefore, the prices of raw materials can remain elevated for some time. But
that is not the same as inflation.

Finally, technology remains a
disinflationary force. And while it may be too soon to tell if it is the start
of a trend, productivity growth seems to be making a comeback. For instance, US
productivity growth hit a decade high of 4% in the first quarter. Productivity
growth means firms can absorb higher input costs – wages and raw materials –
without it leading to higher inflation.

Investment implications

The first and most obvious point is
that money market returns will be close to zero in real terms over the medium
term since they are closely linked to the repo rate. This is in contrast to the
generous positive real returns in the pre-pandemic years. However, if inflation
is to be around 4.5% over the medium term, it is a very achievable hurdle for
other asset classes to achieve.

A very simple metric is the
starting yield, which is around 6% for SA equities (forward earnings yield), 9%
for SA bonds (10-year government bond yield) and 9% for SA property. All are
well above inflation. Global investments are not quite as attractive from a
starting valuation point of view, and fixed income in the developed world
remains outright expensive. But offshore investments remain an important
diversifier to SA-specific risks, as well as sources of returns not available

Izak Odendaal and Dave Mohr are investment strategists at Old Mutual. Views expressed are their own. 

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