Lower inflation improves outlook

Inflation declined to below 5% for the first time since November 2015. The consumer price index rose by 4.6% in July compared to a year ago, while the comparative figure for June was 5.1% (in January it was 6.6%).

Food inflation of 6.8% remains the main contributor to the overall inflation rate, but this too has declined from double-digit rates at the start of the year, and should continue trending lower. Traded maize prices are currently around R2 000 per tonne, about R1 500 lower than a year ago. Global maize prices are also under pressure. Meat prices remain the outlier. Meat inflation has accelerated to 14% as farmers have been rebuilding herds after last year’s drought, reducing supply.

Core inflation, excluding volatile food and fuel prices, declined marginally to 4.7%. The appreciation of the rand against the dollar over the past 18 months has put downward pressure on the prices of imported items (and locally produced items that compete with imports). For instance, vehicle inflation fell from 9% at the start of the year to just under 4% in July. Vehicles make up a sizable component of 6% of the consumer price index.

Disinflationary pressures

Downward pressure on local inflation will probably remain intact for a number of reasons. Apart from declining food prices and a firmer currency, global inflation is also missing in action, with goods prices falling outright in many instances. Meanwhile, the weak domestic economy is also disinflationary.

The wage agreement in the metals engineering industry (covering about 340 000 employees and 10 000 companies) is significant as it means a repeat of the devastating 2014 strike is avoided (and indeed it will be the first time in a decade a wage agreement is reached without a strike in this sector). Faced with potential job losses due to a weak economy and competition from cheap imports, Numsa, the largest union, settled for much less than its initial 15% demand. In terms of the agreement wages, the sector will rise 7% in 2017, 6.75% in 2018 and 6.5% in 2019. It is also indicative of a greater realism on the part of unions, and a downward shift in inflation expectations.

Similarly in this environment, companies cannot simply pass on cost increases to consumers, while competitive pressures are slowly and relentlessly grinding inflation lower, just as they have globally. For instance, even though basic meat prices are shooting up, it constitutes a relatively small portion of what consumers end up paying at the shop. Consumers also pay for packaging, transport and preparation, along with the margin of each participant in the value chain, especially the retailer’s at the end. But, margins can also come under competitive pressure at each stage of the value chain.

A slightly different example comes from the US, where e-commerce giant Amazon.com announced last week that it would cut prices at Whole Foods, the grocery chain it recently acquired. This could start a price war between retailers, adding to disinflationary pressures. US food inflation (excluding restaurants) has been negative since December 2015.

Interest rate and bond implications

Though second quarter economic growth is likely to be positive, the economy is still weak and the repo rate of 6.75% (2% in real terms) too high. The SA Reserve Bank is likely to cut again, but will be cautious and sceptical that the favourable global conditions will last. Further interest rate cuts will provide some relief for indebted consumers, but are unlikely to spur much new borrowing given depressed confidence levels.

Bonds should benefit from declining inflation. Since bonds pay out a fixed coupon over the life of the bond, and return the initial capital at maturity, bondholders are very exposed to inflation eroding the real value of their investment. Nominal bonds therefore tend to rally (yields decline) when inflation is expected to decline. Cuts in short-term rates are a further shot in the arm, since a long bond yield reflects the expected short-term rates over the life of the bond.

Political and ratings risk

However, political risk is weighing on bond markets. It is touch-and-go whether Moody’s and S&P will further cut South Africa’s local currency ratings. Credit ratings usually matter less than commonly assumed, but in this instance further cuts would see local bonds removed from a key investment grade index, leading to forced selling by foreign investors who track the Citigroup World Government Bond Index.

In a favourable global environment, there would still be plenty of buyers of South African rand bonds even after a further downgrade, but how much would the yield have to move up to entice them? This will of course depend on what else is available. Therefore, local political developments always have to be seen in a global context. While South Africa’s position relative to other emerging markets has deteriorated (due to politics, ratings and slow growth), the overall emerging market group has rallied over the past year, benefiting from a benign global inflation and interest rate outlook. Chart 1 shows how South Africa’s bond yield has diverged from India’s, while Chart 2 indicates how local currency emerging market bonds have rallied relative to developed market bonds.

While alleged corruption at state-owned enterprises is grabbing headlines, along with the proposed bail-out of SAA, the biggest problem is simply that growth is too low. The local economy was hit by a number of shocks since 2013 (commodity prices, load shedding, drought, policy own goals), and confidence is very low as a result. Consequently, South Africa has decoupled from global growth, with the latter improving of late. While there is widespread evidence that the worst is over in terms of the growth slowdown (culminating in a technical recession), economic growth for the current fiscal year is likely to be lower than forecasted in February.

Lower-than-expected growth means tax revenues could undershoot budgeted amounts. In the absence of spending cuts or tax rate increases, Treasury would not be able to close the fiscal deficit as much as promised, and the overall debt level would not stabilise as quickly as promised. As the ratings agencies have warned, the factional battles in the lead-up to the ANC’s elective conference in December means decisive policy interventions to stimulate growth are unlikely. But it shouldn’t take too much for us to recouple with the global cycle if some of the dark political and policy clouds lift. Already tourism is growing nicely, and commodity prices have firmed up.

Since none of this is new, it should be largely reflected in the price of local assets. Since the start of the year, shorter dated bonds have rallied, reflecting the improved inflation outlook, but longer dated bond yields have risen marginally in response to the uncertain political outlook. The 5-year bond yield rallied from 8% to 7.5%, but the 20-year yield drifted up from 9.4% to 9.5%. These are attractive real yields in a context of a diversified portfolio where other assets (like SA and global equities) provide protection should the political uncertainty not improve after December and the fiscal situation deteriorate more than expected.

Chart 1: South African and Indian 10-year local currency government bond yields, %

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Chart 2: Emerging market vs developed market bond indices

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Chart 3: South African inflation and repo rate, %

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Source: Datastream

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