Rate cut: A lovely surprise

In an unexpected but welcome move, the Monetary Policy Committee (MPC) of the South African Reserve Bank (Sarb) cut the repo rate by 25 basis points to 6.75% after sharp downward revisions to its growth and inflation forecasts.

Global backdrop

The global backdrop to last week’s MPC meeting is one of fairly robust economic growth and stubbornly low inflation (global equity markets also hit fresh record-highs last week). Chinese growth picked up to 6.9% in the second quarter, showing resilience despite the government’s efforts to clamp down on excessive credit. While these numbers are often viewed as suspiciously smooth by some, other credible data points (like exports and imports) also show robust growth.

This combination of robust growth and low inflation is creating some confusion in central banking circles, as one would normally expect stronger growth to push up inflation as the economy runs out of resources (workers, factories, machines). Last week, the Bank of Japan had to delay the window for achieving its 2% inflation target for the sixth time to 2019, despite unemployment at a 20-year low of 2.8%.

The divergence between growth and inflation is also causing uncertainty in terms of market expectations of central bank actions, particularly the European Central Bank and the US Federal Reserve. Global bond yields jumped and then receded somewhat as investors re-price central bank policy. Generally speaking though, bond yields in the US, Europe and Japan are still lower today than their average post-2008 crisis level.

The ECB left rates unchanged last week and also did not change its guidance in terms of how it expects policy to evolve over time. Some market participants expected it to signal a tapering of its €80 billion monthly bond buying programme, and given the surging euro, clearly still expect a taper announcement soon. Its policy interest rate is expected to remain negative well into 2018, but despite this and large-scale quantitative easing, core inflation is only 1.2%.

Meanwhile, the Fed is on a stated course to continue gradually hiking interest rates and eventually reduce the size of its balance sheet. But how gradually it does this is the issue. The Fed expected to hike three times this year but has consistently overestimated its own hiking cycle. As recently as June 2015 it expected core inflation to be 2% (currently 1.5%) this year and the Fed funds rate 3% (currently 1.25%). The Fed is expected to leave interest rates unchanged this week, while the market is now only pricing in a 40% probability of a third rate increase this year, as inflation remains stubbornly low.

While this combination of stronger global growth and below target inflation may create headaches for central bankers, it is generally seen as a benign backdrop for financial markets.

Local backdrop

The rand has been volatile over the past two months, exposed to shifts in perceptions of global central bank policy and local political developments. Specifically, a debate has flared up over the Reserve Bank’s independence and the appropriateness of inflation targeting. However, the rand gained against the US dollar since the previous MPC meeting in May, while the dollar itself is weaker against major currencies.

June consumer inflation declined to 5.1%, while core inflation, excluding volatile food and energy prices, was steady at 4.8%.

Inflation expectations among unions, analysts and business people, as surveyed by the Bureau for Economic Research, also showed a marginal decline over the next three years. On average, these groups expect inflation to be just within the 3-6% target range. Households still expect inflation to be 6.6% over the next year. The Reserve Bank has in the past emphasised the fact that expected inflation is still too high, hugging the top-end of the target range instead of the middle. High expected inflation can turn into high actual inflation if firms have pricing power and workers can demand inflation-plus salary increases. But in a weak economy, competition erodes this ability.

Inflation and growth forecasts cut

The MPC sets interest rates to influence the trajectory of future inflation (one to two years out), since rates changes take time to impact the economy. The updated inflation forecast is therefore important. Inflation is expected to average 5.3% this year, down from 5.7%, while forecasts for 2018 and 2019 were also cut. The Sarb expects inflation to remain within the target range throughout 2018 and 2019. Core inflation is expected to be below 5% over this period.

Based on this forecast, a repo rate of 7% would result in a real interest rate of close to 2%, which is clearly too much for a weak economy. The Reserve Bank has not historically targeted a certain real interest rate, but 1% is more reasonable under current conditions. This would imply more rate cuts than priced in by the market.

After the unexpected decline in the first quarter, the growth outlook for the year has been halved to 0.5%. Second quarter data suggests that the economy has already exited the technical recession. For instance, retail sales posted a third consecutive positive month of annual growth in May. However, business and consumer confidence remain depressed. The Sarb expects growth to improve somewhat to 1.2% in 2018 and 1.5% in 2019. These lacklustre growth rates are completely out of sync with global growth and clearly too low to make any inroads into South Africa’s social problems (population growth is around 1.5%, so the economy is still shrinking on a GDP per person basis).

Market reaction and investment implications

The rand briefly weakened after the surprise announcement. However, the turning of the rate cycle does not mean that the rand will persistently weaken, as the relationship between interest rates and exchange rates is not nearly as mechanical as is often assumed. Rather, commodity prices, perceptions of global monetary policy and sentiment towards emerging markets will determine the outlook for the rand over the medium term, and if favourable, the currency could even continue strengthening despite possible further rate cuts.

Long-bonds predictably rallied and yields declined, but long-bond yields of around 8.5% are still attractive relative to expected inflation, and more so if further rate cuts are forthcoming. In a global context, South African yields are still among the highest of major emerging economies (see below).

Emerging market 10-year local currency government bond yields, %

Source: Old Mutual Multi-Managers

On the JSE, interest rate-sensitive sectors such as banks, retailers and property also responded positively to the surprise cut, which came on top of an overall better performance from local equities following the sharp declines in June. However, a single rate cut will not do much to change the underlying revenue growth prospects of these companies, especially if the Reserve Bank’s gloomy GDP forecast materialises. As the Reserve Bank said in its statement, the rate cut would not provide “significant stimulus” given the current environment of “low confidence and political uncertainty. Given current conditions, further rate reductions are possible, providing some further relief.

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