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Lower inflation, but no rate cut

By: Dave Mohr (Chief Investment Strategist) & Izak Odendaal (Investment Strategist) from Old Mutual Wealth

Local consumer inflation fell to 3.7% in October, the lowest since February 2011. This fact has a number of implications, not least for the South African Reserve Bank’s Monetary Policy Committee (MPC). In many ways, inflation is fundamental to how asset classes behave. And of course, many investment mandates these days (including our own) have an explicit goal of outperforming inflation by some percentage, so that investors can experience real growth in the purchasing power of their money.

Lower inflation does not mean widespread price declines but rather that overall prices of goods and services as measured by Stats SA’s consumer price index (CPI) is rising less. Low inflation should also not be confused with ‘inexpensive’. Something can be expensive but not experience any price increases.

Persistent undershoot

What is notable is not just that inflation is lower, but that it has persistently been lower than expected by both private sector economists and the National Treasury and SA Reserve Bank forecasters. The Reuters consensus expectation for October was 3.9%. Since the start of 2017, 18 out of 33 months saw lower than expected inflation, and only seven months higher than expected. Under normal conditions, you would expect economists to be similarly wrong on the up and downside. Unless there is a persistent underlying downward trend.

Chart 1: South African consumer inflation measures

Source: StatsSA

In any given month, there are a number of factors pushing inflation higher or lower. Usually the fuel price causes a lot of volatility, as it depends on global oil and petroleum prices and the rand-dollar exchange rate. Food prices can also be volatile, since they are largely a function of weather conditions a few months ago. Since headline inflation measures the change over 12 months, what happened a year ago also matters. Higher prices a year ago often means lower inflation today, while the opposite is also true. In October, fuel prices were 4.9% lower than a year ago because of a big petrol price hike in October 2018, but 0.7% higher than a month ago. Food prices were 3.5% higher than a year ago. Food inflation is widely expected to increase due to a low base, and current drought conditions. However, the pace of increase has been surprisingly muted.

Core inflation gives a better indication of underlying inflationary dynamics, since it excludes food, fuel and energy prices. It was 4% in October and has been below the mid-point of the Reserve Bank’s 3% to 6% target range since October 2017.

The big drivers

If we zoom out from looking at the short-term particulars, there are broadly speaking four drivers of low inflation. The first is low global inflation. South Africa is not the only country with lower inflation. International inflation declined steadily from extremely elevated levels in the early 1980s. Technology, globalisation and deregulation have played a big role.

Since the fall of the Berlin Wall 30 years ago, several large countries abandoned their various versions of communism and self-imposed isolation. The global labour pool increased dramatically with workers willing to work for very low wages. This meant workers everywhere lost bargaining power as factories and call centres in far-flung corners of the world could always do it cheaper. Companies benefited from the decline in wage inflation boosting their margins, but in turn lost the ability to set their own selling prices in a competitive global marketplace. Again, most goods and many services could be procured cheaply somewhere else. This inflation decline became known as the Great Moderation. Over this period central banks also took a much more explicit focus on inflation. However, since the Financial Crisis, central banks in the US, Japan and Europe have missed their 2% inflation targets time and again. For instance, core inflation in Japan averaged 0.2% over the past decade and 1% in the Eurozone.

Even with its relatively stronger economy, US core inflation has averaged only 1.3%. Pricing power and labour bargaining power is even weaker than before, and technology even more disruptive. While there are fears of globalisation going into reverse due to the US-China trade wars, these are still overblown. The problem today is still too little inflation, not too much. If the ability of central banks to create inflation is lacking, perhaps they also deserve less credit for bringing inflation down.

The second factor is the weak local economy and the concomitant persistent lack of demand. If demand is muted, there is little upward pressure on prices or “demand pull” inflation. Excessive credit growth, often fuel to inflation’s fire, has also been barely noticeable. If companies raise selling prices – irrespective of their input costs – they risk losing customers. The clearest indication of this is that annual rent increases are 3.3% on a countrywide-basis as reported by Stats SA. Local tenant management company PayProp has reported a similar number. In general, landlords cannot increase rents.

What we do have is some “cost push” inflation in the form of high electricity and municipal tax increases. These aren’t determined by market forces but by the government’s need for revenue. Since the Reserve Bank’s inflation target was assigned to it by the government, it is ironic that the government is the big culprit with price increases well above this range. Excluding administered prices, inflation was 3.6%.

The third broad reason is that the local economy has become more competitive and less rigid. As in other countries, local firms face disruption from deregulation, technological change, new entrants and global forces. Trade union membership has declined over time, and the three million workers who do belong to unions are far fewer than commonly assumed. Only another one million workers have their wages negotiated in a sector bargaining council. The other 60% of formal employees have little choice but to accept wage increases offered by their employers.

In a rigid economy, price increases are often automatic, for instance if margins are regulated and if wages are indexed to inflation. The former is still the case with petrol filling stations and the latter largely applies to government, but both examples are increasingly rare.  Any price shock, such as a slump in the rand, will then reverberate throughout the economy, with higher prices leading to higher wages and then even higher prices. In a more flexible economy, however, prices can go up as well as down, and the economy is therefore more resilient against shocks. Low inflation levels also make it more difficult for companies to hide inefficiencies.

Great expectations

The final factor is expectations. The more people experience low inflation and believe inflation will remain low, the more their behaviour will reflect it. For instance, if you believe future inflation will remain around 4.5%, you will accept a similar salary increase and negotiate a similar rent increase with your landlord. According to the Bureau for Economic Research, consumers’ expectations of inflation over the next five years has fallen to 5%, the lowest level since the start of the survey. Inflation expectations are also captured in the difference between standard (nominal) bond yields and yields on inflation-linked bonds. This ‘break-even’ measure of inflation over ten years is at 5.6%, close to the lowest levels in a decade. The Reserve Bank wants to see inflation expectations decline further and anchor on 4.5%.

Chart 2: Surveyed inflation expectations over the next five years

Source: Bureau for Economic Research

The Reserve Bank’s focus is not on past inflation, but on how inflation is likely to evolve over the next year or two. For the reasons listed above, economists inside and outside the Bank expect inflation to be well-behaved. The Bank has long focused on the risk that capital outflows – whether due to a Moody’s downgrade, rising global interest rates or some other reason – would cause the rand to weaken sharply, which could in turn result in much higher inflation.

For this reason, it has maintained real interest rates that are almost unheard of in the current global context (and rising, as seen in Chart 3) despite a stumbling local economy and rising unemployment. This thinking played a role in its decision to keep the repo rate unchanged at 6.5% last week, though two of the five MPC members favoured a cut. The rand is always volatile and at the risk of global investor sentiment. Despite this, the pass-through of rand weakness to higher consumer prices has been much lower than expected. Local interest rates therefore appear to be too high, even when judged against the Reserve Bank’s own criteria.

Chart 3: The repo rate

Source: Refinitiv Datastream

Implications for asset classes

First of all, lower inflation means lower nominal returns can still result on steady real returns, and investors should therefore not anchor on past returns. Secondly, fixed income assets hate inflation, because as the name suggests, the interest income tends to be fixed and can be eroded by higher than expected inflation. A bond therefore becomes more valuable if inflation declines, since the real value of interest payments increase.

If lower inflation causes the Reserve Bank to cut rates, bonds will become even more valuable. But for the time being the Reserve Bank is still maintaining high interest rates, and the bond market echoes this with a steep yield curve (longer-dated bonds have higher yields than cash). If the market thought the Reserve Bank was completely wrong, the yield curve would be flat to negative.

Thirdly, equities and listed property are considered inflation hedges, since they capture inflation (what you spend is what they earn), and generate profit growth above that through increasing efficiencies or expansion. The problem is that the transition to a lower-inflation environment has been painful. The inflation rate of goods and services sold has in some cases fallen faster than that of input costs. Over the longer term, equities and property should continue to be a good inflation hedge. JSE-listed rand hedges and global shares offer some protection against currency depreciation. As it happens, local investors have benefited as a weak currency immediately boosts offshore returns, but the lagged impact on inflation has been muted. Over the past decade, the rand fell from R7.40 per dollar to R14.75 (7% per year), while consumer prices only increased at 5% per year (60% in total).

In short, low inflation and high interest rates mean bonds and other fixed interest investments are very attractive asset classes right now. For local equities, the low inflation complicates the picture in the shorter term, and has been a headwind for the profits of local companies. But as inflation expectations continue to decline, the Reserve Bank will cut rates and company profits will benefit. Keep in mind that even at a low inflation rate, your purchasing power will decline quickly over time. Local growth assets such as equities and listed property, volatile as they are, should remain important parts of a long-term portfolio.

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