It could get worse before it gets better

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By Neels van Schaik

The most important catalyst that we need for the rerating of domestic equities is clarity on the direction of domestic interest rates.

After four years of very controlled inflation, this nemesis has once again reared its ugly head as a result of its impact on interest rates. Since June 2006, interest rates have increased by 4% to the current level of 14.5%. This was driven by the exceptionally strong consumer spending at the time and the Reserve Bank’s view that inflation could peak “slightly” above the upper band of its 3% to 6% inflation target.

Initially, interest rates increased 2% between June 2006 and December 2006. Ironically most economists at the start of the raises forecasted around 2% for the full tightening cycle and at the start of 2007 the Reserve Bank appeared to adopt a wait-and-see approach, keeping interest rates flat up to June 2007. Most investors took the view that the end of tightening monetary policy was nigh, but the biggest shock came after June 2007, which saw the Reserve Bank tightening by a further 2%.

If you would have told any economist in June 2006 that inflation would sit at 8.7% in 20 months time, most of them would probably have laughed at you, but this is indeed what has unfolded. The equity and bond markets are now taking the view that the next move in domestic rates may well be up and not down – in other words a repeat of the 2007 cycle. Given that inflation is sitting at 8.7%, 2.7% above the upper band of the inflation target range, you cannot really fault the market for taking this stance.

17-maart-alphen-1.jpg

Source: I-Net Bridge

The most important difference though between December 2006, when the SARB first went on hold, and the current situation, is the fact that real (after inflation) growth in retail sales accelerated from 6.1% in December 2006 to 10.5% in March 2007. The picture, however, has changed significantly from then as growth in the consumption of durable goods, or big ticket items, has slowed from just over 12% in March 2007 to 3.4% currently. Growth in general personal consumption has similarly slowed from 8.7% to 6.5% and this decelerating trend is likely to deteriorate in the short term as the last rate hikes continue to carve away consumers’ spending powers.

Forecasting inflation these days is extremely difficult, and I would not attempt to do so, but I think it is clear (given the data that is already at our disposal) that inflation could peak close to 10%. What is important to remember as well is that the inflation pressures we are seeing at the moment are not really being driven by domestic demand as the economy is clearly slowing down at a quicker pace than most expected.

The cost-push inflation that we are seeing at the moment is therefore driven by offshore factors like global food shortages and the rising oil price. Including the food, transport and energy components, roughly 45% percent of our inflation basket is therefore largely out of the Reserve Bank’s control. The Monetary Policy Committee’s job has already been done, in terms of slowing down economic activity and bringing down secondary inflationary pressures due to excess demand. There is little they can do about global food prices and energy prices, which is why they are likely to keep interest rates on hold for the foreseeable future.

Unfortunately, given the outlook for food prices and the oil price, inflation should stay at elevated levels for about the next 12 months. Although the base effect should result in a slowdown in the inflation rate, it is unlikely to meaningfully fall back within the target range in the near future, unless global food and energy prices retract meaningfully in the shortterm. If the SARB were to stick to their inflation mandate, we should not really expect any interest rate cuts in the near term, which is of course why everyone is once again questioning the validity of our current inflation band.

On the positive side, accelerating real wage growth should play a meaningful role in the recovery of domestic consumption in a way similar to the situation that occurred in 2002 when the inflation rate decelerated significantly off a very high base. Compared to the deceleration in inflation during 2002 though, the expected deceleration now could be less pronounced due to the currency risk this time round, but an improvement in real wage growth could be expected towards the end of 2008.

We believe that whilst domestic companies have largely factored in the poor inflation and interest rate outlook, they can remain value traps in the short term, until we get clarity on the future direction of interest rates. Investors with a long investment horizon though should be well-advised to use the current weakness to build positions in local industrial companies with long track records that are currently offering very competitive dividend yields at very attractive ratings.

Source: Neels van Schaik, Alphen Asset Management, March 17, 2008.

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