Investment Postcards from Cape Town

The  seasonally  adjusted  Kagiso  PMI  for  June  increased  slightly  for  the  second  consecutive  month  to  37.9  points  from  37.3  during  May, confirming a bottoming out of the index in May.

The slowing in the contraction of output volumes continued with both the seasonally adjusted business activity and seasonally adjusted new sales orders indices increasing from 35.1 and 35.7 to 37.9 and 38.2 points respectively.

May’s  inventory  turnaround  was  not  sustained  œ  the  seasonally  adjusted  inventories index dropped from 35.4 to 29.1. In contrast, purchasing commitments posted a slight increase from 29.6 to 31.1 index points. The erratic behaviour of these indicators may reflect high levels of uncertainty amongst purchasing managers regarding future demand prospects, while the low index levels remain consistent with a contracting manufacturing sector.

In contrast to the weak near-term indicators, a majority of managers still expect  business  conditions  to  improve  in  6  months’  time  œ  the expected   business   conditions index remained above 50 at 52.8 points. The PMI component results are a mixed bag with some disappointment on inventories being countered by moderating output volume declines and a more positive outlook.

Although the May and June PMI data indicate that the worst of the factory recession may be over, the low index levels (significantly below 50) hint that positive growth is not on the cards anytime soon. Indeed, the average PMI for 2009Q2 was 36.9, down from 38.6 index points during 2009Q1.

Source: Kagiso Securities, June 30, 2009.

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By Cees Bruggemans

With the SARB going on hold last week, the prime interest rate remaining at 11%, the question is what next.

Another cut of 0.5% in August, prime falling to 10.5%?

Or have we reached a bottom, prime remaining at 11% through next year, with the speculation shifting as to when the first tightening move will occur (2010-2012?).

My sense is that we have reached an abrupt bottom at 11%.

This isn’t warranted by the current CPI inflation forecast and the recessionary condition of the economy.

Its reasons lie elsewhere, in the risks to the inflation forecast (which may change but will probably not improve) and especially the global picture (where the strength of industrial recovery is probably going to surprise many).

In terms of a simple Taylor Rule, the bedrock assumption is for our prime interest rate to incorporate a stable real premium longer term (in our case 5.5%) and to match the CPI inflation rate towards the end of the forecast period (here taken as 5% in 4Q2010).

That gives us a basic prime interest target today of 10.5% before corrections aimed at addressing deviations such as an inflation gap and an output gap.

By August 2009, the positive inflation gap should have shrunk some more, with CPI inflation nearer 6.9% and the gap narrowing to 2.4% (being 6.9% minus 4.5%, the midpoint of the 3%-6% target range).

That drop in CPI will for many observers be a reason to still give a 0.5% interest rate cut, and the MPC may well oblige such sentiment by cutting rates one more time. Analytically, however, the picture is far from complete.

The negative output gap, the difference between rising potential GDP and depressed actual GDP is currently estimated at between 4% and 5%.

By August this picture won’t yet have improved. If anything, it may have deteriorated if, as expected, 2Q2009 shows another GDP decline, with 3Q2009 also still suspect as the recession struggles to end.

If SARB interest rate policy tries to address both this positive inflation gap and negative output gap simultaneously, the basic targeted prime interest rate of 10.5% is further lowered by 0.5(+2.4%)+0.5(-4.4%), that is by -1%.

Thus according to Taylor, SARB should really be gunning for a 9.5% prime rate. This provides yet more ammunition for favouring a rate cut from the present prime 11%.

However, we still have to take into account asset prices (which isn’t apparently yet the fashion at the SARB, but we might as well here anticipate a global future) and especially risks to the inflation forecast (already beloved of the SARB, and a throwback to Greenspan’s risk management at the Fed, which of course in the end didn’t come close to saving him for he ignored asset prices for far too long, leaving the subsequent mess to Bernanke and the US government to clean up).

By August our main asset price picture shouldn’t be materially different from today. House price indices should still be falling gradually (Erwin Rode for one expecting a nominal bottom sometime next year). Equity prices could be a little higher, anticipating recovery, following the global fashion. Bond prices could be lower and yields higher, anticipating the end of inflation decline and a new cycle shaping sometime, aside of government funding needs and central banks on hold.

There is not much in this soup that may influence our SARB in the short term (its Greenspan Moment when asset prices overheat once again probably only lying in the distant future).

That leaves risks to the inflation forecast. And may I add the shaping global recovery and how it is going to change expectations worldwide, in markets, at central banks, with presumably implications for us.

The first question, with Taylor’s targeted prime rate actually dropping from an estimated 10% today to closer to 9.5% by August, is whether the SARB will have need to revise its risks to the inflation forecast as it saw them last week? If no change to the risks, with Taylor’s floor lowered, the case cements for another 0.5% cut, prime being lowered to 10.5%.

But this isn’t a simple question to answer, because these risks are so vague and in the eye of the beholder (reflecting a sense of foreboding).

Where is the good news? With wage and salary settlements backward-looking and CPI inflation likely steadily falling, the wage trend should also erode, if with a lag. With economic recovery at some point taking off even as job shedding still continues, productivity growth should accelerate and unit costs decelerate, even dramatically.

But August may be far too soon. Next year is this story.

The high core (services) inflation may moderate, but then again it may not. Many politically insulated or otherwise well placed businesses respond to recessions and revenue falloffs with raising their prices. That probably won’t have changed by August either.

So the underlying SARB concern about our product and labour market rigidities translating into high resistance core inflation should remain real and mostly unchanging.

More job losses may have tempered union demands somewhat but it may also have inflamed their rhetoric, especially as the falling CPI inflation will be lowering the floor under their wage demands monthly. That won’t be fun.

But all of this may remain shadow boxing. The real threat lies external. Here we have the setoff of a firming Rand as the global picture improves, risk appetite with it, and more capital flooding in even as our current account deficit contracts (net of unexplained transactions).

But the firming Rand may not be enough. The global industrial revival could be robust in coming quarters, as final global demand is already showing signs of recovering while the inventory destocking and capex cutbacks since 4Q2008 were probably overdone in response to credit fears and beyond.

This changing dynamic may once again change things and only the agile of mind and reflexes will take it in early and fully. For us, the implications are many, for our export prices, for our industrial import prices, and for our commodity base, imports and locally produced.

We know by now electricity will be adding to our pricing woes. But so will probably oil, though this isn’t guaranteed in the short term. As to the current food price decline build into the CPI inflation playout through 2010, it presumably will eventually start a new up cycle as well.

But oil (the entire energy complex) is the main suspect.

So far I haven’t touched anything that wasn’t touched upon by SARB Governor Mboweni in his commentary last week. The risks are staring us in the face and apparently we don’t like what we are seeing.

So two questions then. Will the actual CPI inflation reality keep declining as forecast, through August and beyond? And will the SARB keep its sense of risk as expressed last week unchanged?

A qualified ‘yes’ to both questions could still yield an 0.5% rate cut in August, prime falling to 10.5%, but you will really be mining gutfeel to get there.

On the other hand, the CPI inflation reality may keep disappointing with its slow easing (not my main assumption).

More likely, the global reality will keep erring towards strength (a flood of flowering green shoots) and especially the commodity universe eventually flexing its muscle, with central banks worldwide slipping into defensive mode anew (ending rate cutting but not as yet monetary accommodation, yet likely becoming more ‘vigilant’ as they prepare to welcome the new cycle).

Watch for instance last week the Fed by its use of language ever so diffidently signaling its sense of market repair steadily progressing.

With SARB Governor Mboweni presumably reappointed for a third term shortly, SARB’s inflation-fighting credibility and independence once again confirmed, with global peace (I mean recovery) at hand, with our own recession ending and recovery in sight, and with inflation gradually trundling towards a cyclical bottom in 2010 high within the target zone, why would we want to resume cutting rates during 3Q2009?

Because Taylor suggests a 9.5% base prime target in the short term? Sure, but consider the cyclical risks to the inflation forecast. Put differently, how long before the Taylor base target matches the current prime 11%.

If our CPI inflation gets stuck north of 5%, Taylor’s base prime target before deviations revises to 11% (meaning 5.5% + 5.5%), while also implying a positive inflation gap of 1%. Therefore, a narrowing of the negative GDP output gap from 4%-5% now to 0.5%-1.5% by some future date would do the trick.

Admittedly closing the yawning output gap to such a degree may take two to three years (2010-2012).

Oh happy days! Does that mean prime will stay unchanged at 11% through 2012?

Not necessarily, because the world will keep on changing, probably fast too. Watch commodity inflation starting to surge again. How will this wash ashore here, on what Rand and global risk appetite assumptions?

More importantly, at what point will the SARB lift its risk ceiling (and less sure at what point will it discover asset prices?). That comes on top Taylor’s revised base prime target of 11% through 2010-2012, to which we must still add any lift in our CPI (nearly immediately threatening to leave the targeting reservation, something that won’t be kindly welcomed).

So sooner rather than later our next interest rate cycle may make its appearance, the more is the pity. But this is in the nature of dynamic global growth and financial cycles and the inflation disturbances following in their wake and central banks trying to keep on top of their game throughout.

We would be so lucky not to encounter our first rate increase from prime 11% in the course of 2010. Hope it is later, but probably only somewhat (not much) later.

Source: Cees Bruggemans, FNB, June 29, 2009.

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By Cees Bruggemans

Interest rate decisions are not easy moments, as today showed once again, with the SARB keeping interest rates unchanged, prime being kept unchanged at 11%.

It may have looked effortless, keeping rates unchanged, yet so many private analysts expected a 0.5% rate cut. Then again, then there had been the SARB Governor’s warning in May that there wouldn’t be cuts at every MPC meeting (a reliable prediction in the long run) and that there was no more scope for ’significant’ cuts (sounding as if at least keeping a small backdoor half open).

But ultimately every interest rate decision remains a difficult one, given that so much is at issue, considering the level of indebtedness in the economy and the way economic agents respond to changes in rates.

There are many aspects taken into account when deciding where to pitch interest rates. Given today’s fashions in the world at large, where our SARB finds itself in good company, the main considerations can be simply summarized and constitute perhaps a useful checklist for future occasions to signal rate changes.

The Taylor Rule, now about two decades old, tries to capture four thoughts. In addition, we also now have to take into account asset prices and risks to the forecast.

In terms of Taylor, firstly, any market-based capitalistic system with an active well-developed banking system at its core needs real interest rates to reflect the cost of money over time relative to generally changing price trends (inflation/deflation).

To discount the future to the present should cost something, if only to signal scarcity. This premium should be high enough to prevent excesses but low enough not to intimidate unduly. Similarly, saving resources in the present for the purpose of delayed consumption in the future should be worth a premium reward.

The Fed unofficially defines this real rate required as being 2% (for its intervention rate, our repo rate, over time). If banks maintain a 3.5% spread, a real prime rate of 5.5% comes into focus, something that we can observe over long periods of time in our own financial history.

Secondly, interest rates are one of the most important prices in the economy, with the exchange rate being the other major pivotal.

In an increasingly integrated world with free capital flows, a policymaker stands little change of controlling the exchange rate. Indeed, trying to do so (betting against market forces) can prove very costly.

For policymakers to influence the economy successfully, the preferred lever is short-term interest rates. Such policy interventions may at times be necessary as and when the economy starts to show signs of imbalances and disturbances, preventing optimal performance.

The central aim of policy in support of long-term growth is to maintain financial stability. To this end a stable real short-term interest rate is seen as anchoring the economy and expectations.

But things hardly ever remain stable. Shocks occur (from the outside) and human behaviour is temperamental (from the inside).

Both these forces have a way of deflecting economic growth from a stable potential trajectory (determined by long-run institutional features such as rate of fixed investment, supply of labour, rate of technological change, including qualitative changes in the labour force, regulatory limitations and policy interventions, for good or bad).

These same forces, and other influences, decide the extent to which prices are behaving, and any broad inflationary or deflationary tendencies.

Bearing all these aspects in mind, these many forces are on the loose daily, threatening the stability of real interest rates and thus the optimal growth trajectory, from time to time inviting policymakers to act and undertake course corrections.

Thus besides incorporating a real rate premium, interest rates should at least match (reflect/incorporate) the expected inflation rate to come.

In addition, there is embodied within Taylor the analysis and proposed treatment of two major possible deviations from stability inviting policymaker activism, namely deviating output tendencies (over- or undershooting potential growth) and changing inflationary conditions (over- or undershooting an optimal price trend).

Thus, thirdly, Taylor interrogates the inflationary condition. Is the inflation condition stable, near the ideal policy norm (2% in most industrial countries today, but in our instance still pitched at 3%-6%)?

Or is the inflation trend deviating, and changing future expectations, reinforcing this change and starting to influence the economic growth trajectory as well?

If deviating, and creating a so-called ‘inflation gap’, Taylor suggests that in order to dampen accelerating inflation behaviour beyond the policy norm, nominal interest rates should be raised sufficiently to undo such expected inflation acceleration (and its expectation).

This is done by ensuring that the real interest rate is being maintained. In other words, the expected rise in inflation over and above the policy norm is matched with a rise in nominal short-term interest rates, thereby exerting countervailing pressure to the disturbing influences emitted by the accelerating inflation signal, inviting it to subside back towards the policy norm.

Fourthly, the condition of the economy may also become disturbed. Growth may be under- or overshooting its potential, best described by an ‘output gap’ observed by comparing actual resource utilization with potential resource utilisation (a combination of labour force and physical production capacity utilisation).

To the extent that the economy is underperforming its potential, interest rates may be lowered temporarily. Similarly, if the economy is outperforming potential it could overheat, inviting temporary interest rate increases to temper such excess demand on resources.

So far, we have established an ideal policy setting, in which the economy is progressing along its potential growth trajectory accompanied by appropriately limited inflation reinforcing this ideal growth condition.

Guiding this condition is an appropriate real interest rate regime. If deviations occur within the inflation and/or the growth condition, countervailing action can be taken to raise, lower or keep nominal interest rates largely unchanged.

Thus the policymaker is now mostly prepared to meet nearly all eventualities, or so it seemed until very recently. Over the years, however, refinements to this simple Taylor guide became necessary. One concerned asset prices. The other concerned risk (that things may not work out as thought).

Besides deviating inflation and growth conditions having a pivotal influence over the economy’s performance, asset prices also can have a way of fundamentally influencing the condition shaping the economy’s growth trajectory.

Exuberantly rising asset prices can invite excessive risk taking and can lead to overheated growth conditions because rising asset prices generate wealth effects that boost consumption expenditure. Similarly declining or excessively depressed and stagnant financial asset prices may inhibit risk-taking, thereby creating a drag effect on actual economic growth through negative wealth effects.

Whereas it is extremely difficult to judge market price signals as to whether asset prices are acting excessively exuberantly or depressed, it is nonetheless accepted today that there can be feedback loops to inflation and growth over time.

It would be nice if a simple ‘asset price gap’ could be defined guiding policy, just lik the inflation and output gaps embedded in the Taylor Rule already roughly do.

But such an ‘asset price gap’ definition keeps defying attempts to pin it down. Instead, the consensus seems to lean in favour of regulatory intervention - influencing the pace and extent of credit lending through varying bank capital requirements and other guidelines regarding leverage (gearing).

Still, nothing prevents the central bank from taking into account the state of asset prices in its interest rate deliberations and deciding whether it should be a factor calling for ‘leaning into the wind’ or the contrary (at all times showing a certain humility in making such calls, given the difficulty of doing so correctly).

Lastly, every central bank is confronted with risk, that its readings of the future turn out to be wrong (wrong assumptions), or that new developments, unforeseen or otherwise, cause a different outcome from the one presumed in the policy stance at any moment in time.

As interest rate changes take up to two years to fully work in on the economy, central banks face potentially a two year window of risky uncertainty in which their original actions may or may not be derailed.

Therefore, after taking into account current views of the likely inflation and output gaps expected over the next two years, and the likely behaviour of asset prices (especially houses, equities and bonds), there comes a final moment where the central bank should second-guess its own main assumptions and bias.

If there is a clear risk formulation of potentially being wrong in a particular direction, this may encourage insurance being taken out in pitching the interest rate decision accordingly with some bias built in (out of safety, just in case).

The Americans call this over-engineering, but such safety precautions are taken for good reason. One rarely can foresee all future mishap and surprises, and to the extent that there is disagreement about the likely course of events, such sense of risk should be incorporated in any decision to a sensible degree.

One is now ready (as ready as one will ever be) to take the plunge daily and set interest rates.

Because certain things change only slowly, and one does not want to confuse market participants unduly with frequent policy changes, a certain time lapse is advisable between policy deliberations about any course changes to be made.

This year, the SARB’s Monetary Policy Committee meets every month except July.

Today’s decision probably had a few simple ingredients.

The CPI inflation rate is now 8% and is forecast to decline towards 5% later next year. The inflation gap is at least 3.5% (the difference between 8% and the midrange of the 3%-6% CPI target range).

Meanwhile the economy is in serious recession, this year probably registering 1.5% decline in GDP, even though the potential growth rate is closer to 3.5%.

Depending on how one wants to calculate potential relative to actual GDP, the output gap could already be in the 4% to 5% range across the broader economy.

Asset prices remain currently depressed or are still declining. Equity prices are at least 35% below their (overheated) peak of last year, though stabilizing with an upward bias, while price/earnings multiples today seem to be more realistically priced for the long term.

House prices will likely fall 10% in nominal terms peak-to-trough, but again from probably overheated levels, with at least another five years of eroding real house prices ahead of us (by at least 3% annually according Erwin Rode).

Risk today mainly focuses on the depth of the recession and output gap (it could get somewhat bigger than expected), implying also downward pressure on inflation.

But core inflation also shows evidence of rigidity. Food price inflation is slow in coming down. Services inflation is high and sticky. Wage and salary trends are typically backward-looking, seeking compensation for recent inflation surges, besides demanding any premiums for reasons of skill scarcity, political influence or simply union size and strength.

In addition, there are future commodity price surges to worry about, oil having again risen by half this year and markets generally being worried about current central bank actions and future inflation playouts (such worries creating premiums, whether warranted or not).

Summarising all this requires some appeal to the Wisdom of Solomon. The main idea, though, is that the real interest rate premium of 5.5% is sacrosanct. We are expecting a 5% CPI inflation rate next year which needs to be matched by interest rates today.

That gives us a minimum prime of 10.5% before deviations and risks are to be addressed (policy activism).

Here we have at least a 3.5% positive inflation gap and a 4%-5% negative output gap. Adding up and dividing by two (as is done in the real world) gives us a small negative 0.5% policy activism requirement, lowering the intended prime to 10%.

Asset prices look low and depressed and are possibly exposed to further decline, though there seems to be an upward bias globally. Yet when these current asset values are set off against recent overheated peaks, and taking into account cyclical behaviour and likely future income streams, these asset values don’t look overly out of place. Perhaps a slight accommodation bias may be warranted, but let us not overstate our case.

That leaves risk, all of it negative on the inflation side (as mentioned) but also on the output side, with the growth and employment loss possibly turning out bigger than expected, still undershooting over the coming year.

Is all that risk worth a 1% premium, the targeted prime rate rising to 11%, matching the ruling prime interest rate and warranting no change to today’s policy stance, with perhaps a rain cheque taken to look again at the situation at the next MPC meeting in August?

Or should we build in only a 0.5% risk premium, boosting the target prime rate back to only 10.5% and warranting a 0.5% rate cut from the ruling 11% prime to 10.5% today?

You know the verdict: the SARB kept interest rates unchanged, prime staying at 11%. The risks to the upside of the inflation forecast clearly won out, at least at this MPC meeting.

As to future movements in interest rates, keep track of the real rate at 5.5% (still sacrosanct, but watch the debate about asset prices), the CPI inflation 18 months out (how will it deviate from 5%?), the current inflation rate (it will fall from the current 8%, reducing the size of the inflation gap), the output gap (it will eventually stabilize and then narrow as recovery proceeds, but how fast will this in fact happen?), asset price behaviour (stabilization and gradual recovery, but nothing that needs more policy support?) and risks, risks, glorious risks to the SARB policy forecast in every dimension.

For such is life.

Source: Cees Bruggemans, FNB, June 8, 2009.

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By Cees Bruggemans

With the rich industrial world facing slow growth recovery (Europe more so than the US because of internal rigidities and export dependence), and our own domestic political economy strained (more signs of labour strive), what kind of growth prospects do we have?

Or as a previous chairman never ceased asking me in jest whenever he saw me “Prospects? Are there any prospects?”

Happily, things are hardly this dark, for cyclical and structural reasons. After losing 1% of GDP in 2009, we are likely to bounce back to our long-term average growth of 3.5% quite quickly.

Thereafter, the longevity of our next expansion will depend on global forces and our policymakers. Whether we get eventually another period of outperformance will depend on circumstance, mostly capital-linked.

Recession will end for the same reasons it started, namely the industrial inventory destocking will end, restoring more normal industrial output conditions. This will apply as much globally as locally, so our non-gold mining export volumes and our manufacturing output should start bouncing back later this year.

We should also see a gradual recovery in consumer durable expenditure such as cars, furniture and household appliances. While currently still cautious and credit-restricted, these conditions will ease as consumers make adjustments to their debt and cash flow conditions, with lower interest rates reducing debt servicing burdens, the stock of durables not getting any younger, and the various trades in need eventually likely to start raising alternative finance to service their clients.

Private fixed investment will be late bouncing back (remaining depressed for another year on account of generous resource slack). Household expenditure will also take time recovering, given limited income gains. Unions should still win good wage increases if at the expense of widespread employment losses, but flexible income (commissions, overtime, bonuses) will initially still be under pressure in favour of productivity and business income recovery.

Meanwhile government spending will remain strongly supportive, both infrastructure and social spending-wise. Net exports should be favourable, too.

The main growth engine will be global, Asia leading (China recovering to 10% growth next year, closely followed by India to 7%, with others more dependent on global exports recovering more slowly).

Asian recovery will this time be more domestic-led, also the reason why leading elements didn’t descent into recession. Meanwhile, US growth is set to recover gradually these next twelve months on the back of inventory bounces, strong government spending, slow household recovery, ending of business cutbacks and favourable trade effects.

Europe will probably be the slowest coach, offering only inadequate domestic responses and remaining nearly entirely dependent for its growth on export impulses, probably more so than Asia.

Important for us will be Asian recovery in commodity demand and our export prices. Slow Western recovery should mean excess capital, even after funding domestic government borrowing needs. Together with Asian and commodity producer surpluses the world will remain awash in capital, central bank underwritten for the time being. The cherry on top will be even greater appetite for diversification to emerging markets.

The firming Rand in recent months reflects capital availability. This should not cease soon, keeping the Rand firm (to the extent of unwanted attention, as seen before). This will provide some bulwark against rising commodity prices and renewed inflation surges.

Though interest rates will probably lift during 2011-12, inflation-driven, this need not prematurely end our expansion, provided the world economy keeps expanding. Given impatient Asian growth aspirations and resource slack in the industrial world, two Obama presidential terms may be required to get the world back to full growth potential, also shaping our cyclical expansion.

Source: Cees Bruggemans, FNB, June 17, 2009.

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