Hawkish central bank rhetoric feeds recession fear and market weakness
The word “happiness” and the phrase “higher sacrifice ratio” received a new meaning in financial markets in August. As should have been expected, central bankers, specifically policy makers from the US Federal Reserve (Fed) and the European Central Bank (ECB), used as much airtime as possible at the Kansas City Fed symposium in Jackson Hole to reiterate a strong commitment to force inflation back into the genie-bottle. While none of this belated central bank resolve should have been a surprise to markets because global inflation had been hovering well above 10-year averages for a while, investors nonetheless rushed for the exit as recession anxiety reached new highs.
The extent of the newfound commitment by central bank hawks was best demonstrated when Neel Kashkari, one of the Fed officials expressed “happiness” with how financial markets sold off in response to Fed chair Jerome Powell’s speech. Similarly, ECB officials made their intentions clear, while some used the opportunity to highlight the complexity of the current global inflation cycle. Isabel Schnabel, an ECB executive board member, was quoted as saying that central banks “face a higher sacrifice ratio (the loss in economic growth and employment to bring inflation under control) compared to the 1980s given that the globalisation of inflation makes it more difficult for central banks to control price pressure.
The inflation issue boils down to potential higher future volatility around a higher underlying trend. Moreover, policy makers are dealing with shifting risks, including developments beyond their control. The message could hardly be clearer: expect policy rates to be higher for longer and do not expect rates to be cut at the first sign of economic slowdown. This is in stark contrast to the “lower for longer” mantra that, until not too long ago, dominated financial market airwaves for a long time.
Figure 1: More economies are drifting ever so slowly into to the stagflation zone
Source: Bloomberg, Futuregrowth
Central bank rhetoric is hawkish despite some evidence that underlying inflation is moderating
The fact that global inflation is still hovering at sky-high levels and well above central bank target levels is undisputed. However, one should not lose sight of evidence of a moderation in the rate of increase across several economies. In the US, just as the hawks have become noisier, a telling indicator of this moderation is the seasonally adjusted rolling 3-month annualised rate of change for both the Headline and Core PCE (Personal Consumption Expenditure) deflator data series. This is supported by the fact that crude oil prices, grain prices and the CRB (Commodity Research Bureau) Food Price index are all off their more recent peaks. This recent trend is also reflected in the recent sharp drop in the Prices Paid sub-component of the USA Producer Manager Index (PMI). Similarly, the combined effect of slower economic activity, the continued unwinding of supply chain bottlenecks and the slow normalisation of shipping activity and the cost thereof are also contributing to some pipeline price pressure relief. Of course, this excludes the Euro area and UK as they are still in the midst of a pre-winter energy crisis, a clear upside risk to inflation.
Figure 2: Central bank policy rates in most markets are above the lows of a year ago
Source: Bloomberg, Futuregrowth
South African inflation probably peaked in July
The South African Headline Consumer Price Index (CPI) accelerated by 7.8% year-on-year in July from 7.4% the previous month. This was broadly in line with market expectations. Unsurprisingly, the food and transport components of the index remained prominent contributors to the higher rate of increase. Core CPI rose by a more subdued 4.6% from 4.4%, while (worryingly) services inflation accelerated from 3.9% to 4.3%. Even so, the July Headline CPI data point is deemed to be the peak in this cycle, in light of sizeable petrol price decreases in August and September which are expected to offset a further increase of food prices. In July the Producer Price Index (PPI) for final manufactured goods accelerated to 18.0% from 16.2% in June on a year-on-year basis, with the sharp rise in fuel prices once again a significant contributor. While producer inflation rose in seven of the nine categories, easing trends in the Intermediate Manufactured Goods and Agriculture sub-components of the index are noteworthy. Moreover, crude oil prices, global grain/food indices and SAFEX futures prices for key grain crops continued to ease from exceptionally elevated levels. In addition, the Prices Paid subindex of the ABSA PMI decreased to 87.5 in July, its lowest level in eight months. While still exceptionally high, the lower reading does (at least anecdotally) point to some deceleration in the rate of price increases at the production level. All in all, these developments point to a possible peak in PPI for final manufactured goods in July.
Figure 3: Higher South African inflation is creating a high base for significant disinflation next year
Source: OMIG, Futuregrowth
Strong first fiscal quarter is followed by a larger than expected deficit in July
For the first three months of the current fiscal year, sustained higher-than-expected tax revenue collection and contained expenditure resulted in a small budget surplus of R12 billion - the first in 16 years. The promising start was followed by worse than expected main budget data for July. While provisional financing data for July pointed to a large monthly deficit of around R83 billion, the actual data print turned out to be worse at R130 billion. While the large monthly deficit could be explained by seasonal factors, mainly the timing of large coupon payments and a sharp decline in corporate income tax receipts, the larger-than-expected deficit turned out to be the result of a worrying 4% year-on-year decrease in Personal Income Tax receipts. On the positive side, total expenditure growth remained subdued, with a modest 1.2% year-on-year rate of increase. All considered, actual data for the first four months of the fiscal year continue to support our expectation of a markedly smaller budget deficit compared to the official estimate.
The merchandise trade surplus is still sizeable despite strengthening headwinds
The country’s merchandise trade surplus is holding up relatively well despite global weakening demand and local intensified electricity loadshedding and rail network issues. The July surplus of R24.8 billion turned out to be marginally higher than the R24.2 billion recorded in June. The monthly decrease in total imports of 5% exceeded the 4% drop in total exports. While the export of metals and precious stones decreased sharply by 17% in July, this was offset by a strong increase by other major export products. A sharp drop in the import of mineral products was also noteworthy. While the trade surplus is still sizeable, our view of a gradual narrowing of the current account surplus, especially against the background of weakening global demand, is unchanged.
Potential grey listing becoming a more prominent risk
The Financial Action task Force (FAFT) evaluated South Africa in October last year and found several deficiencies in the country’s policies and efforts to combat money laundering and terrorism financing. Although significant progress has been made in terms of addressing the deficiencies pointed out by the FATF, much of this has been on the legislative side. The FATF is due to review South Africa in October this year to gauge if enough progress has been made to combat money laundering and terrorism financing, and to assess whether the country has a credible plan to deal with areas of concern. The FATF will then have a plenary meeting February 2023 where it will be decided whether or not to add South Africa to the grey list. Our view is that, although the legislative changes are a positive step, a turnaround from a law enforcement implementation perspective will take some time. As a result, we see it as probable that South Africa will be added to the grey list. Please see here for a more comprehensive analysis. Suffice to state that grey listing is more than likely to inhibit much-needed foreign capital flows.
SA nominal bonds lost some ground in August
Following very strong performance in July when the FTSE JSE All Bond Index (ALBI) returned a heady 2.44%, nominal bond returns lost some momentum in August. The combination of rising global bond yields in response to hawkish central bank rhetoric, heightened concern about weaker global growth which in turn dampened risk appetite and by extension demand for SA bonds and rand weakness caused local yields to drift higher. As a result, the FTSE JSE All Bond Index (ALBI) returned 0.31% in August, with bonds in the 12+ year maturity band rendering the lowest return of 0.23%. Cash marginally outperformed bonds over the period by rendering a return of 0.45%. In contrast, real yields ground lower as demand continued to be boosted by an attractive inflation carry in the short term. The combination of a higher inflation carry and capital gains from falling real yields caused the FTSE JSE Government Inflation-linked Bond Index (IGOV) to render a strong return of 2.53%, a significant swing from the -1.30% in July. As a result, the return from nominal bonds still lags behind that of inflation-linked bonds (and even cash) for the eight-month period ending August.
Figure 4: Bond market index returns (periods ending 31 August 2022)
Source: Iress, Futuregrowth
// THE TAKEOUT
Globally, monetary policy tightening has kept gaining momentum, with central banks focused on getting the inflation genie back into the proverbial bottle. This new-found resolve has raised lingering concerns about economic growth prospects and, in contrast to July, caused sovereign global bond yields to drift higher as focus has shifted to the risk of higher policy rates for longer. Locally, both CPI and PPI data prints for July probably represent the peak in the current inflation cycle. On the fiscal front, main budget data for July disappointed with a larger than expected deficit although seasonal factors played a role in this. The combination of the above factors forced local nominal bond yields higher, while inflation-linked bonds benefitted from inflation-hedging demand, in turn backed by an attractive inflation carry for the next three months. As a result, inflation-linked bonds outperformed, with the IGOV rendering a return of 2.53%, well in excess of ALBI and cash, which returned 0.31% and 0.45%. respectively.
