Hawkish Central Bank Rhetoric Feeds Recession Fears and Market Weakness
As we should have expected, central bankers, specifically the US Federal Reserve (Fed) and European Central Bank (ECB), received an abundance of airtime to reiterate their strong commitment to forcing inflation back into the genie bottle during the past quarter. The investor-unfriendly combination of persistent inflationary pressure stuck well above their long-term average rates, newfound central bank inflation-fighting resolve and evidence/expectations of weaker economic activity continued to keep most asset classes on the defensive and the US Dollar on a strong footing. 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 had weakened in response to Fed chair Jerome Powell’s speech at the Kansas City Fed symposium in Jackson Hole in August. Similarly, ECB officials made their policy 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 an 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. Hawkish policy messaging was duly followed by action as a large number of central banks increased their respective policy rates during September, with stern warnings of more to come.
Locally, the South African Reserve Bank kept to the global monetary policy script as it increased the repo rate by a further 75 basis points to the pre-COVID level of 6.25% at its September monetary policy meeting. While this was aligned with market expectations, interest rate bears took delight in the fact that two of the five MPC members opted for a 100bps rate increase.
Global bond markets are reeling in response to the new policy mantra
Global bond markets continued to weaken in a dramatic fashion in the past quarter, fueled by the belated hawkish central bank policy response to persistent inflation. Investors were spooked by the “higher for long” mantra, especially the message that central bank sensitivity to weaker growth has taken a back seat to getting the inflation genie back into the proverbial bottle. This angst caused US Treasury and other advanced market bond yields to drift to levels last seen prior to the 2008 global financial crisis. In the case of the 10-year US Treasury yield, it reached a high of 3.95%, well above the all-time low of 0.51% about two years ago.
Figure 1: More economies are drifting ever so slowly into to the stagflation zone
Source: Bloomberg, Futuregrowth
Central bank rhetoric remains 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 7.6% year-on-year in August from 7.8% the previous month. Core CPI rose by a more subdued 4.4% from 4.6%. while (worryingly) services inflation is trending upwards. Even so, the July Headline CPI data point is deemed to be the peak in this cycle, as more subdued core inflation and the sizeable petrol price decrease in September 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 79 in September, its lowest level since July 2021. While still high, the lower reading does point to some deceleration in the rate of price increases at the production level.
Figure 3: Higher South African inflation is creating a high base for significant disinflation from here on
Source: OMIG, Futuregrowth
The fiscal position continues to improve relative to the budget forecast
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. While a main budget deficit has since been reestablished following two additional data prints, the deficit continues to track considerably ahead of our estimated year-to-date target based on historic seasonal trends and relative to the -6.0% deficit that National Treasury has tabled for the 2022/23 fiscal year. The year-to-date outperformance of the main budget balance is primarily the result of exceptionally strong corporate income tax receipts in June, with mining companies still benefitting from elevated commodity prices. Value-added Tax (VAT) receipts, on the other hand, have underperformed relative to our year-to-date estimates, perhaps pointing to the damage wrought to the economy by severe electricity loadshedding. Notwithstanding this continued risk, actual data for the first five months of the fiscal year continue to support our expectation of a markedly smaller budget deficit compared to National Treasury’s official estimates tabled in the 2022 Budget.
Economic activity slowed while the current account surplus unexpectedly swung into a deficit
The South African economy contracted by 0.7% in the second quarter while the year-on-year expansion slowed to a disappointing 0.2%. The slowdown in economic activity was the combined result of an unfortunate confluence of internal and external drivers. Locally, devasting flooding in KwaZulu Natal, intensified load shedding, a sharp increase in lost workdays due to strike action and rising interest rates were the main detractors. Being a small, open economy, the country also faced increased global headwinds, specifically weaker demand, in turn the result of persistent and sharply higher inflation, broad based monetary policy tightening and the lingering negative impact from the ongoing conflict in Ukraine. The current account also slipped into a deficit of 1.3% of GDP in the second quarter, the first deficit in seven quarters. While the general market view was for a downward current account surplus trajectory as support from the recent commodity boon was widely regarded as unsustainable, the significant swing did come as a surprise. The surprise was the result of a sharp rise in dividend payments. While the exact reason for such a large net dividend payment is unknown, it could possibly be explained by corporates rewarding shareholders via dividend payments instead of earmarking profits for fixed investment, or offshore parent companies looking for ways to support ailing balance sheets in an increasingly weak economic environment.
Potential grey listing is 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, most of this has been merely 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 action plan to deal with areas of concern. The FATF will then have a plenary meeting in 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 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 ground in the third quarter
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 and September. 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) only managed to eke out a return of 0.60% during the third quarter. Following exceptional strong performance for an extended period in response to a strong inflation accrual and inflation-hedging demand, inflation-linked bond yields started rising to higher levels in September. Earlier support from the inflation carry is expected to wane in coming months, while global risk aversion has also played a part in diluting earlier stronger demand. The increase in real yields more than offset any support from the inflation accrual. As a result, the FTSE JSE Government Inflation-linked Bond Index (IGOV) returned -1.16%. Cash managed to outperform both nominal and inflation-linked bonds over the period by rendering a return of 1.28%.
Figure 4: Bond market index returns (periods ending 30 September 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 in August and September 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, even though main budget data for July disappointed with a larger than expected deficit (mainly due to seasonal factors) budget data for the first five months of the 2022/23 fiscal year still point to a smaller-than-budgeted main budget deficit. Even so, heightened global risk aversion forced both local nominal and inflation-linked bond yields higher. As a result, cash (1.28%) managed to outperform both the ALBI (0.60%) and IGOV (-1.16%) for the quarter ending September.
