Inflation remains elevated…and still exceeding expectations
Inflation rates continued to reach new highs around the globe. The march higher in crude oil prices because of the escalation of the economic fall-out between the West and Russia is still the main catalyst. This is in addition to rising food prices, also linked to the Ukraine war, and stubborn supply bottlenecks and constraints worsened by recent COVID-related hard lockdowns in China. More concerning is the fact that inflation keeps surprising expectations on the upside, especially in advanced markets that have managed to maintain price stability successfully for decades. One noticeable possible exception is US headline consumer expenditure inflation, or the PCE deflator, which shows tentative signs of a possible peak, with both the year-on-year and month-on-month rates of change down from the previous month.
Headwinds to economic growth are picking up, but no collapse - yet
Latest real activity data releases, including Production Managers Indices (PMIs) for the US and the Euro area, are holding up relatively well in the face of supply constraints, commodity price spikes and monetary policy tightening. However, this contrasts with some sectors, like the US housing market, where the recent spike in mortgage rates has dragged down activity. This also coincides with the sustained weakening in US consumer sentiment, as real income growth remains negative. In fact, the latest US Federal Reserve (Fed) Beige Book release points to slowing economic activity, with surging inflation. Elsewhere, emerging economy manufacturing PMIs were broadly weaker, with only South Africa and Russia holding some ground. Compared to a year ago, activity is down across the board.
Figure 1: Stagflation risks are rising
Source: Bloomberg, Futuregrowth
Central banks are eagerly tightening the monetary screws
Actual policy action and expectations of a more aggressive monetary policy response are contributing to rising recession fears, especially in advanced economies. Central banks have become increasingly hawkish in response to inflation developments, which, in turn, is feeding concerns that indecisive policy action risks the credibility of inflation targets and its potential negative impact on inflation expectations. The belated central bank hawkishness seems to increasingly supersede sensitivity to the impact of higher rates on economic activity. In the US, the minutes of the Federal Reserve’s May Monetary Policy Committee meeting revealed that it agreed that the current inflation rate and risks to inflation support a faster tightening pace. Elsewhere, one of the policy laggards, the European Central Bank (ECB), is finally preparing the market for the start of its policy tightening process as it aims to reach positive rates by the end of this year. Like most other economies, the main driving force behind the ECB’s change of tack has been persistent rising inflation in the Euro-area that continues to exceed expectations. For instance, in Germany, consumer price inflation accelerated to a multi-decade high of 8.7% in April due to soaring energy and food prices.
Figure 2: Central bank policy rates: 12-month change
Source: IRESS, Futuregrowth
Global bond market sell-off took a breather, while the US dollar weakened
The US Treasury market and other more prominent bond markets recovered some lost ground in May following the strong sell-off across the board in April. The US dollar also lost some steam, in turn allowing the rand to take a breather. While crude oil prices continued to head higher, the industrial metal complex was negatively impacted by concerns about global economic activity in general and lower manufacturing activity in China as a result of COVID-related lockdowns in particular.
Domestic economic news is a mixed bag
While consumer price inflation is still reasonably well contained at a year-on-year increase of 5.9%, especially against the global backdrop, wholesale prices are reflecting price pressures more acutely. Headline Producer Price Inflation (PPI) recorded a year-on-year increase of 13.1% in April. While the spike in petroleum product prices and, to some extent, food prices are mainly to be blamed, increases north of 10% have also been recorded for broader categories, such as Final Manufactured Goods and PPI excluding petroleum products.
The April public sector main budget balance recorded a deficit of R45.2bn, slightly higher than the deficit of R37.2bn in March. Although wider than a month ago, the April budget deficit represents a 44% improvement over the 12-month period. The improvement is the result of a 17% decline in total expenditure, while total revenue increased by 9%. A strong 12-month increase of 13% in personal income tax is particularly encouraging. The strong tax revenue collection performance outweighed a decrease in fuel levy receipts, a direct result of the temporary reduction in the fuel levy to ease the burden of sharply rising petrol and diesel prices. Looking forward, the recently announced two-month extension of the temporary fuel levy reduction will result in foregone tax revenue of R4.5bn, which is not an insignificant amount.
The country’s merchandise trade surplus narrowed sharply from R47.2bn in March to R15.5bn in April. Substantial swings in the exchange rate of the rand and commodity prices negatively impacted the country’s terms of trade. Moreover, disruptions to road, rail and port handling operations at the Durban port caused by the recent flooding and more intense load shedding also hampered export traffic flow.
Figure 3: SA Headline CPI: Expected peak keeps creeping higher
Source: OMIG, Futuregrowth
SA nominal bonds regained some lost ground, with inflation-linked bonds in pole position
Against the backdrop described above, the FTSE JSE All Bond Index (ALBI) returned 1.01% in May, a significant turnaround from the -1.67% in April, with bonds in the 7- to 12-year maturity band rendering the highest return of 1.42%. The combination of rising inflation concerns and reasonable inflation accrual continued to lend support to the inflation-linked bond market. As a result, the FTSE JSE Government Inflation-linked Bond Index (IGOV) rendered a strong return of 1.99%, marginally bettering the April return of 1.97% and outperforming nominal bonds and cash (+0.36%) by a decent margin.
Figure 4: Bond market index returns (periods ending 31 May 2022)
Source: IRESS, Futuregrowth
// THE TAKEOUT
Stagflation fears are rising, fed by sustained upward pressure on inflation, the influence of COVID-related lockdowns in China, the economic fall-out from the ongoing conflict in Ukraine, and concern about the impact of tightening monetary and fiscal policy on growth prospects. Broader macroeconomic developments, specifically rising concerns about the reversal of the gains from globalisation, are more fundamental in nature. While global bond yields remained at elevated levels, locally, bond market volatility subsided somewhat in May while the rand regained some lost ground. Both nominal and inflation-linked bond markets rendered cash-beating returns, with inflation-linked bonds delivering a stellar performance for the second consecutive month.