Insights

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Persistent Inflation Pressure, Belated Policy Tightening And Recession Concerns

30 Jun 2022

Wikus Furstenberg, Rhandzo Mukansi, Yunus January, Aidan Kilian / Interest Rate Team

Economic & bond market review

Globally, inflation remains elevated

Inflation rates continued to reach new highs around the globe. The march higher in crude oil prices due to the escalation of the economic fallout between the West and Russia is still the main catalyst. This is in addition to rising food prices, also linked to the war in Ukraine, 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 successfully maintain price stability for decades.

Central banks are belatedly 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 inflationary developments, which, in turn, feed concerns that indecisive policy action risks the credibility of inflation targets and their 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 most recent 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, which continues to exceed expectations. 

Figure 1: Central bank policy rates: 12-month change


Source: Bloomberg, Futuregrowth

South African is dragged along the global inflation and monetary policy storm

Being a small open economy and a net importer of oil, South Africa is not escaping the global turmoil unharmed. On the inflation front, the country’s Headline Consumer Prices Index (CPI) accelerated by 6.5% year-on-year in May and breached the top end of 3% to 6% inflation target band of the South African Reserve Bank (SARB) in the process. Unsurprisingly, a marked jump of 7.8% year-on-year in food inflation turned out to be the primary driver of this sharp acceleration. In contrast, Core CPI rose by a more subdued 4.1% in May, from 3.8% the previous month. More concerning, and closely aligned with global developments, is the continued sharp acceleration of prices at the producer level, with some risk of spill over to the consumer side. In May, the Producer Price Index (PPI) for final manufactured goods accelerated from 13.1% in April to 14.7%. This was broad based, with prices in seven out of nine categories rising. While it still appears that price pressures at both producer and consumer levels are mainly supply (and not demand) driven, the SARB wisely opted to stay the course with its tighter monetary policy. Following the 50 basis points (bps) increase in the repo rate to 4.75% at the May Monetary Policy Committee Meeting, for a total increase of 1.25% so far in this cycle, the central bank has clearly evidenced its commitment to containing second round effects before they become entrenched.      

Figure 2: South African inflation heading higher in the short term


Source: OMIG, Futuregrowth

South African fiscal performance is off to a promising start

The May public sector main budget balance recorded a deficit of R17.1 billion; significantly smaller than the deficit of the first month of the 2022/23 fiscal year. It also represents an improvement over the 12-month period. Moreover, provisional financing data issued by National Treasury points to a main budget surplus in June 2022, which may be significantly larger than the surplus recorded for June 2021. Notably, tax revenue receipts continued their strong growth momentum, with both VAT and personal income tax showing promising performance despite a challenging macro-economic backdrop. 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. Similarly, the June 2022 provisional financing data suggests strong corporate tax receipts. On the negative side, the two-month extension of the temporary fuel levy reduction will result in foregone tax revenue of R4.5 billion, which is not an insignificant amount. Of course, it is still early days, especially considering the risk to local economic activity from global growth headwinds together with local developments such as intensified Eskom load shedding. On a positive note, high commodity prices (especially coal prices) continue to bode well for corporate tax receipts.

Merchandise trade surplus is still sizeable despite headwinds

While the country’s merchandise trade surplus initially narrowed sharply from R47.2 billion in March 2022 to R16.0 billion in April, it regained some lost ground with a R28.3 billion surplus recorded in May. During the period under review, substantial swings in the exchange rate of the rand and commodity prices impacted the country’s terms of trade. On the negative side, disruptions to road, rail and port handling operations at the Durban port (due to the Kwa-Zulu Natal flooding) and intensified electricity load shedding hampered export traffic flow. With crude oil prices kept hostage at elevated levels, 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 earlier COVID-related lockdowns.

Figure 3: SA current account: large merchandise trade surplus, but terms of trade are turning for the worse


Source: Bloomberg, Futuregrowth

SA nominal bonds lost ground while inflation-linked bonds retained pole position

During the second quarter, the FTSE JSE All Bond Index (ALBI) returned -3.71%. Bonds in the 12+ year maturity band rendered the worst return as yields of the longest-dated bonds rose in excess of 100 basis points over the period. The sell-off was the combined result of the global economic fallout from the eastern Europe conflict, the feed into persistent rising inflation, tighter monetary conditions, global recession fears and local developments such as intensified load shedding, which added to an already clouded growth outlook. This fed risk aversion, which was followed by significant sales of local bonds by foreign investors. In contrast, rising inflation concern and a higher inflation accrual lend support to the inflation-linked bond market. Consequently, the FTSE JSE Government Inflation-linked Bond Index (IGOV) rendered a relatively strong return of 2.95%, outperforming nominal bonds by a significant margin. Cash rendered a return of 1.07% over this period.

Figure 4: Bond market index returns (periods ending 30 June 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, the nominal bond market weakened sharply during the quarter, underperforming both inflation-linked bonds and cash. Rising inflation angst and an attractive inflation carry boosted inflation-linked bond performance significantly.

Key economic indicators and forecasts (annual averages)

 

    2018 2019 2020 2021 2022 2023
Gobal GDP   3.2% 2.6% -3.6% 5.9% 3.1% 2.8%
SA GDP   1.5% 0.1% -6.4% 4.9% 2.4% 2.5%
SA Headline CPI   4.6% 4.1% 3.3% 4.5% 6.4% 4.7%
SA Current Account (% of GDP)   -3.0% -2.6% 2.0% 3.7% 2.2% 1.2%

Source: Old Mutual Investment Group