Scaling the Peak in Local Rates

South African Reserve Bank is among the first of the central banks to scale the peak in policy rates.

Until late last year, central banks across a swathe of developed markets doggedly stuck to the task of quelling multi-decade high inflation. This lingering response pushed policy rates to levels last seen prior to the global financial crisis of 2008. While the monetary policy hawks continue to rule the roost, contributing to policy tightening intended to contain broad and stubborn inflation pressures, policy action and forward guidance provided by some central bankers increasingly indicates acknowledgement of the growing risk to macroeconomic growth in the coming years. In the case of the US, the deceleration in the pace of monetary policy tightening to 50 basis points (bps) in December and 25bps in February relative to the 75bps increments preferred throughout 2022 speaks to the increasingly fine balance that will need to be struck between fending off inflation pressure and not unduly choking the economy’s growth potential. In contrast to this step-down in tightening pace by the US Federal Reserve, the Bank of England and the European Central Bank are still frantically fighting decades-high inflation after being relatively slow to get out of the proverbial blocks last year.

In contrast, to this belated response, the South African Reserve Bank (SARB) responded earlier and in a more focused manner. The 25bps increase at the January Monetary Policy Committee meeting (MPC), a step down from the earlier larger incremental increases, lifted the repo rate to 7.25%. This increase took the policy rate to a neutral real level for the first time since the first quarter of 2021. The combination of lower inflation, weaker economic growth prospects and the slowdown in global policy tightening forms the base of our view that South Africa has reached the peak in the current interest rate cycle.

The Local Disinflation Trend Continues to Gain Momentum

Apart from worsening economic growth prospects, the SARB’s monetary policy management has been guided by the sustained downward trend in local inflation at both consumer and producer levels. Headline Consumer Price Index (CPI) slowed to a year-on-year rate of increase of 7.2% in December from 7.4 % the previous month. CPI is now well below the peak of 7.8% reached in July last year. While the more volatile components like food showed signs of peaking, more pleasing is the fact that Core CPI eased to a year-on-year rate of increase of 4.9% from 5.0%, even though mainly due to a slowdown in the rental component. On a month-on-month basis, Core CPI accelerated by 0.2% against a much quicker pace of 0.5% in the three months prior. Even though there are pockets of faster rising prices, for instance more rand-sensitive products such as appliances and vehicles, the disinflation trend seems to be gaining momentum for now.

On the production side of the economy, the December Producer Price Index (PPI) data release also served to confirm the disinflation trend. While still at a high level compared to CPI, the rate of increase for final manufactured goods eased to 13.5% year-on-year in December from 15.0% the previous month. The deceleration in the rate of increase was across a broad range of products.

Figure 1: South African inflation-adjusted repo rate back at a neutral level, and expected to rise from here on as inflation gradually moderates

Pricing the Start of Policy Easing: Curb Your Enthusiasm

Markets are forward looking for obvious reasons. So, it comes as no surprise that the market has started pricing a likelihood that the SARB may be convinced or forced to start reducing the repo rate towards the end of this year. While we accept that the next major move would be monetary policy easing, for now it would be prudent to keep one eye on rising inflation expectations, which, although backward looking, have been steadily creeping higher in the past few months. This would have caught the attention of policy hawks at the SARB. While this situation may not imply more rate increases unless it starts feeding into higher prices on a more sustained basis, it does call for caution and make us hesitant to share the more optimistic market expectation. This is in a similar vein to our push against more bearish rate expectations during 2022. For now, we feel comfortable with a higher repo rate for a longer period until the rate of inflation has decelerated to the mid-point of the target band (4.5%) on a more sustainable basis.

We Remain Sceptical About the Fiscal Outlook

The tabling of the Medium-Term Budget Policy Statement (MTBPS) on 26 October 2022 confirmed general market expectations of stronger fiscal consolidation for the current fiscal year. Subsequent monthly data continues to support this outlook, primarily due to buoyant corporate income tax receipts which continue to exceed budgeted targets. We now expect a marginal improvement on National Treasury’s main budget balance target of -4.9% relative to GDP for the 2022/23 fiscal year. Such an outcome could open the door to the attainment of the first primary surplus in the post Global Financial Crisis (GFC) period, and a decline in of the gross load debt to GDP ratio below the 71.4% that was estimated in the MTBPS for the current fiscal year.

However, given South Africa’s structural economic growth constraints and elevated expenditure pressure, we continue to caution against the significant fiscal execution risk in the medium term. Against a constrained global growth backdrop and its negative implications for the domestic economy, Eskom’s dark shadow continues to blight economic growth and fiscal consolidation prospects. Moreover, Transnet has now worryingly joined the ranks of the beleaguered state-owned enterprises clambering for fiscal support – only further impinging on fruitful, growth-enhancing fiscal expenditure in the medium term.

Accounting for sharp, downward economic growth revisions, given the severity of the domestic electricity shortfall as well as persistent expenditure pressure to address the myriad of social and economic challenges, we are of the view that National Treasury’s fiscal estimates for the forthcoming fiscal years are particularly optimistic. Relative to National Treasury’s expectations for the consolidated budget deficit to narrow to 3.2% of GDP in 2025/26, our estimates, accounting for growth downside and expenditure upside, suggest these estimates are well off the mark – with the budget deficit remaining anchored towards -4.5% relative to GDP in the medium-term. In our view, without significant improvement in domestic energy availability and the successful implementation of other structural reforms, the domestic economy will continue to fall short of its growth potential and fiscal consolidation targets.

Figure 2: We remain less positive on continued fiscal consolidation

External Trade Account Balance Continues to Roll From Last Year's Much Better Levels

The December external trade balance recorded a deficit of R4 billion. This was the largest monthly trade deficit since April 2020 and the latest in the more recent weakening trend, due to a combination of higher import volumes as well as sharply reduced terms of trade support. The reduced terms of trade support was in turn mainly driven by lower export prices, concentrated in the dramatic drop in coal prices following the spike caused by Russia’s invasion of Ukraine last year. While this weakening had been anticipated, the worsening external trade position nonetheless adds to a growing list of South African macro-economic challenges.

Figure 3: Significant weakening of the South African terms of trade

A Strong Start for the Year for Nominal Bonds

The nominal bond market got out of the 2023 starting blocks at pace. Bond yields decreased to lower levels across the yield curve and, despite giving back some of the gains at month-end, the FTSE JSE All Bond Index (ALBI) still rendered a remarkably strong return of 2.94% for the month. Against the backdrop of the sustained slowdown in the rate of inflation, the inflation-linked bond market (ILB) continued to be negatively impacted by the reduced inflation carry and weaker inflation-hedging demand. This combined to exert upward pressure on longer-dated real yields. In fact, relative to the more liquid nominal bond market with much better price discovery dynamics, the ILB market demonstrated even more price volatility than usual. As a result, the FTSE JSE Government Inflation-linked Bond Index (IGOV) returned a weak -1.05% in January, underperforming both nominal bonds and cash. Cash rendered a return of 0.57%, well below that of nominal bonds despite the very significant rise in the level of the policy rate since the end of 2021. This is partly a reflection of the steep positive slope of the nominal bond yield curve, with longer-dated nominal bonds still offered at attractive inflation adjusted yields.

Figure 4: Bond market index returns (periods ending 31 January 2023)

Potential Grey Listing Remains a Prominent Risk

The Financial Action Task Force (FAFT) evaluated South Africa in October 2021 and found several deficiencies in the country’s policies and efforts to combat money laundering and terrorism financing. The FATF reviewed South Africa again in October 2022 to gauge if enough progress had 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.

Although significant progress has been made in terms of addressing the deficiencies pointed out by the FATF in 2021, much of this has been on the legislative side. The FATF is due to have a plenary meeting in February 2023 where it will be decided whether to add South Africa to the grey list. While the legislative changes are progressing, our view remains that 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, inhibiting much-needed foreign direct investment (FDI).

THE TAKEOUT

Global central banks doggedly stuck to the task of reining in consumer price inflation which had been at multi-decade highs for most of the past year. This resolve has raised nascent concerns for economic growth downside in 2023. Locally, CPI and PPI data prints continued to serve as confirmation that the disinflation trend is gaining momentum. This positive development, as well as rising concern about the potential devastating impact of ongoing intensified loadshedding on a fragile economic environment, convinced the SARB to reduce the pace of policy tightening to 25bps at the January MPC meeting. This, we believe, took us to the peak in the current interest rate cycle. On the fiscal front, notwithstanding downward growth revisions in the medium-term, strong tax revenue performance relative to budget estimates has confirmed our expectations of stronger fiscal consolidation for the current fiscal year. We, however, remain alert to the significant fiscal execution risk in the medium to longer term. Against this backdrop, nominal bonds (ALBI) managed to return an excellent +2.94%, well in excess of the -1.05% rendered by inflation-linked bonds (IGOV) and cash (+0.57%).