Sticky Inflation Sets the Table for More Tightening

Local consumer inflation is still hovering at elevated levels

Headline Consumer Price Inflation (CPI) remained sticky in March as it edged up to a year-on-year increase of 7.1% from 7.0% the previous month. The main source of the short-term upward price pressure was the food component, with vegetable prices the biggest culprit with a very significant month-on-month spike of 3.8%. Core CPI, the less volatile inflation indicator, printed an unchanged 5.2% annual rate of increase from the previous release. While the slowdown in the pace of disinflation is disheartening, a more pronounced acceleration in disinflation had always been expected to start unfolding in the second quarter.

On a more positive note, the pace of disinflation at the producer level, albeit from a much higher base, was more pronounced. In the case of Producer Price Inflation (PPI) for final manufactured goods, the index increase slowed to 10.6% in March from 12.2% the previous month. This was the eighth consecutive year-on-year decrease. Encouragingly, producer food inflation, which has a strong correlation with food inflation at the consumer level, also eased significantly.

Figure 1: The slowdown of producer food inflation bodes well for consumer prices

Merchandise trade account surplus continues to shrink

The merchandised trade surplus narrowed to R6.9 billion in March, from a significantly downwardly revised R10.7 billion the previous month. Similar to recent months, this was due to a strong rise in imports, mainly from higher crude oil and petroleum products demand. The combination of a narrowing merchandise surplus and a large deficit on net income, service and current transfers supports our long-held view of a widening current account deficit.

Figure 2: Current account balance swinging back to pre-COVID levels

A hawkish SARB is most likely to over tighten monetary policy

The South African Reserve Bank (SARB) proved the market (and us) wrong by lifting the repo rate by more than anticipated in the first quarter of this year. The combination of sticky and high inflation in many advanced economies, the slow shift to local disinflation, perceived upside risks due to renewed currency weakness, intensified loadshedding and rising inflation expectations convinced three of the five Monetary Policy Committee (MPC) members to support a larger than expected 50 basis points (bps) at the March meeting. The concern about risks to the inflation outlook is striking considering its downward economic growth revision to 0.2% for this year. Considering the hawkish monetary policy mindset, the recent stickiness to both Core and Headline CPI as well as the fact that it remains well above the inflation target band, most market participants expect the Bank to adjust the repo rate upwards by 25bps at the May MPC Meeting.

Figure 3: The South African inflation-adjusted repo rate is back in positive territory and expected to rise sharply to pre-COVID levels

The fiscal 2022/23 budget deficit ends wider than budgeted

The budget deficit for the fiscal year ending March 2023 ended at 4.7% of Gross Domestic Product (GDP), slightly wider than the 4.5% formal estimate. While a late expenditure surge is mainly to be blamed, total revenue collection for the fiscal year also marginally underperformed relative to budget estimates. Even though this is still the smallest budget deficit since 2019, sustained expenditure pressure and waning tax revenue performance against a background of sustained weak economic growth continue to highlight our long-held concern about the state of the country’s fiscal health.

Nominal bonds achieve some payback, while inflation-linked bonds benefit from sticky inflation

The combination of rising developed market bond yields, some rand weakness, the perceived implication of sticky local consumer inflation to the rising risk of more policy tightening at the May MPC meeting, reduced the demand for nominal bonds. Bonds in the 7-12 and 12+ maturity bands rendered the worst returns as the yield curve bear steepened. As a result, the FTSE JSE All Bond Index (ALBI) rendered a return of -1.11% for April. In contrast, the inflation-linked bond market (ILB) continued to recover lost ground in April as the FTSE JSE Government Inflation-linked Bond Index (IGOV) returned 0.38%. Even so, cash still managed to outperform the previous month as it rendered a return of 0.59%.

While the ALBI (2.24%) is still ahead of the IGOV (1.25%) for the first four months of 2023, cash (with a return of 2.30%) is now leading the pack with a marginal outperformance over nominal bonds.

Figure 4: Bond market index returns (periods ending 30 April 2023)

The takeout

The South African disinflation trend experienced another disruption following the March year-on-year increase of 7.1%, mainly due to sustained food price pressure. Concerns about the higher print were partly offset by an easing of food prices at the producer level, which are expected to filter down to consumer prices with a short time lag. The combination of sticky consumer inflation at elevated levels relative to the inflation target band and a well-telegraphed hawkish SARB policy stance convinced most financial market participants to pencil in another round of policy tightening at the May MPC meeting. The latest external trade data, which confirmed weakening current account dynamics, added to the list of growing concerns. The budget deficit for the fiscal year 2022/23 was reported at 4.7% of GDP. The slightly worse outcome compared to the official budget estimate of 4.5%, was mainly the result of some overspending in March. Against this backdrop, nominal bond yields increased, causing the ALBI to lose ground with a return of -1.11%, with long-dated bonds rendering the worst performance as the yield curve bear steepened. In contrast, the combination of the decent inflation accrual and demand for inflation-linked bonds lifted the IGOV total return for the month to 0.38%. While still worse than the 0.55% rendered by cash, inflation-linked bonds managed to regain some lost ground relative to both nominal bonds and cash.