July 2009 – ZA Economist

A New York state of mind: Some judgments about the economic and financial state of play

Financial markets have normalised. Much of the dislocation has been resolved – and the more obvious opportunities provided by dislocated markets have to a large degree been exercised (think of recent moves in sovereign bonds, corporate bonds, bank credit, emerging equity markets). Equity market volatility has subsided.

The US economy will come out of recession in H2 2009: positive growth will be achieved and is well under way. Preliminary Q2 estimates of GDP will be released on Friday. Even the housing market has turned with sales of new houses off their bottom. Yesterday’s Durable Goods number – excluding volatile aircraft orders – was a good number. Such a view of recession being over is not contentious but is now consensus.

The normal forces of economic growth and earnings growth surprises (up or down) therefore take over as the main drivers of equity and bond markets. Higher short and long term interest rates – while a sign of recovery under way – will not be welcome.

The key issues will be the pace of US recovery, V or U shaped – and even it is V shaped (driven by depressed output catching up with stable final demand) – the question that will be asked of the US is: can such fast growth be sustained over the next few years? That the US recovery is ahead of Europe’s should be helpful to the US dollar/euro rate of exchange.

The answer to this issue about the long term growth potential of the US economy is for observers to expect less long term growth. Given the state of fiscal policy, higher taxes and more intrusive government will be expected to restrain growth. The ability of the Fed to withdraw the punch bowl before the party gets raucous will remain a live one – inflationary expectations remain very low and explicit real interest rates remain depressed. The bond market vigilantes are sleeping soundly at home for now. Any inflation threat to bond yields and mortgage rates will be most unwelcome but always possible. Corporate bonds remain more enticing than government bonds.

Emerging market economies offer a much healthier prospect, but their equity markets have run very hard, as have their currencies. The EM index and the JSE ALSI in US dollars are both up 80% from their lows in early March and the rand is up there with the best performing EM and commodity currencies. This is a very powerful run indeed. China has led the way and possible oriental bubbles will be of concern.

The SA economy continues to languish without active enough assistance form monetary policy. But the better state of the global economy will be helpful to SA exporters. Lower inflation and the strong rand will be helpful for consumers.

Reserve Bank Governor Tito Mboweni’s decision not to lower rates in June can perhaps be regarded as a final act of defiance. Knowing (presumably) that he was to lose his job he stuck to his inflation target guns even as his ship was sinking. He had failed to seize his opportunity to save the economy with an activist programme. Even as central bankers elsewhere put on the Superman capes he remained aloof as if all that mattered was inflation. This was not only arguably an error of judgment but obviously very poor survival tactics.

The case for lower interest rates remains as strong as ever and if Gill Marcus is in the next MPC chair – one assumes she will be – she will surely wish to distance herself from her predecessor. They apparently did not get on at all well when she worked at the Bank as Deputy Governor and resigned accordingly.

There is in this author’s mind at least a 50% chance of a 50bps cut at the August MPC meeting; and if August is too soon to signal change in direction of monetary policy then there is a much greater chance of a cut, perhaps even a 100bps cut, at the following meeting. The money market is not expecting any change in rates for now – or at least wasn’t yesterday. Watch this space.

*The author wrote this piece while on a visit to the US

Expecting much from Governor Marcus

The market is waiting to see what the new Governor will deliver

The SA market in fixed interest securities has adopted a mostly wait and see attitude to the appointment of Gill Marcus as Governor of the Reserve Bank. Both long rates represented by the R157 and short term rates represented by the three month Johannesburg Inter Bank rates (Jibar) were largely unmoved in response to the surely surprising announcement. The three month forward rate agreements (FRAs) were unchanged for contracts up to six months and then recede marginally as we also show. This indicates that short rates are still not expected to be reduced for at least six months with only a slightly improved chance of lower rates beyond then (See below).

Long and short rates July 2009 (Daily Data)

Source: I-Net Bridge and Investec Private Client Securities

Three month Forward Rate Agreements (FRAs)

Source: Bloomberg and Investec Private Client Securities

Inflation expected remains at high levels

Expected inflation, or more correctly, compensation for bearing inflation risk in the RSA bond market, had increased sharply in Q2 2009 and has only receded slightly over the past week. This provides the most objective measure of inflation expected. Inflation compensation is measured below as the difference between the yield on the R157 and the inflation indexed R189.

The expected value of the rand has improved

The compensation for bearing the risk of rand weakness against the US dollar – based on expected differences in SA and US inflation over the long run – is recognised in the yield gap between RSA bonds and their US equivalents. This yield difference may be regarded as the market’s measure of expected exchange rate movements. This yield gap has shown little direction this year, unlike the inflation compensation series, but has receded helpfully in the past week (See below).

Inflation compensation and expected rand depreciation July 2009 (Daily data)

Source: I-Net Bridge and Investec Private Client Securities

Mboweni took inflationary expectations very seriously

Governor Tito Mboweni paid particular attention to expected inflation when determining interest rate settings. The decision by the MPC not to reduce interest rates in June, despite the manifest weakness of domestic demand and the wide negative gap between domestic demand and potential supply, was explained as a response to more expected inflation.

The argument for combating expected, and not only actual, inflation with tighter monetary policy, is that expected inflation is self-perpetuating, that more expected inflation leads to more actual inflation. Thus monetary policy, with the long term outlook for inflation in mind, has to fight inflationary expectations as much as inflation itself.

This general argument we find hard to appreciate. For us the ability of price setters in contested markets to raise prices and to keep them up (whatever their inflationary expectations) depends on the actual state of demand. Monetary policy can influence the actual state of demand and by so doing can disabuse falsely held inflationary expectations. Furthermore profit margins may easily shrink if labour costs and employment benefits are not contained when markets conditions deteriorate. Passing on higher wages to customers in the form of higher prices will prove self defeating if demand is weak.

Worrying about inflation expectations at times like these is particularly difficult to accept

We have found such arguments about the self perpetuating nature of inflation expected particularly unhelpful now that actual demand in SA is so patently weak. The sharp deflation of prices now being realised at the SA factory doors and farm gates is very clear evidence of the weakness of aggregate demand and so the lack of pricing power enjoyed by most SA producers – despite more CPI inflation expected. The prices that have driven the CPI higher in recent months are mostly beyond the influence of monetary policy.

A much more activist approach from the Reserve Bank was called for and was not forthcoming – costing Mboweni his job

The MPC of the Reserve Bank under the direction of Mboweni has been unable to accept that monetary policy can affect demand and output and employment very severely, as it has done in SA, without necessarily having much of any immediate impact on the CPI, or indeed on inflationary expectations. The failure of the Bank under Mboweni to adapt monetary policy aggressively and actively, in unusually difficult times and conditions, with appropriate and convincing analysis and explanations, surely made Mboweni’s reappointment politically impossible. The focus of inflation and inflation expectations was not good enough for the times.

The market knew that Mboweni’s tenure was limited – hence more inflation expected

The notion that inflation would rise permanently in SA after Mboweni was inevitably to be replaced by somebody much less concerned about inflation and after the independence of the Reserve Bank had been compromised, understandably gained credence. Hence the increased inflationary expectations the Reserve Bank were fighting so unwisely were unfortunately and unintentionally much of the Reserve Bank’s own making.

Marcus must disabuse markets of the notion of permanently high inflation – by demonstrating a sensible and sensitive regard for the state of the economy

The appointment of Gill Marcus holds every promise of disabusing the markets of the notion that inflation in SA is permanently on the rise. But it will take sensible and sensitive monetary policy to do so. Monetary policy must take and must be seen to take full account of the state of the economy as well as of the causes and consequences of inflation and inflationary expectations for the economy. The current emphasis on fighting inflation has to be moderated with out compromising the importance the Reserve Bank attaches and is believed to attach to realising low inflation as the means to the end of a more efficient economy.

The independence of any central bank is always conditional on its ability to convince the public and the politicians who represent public opinion, that it is fully capable of helping the economy realise its potential- with the aid of low inflation. Ms Marcus will undoubtedly be very well aware of the importance for sustaining the independence of the Bank from direct political interference, of not only doing well by the economy, but of being seen and understood to be doing what is sensible and right for the economy.

The dollar is weak, emerging and commodity markets are buoyant – a sign of growing normality

The dollar is weak and the rand is holding its own

It is not so much that the rand is so strong; rather it is that the US dollar that is so weak against emerging market and commodity currencies. This year the US dollar has lost as much as 20% against the Brazilian Real (BRL) and the rand and is almost 16% weaker versus the Australian dollar. By contrast the US dollar has lost a mere one per cent versus the euro this year (See below). US dollar weakness is thus a distinctly emerging and commodity market affair.

Currencies vs the US dollar 1 January 2009=100

USD weakness against emerging and commodity currencies